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How the SEC's Authority Helps Resolve Accounting Issues

Scott Taub | July 30, 2013

For the past five years, I have served on the IFRS Interpretations Committee, the body that issues authoritative interpretations of International Financial Reporting Standards. During that time I have learned a great deal about how financial reporting works outside of the United States. There are several important differences, of course, some of which are immediately evident, while others are more subtle.

One of the more obvious differences is the role that securities regulators play. While U.S. Generally Accepted Accounting Principles are set by the Financial Accounting Standards Board, the statutory authority to set GAAP for public companies actually rests with the Securities and Exchange Commission. The SEC also has the authority to review and enforce the application of GAAP by public companies. This dual authority makes the SEC the final arbiter of what accounting treatments are acceptable under GAAP.

Recent occurrences at IFRIC have reminded me that the SEC can use this authority to make things easier for FASB and for U.S. reporting companies.

A prime example can be seen in an amendment to IAS 39 recently issued by the International Accounting Standards Board that addresses the effect on hedge accounting of the novation of derivatives in response to new regulations. Regulations requiring or encouraging novation of derivatives—that is when one party in a derivative contract is replaced with a new party without otherwise changing the terms of the instrument—are popping up in jurisdictions around the world, including the United States, Europe, and Japan, as regulators require the use of central clearinghouses in an attempt to make the markets more transparent.

From an accounting perspective, the novation of a derivative results in derecognition of the old derivative and recognition of a new one, because the change in counterparty means that the new derivative cannot be considered a continuation of the same instrument. If the original derivative was part of a qualifying hedge accounting strategy, its extinguishment as part of the novation would require hedge accounting to be discontinued. While the new derivative might also qualify for hedge accounting in a similar strategy, discontinuing hedge accounting and then restarting it with a new instrument adds complexity and could introduce income statement volatility that would not exist if hedge accounting could simply be continued.

When this issue was raised under U.S. GAAP, the SEC staff resolved it quickly by posting a letter to its Website indicating that the SEC staff would accept the continuation of hedge accounting under GAAP when derivatives went through novation to change the counterparty to a central clearinghouse in response to new regulations. The fact that GAAP as written would require discontinuing hedge accounting was, essentially, put to the side. What is, in substance, an exception, was implemented quickly and efficiently, resulting in the accounting answer that virtually everyone felt was fair and appropriate.

When this same issue was raised by companies that report using IFRS, it was brought to IFRIC. IFRIC members quickly came to the conclusion that IFRS, as written, would require discontinuing hedge accounting. We also agreed that an exception should be made in this situation. To effect that exception, IASB undertook a project that led to the amendment issued in late June.

IASB has done an admirable job of responding to these issues within the context of its authority, which certainly goes to show that an entity with the authority of the SEC related to IFRS is not a “must-have” component of the international financial reporting structure.

Despite the fact that nearly everybody agreed on the appropriate outcome when this question first appeared, it took six months and a good bit of administrative effort to accomplish the amendment. In addition, IASB needed to get into the business of writing a rules-based exception to its standard, which it has understandably preferred to avoid in the past.

In this situation, the SEC's authority allowed it to resolve the issue quickly, reducing the period of uncertainty reporting companies would face. Just as important, FASB was spared the need to devote time and effort to create an exception to its standards.

Discount Rates

At about the same time that we were thinking about novation of derivatives, IFRIC was also asked to consider the rate to be used to discount pension obligations. Under U.S. GAAP, Statement 87 established that, in choosing the discount rate to be used to determine the benefit obligation for a defined benefit pension plan, companies may “… look to rates of return of high-quality fixed-income investments.” Shortly after Statement 87 was published, the SEC staff indicated that it believed corporate bonds with a rating of AA or higher meet the principle in Statement 87.

Since then, companies reporting under U.S. GAAP have had a clear objective in their setting of pension discount rates. While there have been many questions about whether companies are appropriately estimating the AA rate, there has been no confusion or even argument as to whether to aim for the AA rate or some other interest rate.

IFRS includes similar guidance on the discount rate, with IAS 19 indicating that: “The rate used to discount post-employment benefit obligations shall be determined by reference to market yields … on high-quality corporate bonds.” Generally, application of that principle has led to the use of the AA bond rate, just as under U.S. GAAP.

Bond spreads have widened during the past few years, however, such that the difference between using the AA rate and the A rate is much more significant than it used to be.  As there is no mandate from any authoritative body to use the AA rate under IFRS, some have argued that an A-rated bond might well be considered “high quality.”

While most IFRIC members are not comfortable with a move from AA rates to A rates for discounting pension obligations driven by a widening of spreads, members are also leery of decreeing that the AA rate is the requirement. Although European securities regulators have done a good job of holding the line on widespread increases in discount rates (which could cause significant reductions in pension liabilities and equal increases in reported equity), they do not have the same ability to interpret and enforce IFRS as the SEC does with GAAP. The issue has already resulted in expenditure of significant time from regulators and IFRIC, and it will most likely lead to more discussion at IASB itself before it can be resolved. The SEC's position in U.S. financial markets has rendered an issue that is causing angst under IFRS to be a complete non-issue in the United States.

Segment Disclosures

One more reminder of the help the SEC brings to the application of U.S. GAAP is the very small forthcoming amendment to IFRS that will require companies that aggregate operating segments into reportable segments to provide disclosures about the basis for that aggregation. The segment reporting requirements in IFRS 8, which was effective in 2009, are almost identical to those published in FASB's Statement 131, which was effective over a decade earlier. Despite the fact that the requirements had been around so much longer, the fact that Statement 131 did not require disclosure of the basis for aggregation had never been flagged as a problem under U.S. GAAP, even after constant SEC focus on segment disclosures. But, only 3 years into the application of IFRS 8, the lack of this disclosure requirement had become problematic under IFRS.

The reason for this came out after some discussion by the IFRIC. In the United States, the fact that the disclosure wasn't specifically in the standard had not stopped the SEC staff from asking about the basis for aggregation or from asking companies to disclose that basis if it felt disclosure was warranted. Regulators outside the United States, however, did not always feel it was appropriate (or did not have the authority) to ask for information or disclosures not specifically required by IFRS. Therefore, a required disclosure on the basis for aggregation is likely to be added to IFRS. Again, the SEC's role has relieved FASB of the need to handle an issue that IASB needed to deal with.

IASB has done an admirable job of responding to these issues within the context of its authority, which certainly goes to show that an entity with the authority of the SEC related to IFRS is not a “must-have” component of the international financial reporting structure. The difference in the way these issues have been handled, however, reveals an advantage of the U.S. structure, in that informal and quick mechanisms exist to resolve issues without new standard setting.