IFRS vs. U.S. GAAP: Porsche controls Volkswagen

by Kurt Schulzke on September 16, 2008

Since the SEC’s announcement of a proposed timetable for implementing IFRS in the United States, a variety of commentators have come forward asserting that IFRS would be “bad” for the United States because, among other things, U.S. GAAP supposedly offers “higher quality” financial accounting standards than IFRS and a smoother, more transparent standards-setting process than the IASB. In fact, the opposite is arguably true. Today’s news that Porsche has upped its stake in Volkswagen to 35.14% offers an illustration.

Among those who know both GAAP systems, it is widely recognized that U.S. GAAP suffers from serious deficiencies explicable only as by-products of a dysfunctional, highly politicized standards-setting process lacking notably in transparency.

One of the longest running and most notorious deficiencies relates to so-called “consolidation policy,” the rules that determine when an investor corporation (like Porsche) must “consolidate” or include in its “group” financial statements of an investee (like VW). The Enron debacle involved, among other things, suspect consolidation policy that allowed Enron to deconsolidate investees that, as a matter of economic reality, should have been consolidated.

With some narrow exceptions, current U.S. GAAP consolidation policy is embodied in three primary “authoritative sources”: FASB Statement No. 94, FIN 46 and EITF 96-16. Under Statement 94, the general rule is a bright-line: if the investor legally controls more than 50 percent of the voting shares, the investee must be “consolidated.” If not, the investee must not be consolidated.

FIN 46 widens the consolidation net narrowly for so-called “special purpose” and “variable interest” entities, the kind of animal that was used by Enron to accomplish off-balance sheet financing. EITF 96-16 narrows the net by excluding from consolidation investees that would be consolidated but for significant power — over only specific kinds of decisions — exerted by minority interest holders.

When all is said and done, current U.S. consolidation policy is a bright line that is routinely “gamed” to keep undesirable investees off the investor’s books. Case in point: Coca Cola — despite very significant influence over Coca Cola Enterprises — has always managed to keep CCE out of its financial statements thanks, in large part, to a politically compliant FASB.

How is IFRS superior? IFRS requires investors to consolidate effectively controlled investees regardless of legal control. In this way, IFRS better reflects the economic reality of investor-investee relationship and forces companies and auditors to exercise good judgment in reporting on that reality to investors. Under IAS 27, an investor — like Coca Cola or Porsche — is required to consolidate effectively dominated (“controlled”) investees over which the investor does not exercise legal control through ownership of a majority of voting shares.

Why is U.S. GAAP so out of touch with reality? Primarily because special interests — among them, Coca Cola — have managed for over a decade to successfully block implementation of a FASB Exposure Draft on consolidation policy. The exposure draft has been sitting on the shelf since 1995. Those who fear political influence over the IASB ought to take a closer look at the FASB.