Renren had a very successful IPO this week. I had previously written that Renren would be a key test of whether Chinese regulators were serious about cracking down on VIEs after Buddha Steel. Certainly there is no more sensitive an industry than social networking, and the fact that Chinese regulators let this one go indicates to me that Buddha Steel was likely a victim of a crackdown on reverse mergers. Renren did have extensive discussions of VIE risk in the financial statements – the most extensive I have seen and I commend them for that.
Renren also disclosed a material weakness in its internal controls; a disclosure that is becoming commonplace with U.S. listed Chinese companies. In Renren’s case the material weakness identified related to insufficient accounting personnel with appropriate U.S. GAAP knowledge. That is no surprise; there are simply not enough people in China with U.S. GAAP knowledge to go around.
What is surprising to me is why all these U.S. listed Chinese companies choose to prepare financial statements using U.S. GAAP. Most of these companies, Renren included, are foreign private issuers. As foreign private issuers, they can submit financial statements prepared under either U.S. GAAP or International Financial Reporting Standards (IFRS).
IFRS is a principle-based system while U.S. GAAP is a rule-based system. Simply said, figuring out an accounting treatment under U.S. GAAP focuses on the literature while doing it under IFRS focuses on interpreting the facts. In my view, it is easier to make a mistake under U.S. GAAP, because the rules are often very specific and not always intuitive. There can be wider latitude, and certainly more wriggle room under a principles based system like IFRS.
U.S. GAAP and IFRS have been converging for a number of years, although the process has been slow moving. Some speculate that IFRS might be adopted in the U.S. for all companies starting in 2015, although I think that date is optimistic. China, however, intends to complete the convergence of Chinese Accounting Standards with IFRS this year.
It is possible to have widely different accounting treatments under IFRS and U.S. GAAP. In practice, that does not often happen. Accounting for most transactions is the same under both systems. Complex transactions may get different treatment, yet few Chinese companies have complex transactions. I believe that most Chinese companies could probably take their U.S. GAAP financial statements and simply reissue them as IFRS statements without modification. It used to be that companies using IFRS also had to reconcile their financial statements to U.S. GAAP, but the SEC removed that requirement in 2008.
There are some significant advantages to adopting IFRS for Chinese companies. First, it is much easier to avoid being tagged with a material weakness because there are many more Chinese accountants who understand CAS (which has converged with IFRS). It is also easier to avoid misapplying a technical rule under U.S. GAAP because IFRS has fewer bright-line tests. As a result, the risk of making an error that results in restatement is lower.
So why do companies persist in using U.S. GAAP? I have discussed this with accountants, lawyers, and investment bankers. Some think U.S. GAAP is what investors prefer. Investors who think they are getting higher quality information because a Chinese company is using U.S. GAAP are misinformed. Others say it has just become the standard practice. In my view, companies and accountants ought to give some thought as to whether it is time to switch to IFRS.