The SEC has long acknowledged the increased globalization of capital markets and the disparity in financial reporting between US companies following US generally accepted accounting principles, or US GAAP, and non-US companies using a variety of financial reporting standards. In the interest of reducing this disparity, the SEC has proposed a roadmap to require US issuers to report their financial statements in accordance with International Financial Reporting Standards, or IFRS.1 The Roadmap sets forth a voluntary early adoption program for certain US reporting companies as well as an eventual mandatory transition for all US reporting companies. However, the Roadmap requires significant improvements in IFRS and the achievement of certain milestones before the SEC would require IFRS reporting. In addition, Mary Schapiro, President Obama's SEC Chairman, expressed concerns during her confirmation hearing about the mandatory use of IFRS in the US based on both the cost to US reporting companies and the principles-based nature of IFRS accounting standards.2 Therefore, the ultimate adoption of IFRS for US reporting companies and the timing thereof is uncertain.
The mandatory adoption of IFRS3 would require US reporting companies to consider the effects of applying IFRS on their internal and external accounting personnel, contractual obligations and significant accounting policies in areas such as investment and revenue recognition. Additional implications for US reporting companies are detailed below.
If the SEC decides to implement the Roadmap, it has set forth a series of milestones that must be achieved by 2011 before the SEC would require reporting in accordance with IFRS. If the milestones are met by 2011 and the SEC were to require the use of IFRS, reporting companies that file annual reports on Form 10-K would be required to use IFRS beginning with fiscal years ending on or after December 15, 2014, for large accelerated filers, December 15, 2015, for accelerated filers and December 15, 2016, for all other filers. However, since the SEC will still require three years of audited financials in a company's Form 10-K, companies would need to begin preparing IFRS statements for the prior three years. Accordingly, large accelerated filers would need to begin preparing IFRS statements for 2012 and 2013 to include with their financials for the Form 10-Ks for the year ended 2014. The voluntary early adoption program would allow certain US companies to file their financial statements using IFRS as early as an annual report on Form 10-K for the year ending on or after December 15, 2009.
This memorandum summarizes the proposed Roadmap and its effects on the current US financial reporting structure, including several consequences for US reporting companies if the SEC were to require or allow IFRS use.
I. About IFRS
IFRS are developed and issued by the International Accounting Standards Board, or IASB, an organization responsible for developing global accounting standards for financial reporting. The SEC estimates that approximately 113 countries around the world, including all members of the European Union, Hong Kong, India and Russia, currently require or permit IFRS reporting for listed companies. In the past, the SEC has considered allowing, but not mandating, financial reporting using IFRS. There has been some narrowing of the differences between US GAAP and IFRS in recent years, making a mandatory transition more feasible and potentially easier than it would have been in past periods.
The SEC Release noted that investors, who have an increasing interest in international investment opportunities, would benefit from an enhanced ability to compare financial information of US companies with non-US companies because IFRS use would promote a more uniform financial reporting system. More uniform global financial reporting might also enhance the ability of US issuers to compete for global capital.
II. Proposed IFRS Implementation
Applicability. As currently proposed, the Roadmap would apply only to reports filed by US issuers subject to the reporting requirements under Section 13 or 15(d) of the Securities Exchange Act of 1934, including annual and quarterly reports, proxy and information statements, and registration statements under the Securities Act of 1933.4 The SEC will likewise consider the options available to foreign private issuers for their financial reporting in filings with the SEC. Currently, foreign private issuers are permitted to prepare their financial statements in accordance with US GAAP, IFRS as issued by the IASB, or another comprehensive accounting standard so long as a reconciliation to US GAAP is included. The reconciliation practice is cumbersome and makes direct comparisons between companies difficult. Also, some foreign private issuers choose to prepare their financial statements in accordance with US GAAP instead of IFRS, which may be less burdensome and expensive. IFRS use may increase the number of foreign companies willing to register in the US or decrease the number of foreign companies deregistering, which have been goals of the SEC.
Transition dates. Although mandatory use of IFRS would not occur until at least 2014, the Roadmap proposes an early voluntary adoption program that would allow US reporting companies meeting certain standards to use IFRS as early as for the fiscal year ending on or after December 15, 2009. Additionally, the Roadmap describes milestones that must be met by 2011 before the SEC would engage in rulemaking to require US reporting companies to use IFRS.
Voluntary Early Adoption for Certain US Reporting Companies
The SEC proposal includes an option for certain companies to begin using IFRS voluntarily. Companies may wish to adopt early for various reasons, including: (i) to be better positioned in the globalized financial markets; (ii) if IFRS use is inevitable, it may be more practicable to switch financial reporting as soon as possible; and (iii) to make use of certain IFRS accounting principles that a company deems more appropriate to its business.
Timing and Form. A participant in the voluntary program could begin reporting its financials using IFRS with its annual report on Form 10-K for the fiscal year ending on or after December 15, 2009. The initial IFRS filing, under the proposal, would not be allowed on a quarterly report, proxy statement, information statement or registration statement. Once an early adopting company files an annual report on Form 10-K using IFRS, it may use IFRS for its other filings and in financial statements required to be provided in connection with certain transactions, including tender offers, exempt offerings and going private transactions.
Eligibility. A company would be eligible to adopt IFRS early if (1) the company is in an industry where IFRS is the prevalent basis of financial reporting within the 20 largest companies worldwide in the industry and (2) the company is one of the 20 largest listed companies worldwide in the industry based on market capitalization.5 The SEC estimates that approximately 110 US reporting companies across 34 industries would meet these requirements and be eligible for early adoption of IFRS.
No-objection letter. A company that met the above eligibility requirements and desired to participate in the early adoption of IFRS would be required to obtain a no-objection letter from the SEC before it could file financial statements prepared in accordance with IFRS. A company in receipt of a no-objection letter could elect to adopt IFRS within three years following the issuance of the letter.6
Reconciliation to US GAAP. The SEC has proposed two alternatives for the reconciliation from US GAAP to IFRS for companies choosing to adopt early, and has solicited comment on which alternative to use:
- Proposal A: One-Time Reconciliation. Under Proposal A, a company electing to adopt IFRS early would be required to provide an audited reconciliation from US GAAP to IFRS in a footnote to its financials prepared under IFRS. According to the SEC Release, the disclosures, referred to as IFRS 1, would include:
- an explanation of how the transition to IFRS affected the company's financial performance and cash flows;
- reconciliations of the company's equity reported under previous US GAAP to its equity under IFRS for the date of transition to IFRS and the end of the latest period presented in the most recent annual financial statements prepared under previous US GAAP; and
- a reconciliation of the company's profit and loss, and cash flows, reported under previous US GAAP for the latest period in the most recent annual financial statements to its profit and loss under IFRS for the same period.7
This one-time reconciliation would not require companies to provide any further reconciliation from US GAAP to IFRS after the initial Form 10-K filed with financials prepared in accordance with IFRS.
Proposal B: Continuing Reconciliation. Under Proposal B, a company would first be required to provide the reconciliation from US GAAP to IFRS that is required by IFRS 1. A company would then be required to provide unaudited supplemental financial information reconciling IFRS to US GAAP in subsequent annual reports. Reconciliation to US GAAP would be required for financial statements presented under IFRS, including balance sheets, statements of income (loss), statements of cash flow, statements of changes in shareholders' equity and statements of comprehensive income for the three years of financial information included in each annual report. While the supplemental information may be unaudited, it would still require Sarbanes-Oxley certification by principal executive and financial officers.
If the SEC decides not to allow financial reporting under IFRS, Proposal B could facilitate an easier transition back to US GAAP, since the company effectively would prepare US GAAP financials on an ongoing basis in order to do the reconciliation (although the Roadmap was unclear as to whether companies choosing to voluntarily adopt IFRS would be required to transition back to US GAAP should the SEC decide not to issue a mandatory requirement). As a result of the continued reconciliation required by Proposal B, it would involve more time and expense for participating companies than the one-time reconciliation contemplated under Proposal A.
Milestones That Must be Achieved by 2011
The Roadmap also sets forth seven milestones that, if achieved, could lead to mandatory use of IFRS by US reporting companies. Four of these milestones must be achieved by 2011 before the SEC would require US reporting companies to use IFRS:
- Improvements in Accounting Standards. In 2002, the US Financial Accounting Standards Board, or FASB, and the IASB jointly undertook to use their best efforts to develop "high quality, compatible accounting standards [to] be used for both domestic and cross-border financial reporting." The SEC will continue to monitor their progress in developing current accounting standards that can adapt to a changing business environment. The SEC will also consider whether the process by which the accounting standards are established will improve the accuracy and effectiveness of financial reporting, provide sufficient investor protection and allow adequate input from affected capital markets participants.
- Accountability and Funding of the IASC Foundation. The SEC believes that effective oversight of the International Accounting Standards Committee Foundation, or IASC Foundation, which oversees the IASB, is critical to determining whether to adopt IFRS. While the IASC Foundation currently has no oversight authority,8 it is currently searching for a monitoring group of securities authorities. The SEC will consider whether such oversight is effective before requiring IFRS use in the US. In addition, the SEC will consider whether the IASC Foundation, which currently funds the IASB through voluntary contributions from worldwide capital markets participants, maintains a funding program that encourages the independence of the IASB.
- Improvement in the Ability to Use Interactive Data for IFRS Reporting. Prior to proceeding with rulemaking requiring IFRS use, the SEC will evaluate whether an effective interactive data format exists which companies may use to submit IFRS financial statements.9
- Education and Training. The SEC will consider the progress of educational institutions, professional associations and industry groups to include IFRS training in their curricula, testing and certification programs. The SEC will also take into account the overall readiness of investors, accounting professionals and other capital markets participants for a transition to IFRS.
In addition to these mandatory milestones, the SEC will consider three other important milestones in deciding whether to require IFRS use:
- The Early Adoption Program. The SEC will examine the success of the early adoption program in enhancing comparability for investors.
- Timing and Preparation. The SEC will consider the timing of a mandatory IFRS rulemaking and whether a 2011 rulemaking would provide US reporting companies with sufficient time to prepare for the transition.
- Effect on Comparability. The SEC will also consider the impact of mandatory IFRS use on reporting companies. In the Roadmap, the SEC acknowledged that dual preparation would be required of financial statements for the three years prior to 2014, the earliest date that IFRS would be required. Also, given the impact of the staggered nature of the planned transition on comparability among competitors,10 the SEC is also considering expanding the eligibility criteria for early IFRS adoption.
A transition to IFRS, whether on an early voluntary or a mandatory basis, will have important consequences for reporting companies:
- Company boards, particularly audit committees, will need to take an active role in the transition to IFRS. The adoption of IFRS will be a company-wide issue that will require a coordinated approach from the board to management (top down) and management to the board (top up).
- Companies should consider establishing a team composed of its accounting personnel, auditors and counsel to develop an agenda and timetable in advance of using IFRS in order to smoothly transition to IFRS.
- Companies will need to devote substantial time, resources and effort to preparing and auditing financial statements in accordance with IFRS. Companies already burdened with the cost of Sarbanes-Oxley compliance may need to increase their accounting staff and training personnel. Companies may experience challenges maintaining internal controls and procedures during the transition period, when internal accountants and other financial personnel may be unfamiliar with IFRS. Likewise, auditing firms would need to examine their ability to staff audits of financial statements prepared under IFRS, and take an IFRS transition into account in their hiring practices and professional development programs.
- A company with equity method investments in another entity would also need to obtain IFRSbased financial reporting from that entity in order to accurately record and report the investment. If the investee entity prepares its financial statements in accordance with US GAAP, it would take considerable time and expense each reporting period to obtain IFRS-based financial statements. Companies may have no right under their investment documents to obtain such financials and will have to negotiate with the investee entity in order to obtain such rights and perhaps assume the added costs of preparing financials under IFRS.
- As the use of IFRS may impact indentures, credit facilities and other contracts or agreements with covenants or obligations tied to US GAAP, companies may need to amend these covenants to stay in compliance. Companies need to consider these issues in advance of adopting IFRS, perhaps by tying affected provisions to a fixed US GAAP standard or arranging to have the financial covenants automatically adjust when the company switches to IFRS so the company's compliance will not be impacted by changes in US GAAP. However, this type of adjustment would lead to the added cost of maintaining two sets of books. Companies should also consider the implications of this transition when negotiating agreements that would extend beyond the implementation period.
- The accounting treatment of significant transactions, as well as revenue-generating agreements, may be impacted by a change from US GAAP to IFRS.
- Since US GAAP is often a measure of performance-based executive pay, financial reporting in accordance with IFRS may also affect calculations under compensation and employment agreements. Board committees considering performance-based compensation will need to become familiar with IFRS in order to accurately grant and adjust equity-based compensation awards.
- The US Internal Revenue Code contains conformity provisions requiring taxpayers that use the last-in, first-out, or LIFO, method of accounting for inventory for tax purposes to use the same method for financial statement purposes. However, IFRS does not permit the use of the LIFO method. As a result, companies using the LIFO method may be required to use a different method of accounting for inventory for tax purposes, which could produce a change in taxable income. The IRS may, however, determine to make changes to address this issue.
- Similar to the Public Company Accounting Oversight Board, or PCAOB, IFRS has a counterpart called the International Auditing and Assurance Standards Board, or IAASB. It remains uncertain whether the PCAOB will retain its current role and what relationship the PCAOB and IAASB will have if IFRS is adopted by the SEC.
- Listing standards of several market indices, including the S&P 500, require companies to report their financials in accordance with US GAAP. Absent changes to these indices, which may occur, an early adopting company could risk removal. Similarly, the exchanges will also need to adjust their listing standards if the SEC adopts IFRS, and they are closely monitoring the SEC in this respect.
- Companies should also consider an investor relations strategy to help their shareholders adjust to financials reported in accordance with IFRS. In particular, a company should ensure that investors are aware of the new financial standards and the impact IFRS may have on earnings releases and other regular financial reporting.
Private Companies and IFRS.
If the Roadmap is adopted, we would expect many private companies to switch to IFRS in order for their financial statements to be comparable to public companies. Also, private companies considering an initial public offering or whose exit strategy might include a sale to a public company may want to begin using IFRS. At a minimum, private companies will need to plan for and consider the added expense, time and personnel required to convert financial statements from US GAAP to IFRS.
The SEC is accepting public comment on the IFRS Roadmap until February 19, 2009.11 In particular, the SEC has asked for comment on whether the broader use of IFRS standards will lead to improved financial reporting. The SEC has also requested comment on its alternative early adoption Proposals A and B, and solicited suggestions for factors the SEC might consider in measuring the progress of market participants in the transition to IFRS and on the timing of the transition as proposed in the Roadmap.
1 "Roadmap for the Potential Use of Financial Statements Prepared in Accordance with International Financial Reporting Standards by US Issuers," SEC Release No. 33-8892 (Nov. 14, 2008) (The "SEC Release"), available at http://www.sec.gov/rules/proposed/2008/33-8982.pdf .
2 Nomination Hearing before the S. Comm. On Banking, Housing and Urban Affairs, 111th Cong. (2009) (testimony of Hon. Mary Schapiro).
3 While many jurisdictions worldwide adopt modified versions of IFRS, the Roadmap applies to "IFRS as issued by the IASB" without any of these jurisdictional distinctions.
4 As drafted, the Roadmap does not apply to financial reports filed by investment companies or other regulated entities, including broker-dealers. However, when adopted, the Roadmap could include these types of entities, as the SEC has solicited comment on whether it should include these regulated entities. The Roadmap also does not apply to privately held companies, although many private companies may switch to IFRS to maintain comparability with public companies and to facilitate going public in the future.
5 To qualify, a company must establish that it is one of the 20 largest companies worldwide based upon a published, widelyaccepted industry source or list.
6 A company would need to prominently disclose: (i) that it used IFRS to prepare its financial statements; (ii) why it decided to adopt early; (iii) the corporate governance processes in making the change (including whether a shareholder vote was held and the extent to which the company's board of directors and audit committee participated in the decision-making process); and (iv) the dates of its no-objection request and the SEC's no-objection issuance. If a company subsequently chose to revert back to US GAAP, it would be required to do so in an annual report on Form 10-K and it would also need to disclose (i) through (iii), above, regarding the reversion to US GAAP.
7 For example, as described in the SEC Release, if a company filed an annual report for its fiscal year ending on December 31, 2009, in accordance with IFRS for the first time, it would need to include a reconciliation of its reported equity from US GAAP to IFRS as of January 1, 2007, and December 31, 2008, and a reconciliation for the year ended December 31, 2008, of its total comprehensive income.
8 The IASC Foundation is a stand-alone organization, unlike many other accounting standard-setting bodies which are subject to national securities or governmental authority. In the US, the FASB (which promulgates US GAAP) is subject to regular SEC oversight.
9 The SEC voted on December 18, 2008, to adopt its proposal for the use of a particular interactive data provision format called XBRL for the submission of financial statements to the SEC. While XBRL is suited for the submission of financials prepared in accordance with US GAAP, it cannot provide for submission of IFRS-prepared financials with the same level of detail. "Interactive Data to Improve Financial Reporting," SEC Release No. 33-8924 (May 30, 2008), available at http://www.sec.gov/rules/proposed/2008/33-8924.pdf .
10 Mandatory IFRS reporting could begin with fiscal years ending on or after December 15, 2014, for large accelerated filers, December 15, 2015, for accelerated filers and December 15, 2016, for all other filers.
11 Several companies have requested the comment period be extended through April 30, 2009, as a thorough analysis of the proposal is difficult, given that the current deadline falls during earnings and Form 10-K season.
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