With an announcement in August 2008, the U.S. Securities and Exchange Commission (SEC) moved the United States closer to adopting International Financial Reporting Standards (IFRS). The SEC is proposing a "road map" that could lead to the use of IFRS by U.S. issuers beginning as early as 2014 for large accelerated filers, 2015 for accelerated filers, and 2016 for nonaccelerated filers. Although the SEC will not decide until 2011 whether to adopt IFRS, speeches by several members of the SEC staff, made in connection with the announcement of its IFRS road map, referred to seven milestones that must be accomplished prior to adoption.
Management and boards of directors of U.S. companies would be wise to start planning for the eventual convergence of U.S. generally accepted accounting principles (GAAP) and IFRS. The first steps should be to perform an impact analysis and assess your road map, technical accounting, technology, and organizational issues.
Reading The Road Map
In connection with the SEC's announcement of its planned issuance of an IFRS road map, Paul Dudek, chief of the Office of International Corporation Finance, along with other members of the SEC staff, outlined on Aug. 27, 2008, seven milestones that could eventually result in the required use of IFRS by U.S. issuers by 2014. The seven milestones that could influence the SEC's 2011 decision are:
- Improvements in accounting standards;
- The accountability and funding of the International Accounting Standards Committee Foundation;
- Improvement in the ability to use interactive data for IFRS reporting;
- Education and training in the United States related to IFRS;
- The anticipated timing of future rule making by the SEC;
- Potential implementation of the mandatory use of IFRS, including considerations relating to whether any mandatory use of IFRS should be staged or sequenced among groups of companies based on their market capitalization; and
- The limited early use of IFRS.
As to the seventh milestone, SEC staff members indicated that the SEC would allow approximately 110 of the largest publicly held U.S. companies to adopt IFRS early and file IFRS financial statements in connection with their 2010 filings. To qualify, a company must be one of the 20 largest in its industry as measured by market capitalization, and others in the company's industry must predominantly use IFRS already.
U.S. GAAP vs. IFRS
Several significant differences distinguish U.S. GAAP from IFRS. For example, the identification and measurement of an impairment loss of a long-lived asset is a multistep process under U.S. GAAP. First, if indicators of financial reporting impairment exist, a financial statement preparer must look at the undiscounted cash flows expected to result from the use and eventual disposition of the asset. If the undiscounted cash flows are less than the net asset value – that is, the carrying amount – they create a triggering event requiring the measurement of the potential impairment loss.
Under IFRS, however, the identification and measurement of an impairment loss of a long-lived asset is a single-step process that requires the financial statement preparer to look only at the discounted cash flows to determine if a triggering event occurred and the appropriate impairment amount. Such a difference could dramatically affect acquisitions and cross-border transactions, particularly in a volatile market environment with fluctuating currency rates.
Other differences between IFRS and U.S. GAAP include the following:
- Generally speaking, IFRS is "principles based" as compared to U.S. GAAP, which is more "rules based" and has many industry-specific requirements.
- In the area of inventory accounting, IFRS prohibits entities from using the familiar last in, first out (LIFO) cost basis method that many U.S. companies employ. In addition, IFRS uses a simpler method to calculate inventory basis.
- Unlike U.S. GAAP, under certain circumstances IFRS allows the reversal of a previously recognized impairment loss, excluding goodwill impairment losses, up to the original carrying amount of the related asset.
- IFRS requires all entities to present a reconciliation between the statutory federal income tax rate and the effective tax rate. In the United States, only public companies are required to provide such a reconciliation.
- When reporting on business segments, IFRS requires public companies to report according to lines of business and geographic areas. Under U.S. GAAP, companies are required to present only one basis of segmentation, which may or may not be according to lines of business or geographical areas but must be the basis on which information is reported internally to senior management.
- IFRS allows companies to use either revalued amounts or historical cost as the basis of measurement for property, plant, and equipment; U.S. GAAP requires businesses to use historical cost only.
These and other differences appear to set IFRS and GAAP apart, but in reality the two accounting systems are more similar than dissimilar.
Leading Up To The SEC's Actions
Achieving greater harmony among international accounting standards has been a goal of the international accounting community for more than 30 years.
The movement started in 1973 with the formation of the International Accounting Standards Committee (IASC) and gained momentum in 2000 with the creation of its successor, the International Accounting Standards Board (IASB). Both organizations worked closely with national accounting standards bodies, including the United States' Financial Accounting Standards Board (FASB), to eliminate differences in accounting standards from country to country.
One of the first landmarks was reached in 1995, when the IASC and the International Organization of Securities Commissions (IOSCO) agreed to complete core standards on IFRS by 1999. Upon successful completion of that goal, IOSCO agreed to endorse international accounting standards for all cross-border offerings.
The movement toward a common set of accounting standards for all countries picked up steam as capital markets around the world became increasingly global. Investors and other participants in these markets began to view national differences in accounting standards as unnecessary barriers that made cross-border comparisons difficult and inefficient.
In May 2002, the European Union (EU) voted to require virtually all public companies domiciled in the EU with public shares listed on an EU stock exchange to prepare their financial statements using IFRS beginning in 2005. That decision resulted in thousands of companies adopting IFRS and was yet another milestone in the development of globally accepted accounting and financial reporting standards.
Later in 2002, the FASB and the IASB jointly issued a memorandum of understanding, marking a critical step toward formalizing their commitment to the convergence of U.S. and international accounting standards. Known as the Norwalk Agreement, the memorandum reflected the commitment of both organizations to eliminate accounting differences through continued progress on joint projects and coordination of future work programs, with the ultimate goal of improving the comparability of financial statements across national jurisdictions.
The SEC also has intensified its focus on this issue in recent years. In 2007, it published a "concept release" to obtain information on the nature of the public's interest in allowing U.S. companies to prepare their financial statements using IFRS instead of U.S. GAAP.1 The SEC subsequently held two round tables in December that same year on the topic of U.S. issuers using IFRS, with more than two dozen experts from varying constituencies. And, in early 2008, the SEC adopted a rule to accept from foreign private issuers their financial statements prepared in accordance with IFRS without a reconciliation to U.S. GAAP as previously required in the United States.2
More than 100 countries, including all of Europe, already require or permit publicly traded companies to report their financial results using IFRS. Three other countries with a significant presence in the U.S. capital markets – Canada, Israel, and Japan – have announced that they will require the use of IFRS by 2011. In light of the SEC's publication of the road map, it seems likely that the United States will eventually follow their lead.
The Mid-Market Effect
The adoption of IFRS would affect growth-oriented small and midsized companies as well as multinational corporations with hundreds of thousands of employees at various locations around the world. Over the past few years, an increasing number of smaller companies in the United States have started to look overseas for new investors or potential alternative financing sources. Along with companies that contemplate potential overseas acquisitions or dispositions, those managing these entities will likely be forced to deal with IFRS in the very near future. Indeed, the weakness of the U.S. dollar in comparison to other currencies makes U.S. companies attractive targets for foreign investment.
Forewarned Is Forearmed
While regulators are discussing the possible use of IFRS in the United States, U.S. companies have an opportunity to educate themselves on the subject and understand what steps they will need to take to adopt international accounting standards when they become mandatory. Savvy companies will learn from the experiences of their counterparts in Canada, Israel, and Japan as those companies prepare for implementation of IFRS by 2011.
Depending on the size of the company, the conversion process from U.S. GAAP to IFRS will require two to four years. Conversion is not merely a matter of applying different accounting rules to a balance of figures. It requires analysis of virtually every legal contract, from debt agreements to performance-based salary agreements to leases, to determine the impact on the financial statements. For example, debt covenants with trigger events could come due early if the relevant ratios change under an IFRS conversion. Furthermore, net income figures could be higher or lower – companies need adequate lead time to understand the differences to expect and to manage the expectations of their stakeholders. Finally, adoption of IFRS might also affect a company's transfer pricing and other tax optimization arrangements, so the company should be prepared to benefit as soon as possible.
Also bear in mind that financial statements for 2014 will include a comparative period that looks backward two to four years. Any company that might be included in the first wave of required users in 2014 should start formulating its game plan now.
The Bottom Line
When the day comes, U.S. companies will find themselves on equal footing, from a financial reporting perspective, with companies in other countries around the world – and then organizations worldwide will speak a common language of accounting.
1. Concept Release 33-8831, "Concept Release on Allowing U.S. Issuers to Prepare Financial Statements in Accordance With International Financial Reporting Standards."
2. Release 33-8879, "Acceptance From Foreign Private Issuers of Financial Statements Prepared in Accordance With International Financial Reporting Standards Without Reconciliation to U.S. GAAP."
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