US companies face tough decision: GAAP or IFRS?
On July 25, the SEC announced it would issue a concept release to explore whether US companies should be able to report their financials in International Financial Reporting Standards, or, IFRS.
At first blush, the idea that the US might permit companies to bypass US GAAP seems radical. Not only does it point to how far the world’s accounting standards have already converged, but it confirms that globalization is steadily and irrevocably remaking financial markets.
Such a move has its practical side too. The SEC almost certainly feels compelled to give US companies an accounting choice because it’s engaged in rule-making to offer non-US companies listed here the option of reporting in IFRS rather than reconciling to US GAAP. SEC spokesman John Heine describes the concept release as ‘the mirror image’ of the choice foreign companies may soon face.
Although US companies haven’t necessarily been beating down doors to report in IFRS, denying them the option wouldn’t seem sporting. Christian Leuz, a professor of accounting at the University of Chicago’s graduate school of business, puts its this way: ‘The US is saying, if we drop the requirement for foreign companies, we’ll have to give the same option to domestic companies. Otherwise, we’d be holding the domestic companies to a higher standard than the foreign companies.’
Accounting principles are sufficiently arcane that companies aren’t likely to switch impetuously. The expense of such changes guarantees nothing will be done without detailed calculations. But Neri Bukspan, managing director and chief accountant for New York City’s Standard & Poor’s, says that if a changeover is inevitable, embracing IFRS early may make long-term financial sense. ‘It’s like refurbishing your elevator. Do you want to pay the ongoing repair costs or do you want to bite the bullet and invest in a new elevator?’
Mapping the differences
Although IFRS and US GAAP are both considered high quality accounting standards, differences do exist.
Conventional wisdom says that IFRS is more principles-based, while US GAAP tends to be more rules-based. ‘The US standards are by far the most comprehensive set of standards and the US has evolved in some areas to a very rules-based approach that has led to some complexity,’ says Sam Ranzilla, partner in charge of professional practice at accounting firm KPMG in Manhattan.
David Kaplan, leader of the international accounting and SEC services group in the national office of PricewaterhouseCoopers, makes a similar point: ‘US GAAP has been continually drafted and re-drafted and new interpretations have been added over a longer period of time, so there’s much more detail in it.’
DJ Gannon, a partner at Deloitte & Touche in Washington, DC, and leader of the firm’s IFRS Center of Excellence for the Americas, observes that there’s a lot of industry-specific information embedded in US GAAP that hasn’t yet been encoded in IFRS. For instance, he notes that the standards for insurance contracts are only now being developed under IFRS, while US GAAP already has ‘a very comprehensive body of knowledge around insurance accounting.’
However, the experts caution that generalizations about the two standards too often veer into oversimplification. ‘If you look at the standards,’ says Gannon, ‘a lot of IFRS is based on US GAAP so for certain areas you do have detailed rules leading to a similar level of complexity.’
What’s more, the standards are continually evolving meaning many historical problems no longer exist. Meredith Cross, a partner at Wilmer Cutler Pickering Hale and Dorr in Washington, DC, notes that ‘the big knock against IFRS in the past was that there were too many choices and there would be too much variation within companies. There wasn’t enough discipline within IFRS. But I understand those significant choices within IFRS have been reduced.’
Mass confusion?
Just how difficult and messy would it be to have two accounting standards both in use at the same time?
Bukspan believes that the problem is conceivably serious: ‘It’s almost as if the US would allow people to drive both on the right side of the road and the left side of the road. You can have extremely risky and dangerous chaos.’ He contends that the confusion would be dramatically reduced if companies within certain industries chose the same accounting standard. ‘If in certain areas people would only drive on the right, and in certain areas they’d only drive on the left, that would be clearly useful,’ avers Bukspan.
Leuz argues that changing from one standard to another doesn’t necessarily mean you’ll dramatically alter reporting outcomes. Both standards, he says, offer choices and give companies the latitude to treat the same situation in different ways. ‘Even if you choose to use US GAAP,’ he notes, ‘there are certain choices that would allow you to report quite differently within the bounds of GAAP.’
The potential to confuse your investors and analysts who will compare your financial statements against competitors’ is just one problem. Another is the potentially large infrastructure questions that need to be considered before US companies embrace IFRS. As Bukspan says, ‘IFRS accountants don’t commonly walk the streets of New York.’
‘The level of understanding of IFRS is extremely varied across groups like the auditing firms, audit committees, executive teams and users,’ says Ranzilla. Clearly, though, help is on the way. KPMG has, for instance, just published a 300-page-plus manual entitled ‘IFRS Compared to US GAAP’.
Lawrence Gill, a partner at Chicago-based Schiff & Hardin and chair of the American Institute of Chartered Public Accountants’ (AICPA) international issues committee, asserts that most companies should run both accounting systems for some time before making a change. ‘You need to train your finance and accounting staff, and make sure your board and senior management understand IFRS,’ he says, adding that ‘they wouldn’t want to be surprised.’
Although it’s easy to wring your hands over the looming accounting hassles, reassuring signs exist too. ‘One thing to keep in mind is that the rest of the world, for the most part, has converted to IFRS,’ says Ranzilla, ‘and so we know it can be done.’ In 2005, the European Union mandated that public companies abandon their own local accounting principles and embrace IFRS. In a July 25 speech, SEC chairman Christopher Cox said that nearly 100 countries now require or allow the use of IFRS.
But even this impressive statistic is open to some interpretation. Gill notes that not all of these countries use ‘IFRS as adopted by the IASB (International Accounting Standards Board) – some are only distant cousins.’
IFRS: Likely takers
Switching to IFRS may be an avenue that only a handful of US companies choose to pursue.
Prime candidates would include true multinationals since many of them are already completing statutory reports in IFRS. Companies that are, in effect, keeping two sets of books might gladly embrace a single standard and may realize considerable cost-savings by doing so.
Another group that might find IFRS appealing are companies facing stiff competition from public companies outside the US. Gannon, for instance, points out that the automotive manufacturing and life science industries are dominated by non-US players.
Companies in industries with well-known, non-US competitors may want their financial statements to be calculated in a way that facilitates comparisons. ‘If your competitors are all on IFRS,’ says Ranzilla, ‘it might improve the ability of investors and analysts to make comparisons across companies.’
Of course, every company’s situation is unique. ‘The ultimate impact on any one company is going to depend on the nature of the accounting policies, and what practices they’ve undertaken under GAAP,’ says Gannon. As one example, he notes that companies can elect to measure tangible assets on a fair value basis under IFRS in situations where this normally wouldn’t be done under US GAAP.
Gill points out that the way pre-operating and pre-opening costs are reported differ under both systems. Discrepancies also exist in borrowing costs, fair value, revenue recognition and extraordinary items.
Given these differences, one commonly expressed concern is that a company might move to IFRS to gain a form of ‘financial statement arbitrage’, or to take advantage of the fact that its numbers might look more favorable under another system.
Although this possibility exists, most experts don’t fear financial shenanigans since the decision to report in IFRS is so transparent and will therefore be carefully scrutinized. ‘Significant credit should be given to analysts that companies will not switch to IFRS for the wrong reason,’ says Bukspan.
Cross concurs with Bukspan: ‘Analysts do much of the translating for everyone anyway. If there’s enough disclosure, then over time you’ll get an accurate picture of the company.’
Cross also trusts that the required disclosures will prevent anything untoward from occurring. ‘The disclosures around the critical accounting policies that you’re required to do in the SEC filings help people understand what the accounting policies are,’ she says. ‘If there’s something that would have a significant impact, you’d have to talk about it anyway.’ She continues: ‘If pension accounting is materially different between the two systems and pension accounting is material to you, the SEC rules require you to talk in your MD&A about critical accounting policies and estimates.’
Finally, even though a company’s financial statements might look slightly better under one set of accounting standards, switching accounting standards is in and of itself an expensive, labor-intensive endeavor and not something undertaken lightly.
‘When companies in Europe went from local GAAP to IFRS, it took between 18 and 24 months,’ says Gannon. He elaborates by saying, ‘This is not just about scratching a couple of journal entries on a napkin. It means changing accounting systems, it means gathering different types of information, it means educating your people, it means developing new accounting manuals and it means changing your financial statement disclosures.’
Back to the future
If working with two accounting standards is confusing, perhaps US companies should borrow a page from the European Union and simply mandate that all public companies move to IFRS.
Then again, maybe such a dramatic step isn’t even necessary. In the long run, most experts agree that one standard will almost certainly be used globally, and it will probably look like an amalgam of US GAAP and IFRS. ‘Over time,’ says Gill, ‘it won’t be such a significant decision to choose between IFRS and US GAAP because the two will be very similar.’
Gannon raises a similar point: ‘Whether you call something IFRS or US GAAP, down the road, it won’t make much of a difference because ultimately it’s going to be the same standard. And even if a US company doesn’t use IFRS outright, US GAAP is changing.’ To cite an example, he says that standards on share-based payments and business combinations under GAAP have converged with IFRS.
In another July 25 speech, then SEC commissioner Roel Campos emphasized that convergence of the world’s accounting standards is the ultimate goal. But one of his key concerns with offering US companies a choice between IFRS and US GAAP, is that this might lead to the unintended consequence of completely removing ‘the incentive for convergence between IFRS and US GAAP.’
What’s more, convergence is the express dream of many public companies. ‘A lot of foreign issuer companies frankly want to minimize differences,’ says Gannon. ‘They won’t take certain choices under IFRS if it won’t be consistent with US GAAP.’
But even if convergence is the Holy Grail, true convergence isn’t necessarily going to be easily achieved. ‘There’s a concern,’ says Gill, ‘that even if IFRS becomes the lingua franca of the accounting world, we’ll nevertheless have the problem of dialects. Just like Americans speak French with an American accent, we may speak IFRS with an American accent.’ He continues: ‘We don’t want a Babel here. We don’t want to start with one language and find it turns into 100 different languages.’
Talking it over
Although public companies seem intrigued by the option of using IFRS, for the most part they continue to remain cautious in their judgments. Fred Gill, senior technical manager, accounting standards at AICPA, sums up public sentiment this way: ‘Most people I’ve spoken to have said, This is interesting. I’d like to look into it.’ AICPA began assembling a taskforce in August to elicit various opinions but has yet to formulate a view on this issue.
Even though a wait-and-see attitude makes sense, most experts agree that corporate secretaries should bring the IFRS issue to the attention of both the audit committee and the board at large.
Ranzilla maintains that this topic deserves consideration now, even though the SEC is only at the very preliminary stages of its decision process, which given the vehement discussion it has inspired could still see many developments. ‘Companies should begin engaging in conversations with the audit committee as to whether they would support proposals allowing the company an option to adopt IFRS,’ he recommends.
Roberta Karmel, professor of corporate law and securities regulations at the University of Brooklyn Law School, also believes that a change in accounting standards is nothing to foist on a board suddenly. ‘If I were on the audit committee of a board and the CEO said, Hey, we’re going to switch to IFRS, I’d ask a lot of questions. At the end of the day, if there were good reasons for doing it, such as every one of our competitors is reporting in IFRS and we should too, then I might think: Why, yes, that’s a good idea.’
