Goodbye GAAP, Hello IFRS; Will You Be Ready?

It’s become clear throughout the past five years that GAAP and financial reporting in the United States are on a clear path toward change in the form of a convergence with the International Financial Reporting Standards (IFRS). World events, most notably the London G-20 Summit, have been calling for a single, high quality set of accounting standards that all companies will use to file. The SEC has recently made definitive steps toward this change, enough to make me believe that IFRS will be here before we know it, so it’s time to get ready.

Background

Since 2005, the convergence to IFRS was apparent with the European Union requiring companies listed on the EU regulated stock exchanges to file consolidated statements using IFRS. The SEC responded to this in 2007, agreeing to accept these IFRS statements from the foreign issuers without forcing reconciliation to GAAP. This proved the SEC’s acceptance and belief that the international standards were in fact high quality.

Throughout this time, strong debate evolved regarding the United States adopting IFRS. FASB and IASB were working together, and in September of last year, they both reaffirmed their commitment to converge all major accounting standards by 2011, the year in which every capital market except the US will be using IFRS as a basis for financial reporting. The SEC again came into play just recently, proposing a roadmap for IFRS adoption that concludes with a 2011 decision on whether the international standards will become mandatory for all US issuers.

The SEC’s proposed roadmap consisted of a timeline towards a mandatory conversion in FY 2014, with companies being able to voluntary convert as soon as this FY 2009. Regardless of when they choose to make the switch, they must begin their IFRS reporting in the annual 10-k, where they must file audited IFRS statements for the year of adoption and the two preceding years. For example, a company that decides to wait until the mandatory conversion at the beginning of FY 2014 must file their 2012 and 2013 statements under IFRS as well as 2014.

While there are many similarities, there are also quite distinct differences between US GAAP and IFRS that need to be illustrated. Of utmost importance, GAAP standards are highly rules-based, consisting of over 17,000 pages of detailed guidance. IFRS, however, is much more principles-based with its 2,500 pages, requiring the managers to exercise much more judgment in their valuations. For example, revenue recognition is one of the most complex elements of GAAP accounting due to its comprehensive guidance on industries and different types of contracts. Under IFRS, revenue recognition is based on a single standard with general principles applicable to different transactions. The reasoning behind this is put forth by Tom Jones, Vice Chairman of the International Accounting Standards Board (IASB) that develops IFRS. He responds to criticisms on the lack of rules by claiming, “When you write rules, smart people can get around them.”

The debate has been intense regarding whether the SEC will mandate a complete switch to IFRS or a convergence between IFRS and GAAP. Recent evidence leads to the belief that the adopted IFRS will be more of a convergence. A few weeks ago FASB changed its GAAP guidelines on fair value measurements and mark-to-market accounting.

As a result, EU banks under IFRS have been expressing concern that the US banks have an advantage. The IASB is expected to issue guidance on the subject that is very similar to FASB’s, showing agreement between the two boards and a converging of GAAP with IFRS. Public comments to the proposed roadmap show the agreement among companies that negotiations like these need to happen to lessen the cost of adoption, a prominent concern regarding the switch. At this point in time, the IFRS still needs development, but once the certain areas the SEC deems weak are taken care of (ex; accounting insurance contracts), the standards will be ready for adoption.

It Will Happen Before You Know It

Although SEC Chair Mary Schapiro has stated that a transition to IFRS in the United States “will take a back burner” due to the overhaul of the regulatory system, the rebound of the global economy needs to bring with it a global accounting standard. With Brazil, Canada, Chile, India, China, Japan, and Korea all committed to adopting IFRS, as well as the current EU members already under the standards, IASB member John Smith recently told a European audience that “it is in the interest of the United States to adopt IFRS in the next five years,” and that the “cost to the US of failing to adopt will be high.” This makes sense, considering the fact that if every other country in the world is using the international standards, how would the US maintain credibility in the accounting realm? With the inevitable trend towards globalization that has been hitting the economy, not adopting IFRS would weaken American companies’ strength in the global capital markets.

Committees and groups are in place to make the convergence happen in the most efficient way possible. The Financial Crisis Advisory Group (FCAG) was established by FASB and the IASB to give guidance to the two boards about the implications of the global recession and the changes that may need to be made as a result. Their job is to recognize where reform needs to be made and ensure the proper improvements are enforced. The FCAG fully supports IFRS, and have written letters to the G-20 summits expressing the urgency. The topic made it into the G-20 discussions in London, with the world leaders conveying that a global standard needs to happen.

Why It Matters to Investors

Throughout the next few years, companies will be making the steps towards filing their statements under IFRS. Certain aspects of the statements will change. Revenue recognition will be different, along with specific standards regarding pensions, leases, loan provisions, and many other items. To give an example, under US GAAP an operating lease must be expensed through the income statement and cannot be recognized on the balance sheet, thereby reporting lower earnings. Under IFRS, an operating lease need not be expensed as it may be held by a lessee as an investment property if certain conditions are met. It is specific differences like these, as well as the extra judgment that comes along with a principles-based system, that has resulted in companies under IFRS often not reporting higher earnings.

Additional expenses, however, will definitely occur. When the EU companies in 2005 made the switch from local GAAP to IFRS, the Institute of Chartered Accountants in England and Wales estimate that European companies spent about .05% of revenues in the first year on making the switch. Performance based compensations and dividends will be affected. The entire education process will need to be changed, all the way from accounting students to senior executives (under Sarbanes-Oxley the CEO and CFO must attest for the accuracy of the statements). Each statement will be affected, and investors need to stay aware and educated about the implications.

What Investors Need To Do

Stay in tune with FASB and IASB’s agenda to be up to date on what is happening next. Understand the differences between US GAAP and IFRS and their impacts on financial reporting. Make sure to read through the full disclosures, as a move from a rules-based system to a principles-based system will result in more detailed footnotes. By staying educated and knowledgeable of what is happening in the accounting world, when the time comes, investors will be able to focus on the company’s operations instead of the change in accounting standards.

-Phillip J. Harper

Disclosure: None

Comments

[dybydx:]

i bet you a dollar that the moment congress hears that IFRS requires the use of mark-to-market accounting, they will legislate against it.

May 26 03:02 PM

[Fred Voetsch:]

It is time we had some REAL standards but I doubt that will stop analysts from using operating earnings, forward earnings, normalized earnings or as Birinyi Associates does, just plain made up earnings that completely ignore reality.

Don't know what I'm referring to? Take a look here:

online.wsj.com/mdc/pub...

...and then here, at the REAL data from S&P:

www2.standardandpoors....

and an up-to-the-minute P/E for the NASDAQ 100:

www.bullandbearwise.co...

Now you explain how they come up with a 15 P/E for the S&P 500 and 13 on the NASDAQ? Lies, that's how.

May 26 03:52 PM

[Lummox:]

I am adamantly opposed to Mark to market, because it can have no relationship to reality. In the long run the Market will eventually correct, but in the short term, it can be drastically wrong. Just because no one wants to buy at a particular time doesn't mean that the asset has no value. Or while because one asset sold below market all assets should valused below market.

Aas an example, I know of houses and condo's selling 70% belowmarket, They were abandoned, stripped of all fixtures, plumbing, furnishings, and moved into by squatters. The only people willing to buy a house like this, are those that are willing to gut the house to the frame, and rebuild. For this will they bid low to cover their investment, risk, and guarantee a profit. Also a mansion is appraised at twice everyone else's house in the area. Now why should your house be appraised at the same value as either the abandoned house or the mansion. The answer is they aren't, so why should we apply the same rule to financial investments.

In financial markets the same can be true. A bank has a portfolio of building loan packages. Someone or several someones bid up a package. Suddenly all the packages in the portfolio are worth more, the bank has more money to loan as its assets have no gone up. They in turn start bidding on more loan packages, because the price on them is going up. Soon everyone starts doing this. This is a bubble because the actual worth of the package is not what someone wants to pay. But how much money are the loans for, what is the interest rate being paid on the loans. Also if there is a chance of the loan being defaulted will you lose money. In a downturn, when no one wants to buy, the price drops, but the value of the loan is still dependent on amount of money loande, rate of return, and risk.

The mark to market rule, was made illegal after the Great Depression, because it contributed to the stock market crash. We re-instated it, and it caused problems. All assets should be valued based upon their cash value. This confusion come because the finacial market packaged loans together, and labeled the as securities. If you have a million dolar COD in the bank, that is an asset and is worth one million dollars. I f you have a million dollars in stock, that is a security and is worth what some is willing to pay you.

May 26 08:07 PM

[atlasman:]

Yet another reason not to go public.
-AM

May 27 07:38 AM

[The AntiCramer:]

M2M was reinstated at the insistence of bankers. If they desired the ability to mark to bubble they shouldn't be allowed to mark to fantasy when the bubble bursts.

You also make the assumption that all markets must correct all of the time at some point in the future. This is a dangerous assumption.

I'll leave the pros and cons of M2M up for debate but you must concede that consistency is key. Otherwise how is an investor to discern fantasy from reality?


On May 26 08:07 PM Lummox wrote:

> I am adamantly opposed to Mark to market, because it can have no
> relationship to reality. In the long run the Market will eventually
> correct, but in the short term, it can be drastically wrong. Just
> because no one wants to buy at a particular time doesn't mean that
> the asset has no value. Or while because one asset sold below market
> all assets should valused below market.
>
> Aas an example, I know of houses and condo's selling 70% belowmarket,
> They were abandoned, stripped of all fixtures, plumbing, furnishings,
> and moved into by squatters. The only people willing to buy a house
> like this, are those that are willing to gut the house to the frame,
> and rebuild. For this will they bid low to cover their investment,
> risk, and guarantee a profit. Also a mansion is appraised at twice
> everyone else's house in the area. Now why should your house be
> appraised at the same value as either the abandoned house or the
> mansion. The answer is they aren't, so why should we apply the same
> rule to financial investments.
>
> In financial markets the same can be true. A bank has a portfolio
> of building loan packages. Someone or several someones bid up a
> package. Suddenly all the packages in the portfolio are worth more,
> the bank has more money to loan as its assets have no gone up. They
> in turn start bidding on more loan packages, because the price on
> them is going up. Soon everyone starts doing this. This is a bubble
> because the actual worth of the package is not what someone wants
> to pay. But how much money are the loans for, what is the interest
> rate being paid on the loans. Also if there is a chance of the loan
> being defaulted will you lose money. In a downturn, when no one
> wants to buy, the price drops, but the value of the loan is still
> dependent on amount of money loande, rate of return, and risk.
>
>
> The mark to market rule, was made illegal after the Great Depression,
> because it contributed to the stock market crash. We re-instated
> it, and it caused problems. All assets should be valued based upon
> their cash value. This confusion come because the finacial market
> packaged loans together, and labeled the as securities. If you have
> a million dolar COD in the bank, that is an asset and is worth one
> million dollars. I f you have a million dollars in stock, that is
> a security and is worth what some is willing to pay you.

May 27 08:24 AM

[Tom Armistead:]

One of the troubling aspects of the US move to mark to market was the alacrity with which organized short-sellers seized on the opportunity to slam financials. Bill Ackman, for one, was literally counting the days...

If the adatptation of IFRS in the US creates another such opportunity, short-sellers will have another field day, perhaps around the same or similar issues.

To judge by what happened this time around, the best response for the concerned investor will be to avoid the affected areas until the whole thing has reached some new height of absurdity. Then there will be profits, along the lines of what JPM is extracting from WaMu's assets...

May 27 08:44 AM

[La Marque:]

In a global economy, everybody needs a clear standard; if IFRS is it, then so be it. The article states that the accounting boards are working to reconcile the differences and that means that IFRS will be the standard. Goodbye 17,000 pages of arcane rules.

May 27 09:45 AM

[Henry Buttal:]

One of the positive things about IFRS is that it is much more pragmatic about many day to day operating conditions, and as this article and La Marque pointed out, less about generating excessive rule making. GAAP and FASB had gotten to the point where it was more about creating business for the accountants and the auditors than it was actually about representative accounting across a broad spectrum of company sizes and classes. FASB has only lately discovered there are businesses with market caps under the $1 Billion range.

ANTICRAMER, I don't follow your thinking here. A large number of banks balked at FAS 157, and actively complained in advance of the implementation, and thereafter.

I always thought that FAS 157 made no sense for most financial institutions. If you applied an equivalent test at a given instance of time to a broad spectrum of companies in the U.S., my guess is that the failure rate would literally vary from sampling to sampling. At some point, every company would lack sufficient liquidity, have critical illiquid assets, etc. So the outcome really should have been expected, and FASB should have paid heed when the complaints began, even if it was from entities that hadn't performed adequate VAR management

May 27 11:17 AM

[Moon Kil Woong:]

There are clear issues for and against mark to market. The biggest actually being mark to market incorrectly appreciates assets in an upturn, not the reverse (that is just a correction back to pre mark to market actually). The anti-Cramer had it right.

However as they stated, the issue is not to get bogged down on finer points. The main issue regarding why IFRS is superior is because it takes into account intent. Intent to lie about earnings, commit fraud, and incorrectly disclose legeraging, losses, and risk profiles is not permitted no matter if you can find a convenient loophole to expoit (usually placed there by a lobbyist in some arcane bill like the Graham Leech Bliley Act). These are all the reasons why banks and financials will rally against it since we already know they have tons of loophole laws in the currect system that lets them hide derivatives losses from their own shareholders, off balance sheet their losses, and generally be as crooked as they like without consequence.

The ramification of the status quo is dramatic and devestating. Not only does it obscure fact so much no one can see the economic train wreck caused by inappropriate behavior of financial institutions, it will lead the US into a cycle of boom and bust that will lead to an absolute lack of credibility of our financial system and their participants. This is already happening. When there is no credibility in the financial system then money has a way of becoming worthless very fast.

IFRS and tighter accounting is neccesary to save us, not a hinderance to prosperity as proponents of the status quo would claim.

May 27 03:01 PM