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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

Source: Goodbye GAAP, Hello IFRS; Will You Be Ready?