The Globalization of Accounting Standards

Over 100 countries, including all of the European Union, utilize International Financial Reporting Standards (“IFRS”), which is the universally accepted accounting standard for the majority of non-North American companies. Until last year, a foreign entity that filed financial statements with the United States Securities and Exchange Commission (“SEC”) which were prepared using IFRS was required to file a reconciliation of those financial statements to what would have resulted using Generally Accepted Accounting Standards (“GAAP”), the accounting standard used by US companies and exchanges. That requirement ended in 2007. This change marks a fundamental shift in the SEC’s thinking.  The SEC is now proposing that certain large multinational companies be allowed to report to the SEC using IFRS beginning in 2010. In a recent interview, SEC Chairman Christopher Cox indicated that over 110 US companies would qualify under the new rules. The SEC plan anticipates that all US companies will utilize IFRS beginning in 2014. Another driving force for the change is that foreign exchanges currently willing to accept GAAP financial statements from US registrants are likely to require IFRS filings in the future. There is clearly a push to develop a global accounting standard for all markets to facilitate cross-country investing.

In a recent podcast, US public accounting firm, Deloitte & Touche LLP, stated that there are approximately 25,000 pages of rules applicable to financial statements prepared in accordance with GAAP, and approximately 2,000 pages of “principles” applicable to financial statements prepared in accordance with IFRS. For at least two decades, there has been a debate within the US accounting profession as to whether “rules-based” or “principles-based” accounting is better for preparing relevant and informative financial statements. The US follows a rules-based approach, which requires a particular accounting treatment for a specific transaction so that two entities engaging in the same transaction don’t account for it differently. Most foreign and global entities follow a principles-based accounting approach which looks to the economics of the transaction for the proper accounting.

There are numerous differences between IFRS and GAAP, and the SEC and the International Accounting Standards Board are attempting to meld their views. For instance, there are over 200 GAAP pronouncements dealing with revenue recognition. Under IFRS there are two principles. IFRS makes no distinction in its principles if the filer is a manufacturer, bank, construction company, or insurance company, while GAAP prescribes unique rules for these and a number of other industries. While a detailed analysis of the differences between GAAP and IFRS is not possible in this brief discussion.

A major question for companies as they navigate the transition to IFRS is whether to adopt the new standards in a way that minimizes the impact of the change from GAAP or to begin with a clean slate. Because the SEC had previously required a reconciliation to GAAP and companies generally want to meet compliance requirements at the lowest cost, many European companies adopt a minimalist approach. Now that the reconciliation is no longer required, some are questioning that choice.

The adoption of IFRS will require US investors to retrain themselves to read IFRS financial statements. It provides an opportunity to look into the quality of management through judgments made when reporting financial results. Disclosures related to how companies account for their businesses and the logic behind their choices are indicative of the integrity and common sense of management. But, as with all opportunities there is risk. Because IFRS allows management more flexibility to present their financial results in a manner they determine better reflects the economics of their business, it puts their judgments “front and center” in assessing the accuracy of those financial statements. This creates a clearer causal link between bad financial statements and bad management. Perhaps this is a good incentive for corporate boards and senior management to enhance the clarity, completeness and quality of information provided to investors.

Under any system of accounting, however, the underlying principles of fair and proper disclosure under the US securities laws require that companies refrain from making false or misleading statements or failing to disclose material adverse information. 


newsletter_oct2008.jpg Source : Scott+Scott October 2008 Newsletter