Introduction. Background
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1 Jeffrey Howard International Financial Reporting Standards Copyright Gatton Student Research Publication. Volume 1, Number 1.Gatton College of Business & Economics, University of Kentucky March 2009
2 Introduction A winning effort begins with preparation, states Super Bowl football coach Joe Gibbs, clearly demonstrating his emphasis on preparation as a precursor to successful action. 1 The accounting industry in the United States is currently preparing for an industry changing policy shift that often eludes front-page stories in newspapers and magazines: the replacement of national accounting standards with internationally accepted accounting rules used by other nations throughout the world. Several nations have already adopted these standards, while the United States and others are currently in the process of adopting these standards. While these international standards share conceptual similarities with current national standards, there are specific methodical differences that must be understood by accountants to ensure successful implementation of the new policies. Background Created in 2001, the International Accounting Standards Board (IASB) is an organization working to create a set of high quality international accounting guidelines that are respected globally. 2 These guidelines are known as International Financial Reporting Standards (IFRS). International accounting guidelines of various forms have existed for decades, often as a means to provide developing nations a set of quality standards that they may not have been otherwise create. However, as the forces of globalization have pushed many businesses to operate, produce, and conduct business internationally, developing nations have increasingly strived for unified global standards. 3 Figure 1 demonstrates the perceived importance of IFRS regarding economic growth in nations throughout the world. Figure 1. How important is IFRS adoption to economic growth in your country? Very Important 9% 1% Important Somewhat Important Not Important 35% 55% Source: American Institute of Certified Public Accountants4 1 "Brainy Quote," (accessed March 27, 2009). 2 Heidi Tribunella, "Twenty Questions on International Financial Reporting Standards," CPA Journal 79, no. 3 (2009): American Institute of Certified Public Accountants. "International Financial Reporting Standards (IFRS)," (accessed March 14, 2009): 2. 4 Ibid. Gatton Student Research Publication 43
3 As the data shows, an overwhelming majority of international accounting leaders surveyed believe that adopting a unified set of accounting standards will be a significant factor in the continuing economic growth of their respective nations. The United States The Financial Accounting Standards Board (FASB) is the United States organization that issues United States Generally Accepted Accounting Principles (US GAAP). In September, 2002, the FASB and IASB signed a memorandum know as the Norwalk Agreement, which states that the two agencies will work together to reconcile the differences between US GAAP and IFRS. Although the two standards share a common purpose of providing quality information to decision makers, they differ regarding important accounting principles that result in varied results when accounting for daily business transactions. 5 In November 2007 the SEC ruled that foreign owned companies that issue stock in the United States no longer have to convert financial statements to US GAAP; only IFRS financial statements were necessary. This move demonstrated the SEC s commitment to adopting the international standards by giving preference to IFRS over GAAP for these select companies. 6 Then, on November 14, 2008, the SEC issued a Roadmap that would effectively replace US GAAP with IFRS as the authoritative set of guidelines that govern corporations financial reports in the United States. Experts in the accounting field believe that publicly held companies will be required to file financial reports using IFRS by This document establishes several milestones to ensure that the adoption of IFRS is in the best interest of investors. Improving the accounting standards and expanding financial software to allow for more interactive data are key amongst these benchmarks. 7 Langmead and Soroosh explain a delicate balancing act the SEC and IASB must perform regarding the adoption of International Standards in the United States. The organizations must carefully consider both the world-wide desire for a single set of high-quality reporting guidelines as well as the time consuming efforts to converge IFRS with the divergent standards currently utilized in the United States. 8 Focusing too much on the second element will hurt the first, as global standards are not viewed as truly global without the participation of the United States. World Wide 5 Joseph M. Langmead and Jalal Soroosh, "International Financial Reporting Standards: The Road Ahead," CPA Journal 79, no. 3 (2009): Heidi Tribunella, op cit. 7 Robert N. Rapp and Eric S. Zell, "On the Road to IFRS in the United States," Banking & Financial Services Policy Report 28, no. 2 (2009): 6. 8 Joseph M. Langmead and Jalal Soroosh, op. cit., 18. Gatton Student Research Publication 44
4 More than 100 countries have already adopted International Financial Reporting Standards, including a majority of the economically developed nations. 9 Table 1 lists selected nations and their planned time to adopt IFRS. Table 1. Time of IFRS adoption for selected nations. Nation IFRS Adoption Brazil 2011 Chile 2009 China 2011 European Union Nations 2005 India 2011 South Korea 2009 Source: Robert Rapp 10 Several up-and-coming nations will adopt IFRS very soon, including Chile and South Korea who will finalize the transition this year. Brazil, India, China, and Japan plan to implement IFRS by Of all the transitioning nations, those in the European Union (EU) may offer the most compelling examples of IFRS adoption. The EU mandated in 2003 that its 7,000 publicly traded companies within member nations must adopt the international standards by To understand the huge scale of the multinational convergence in Europe, one must first understand that two types of national accounting standards were prevalent throughout individual nations before 2005: Code-law systems used throughout continental European nations like Germany and common law systems such as the one used in the United Kingdom. IFRS more similar to a common law system, nations like Great Britain found the transition less unsettling. 12 Similarities and Differences To understand the challenges of adopting International Financial Reporting Standards in the United States, it is important to understand both the similarities and differences between US GAAP and IFRS. From a broad perspective, both standards strive to provide relevant information to a wide variety of viewers to make decisions. 13 These users could include investors seeking to evaluate the profitability of a company s stock or managers seeking to study the performance of their industry competitors. Both IFRS and US GAAP promote financial reporting that allows users with a reasonable degree of understanding to compare data between reliable and easily understood format. Additionally, both sets 9 Joseph M. Langmead and Jalal Soroosh, op. cit. 10 Robert N. Rapp and Eric S. Zell, op. cit., Ibid. 12 Barry Epstein, "The Economic Effects of IFRS Adoption," CPA Journal 79, no. 3 (2009): Heidi Tribunella, op. cit., 33. Gatton Student Research Publication 45
5 of standards assume businesses are ongoing entities that strive to continue operations indefinitely and dictate account for transactions using the accrual method. This method states that various costs and revenues should be accounted for when they occur or are earned, not when cash actually exchanges hands. 14 These conceptual similarities suggest that US GAAP and IFRS are very similar in intention and purpose, but several key differences must be accounted for in the transitionary period. International Financial Reporting Standards are principles based guidelines that provide general guidelines on how to account for specific transactions. Because the guidelines are not laid out with definite steps for given transactions, accountants are required to exercise judgment in their work, creating increased risk for accountants as well as creating the possibility of inconsistency regarding different interpretations of similar events. In contrast to principles based IFRS, US GAAP provides strict rules for almost any possible transaction. Although US GAAP is more comprehensive than IFRS and leaves less to the judgment of individual accountants, it is much longer, more complex, and difficult to research than IFRS. 15 These conceptual differences present a broad picture of key differences between the two sets of standards. However, the similarities and differences regarding specific elements of the standards will require careful consideration from companies in this transitionary period. Financial Statements Given the purpose of providing useful information to a wide variety of users, the effects of adopting IFRS on financial reports must be addressed. Both US GAAP and IFRS require a balance sheet, statement of income, statement of cash flows, and notes to disclose any additional required information. These statements contain information regarding a company s assets, liabilities, equity, revenues and expenses, and use of cash for a given company. IFRS, however, requires an additional statement known as the statement of recognized income and expenses. Information included in this statement is typically just disclosed at part of the income statement under US GAAP, such that a separate statement is not necessary. 16 Differences between the standards typically result from divergent advice regarding the handling of specific types of transactions. For example, IFRS requires the inclusion of the previous accounting period s financial data in the format of each of the financial reports. While US GAAP does not specifically call for comparative data regarding financial information, the Securities and Exchange Commission mandates that US companies disclose statements of income for the previous two years and a balance sheet from the previous year. 17 This is a slight difference that, given the change from US GAAP to IFRS, may affect how certain users utilize financial report to evaluate how a company is performing from year to year. Another notable difference between the two accounting standards is the ability for a company to override a given rule. IFRS contains a true and fair override clause that allows a company to circumvent an IFRS rule if they can report a value that is more accurate than the IFRS method would 14 Joseph M. Langmead and Jalal Soroosh, op. cit., Heidi Tribunella, op. cit. 16 Ernst & Young, "U.S. GAAP v. IFRS: The Basics." _ey_us_gaap_v_ifrs_basics/2007_ey_us_gaap_v_ifrs_basics.pdf (accessed March 14, 2009): Heidi Tribunella, op. cit., 36. Gatton Student Research Publication 46
6 allow. A large European bank suffered major losses as a rogue employee scammed the company for millions of Euros. Although IFRS technically would call for these losses to be reported in 2008, when they were discovered, the bank announced it would reflect the losses in the 2007 reports retroactively. The override clause allowed the bank to more accurately describe when the losses were actually incurred by the company. US GAAP, on the other hand, has no such override. 18 It is worth noting that, for most transactions, US GAAP also tends to provide more comprehensive instructions for the accountant. Property, Plant, and Equipment Both US GAAP and IFRS allow long term assets, including items such as land and production facilities, to be accounted for on the balance sheets with their value calculated as original cost less a calculated amount for depreciation. However, IFRS also allows such long term assets to be valued at a fair market value. Under this method, the value of each long term asset must be periodically updated based on current market conditions for the given item. Thus, if property values fall in the general economy, companies reporting land using the fair value method will have to write down the value of land to reflect market conditions. IFRS does allow for write-downs to be reversed as part of this process, given that market prices for property, plants, and equipment rise. The ability for companies to value assets using a fair value system provides businesses with a notably different method of valuation than is allowed under US GAAP. The accounting standards also allow for different methods regarding the estimation of the useful life of buildings and equipment. The value of these buildings and pieces of equipment are typically reduced by a yearly depreciation expense calculated based on the estimated life of the asset. IFRS dictates that companies should annually reevaluate the estimated useful life of these assets, while US GAAP only calls for reevaluation if something signals to managers that the previous estimate may be invalid. Thus, companies in the United States may find that evaluating the useful life of equipment and determining depreciation is much more rigid under IFRS. Readers of financial reports should also understand how the valuation methods of long term assets are different under IFRS than US GAAP so that they make informed decisions. Inventory In contrast to the long term assets such as land or equipment, inventory is typically held for a relatively short period of time either for manufacturing process or for resale. US GAAP and IFRS both call for inventory to be valued based on its cost, but the specific methods differ slightly. IFRS dictates that inventory is valued at the lower of its cost or net realizable value. Net realizable value refers to the estimated amount of revenue that the inventory are expected to create for the company, or simply how much the company can expect to earn by selling it. 19 US GAAP, alternatively, calls for inventory value to be displayed on the balance sheet as the lower of cost or market value. Market value refers to the company s cost to replace the given inventory. This can be easily confused with the net realizable value used under IFRS, and it is important for managers and 18 Joseph M. Langmead and Jalal Soroosh, "International Financial Reporting Standards: The Road Ahead." CPA Journal 79, no. 3 (2009): Ernst & Young, op. cit., 10. Gatton Student Research Publication 47
7 accountants to ensure that financial data complies with all regulations. Attention to detail will be imperative to ensure that US companies are within the rules and regulations as US GAAP converges with IFRS. LIFO. Last-in-first-out inventory valuation (LIFO), a method permitted under US GAAP, is a method that companies often use during times of inflation to minimize the reported value of their held inventory and, ultimately income figures. This allows companies using LIFO to minimize their tax expense during a given period 20. FIFO. First-in-first-out (FIFO) inventory evaluation is a valuation method allowed by IFRS that is conceptually the opposite of LIFO. In this method, the accountant assumes that the oldest goods in inventory are the sold before more recent inventory items. In an environment with rising prices, FIFO will increase a companies reported inventory asset value. Furthermore, FIFO tends to increase earnings presented on the income statement, although this leads to increased tax burdens compared to LIFO. 21 Figure 2 presents Exxon Corporations inventory values under both LIFO and FIFO for comparison. Figure 2. Exxon s inventory value using LIFO and FIFO. Value in $million $40,000 $35,000 $30,000 $25,000 $20,000 $15,000 $10,000 $5,000 $ Year LIFO Inventory Value FIFO Inventory value Source: Georgia Tech College of Management 22 Clearly, the two methods produce drastically different results. International Financial Reporting Standards do not allow the use of LIFO, which is utilized by 36% of US corporations, usually seeking to minimize tax liabilities Georgia Tech College of Management, The Potential Consequences of the Elimination of LIFO as a Part of IFRS Convergence, (accessed March 18, 2009): Ibid. 22 Georgia Tech College of Management, op. cit., 16. Gatton Student Research Publication 48
8 Revenue Recognition Revenues statistics provides users of financial statements with important information regarding how a given business generates income through its normal activities. US GAAP and IFRS both strive to report revenue values that represent cash received, or expected to be received, that an organization earns through providing goods and services. 24 Although US GAAP and IFRS both seek to provide accurate information regarding revenue, differences in revenue recognition could result for companies adopting IFRS, as the methods contain key differences. US GAAP provides substantially more detail than corresponding areas of IFRS. For example, US GAAP contains specific provisions for recognizing the sale of software equipment or accounting for the sale of land. IFRS, on the other hand, offers only general guidance on transaction. Because of this, accountants are required to use individual judgment, which leads to the possibility of similar transactions being recorded in divergent manners. 25 Although international standards would be implemented with hopes of enhancing the comparability of financial data collected worldwide, IFRS does present a possible problem in that it allows key financial data to be presented based on individual accountants judgments. Conclusion The adoption of International Financial Reporting Standards in the United States will require the careful consideration of managers, accountants, and consumers who all rely of financial data to aid decision making. Conceptually, both US GAAP and IFRS strive to provide reliable and usable information to users. However, the relatively vague nature of principles based IFRS will require accountants to make more individual judgments and could allow for divergent practices. Specifically, the adoption of IFRS will result in noticeable changes in financial statement presentation, differences in valuation of long term assets and inventory, and different methods for revenue recognition. However, more than 100 nations have already overcome these challenges to implement IFRS, and the United States can observe these counties experiences to better understand the upcoming convergence. 23 Georgia Tech College of Management, op. cit., Ernst & Young, op. cit., Joseph M. Langmead and Jalal Soroosh, op. cit., 21. Gatton Student Research Publication 49
9 Bibliography American Institute of Certified Public Accountants. "International Financial Reporting Standards (IFRS)." (accessed March 14, 2009). "Brainy Quote." (accessed March 27, 2009). Epstein, Barry. "The Economic Effects of IFRS Adoption." CPA Journal 79, no. 3 (2009): Ernst & Young. "U.S. GAAP v. IFRS: The Basics." items/2007_ey_us_gaap_v_ifrs_basics/2007_ey_us_gaap_v_ifrs_basics.pdf (accessed March 14, 2009). Georgia Tech College of Management. The Potential Consequences of the Elimination of LIFO as a Part of IFRS Convergence. (accessed March 18, 2009). Langmead, Joseph M. and Jalal Soroosh. "International Financial Reporting Standards: The Road Ahead." CPA Journal 79, no. 3 (2009): Rapp, Robert N. and Eric S. Zell. "On the Road to IFRS in the United States." Banking & Financial Services Policy Report 28, no. 2 (2009): 1-6. Tribunella, Heidi. "Twenty Questions on International Financial Reporting Standards." CPA Journal 79, no. 3 (2009): Gatton Student Research Publication 50
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