Attn: The Corner Office – Why U.S. Firms Should Pay Special Dividends Before Year-End 2010

Current low tax rates on dividends, combined with low borrowing costs, represent an historic opportunity for U.S. firms, but the window is almost certain to close Dec. 31, 2010.

[powerpress: http://gsbm-med.pepperdine.edu/gbr/audio/fall2010/briginshaw-dividends.mp3]


Now that the New Year has arrived, read an update from Dr. Briginshaw in the GBR blog!


URGENT MEMO

Attn: The Corner Office

Dec 31 2010 calendarCurrent low tax rates on dividends, combined with low borrowing costs, represent an historic opportunity for U.S. firms to:

  1. Get funds into stockholders’ hands at low tax rates, which stockholders may then reinvest or spend.

  2. Replace equity (at a cost of capital in excess of 10 percent) with debt (at a cost of capital at or below 5 percent).

  3. Leverage up their businesses at low borrowing rates, to maximize interest tax-shield, drive increased efficiency, and position their stock for a period of sustained capital growth.

But the window is closing and dividend tax rates are almost certain to rise on December 31, 2010—possibly by as much as 160 percent.

Dividends: The Basics

Dividends are cash payments to a company’s stockholders out of current or retained earnings (accumulated surplus).  Once a dividend has been declared by a company, stockholders receive cash in proportion to their shareholding—and must pay tax on the dividends received. The effect on the company’s accounting is that assets (cash) and stockholders’ equity (retained earnings) decrease. A company’s board of directors has broad discretion to award dividends, provided the requirements of applicable state and federal law are met. In practice, this means that corporations with accumulated deficits (negative retained earnings on their balance sheet), or in situations where market value of assets is below debt outstanding, usually may not pay dividends.[1] Historically, dividends have accounted for the dominant part of the return on stocks.[2] As Chart 1 shows, dividend yields (defined as annual dividend divided by stock price) for index stocks have been declining over time (as stockholders hoped to rely on capital gains for more of their total returns), but likely changes in dividend tax rates from current levels of zero (for lower earners) to 15 percent (for higher earners), and the risk of excess cash being wasted by firms, suggest this should change. Some widely held dividend paying stocks are listed in Table 1.

Chart 1: Dividend Yield of S&P Composite Index (or Equivalent)







briginshaw-chart1

Source: Data from Professor Robert Shiller's Yale University Web site: www.econ.yale.edu/~shiller/data.htm







Table 1: Examples of high performing dividend paying stocks within the Dow Industrial Average







Sources: Yield (10/15/2010): http://online.wsj.com/mdc/public/page/2_3024-dowyield.html; Total Return (year to 10/26/2010): schwab.com (login required). Past performance is no indication or guarantee of future performance. Yields may go up or down.







Current Zero to 15 Percent Dividend Tax Rates are an Historic Opportunity

Current tax rates on dividends in the U.S. of between zero and 15 percent are remarkably low, especially when compared with the past. Before 2000, dividends were taxed as ordinary income, attracting a maximum tax rate of 39.6 percent. The tax rate then eased slightly over 2001-2002, before falling to the current 15 percent level in 2003. However, since the U.S. has a “classical” tax system, the pre-2000 situation was even worse than the 39.6 percent rate suggests. Under a classical tax system, dividends are taxed twice, since they are paid out of (already taxed) net income. If $100 of pretax income is taxed at 35 percent corporate rate, this leaves $65 of net income or earnings. If a company had paid this entire $65 to a stockholder as dividend pre-2000, 39.6 percent of the $65 would have been taxed at the personal level, leaving a paltry $39.26 for the stockholder. This is an effective tax rate in excess of 60 percent on the original $100 of income, and this is before state taxes of as much as 10 percent.  However, the real question is—how will current dividend tax rates compare to the future?

Dividend Tax Rates Will Likely Go Up in Less than Three Months

It is highly likely that dividend tax rates will rise on December 31, 2010 for some or all taxpayers. The current tax rates are a product of the Jobs and Growth Tax Relief Reconciliation Act of 2003 and the Tax Increase Prevention and Reconciliation Act of 2005—nicknamed the “Bush tax cuts.” The latter act extended the dividend tax rates to the end of 2010, but at that time the tax cuts will “sunset” (expire) and rates will revert to the pre-2000 levels.

Sidebar - background on sunsetting tax cutsAs this issue of the Graziadio Business Review goes to “press,” midterm Congressional elections are taking place, but these may have little effect, for three reasons. Firstly, the newly elected representatives will not take office until January 2011, leaving the “lame duck” 111th Congress as the only source of new law before the tax cuts actually expire—current Democratic party policy is to increase dividend taxes for high earners. Secondly, both parties, confronting horrific budget projections due to ballooning entitlement spending, have a hidden incentive to allow the tax cuts to expire. Thirdly, since the likely outcome of the election is to enhance the Republican position in both houses, the Republicans—looking forward to the 2012 Presidential vote—have a more obvious incentive to “reluctantly” fail to find common ground with the their Democratic colleagues come January 2011, fail to reverse the expiration of the tax cuts, and then try to stick the blame on Obama in November 2012 for the resulting $3-trillion tax raise.

This would mean that dividends will again be treated as ordinary income, resulting in an income tax rate of 39.6 percent for those at the top rate.  As The Wall Street Journal notes, in addition to the 39.6 percent rate, a Medicare supplement of 3.8 percent will also be payable by highest income taxpayers (effective 2013) to pay for the recent “Obamacare” healthcare changes.[3] This means an increase of 160 percent in the tax rate (or 189 percent including the Medicare levy). Obama has proposed that Congress instead adopt a 20 percent dividend rate (33 percent increase), but this has not been taken up by the 111th Congress, even though Democrats have majorities in both houses (albeit a narrow one in the Senate). The best case for stockholders might be for the Republicans to score enormous victories in November 2010 and feel a duty to act to decrease taxes. Looking at the Senate, 37 seats are up for election—34 due to the regular six-year cycle and three special elections.  Of those 37 seats, 19 are Democratic and 18 are Republican. Since the Republicans currently have 41 Senate seats, they must win all 19 Democratic seats to secure a filibuster-proof majority (required for them to take action without some Democratic support) of 60 seats in the Senate. Even if the Republicans did score a notable victory, unfunded tax cuts might run up against concerns that government live within its means, as advanced by the “Tea Party” movement and other groups.

Personal Tax Planning Considerations have Reversed and Corporate Borrowing is Accessible at Low Rates

In order to provide further support for the case for paying substantial dividends now, let us deal with the traditional arguments against such payments. Firstly, the tax-planning argument for deferring the recognition of income or gains is predicated on the likelihood of taxpayers facing lower income tax rates in retirement, due to lower incomes. This loses force for two reasons—firstly, the likely reversion of dividend tax rates to 39.6 percent in the short term and, secondly, the high probability of increases in tax rates in the medium term due to rising budget deficits. Because of the influence and voting power of older voters and the benefits they gain from entitlement programs, Congress is less likely to solve the spending problem than the revenue problem, although both are uncomfortable to confront (Congress may solve neither problem!). Taxpayers (and by extension, directors considering dividend levels) who rely on the traditional tax-planning view must reckon on tax liability being a combination of likely lower income levels in retirement, together with almost inevitably higher tax rates. Finally, low 401K balances for many U.S. workers  will necessitate longer working lives, thus decreasing the number of years where the putative lower incomes will occur.[4][5]

Secondly, the cash conservation and signaling arguments against paying large dividends are mitigated by the low interest rates, at which creditworthy firms can borrow and the alternative of characterizing the payments as special dividends. Firms may balk at paying out cash because they wish to maintain financial flexibility and to protect against the possibility of a liquidity crisis. However, with cash reserves at high levels (see Chart 2), low gearing ratios that suggest plenty of borrowing capacity (see Chart 3), and borrowing rates that are close to their lowest levels since records began, such firms can maintain financial flexibility by borrowing to fund the special dividends and adding additional borrowing to maintain flexibility and fund new projects (see [6] and Chart 4). Firms can also avoid signaling that the dividends will be continued in subsequent quarters by paying these dividends on non-standard dates and making clear in other ways that they are special dividends—one-off events in response to exceptional circumstances.

Chart 2: Cash as a Proportion of Total Assets for U.S. firms in the S&P Compustat Database







briginshaw-chart2

Source: Compustat/WRDS







Chart 3: Debt divided by Equity for U.S. firms in the S&P Compustat Database







briginshaw-chart3

Source: Compustat/WRDS







Chart 4: 30-year corporate (Baa rated) bond rates ( percent)







briginshaw-chart4

Source: Moody's/Federal Reserve St Louis







Paying Dividends is Good for Business

Funding large special dividends with borrowed cash has two positive effects on firms. Firstly, because interest payments are tax-deductible, it reduces the tax bill for firms. However, since dividends are taxable at a higher effective rate (being double taxed), this tax benefit does not of itself justify the transaction. However, other benefits occur when companies take on debt, as laid out in the Jensen “Free Cash Flow Hypothesis” proposed by Harvard Business School Professor Michael Jensen. Jensen hypothesized that firms with large amounts of free cash flow tend to waste it on unprofitable investments or even perks, such as company jets.[7] Debt payments tend to “tie managers’ hands” and force them to be more frugal, to the benefit of profitability. Also, a higher proportion of debt at current rates may decrease weighted average cost of capital, allowing firms to take on more marginal projects and make higher abnormal return from existing projects. This is due to the risk premium on corporate debt having fallen faster than the risk premium on equity (possibly due to a “bubble”” in debt values).[8]

Paying Dividends May Dominate Buybacks in this Environment

If companies wish to return resources to stockholders, stock buybacks or repurchases are both alternative methods to dividends. Buybacks have advantages over dividends in that stockholders who do not wish to receive any resources from the company—either for tax reasons or because they wish to maintain or roll-up their position in the stock—will not receive any benefit or tax liability until they sell. Also, stock buybacks have often been seen as a way of management showing confidence in their company, by buying when share prices are low.[9] However, the effectiveness of stock buybacks requires some current stockholders to sell at these “low” price levels—introducing a conflict between current and future stockholders: buybacks can be seen as slightly favoring future stockholders, whereas management is accountable (as agent) to all owners, not any one class. Also, as Warren Buffett has pointed out, stock option holders, including management, gain clear advantages from buybacks whereas they gain nothing from dividends—introducing a potential incentive for self-dealing in the timing of buybacks.[10] Furthermore, even if management does resist the temptation to self-deal in timing buybacks, they may be unable to successfully “time the market” with their buybacks. In the event that funds are used for buybacks and then the market for the stock falls (either due to company or market-wide factors), then those funds have not added any obvious value to the stockholder. Although, in the long term, buy-and-hold stockholders will gain from securing a larger share of corporate dividends and earnings, management and shorter time-horizon stockholders will see no immediate benefit and the cash will appear to have been wasted. This will tend to dissuade management from executing buybacks at times of market uncertainty, which is unfortunate because these may be times of opportunity and low stock prices. No such problems occur with dividends. Dividends benefit all stockholders equally, give no advantage to insiders and retain their value (once paid), irrespective of stock price moves. With the current (pre-December 31) tax structure and the uncertainty as to stock market direction, dividends are as attractive a method of returning funds as they have ever been. Stock buybacks certainly remain a useful tool in corporate finance and will have their time, but the time for dividends is now.

For Some Classes of Firms, Paying Dividends is Especially Attractive

Paying dividends now will be most attractive for companies that have lower institutional shareholdings, companies that have plans to pay dividends and have the resources to pay the dividends early, and closely-held C-corporations that have a business-related need to make distributions and that have exhausted more tax-efficient distribution avenues.

Institutional shareholdings include holdings in tax advantaged funds, such as 401Ks and IRAs—since dividend payments to these entities are tax sheltered or tax deferred, dividend tax rate does not have an obvious effect on wealth for holders of these funds. These stockholders will therefore be indifferent between receiving dividends now or later, and will not wish management to expend time on the issue. However, it should be noted that institutional shareholdings also include taxable mutual funds, ETFs, hedge funds, and corporate trading vehicles, all of which will be exposed to any change in tax rates.

There is a clear incentive for a firm planning to pay a dividend on January 1, 2011 to pay it instead on December 31, 2010, to ensure that the zero to 15 percent rate is applicable. However, for firms with a long established dividend policy, why not go further? The next three or more years of regular dividends could be rolled up into a special dividend, funded with cash reserves and (if needed) three-year bonds, which for AA-rated firms can be issued at less than 2 percent yield. This would be justifiable in a business sense, as it would constrain the firm’s management from un-needed spending in accordance with the Jensen “Free Cash Flow Hypothesis” discussed above. It would also  eliminate portions of the unproductive cash reserves that businesses are currently holding (see Figure 1). Finally, dividend paying firms will already have attracted a clientele of stockholders whose tax or other circumstances favor dividend payment.

The low dividend tax rates have long been thought of as advantageous for closely held C-corporations.[11] Also, in the past, the IRS has indirectly encouraged small firms to pay dividends by imposing an Accumulated Earnings Tax on retained earnings beyond the firm’s “reasonable needs.”[12] For these firms, if a distribution is being considered and makes sound business sense, now is the time. Closely held firms have an advantage over large public companies in that, while it is difficult for large firms to survey stockholders about whether dividends are attractive to them, closely held firms have a small shareholder base that enables them to do this. However, firms should not perform large dividend payments solely for tax reasons, and uneven usage of dividends versus traditional methods of compensation, such as bonuses, may not survive IRS scrutiny. Also, it should be noted that smaller closely held firms may have more difficulty in borrowing funds than large firms with high credit ratings, and thus may need to fund dividends with existing cash reserves.

While the Accumulated Earnings Tax (AET) is most often applied to small firms, is also applicable to public companies.[13] Note also that the AET rate tracks the tax rate on dividends. The IRS’ incentive to pursue public companies for AET will markedly increase if dividend tax rates rise. As can be seen from Chart 2, publicly traded companies are holding increased amounts of cash. One well-known example is Apple Inc., with cash and marketable securities of more than $40 billion.[14] Apple and other similar firms may be a tempting target for the IRS once tax rates have risen. In other words, companies that do not pay dividends (perhaps out of desire to avoid or postpone taxes), may be forced to disgorge the applicable tax anyway, and at a higher tax rate.

Note that, for S-corporations or for non-incorporated businesses reporting on IRS Schedule C, tax is on income, and distributions such as dividends do not affect tax. These businesses will not see any change in tax liability from the dividend tax increases.  Also, companies that have to repatriate cash from foreign subsidiaries to pay the dividends may have to pay additional taxes on the cash remitted to the U.S.[15]

Pay Dividends Now

Not paying dividends now shows admirable trust in our government to come up with a sensible solution to the problem of dividend tax rates. The best case is that the current dividend rate will persist. More likely, tax rates will rise for some or all taxpayers. And for dividend tax rates to rise by 160 percent, all Congress has to do is … well, nothing. Also, the option of waiting to pay dividends may not be available for long. Projected budget shortfalls and an increased rate of dividend tax (and therefore a higher rate of Accumulated Earnings Tax) will increase the incentive for the IRS to force payment of AET on company cash reserves where earnings have been retained beyond “reasonable needs.” U.S. businesses should anticipate the likely outcomes and, for the good of stockholders and their firms, pay substantial dividends now.

Many thanks to Professor Michael Kinsman, Professor Darrol Stanley and an anonymous reviewer for their helpful comments prior to the publication of this article.



[1] Donald A. Loft, “Wrongful Corporate Cash Distributions Under Delaware and Georgia Law,” (Position Paper), Morris, Manning & Martin, L.L.P. (Atlanta, Georgia), 11/17/2006.

[2] Robert Shiller, Irrational Exuberance, (Princeton, NJ: Princeton University Press, 2000), 13.

[3] Paul Sharma, “Eating Into Apple’s Cash Pile,” The Wall Street Journal Online, April 9, 2010.

[4] Liz P. Weston, “The Basics: 5 critical fixes for 401(k) plan,” MSN Money.

[5] Penelope Wang, “Beyond the 401(k): Seniors must work longer,” CNN Money, Sept. 15, 2010.

[6] Daniel Kruger, “Swap Rates Show Borrowing Costs for Five Years Lowest on Record,” Bloomberg, Aug. 18, 2010.

[7] Michael C.  Jensen, “Agency costs of free cash flow, corporate finance, and the market for takeovers,” American Economic Review, 76, 1988: 323-329.

[8] Jeremy Siegel and Jeremy Schwartz, “The Great American Bond Bubble,” The Wall Street Journal, August 18, 2010.

[9] Peter D. Easton, John J. Wild, Robert F. Halsey, and Mary Lea McAnally, Financial Accounting for MBAs, 4th edition, (Westmont, IL: Cambridge Business Publishers, 2010), 9-7.

[10] Buffett, Warren E., Chairman’s Letter – Berkshire Hathaway Inc, 2006: 16. Available at http://www.berkshirehathaway.com/letters/2005ltr.pdf.

[11] Phillip J. Korb, John N. Sigler, and Thomas E. Vermeer, “Dividend Tax Rate Cuts Benefit Closely Held Corporations,” The CPA Journal, October (2004): 40.

[12] Internal Revenue Service, “Alternative Earnings Tax,” Publication 542: IRS.gov.

[13] Ralph Nader and James A. Love, Public Letter to Bill Gates regarding Microsoft Non-Payment of Dividends, Consumer Project on Technology (Washington, D.C.), 1/4/2002. Retrieved from http://www.cptech.org/ms/rn2bg20020104dividend.html.

[14] “The Dividend Tax Bill Arrives,” Review and Outlook (Editorial), The Wall Street Journal, April 29, 2010.

[15] Tom Braithwaite, Helen Thomas and Jeremy Lemer, “Companies in appeal for US tax amnesty,” Financial Times, October 18, 2010.

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What Will The International Financial Reporting Standards (IFRS) Mean to Businesses and Investors?

On August 27, 2008, the Securities and Exchange Commission (SEC) announced a roadmap for a complete change in U.S. accounting standards. If the roadmap is adopted, U.S. companies will have to change from the country’s existing accounting rulebook to International Financial Reporting Standards (IFRS) in 2014. Under the SEC plan, some very large firms (most likely multinationals) may adopt the new standards as early as 2009. While in recent weeks market turmoil has grabbed headlines, the underlying change in accounting rules could have a deeper and longer lasting impact. If the change goes well, it could usher in easier access to capital for U.S. and foreign firms, lower the costs for U.S. firms operating overseas, and simplify accounting for companies worldwide.

Critics of the switch point to weaknesses in the international standards; for example, they do not provide detailed enough guidance to companies, they may allow managers more potential to manipulate earnings, and they may increase costs and create confusion for businesses. This article examines whether the changeover is likely to happen, and if so, what it will mean to U.S. and foreign firms.







Photo: MBPHOTO







What are the new standards and how have they evolved?

International Financial Reporting Standards (IFRS) were developed by the International Accounting Standards Committee (IASC) and its successor organization, the International Accounting Standards Board (IASB). Because of the standards’ identification with these bodies, IFRS is sometimes referred to as IAS GAAP. A note about terminology: Generally Accepted Accounting Principles (GAAP), either U.S. or IAS, are a set of documents that specify the accounting principles and guidelines that companies use to prepare their financial statements, which are the main way companies communicate with their investors and other stakeholders. GAAP documents give guidance on what component statements should be shown within the published financial statements, how the figures in the financial statements should be calculated, and what notes and additional details should be included.

Although it seems like a major step to replace one set of accounting principles with another, it should be noted that any GAAP is a constantly evolving set of principles. Over the last 10 years, U.S. GAAP has seen complete rewrites in the accounting for mergers and acquisitions and in the accounting for derivatives and hedges, as well as major changes in 28 other areas.

Will the Roadmap Happen?

The SEC has been fairly aggressive in pursuing a convergence agenda thus far. Since November 2007, the SEC has allowed foreign firms to report under IFRS only, without requiring any U.S. GAAP adjustments, a move estimated to have saved affected firms as much as 2.5 billion Euros over time.[1] To be fair, requiring foreign firms to supply less data is never going to foment much opposition. The next stage actively compelling U.S. firms to change their reporting method will be more difficult to achieve.

For investors, the new standards will require an adjustment in how they interpret earnings numbers. For government, it will require ceding some regulatory power to an international body. The gain will be improved access to international capital; however, this is no benefit to the many smaller firms uninterested in international capital, which, in any case, is a difficult benefit to quantify. Adopting IFRS will also require businesses to conduct a one-off reworking of accounting records (at an administrative cost), and it may increase corporate tax payments, due to the “last in, first out” (LIFO) conformity rule, which will be discussed below. Companies with multinational operations will benefit by saving on the ongoing costs of annually converting their foreign reports to U.S. GAAP, but purely domestic companies will have no such countervailing benefit.

With many participants in the process quite committed, change looks more likely than not. But the political process, including the forthcoming general election, may delay or even halt the transition. The SEC’s roadmap includes one obvious “get out” clause: the commission will decide in 2011 whether convergence is “in the public interest and would benefit investors.”[2]

How Will IFRS Differ from U.S. GAAP?

Principles over Rules

IFRS is characterized as more “principles based” than U.S. GAAP, which is seen as largely “rule based.” However, it should be noted that any GAAP is, by definition, a set of principles. U.S. GAAP gives substantial discretion to managers in determining the assumptions behind their accounting statements, even on such basic items as depreciation timescale and inventory costing methods, decisions that can influence annual income by hundreds of millions of dollars for large firms.

The age of U.S. GAAP (resulting in a larger body of policy than that of the younger international accounting standards organizations) and the voracious appetite of U.S. accounting practitioners for official guidance and clarifications of standards (principally as an insulation against liability in the highly litigious United States) are responsible for much of the rule-based characteristics of U.S. GAAP. If IFRS is adopted in America, the demand for guidance will likely not abate. As companies seek guidance on specific situations, standard-setters may feel pressured to expand the IFRS rulebook, thus eroding its principles-based nature. It may also create additional demand for accountants and accounting experts.

Similarities and Differences

Although there is much discretion in U.S. GAAP and IFRS, there are some marked distinctions that will force different treatments on U.S. companies, or make new methods available to U.S. firms. Some of these changes are discussed below note that this is intended to be a representative sample of differences rather than an exhaustive list of the differences between the two sets of standards. Citigroup reports there are as many as 426 total differences,[3] but in many areas there is little divergence. For example, the issue of the marking to market of financial assets (especially hard to value assets such as mortgage backed securities) is one area that has attracted attention in the current credit crisis, but the IFRS standard (IAS 39) is similar to the U.S. GAAP standard (contained in FAS 157, FAS 133, and others). (Incidentally, both standards are being relaxed or “reinterpreted” see Clarifications on Fair Value Accounting and EU Relents on Some Mark-to-Market Accounting.)

Inventory Valuation Conventions

The most frequently discussed difference between IFRS and U.S. GAAP is in the treatment of inventory costing. U.S. GAAP allows the LIFO assumption, which expenses the most recently purchased inventory (last in) as a cost of goods sold expense first (first out), to be used for inventory costing. As prices tend to rise in most industries, this practice results in a high cost of goods sold expense, thereby depressing profits. Nonetheless, most U.S. companies use the LIFO method because it conveys tax advantages, and due to a unique “conformity rule” if the company uses LIFO in tax accounting, it must also use the harsh method in financial accounting. Under IFRS, LIFO is not allowed at all. Unless the SEC seeks an exception for U.S. firms something which the U.S. Financial Accounting Standards Board has advised against or unless the U.S. Internal Revenue Service scraps the conformity rule, U.S. companies will be forced to discontinue LIFO. While the result will be increased net income, it will ultimately be a disadvantage to stockholders because companies will be charged more corporate taxes. This tax penalty could be in the hundreds of millions of dollars for some large industrial firms and is seen as a major impediment to IFRS adoption.

Discretion in the Valuation of Assets

IFRS gives management more discretion in the area of asset valuation as a whole discretion that is also likely to increase company income. In the area of research and development costs and the related area of homegrown intangible assets valuation, IFRS is more generous than U.S. GAAP. IFRS allows development costs, but not basic research costs, to be included in the company’s assets and, therefore, not expensed against income. U.S. GAAP insists that all research and development costs are expensed, except in extremely limited industry-specific circumstances.

Additionally, under U.S. GAAP, writing assets down due to “impairment” (i.e., permanent decreases in value), is a one-way process. Once written down, there is no way that an asset can be written back up, even if economic or industry circumstances improve. IFRS, on the other hand, does allow write-ups, and allows them to benefit income. Moreover, under U.S. GAAP, an acquired asset can never be increased in value as a result of market appreciation. In contrast, based on a long-lived but rarely used UK GAAP convention, IFRS allows assets to be written up in line with market values, as long as the revaluation is carried out with regular frequency. However, the increase in book value does not represent an increase in net income. With IFRS, there is also flexibility in many areas of standard setting, whereby more than one accounting treatment is allowed, although usually, only one treatment is described as the preferred or “benchmark” treatment.

Effect on Income

In many areas, IFRS is less conservative than U.S. GAAP, meaning that it allows an increase in the risk of overstating income in a company’s financial statements. IFRS also allows more flexibility than U.S. GAAP, and since bonus and stock option schemes usually give managers incentives to increase income, this flexibility likely will be used to increase income more often than it will be used to decrease income. It is important to note that income is always an estimate, based on management judgments such as the useful life of long-term assets, the expected losses from bad debts, the expected costs of warranties, and the diminution of large assets such as the value of equipment and the value of accounting goodwill. It can be argued that the income estimate under U.S. GAAP has no more intrinsic validity than the estimate under IFRS. However, setting aside the question of intrinsic validity, it is fairly clear that switching from U.S. GAAP to IFRS will lead to many companies reporting higher income numbers, even while holding cash flows constant. European companies quoted on U.S. markets provide a natural laboratory since they were required to report in both U.S. GAAP and IFRS until very recently. Citigroup London analyzed 73 of the largest European companies quoted in the U.S. and found that 82 percent of the firms reported higher income under IFRS than under U.S. GAAP.[3] [4]







Photo: peepo







Effects on Investors

Looking at these findings, the adoption of IFRS would seem like great news for investors. But this is not the case. Remember, these European companies were reporting two different income figures based on the same financial year, that is, based on the same economic activity and cash flows. The question of which income number is the “true” estimate of underlying profit is irrelevant to some extent. Investors used to analyzing U.S. GAAP income will have to adjust and discount IFRS figures: one additional dollar of IFRS profit indicates slightly lesser incremental economic health and, if the underlying assumptions of accounting are accepted, slightly lesser ability to pay down debt and pay dividends in the future than one dollar of income calculated under U.S. GAAP.

Apart from magnitude, the second useful facet of income numbers is change. Earnings volatility, often minimized by earnings management techniques that are legally dubious, is an important signal to investors of a company’s underlying health. Annual income numbers should reflect the economic performance of the company in that particular year. The pre-IFRS GAAP of many European countries often allowed companies wide latitude to manage earnings and show a smooth pattern of earnings change from year to year that hid changes in company performance investors may have wanted disclosed. Although IFRS has substantially changed those practices, more latitude remains than under U.S. GAAP. This has a deleterious effect on how useful IFRS reports are to shareholders. Research shows that European companies’ IFRS reports, although more informative than pre-IFRS GAAP reports, are less informative than U.S. GAAP reports for the same firms,[5] because IFRS reports show smoother earnings, show less correlation between reported earnings and cash flow, show less timely loss recognition, and crucially, show less association between reported earnings and firms’ stock prices.

But They’ve Come Such a Long Way

Perhaps rumors of U.S. GAAP’s death have been exaggerated. But it is worth noting that 20 years ago, a unification of U.S. standards and Western Europe’s tax-based, low-information-content financial statements would not have been considered. In fact, the actions of a small coterie of accounting regulators effectively exported the “Anglo Saxon” concept of an economic-performance-based, decision-relevant, dual-books accounting system to the world. The IASB now has just under 100 member countries, but management has been tightly concentrated. Between 1973 and 2001, seven of the 12 IAS chairmen came from just three countries[6] (three from the UK, two from America, and two from Australia) and, since 2001, UK-based IASB Chairman David Tweedie has served uninterrupted. The important executive position of secretary/secretary general has been even more tightly controlled with all but one of the secretaries coming from the UK, America, or Australia.[7] Accountants from these three countries do not agree on everything, but there is enormous common ground amongst practitioners and academics on what the aims of a financial accounting system should be. That common ground may be summed up as follows:

  • A financial accounting system should aim to provide information on how well the company is doing (economic performance) and help investors in their resource allocation decisions (decision relevance).
  • If the tax authorities or governments require information for their legal or revenue-raising purposes, this should be accomplished by a separate system (dual books).

These concepts are central to IFRS, but they were not generally accepted by all countries until quite recently. The United States will grapple with substantial change if it adopts IFRS, but for many IASB member countries, including Japan, Germany, and France, the past few decades have already brought changes beyond recognition to their accounting standards, changes that bring them much closer to U.S. GAAP.

Delivering the Promise of Convergence

It would be a pity if the United States backed out of the convergence process after being intimately involved in the process over the last 30 years. For U.S. firms seeking foreign capital and U.S. firms operating overseas, convergence is a promising prospect. Many IASB member countries have undoubtedly favored convergence based on the prospect of gaining access to large U.S. capital markets a carrot that has been implicitly dangled in front of them based on U.S. involvement in the process over the years. Even in the markets’ current weakened state, convergence remains a substantial benefit to foreign firms.

However, the U.S. is likely to act based on its own self interest in this key economic decision. Also, IFRS is unlikely to be adopted in the U.S. without some solution to the LIFO problem, and an assurance of the continued primacy of the SEC in regulating U.S. securities markets.

Read more about why caution should be exercised in relying on foreign issuers’ IFRS-compliant financial statements here.


[1] Penny Sukhraj, “EU May Have to Accept US GAAP next year” Accountancy Age, November 27, 2007. (no longer accessible).

[2] U.S. Securities and Exhange Commission. “SEC Proposes Roadmap Toward Global Accounting Standards to Help Investors Compare Financial Information More Easily.” press release, August 27, 2008.

[3] David Jetuah, “Citigroup Lays Out IFRS-US GAAP gulf” Accountancy Age, August 30, 2007. (no longer accessible).

[4] Jack Ciesielski, “IFRS & GAAP: The Urge To ConvergeThe Analyst’s Accounting Observer, 17, no. 4, March 26, 2008.

[5] Mary E. Barth, Wayne R. Landsman, Mark H. Lang, and Christopher D. Williams, “Accounting Quality: International Accounting Standards and U.S. GAAP” working paper, University of North Carolina and Stanford University, 2006.

[6] IAS Plus, International Accounting Standards Committee History, http://www.iasplus.com/restruct/iaschistory.htm.

[7] Kees Camfferman and Stephen A. Zeff, Financial Reporting and Global Capital Market: A History of the International Accounting Standards Committee 19732000, (New York: Oxford University Press, 2007).

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