Although the U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have been moving toward convergence of their standards, as part of the Norwalk Agreement, the SEC’s recent statement is a significant step forward in the process. It signals that U.S. preparers and users of the financial statements of domestic and foreign companies are likely to become more involved in international accounting issues.
There have been various pressures and issues leading to the SEC decisions, and it has been argued that high-profile American corporate scandals precipitated a shift in U.S. accounting authorities’ views on the best basis for accounting regulations.[2]The result was a move towards the principles-based approach, espoused by the IASB, as opposed to the current U.S. rules-based standards. However, this raises two important questions:
- What are the implications of recognizing foreign issuers’ IFRS statements for those in the U.S. who analyze such statements or those who have subsidiaries, branches, or associates in IFRS regimes?
- In the future, will domestic issuers file IFRS-compliant financial statements, and if so, when, and what will be the procedure?
IFRS Adoption Varies By Country
It is important to remember that the IASB is only a standard setter and it does not have monitoring or enforcement powers. The decision to adopt IFRS either fully or modified is the responsibility of individual countries. The IASB has no part in that process, and national practices often vary with a lack of comparability in financial statements. There is an International Financial Reporting Interpretations Committee, but its role is to consider the substance of standards, which result in unacceptable or divergent practices, and not to consider the problems of individual countries and entities.
The non-involvement of the IASB has led to a complex and variable pattern in the process of establishing IFRS in individual countries. For example, the European Union adopted IFRS for all listed companies publishing consolidated accounts; however, the EU routinely endorses standards before they are adopted, and this led to amendments, limited in time and scope, to IAS 39.[3]
Recent evidence also demonstrates that the degree of IFRS compliance in EU countries is variable.[4] The EU also allows member countries the option of either permitting or requiring IFRS to be applied to non-publicly traded companies and to annual individual entity accounts, i.e., non-consolidated regardless of whether the company is trading on a regulated market in the UK. Consequently, the UK permits such companies to use IFRS; Malta and Cyprus require all companies to use IFRS; Poland and Portugal do not permit individual entities, whether traded or not, to use IFRS; and several countries either require or permit IFRS use for financial institutions, such as banks and insurance companies. This tapestry of regulations makes it difficult for U.S. companies operating in the EU.
Australia did not follow the EU’s approach; it modified some of the standards to meet its needs, while some information was still reported under the old Australian standards, due to a lack of equivalent IFRS.[5] These differences weakened the main benefit of IFRS, international comparability, and led Australia to rethink its strategy.
In 2006, the Canadian Accounting Standards Board adopted IFRS, taking the position that all publicly accountable entities will adopt IFRS for financial statements issued on or after January 1, 2011.[6] As far as private companies are concerned, Canada plans to set its own standards, which will not be linked to IFRS.
In addition to Canada, India and Korea will adopt IFRS in 2011. China is attempting to move toward IFRS with its new Chinese Accounting Standards, but it faces several challenges. China has a long tradition of financial concepts and practices that do not fit easily into the IASB approach. In addition, there are an insufficient number of accountants with the necessary knowledge, and the financial infrastructure is still very immature.[7] Nonetheless, China is continuing to make progress, and several Chinese companies listed on the New York Stock Exchange are issuing financial statements that are compliant with IFRS.
This brief review of some major developments demonstrates that caution must be exercised when using foreign companies’ financial statements. If for listing purposes the SEC has accepted those statements, the user is assured that they are fully IFRS-compliant. In other instances, it is important to examine:
- The particular country’s policy on the extent of IFRS adoption, including considering whether certain entities’ use of IFRS is mandatory or simply permitted.
- The status and the experience of the auditing profession in that country.
Once users are satisfied on these issues, the financial statements can be used with confidence.
IFRS and the U.S.
For several years, America has been going through a process of convergence with IFRS. In October 2002, the FASB and the IASB announced the issuance of a memorandum of understanding, the Norwalk Agreement, in which the two bodies agreed to:
- Undertake a short-term project aimed at removing a variety of individual differences between U.S. GAAP and IFRS,
- Remove other differences between U.S. GAAP and IFRS by working mutually and concurrently on discrete substantial projects,
- Continue progress on current joint projects, and
- Encourage their respective interpretative bodies to coordinate their activities.
Rules versus Principles
While progress is being made, there are substantial issues yet to be resolved. For example, although there is considerable agreement on technical issues, wildly differing fundamental philosophies result in a major debate concerning “rules versus principles.” A principles-based system is heavily dependent on the use of concepts, which can get fuzzy around the edges because concepts are often culturally and contextually derived. As Lenihan and Hume point out: principles require contextualizing.[8] While a rule is expressed in a certain setting and does not require further explanation or interpretation, “principles can be interpreted differently in different situations, but doing so requires judgment, which can be controversial.”[9] Instructing one’s broker to “buy low and sell high” is an example of the principle approach, which places the onus of judgment on the broker to determine what is high and what is low. On the other hand, one can instruct one’s broker to sell holdings in a certain company when the market price is above $20.00 per share. That is a rule.
The phrase “accounting principles” has long caused some problems in the United States. In 1939, the Committee on Accounting Procedure of the American Institute of Accountants, in the absence of any standard-setting body, started to issue statements on accounting principles. Alarm bells sounded and the Wheat Committee weighed in with this judgment: “Accounting principles have proven to be an extraordinary elusive term. To the non-accountant (as well as to many accountants) it connotes things basic and fundamental, of a sort that can be expressed in a few words, relatively timeless in nature, and in no way dependent upon change fashions in business or in the needs of the investment community.[10] With such misgivings, it is not surprising that the term “principles” was abandoned, and with the establishment of the FASB in 1972, the phrase “accounting standards” was adopted.
This was not just a change in terminology but also, with the establishment of the FASB, a change in philosophy and a move towards more prescriptive pronouncements. Gorelik has argued that the environment confronting the FASB has been less favourable than for standard-setters in other countries.[11] In a critical environment, the FASB has had to establish a compact organizational structure and an extensive due process; therefore, the standards it has produced have been much more detailed than those in some other accounting regimes.
While the FASB has stated its willingness to move to a principles-based approach, the problem in making the switch is that one is not comparing two technical systems, but two different mindsets. This raises difficulties in explaining the detailed advantages of one approach over another. The reasons for preferring principles over rules are not always cogently argued. K. Wild, the partner responsible for International Financial Reporting for Deloitte and Touche worldwide, expressed it best: “Tax legislation, for example, is based on rules and is dead easy to get around. Principles-based standards are much harder to avoid.”[12]
Academic evidence appears to support that contention. Duchac, in an investigation of consolidation rules for special purpose entities, concluded that detailed rules have driven out professional judgment, resulting in decisions that have been consistent with the rules but inconsistent with the principle of providing the most useful financial information.[13] Mano and Mouritsen drew similar conclusions in their examination of the FASB’s attempt to measure the expense of stock options. They argued that rules “allow some to stretch the limits of what is permissible under the law, even though it may not be ethically or morally acceptable.”[14]
Although academic evidence indicates the advantages of a principles-based approach in certain settings, there is no denying that those countries adopting IFRS for the first time are confronting practical problems. In a study of Taiwan’s move from FASB standards to IASB standards by the author and Ong, one senior regulator stated that he believed that, in IASB standards, the same word appeared to have different meanings in different paragraphs.[15] In such circumstances, there is a strong temptation to turn to the precision of rule-based standards and the specific examples given in such standards.
The FASB and the IASB have been engaged in an elaborate dance to find a solution to the rules versus principles dilemma. Although leading speakers in America publicly espouse a principles-based approach, they are aware that their sentiments are not shared by all, and possibly not shared by the majority.
The shifting positions on both sides are leading to discontent among various constituents. On the U.S. side, some are arguing that the robustness of the rules approach is lost and that the process of introducing a principle-based approach is not worth the supposed benefits. Many countries, which have adopted IFRS as they are now worded, argue that no further concessions on a rules-based approach should be granted the United States, and it simply needs to make a decision on adoption.
Although such a decision is in the making, it may not occur until 2014. While that may seem to be the distant future, other countries’ experience suggests that a five-year period of preparation is required. Hence, preparations should commence in 2009, even though the final decision will not be taken until 2011. There is a danger that the IASB and those countries already using IFRS may decide that they will not wait and that the prolonged period of U.S. convergence has run a full course.
Conclusions
Increased adoption of IFRS, along with the SEC’s agreement that foreign issuers can file fully compliant IFRS statements without reconciliation, leads to two main questions in the U.S. First, what is the degree of confidence in analysing and using IFRS financial statements? Regarding fully compliant statements, there should be no problems, but the user must be aware that there are differences in approach to certain accounting transactions and events.
A risk lies in using financial statements, when it is not immediately evident that they are fully compliant. Due process must be carried out to assess the foreign country’s strategy on adoption, the particular company’s policies, and the status and the experience of the auditing profession in that country. Caution is of utmost importance.
The second question concerns the future position of domestic issuers in the U.S. Although the FASB and the IASB have been working together on the convergence process, there have been delays and difficulties. A major issue revolves around the two different mindsets regarding standard setting: rules- or principles-based standards. The FASB’s and the SEC’s public announcements suggest that a principles-based approach is acceptable, but there is unspoken recognition that this change could be too drastic.
The SEC’s recent announcement indicates that there is an apparent willingness towards conversion of U.S. GAAP with IFRS, but the intent is not unambiguous. A final decision will be made in 2011, and if IFRS are accepted, the change will take place in 2014. That is a very tight timeline, but not pursuing convergence would make the U.S. one of the few major countries in the world that is not using the international language of accounting.
Read more about what IFRS entails and what convergence could mean to U.S. businesses and investors here.
[1] 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.
[2] Sarah B. Eaton, “Crisis and the Consolidation of International Accounting Standards: Enron, The IASB, and America” Business and Politics, 7, no. 3, (2005): 118.
[3] “REGULATION (EC) No 1606/2002 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 19 July 2002 on the application of international accounting standards” Official Journal of the European Communities, September 11, 2002.
[4] Commission of the European Communities, REPORT FROM THE COMMISSION TO THE COUNCIL AND THE EUROPEAN PARLIAMENT on the operation of Regulation (EC) No 1606/2002 of 19 July 2002, April 24, 2008.
[5] The Association of Chartered Certified Accountants, “Getting the Message: A Snapshot of Company Reporting in Australia” Part 11: Financial Reporting, October 2006.
[6] Accounting Standards Board, Canada, Strategic Planning Publicly Accountable Enterprises, www.acsbcanada.org//3/3/0/3/0/index1.shtml#strategic.
[7] Su Shuhuan and Hu Cathy, “China Part Two: Convergence, Challenges and Conversion” International Accountant, December 2006: 2829.
[8] Donald G. Lenihan and David Hume, “A Question of Standards: Accounting in the 21st Century” Centre for Collaborative Government, CGA-Canada, January 2003.
[9] Ibid.
[10] Establishing Financial Accounting Standards (New York: American Institute Of Certified Public Accountants, 1972).
[11] George Gorelik, “The Setting of Accounting Standards: Canada, the United Kingdom, and the United States” The International Journal of Accounting, 29, (1994): 95122.
[12] R. Bruce, Business Life, Financial Times, November 2, 2006.
[13] Jonathan Duchac, “The Dilemma of Bright Line Accounting Rules and Professional Judgment: Insights from Special Purpose Entity Consolidation Rules” International Journal of Disclosure and Governance, 1, no. 4 (2004): 324339.
[14] R. M. Mano and M. L. Mouritsen, “The Sensibility of Principles-Based Accounting Standards” Strategic Finance, 85, no. 11 (2004): 5558.
[15] R. Hussey and A. Ong, “The IASB and the White Rabbit” Accountancy, 133, no. 1315 (2003): 9899.
