International Financial Reporting Standards

International Financial Reporting Standards By Bill Conner

Global Financial Markets • The world economy is global now, and so there is a need for global accounting rules. • 40 % of the Fortune 500 use International Financial Reporting Standards (IFRS) • The European Union has required IFRS for publicly traded companies, as of 2005.

Global Financial Markets • Currently, over 100 countries require IFRS. • The Unites States requires Generally Accepted Accounting Principles (GAAP), but is considering a switch to IFRS. • The Securities and Exchange Commission arm of the U.S. Congress may require conversion to IFRS by 2014.

IFRS vs. GAAP - Assets • Investments – No AFS or HTM under IFRS • Inventory – No LIFO costing so Tax Consequences with switch to IFRS • Property, Plant and Equipment – Revaluing under IFRS is not limited to impairment

IFRS vs. GAAP – Financial Interests • Differences in the following between IFRS and GAAP: • Contingent Liabilities • Short and Long-Term Debt Classifications • Debt vs. Equity gray areas

IFRS vs. GAAP – Other Items • No Completed Contract Method under IFRS • IFRS is principles based, GAAP is rules based. • Switch to IFRS could improve monitoring.

IFRS – The Financial Statement Approach • Inventory Assets – Under GAAP, firms choose among several ways of accounting for inventory. They may choose to remove inventory cost from the books by assuming a first-in-first-out (FIFO) flow of goods, by assuming an average cost, or even last-in-first-out. Finally, a firm could make no assumption at all and remove the actual cost of each sold item. This method is called specific identification.

IFRS – The Financial Statement Approach • Inventory Assets – IFRS allows FIFO, Average Cost, or Specific Identification. Notice that LIFO is not mentioned as an acceptable costing method. • Analysis: This may be the most important change required by IFRS. The result of a political compromise by the United States Internal Revenue Service, the LIFO costing

IFRS – The Financial Statement Approach • Inventory Assets • Analysis (Con’t.): method has little basis in the true flow of goods through a business’s operations. If costs are rising though, the effect of using LIFO can be an indefinite tax deferral because high (inflationary) costs of sales deducted from net sales result in lower net income. With tax computed as a percentage of net income, low tax follows.

IFRS – The Financial Statement Approach • Inventory Assets • Analysis (Con’t.) – The catch in IRS’s compromise approach is that it requires businesses to use the same flow of goods for financial statement and tax purposes. A change to IFRS could cause many U.S. firms to immediately owe millions in deferred taxes.

IFRS – The Financial Statement Approach • Inventory Assets • Analysis (Con’t): Both a wise and a foolish approach have been offered to deal with the back tax issue. The foolish approach involves uncoupling the financial and tax accounting methods. This is foolish because it doesn’t resolve that LIFO is an illogical method of accounting for inventory. The wise approach would require a change from LIFO, but offer the adopting company a long time period, perhaps in excess of ten years, to pay the back taxes without penalty.

IFRS – The Financial Statement Approach • Investment Assets – Under current U.S. GAAP, any bonds or other debt of another company held as an investment can be accounted for uniquely, depending on whether it will be held until maturity or may be sold before maturity. • If to be held – No gains or losses are reported until maturity of the investment. • If to be sold – Gains/losses may be reported periodically as equity or other comprehensive income.

IFRS – The Financial Statement Approach • Investment Assets – For IFRS purposes, these bonds/debt will always be treated as if they could be sold. Therefore, gains or losses may be recognized periodically. • Analysis: In effect, IFRS requires the treatment of such bonds and other debt using mark-to-market rules. The “Held To Maturity” category was a political compromise to bring fair value accounting to U.S. GAAP. Conversion to IFRS ends the compromise as it should. Few companies can be certain they will never sell such items.

IFRS – The Financial Statement Approach • Property Plant and Equipment – There are two differences between IFRS and GAAP. These involve Fair Value Accounting and Leases: • Fair Value Accounting may be done under IFRS, whether the property, plant and equipment has appreciated or deflated in value. Under GAAP, property, plant and equipment can be written down, but not marked up.

IFRS – The Financial Statement Approach • Property, Plant, and Equipment • Leases are considered “operating” (no ownership) or “capital” (the property rented is considered purchased with a loan) depending on four rigorous tests for GAAP. Under IFRS, the GAAP tests are considered indicators, but are not the only information considered.

IFRS – The Financial Statement Approach • Property, Plant and Equipment • Analysis: The problem with fair value is that it can be very hard to “value” factories in Detroit in an economical and/or accurate way. • The “Lease” change allows flexibility, which in the end may allow companies not to structure lease arrangements to achieve the desired financial statement effect.

IFRS – The Financial Statement Approach • Liabilities and Equity • There are a number of relatively minor differences between IFRS and GAAP. Chief among them is the possibility of considering certain financial interest liabilities under IFRS while they qualify as equity under GAAP and vice-versa.

IFRS – The Financial Statement Approach • Construction Revenue Recognition • Under IFRS only a variation on the “Percentage of Completion” method can be used, while GAAP permits the “Percentage of Completion” or the “Completed Contract” methods in certain instances. • Analysis: The “Completed Contract” method is inconsistent with accrual basis accounting, which is the foundation of both IFRS and GAAP.

IFRS – The Financial Statement Approach • Construction Revenue Recognition • Analysis: Like switching from the LIFO • inventory method, a switch from the Completed Contract method could cause a tax burden. Many small US. construction contractors use the Competed Contract method for tax purposes, resulting in deferral of taxation until contract completion. This should be considered during transition to IFRS.

IFRS – Principles vs. Rules Approach • IFRS has been considered a principles based approach. • GAAP has been considered a rules based approach. • Analysis: With philosophy, principles based approaches are usually wise because slight

IFRS – Principles vs. Rules Approach • Analysis (Con’t.): differences from the principle can usually be forgiven if the spirit of the principle is maintained. Unfortunately, law, and related positive and punitive measures, is usually forged based on compliance with rules. Compliance is rewarded and/or noncompliance is punished. • While the principles approach (IFRS) is likely to produce easier agreement between different national governments, cultures, etc. it is quite

IFRS – Principles vs. Rules • Analysis: Possible that a global switch could produce financial information that is not comparable from company to company. The inability to compare financial investments has often been cited as one contributing factor to the Great Depression.

IFRS - Monitoring • Opportunity to Improve Monitoring of Financial Reporting by Public Companies: • A public corporation today purchases its own audit from a public accounting firm. This transaction is not “arm’s length” in appearance. • The public accounting firms often refer former employees for employment with the audit client, which can produce conflicts of interest.

IFRS - Monitoring • Opportunity to Improve Monitoring (con’t.) – • A public accounting firm can be under enormous pressure to make accounting judgments that favor its clients rather than investors. Such pressure can include loss of a major audit client in exchange for an unfavorable ruling.

IFRS - Monitoring • Opportunity to Improve Monitoring (con’t.) – • Analysis: The switch to new standards provides an opportunity to revisit the monitoring structure in the United States. The Securities and Exchange Commission or Public Companies Accounting Oversight Board could be charged with hiring the auditors of public companies. Alternatively, these government bodies could review the auditor selection process on a regular basis.

IFRS - Opportunities • Global adherence to a single set of accounting principles is clearly worthwhile, if not necessary. • IFRS has the potential to wipe away poor U.S. practices such as LIFO inventory accounting, held-to-maturity accounting for financial assets, and completed contract revenue recognition, which developed for political rather than economic reasons.

IFRS - Opportunities • IFRS could also usher new poor practices into the U.S. method of accounting for public companies. Inflated values could be attributed to property, plant and equipment, for example. Also, an “anything goes” attitude may develop in the U.S. accounting profession if we replace rules with principles.

IFRS - Opportunities • A unique opportunity for oversight could develop with a switch to IFRS. The United States could back away from the concept of “privately purchased” audit opinions.

International Financial Reporting Standards • There is a need for global standards. • There is a responsibility for national leadership. • Will the United States, the largest economy in the world: • Participate in the financial reporting revolution? • Ensure quality reporting by American firms?

International FinanIcial Reporting Standards • References • Bloom, Robert and William Cenker, (2009), “The Death of LIFO?” Journal of Accountancy, January: 44-49 • Dorata, Nina, and Ibrahim Badawi, (2008), “International Convergence: The Case of Accounting for Business Combinations,” The CPA Journal, April: 36 -38.

International Financial reporting Standards • References • Epstein, Barry Jay, (2009), “The Economic Effects of IFRS Adoption,” The CPA Journal, March: 26-31. • King, Alfred, (2008), “GAAP vs. IFRS: Will the Real Fair Value Please Stand Up?,” Financial Executive, December: 14-16

International Financial Reporting Standards • References • Tribunella, Heidi, (2009), “Twenty Questions on International Financial Reporting Standards,” The CPA Journal, March: 32-37

International Financial Reporting Standards