By Bert J. Zarb
SEPTEMBER 2006 – To be useful and timely, financial information must also be reliable, comparable, consistent, and transparent. One way to achieve transparency in financial reporting is to prepare information in accordance with a robust, high-quality set of generally accepted accounting principles. In a global marketplace, a set of financial statements having been prepared using the accounting standards of one country does not necessarily mean that they will be comparable to those in another country. Moreover, accounting measurements used in one country’s generally accepted accounting principles might not be used by, or might be unfamiliar to, users in another country.
If financial statements could be prepared using one set of universally accepted accounting standards, then their understanding could be extended to myriad users in different countries. The quest to acquire such a set of standards is behind the International Financial Reporting Standards (IFRS) promulgated by the International Accounting Standards Board (IASB). IFRS is making an impact on the international scene; it has been endorsed by the International Organization of Securities Commissions (IOSCO) and mandated for consolidated financial reporting in the European Union (EU). Despite IFRS’s international acceptance, the issue is whether it should be substituted for U.S. GAAP in the U.S. or used in conjunction with U.S. GAAP.
Years of effort toward international accounting harmonization have culminated in the promulgation of accounting standards by the International Accounting Standards Committee (IASC) and auditing standards by the International Federation of Accountants (IFAC). Other organizations, such as the United Nations, the EU, and the G4+1, had pursued initiatives toward global accounting standards setting. (The G4+1 comprises members of national standards-setting bodies from Australia, Canada, New Zealand, the United Kingdom, and the United States, and observer representatives from the IASC.) These organizations are no longer involved, however, because the IASC has succeeded in becoming the sole setter of global accounting standards.
In 1997, the IASC deemed it necessary to change its structure so as to, in its own words, “bring about convergence between national accounting standards and practices and high-quality global accounting standards.” A new constitution was drawn up, and in July 2000 the IASC was renamed the International Accounting Standards Board (IASB). In April 2001, the IASB assumed the responsibility for promulgating international accounting standards from the IASC. The IASB stated that its principal responsibilities were to:
a) develop and issue International Financial Reporting Standards and Exposure Drafts, and
b) approve interpretations developed by the International Financial Reporting Interpretations Committee (IFRIC).
Under its new structure, the IASB involved national standards setters in the international accounting standards-setting process while winning the support of the SEC. The IASB scored again when the EU mandated the use of its International Accounting Standards (IAS, the standards that preceded IFRS) for the consolidated accounts of the some 7,000 EU-listed companies starting January 1, 2005. A further endorsement was Japan’s announcement that it would adopt IAS for consolidated accounting purposes. The icing on the cake for the IASB was when the IOSCO endorsed the use of IAS for cross-border stock exchange listings.
For a long time, the promulgation and application of global accounting standards had been fraught with problems. First and foremost was the cumbersome way of reaching consensus on proposed standards. The IASC was criticized for issuing very broad standards that allowed several measurement options and prescribed minimal disclosures. Perhaps the greatest weakness was that compliance was not mandatory, and no enforcement mechanism existed. A further problem hindering the use of global standards was that fact that the SEC did not fully endorse the IASC’s efforts.
The SEC had argued that U.S. investors could be protected only by the use of U.S. GAAP. The SEC’s argument centered on the fact that only U.S. GAAP possessed the quality and robustness to ensure investor protection. In addition, the SEC maintained that U.S. GAAP has been indispensable in providing investors the necessary information for efficient operations.
Only recently has the SEC voiced support for global accounting standards, probably in response to calls from U.S. businesses and stock exchanges. Perhaps the best step in this direction was the memorandum of understanding issued by FASB and the IASB in October 2002 (the Norwalk Agreement), which formalized the convergence of international and U.S. accounting standards. Both boards agreed to add a joint short-term convergence project to their respective agendas, with a view toward proposing changes to both U.S. and international accounting standards that reflect common solutions to specific differences. The New York Stock Exchange successfully lobbied the U.S. Congress to amend the SEC’s governing legislation to require the SEC to enhance its support for high-quality international accounting standards.
The reluctance of the United States to endorse international accounting standards has been very noticeable. Because of the United States’ influence on global markets, this hesitation has been suggested as being the primary impediment to a universal acceptance of international accounting standards. Juxtaposed with this reluctance is the spate of corporate accounting scandals, which has pressured U.S. standard setters to accelerate the move toward the adoption of international accounting standards.
Studies conducted by accounting and investment firms have suggested that international accounting standards will enhance transparency and comparability, facilitate capital formation and European merger activity, and have a significant effect on certain performance evaluation metrics.
U.S. accounting standards are nonetheless universally considered to be the most stringent and of the highest quality. They provide the foundation for the reliability of U.S. financial markets. The seriousness of this presumption manifested itself when news of the corporate accounting scandals broke and the investing public quickly lost faith in the corporate reporting and governance model.
What to Do About IFRS
Perhaps the first step in preparing U.S. accountants for IFRS is education. It is imperative that accounting students be exposed to IFRS. This could be achieved by integrating the topic in current accounting curricula or by delivering a specific course in international accounting that includes IFRS. Accounting students could thus develop an appreciation and understanding of the differences between U.S. GAAP and IFRS. Accounting instructors could use cases dealing with international scenarios and could encourage students to consider internships and study-abroad programs. Additionally, symposia dealing with IFRS could be conducted jointly by members of the academic and business communities.
Accounting organizations could provide IFRS-specific continuing professional education programs. Such programs could open up opportunities for practitioners in the IFRS field.
Because of its adoption by the EU, IFRS is a question of when, not if, for U.S. accountants. Within a short period of time, financial statements prepared under IFRS will confront U.S. accountants. Practitioners will benefit the most from hands-on experience specifically dealing with international accounting issues.
One could argue that, in theory, adopting IFRS as a substitute for U.S. GAAP should not be very traumatic, especially because IFRS is rooted in the same accounting tradition as U.S. GAAP. In certain areas of accounting, such as stock options and pension liability accounting, U.S. GAAP is converging with IFRS. It might not be desirable to substitute IFRS for U.S. GAAP completely, however, because U.S. users of financial statements are familiar with U.S. GAAP. Starting with the standards-setting process itself and ending with application and enforcement, U.S. GAAP has stood the test of time. In addition to users in the U.S., many foreign users of financials statements are familiar with U.S. GAAP. This familiarity has come about in part because U.S. stock exchanges require foreign entities to restate or reconcile their financial statements with U.S. GAAP before listing their stocks. In addition, foreign students are exposed to U.S. GAAP when they study accounting in the U.S.
As with any regulatory system, U.S. GAAP is imperfect; but it is not broken. Therefore, one might ask, why change? The U.S. still uses the imperial system of weights and measures instead of the metric system used in most other parts of the world. Visitors to the U.S. simply adapt to the fact that the country has its own system that has stood the test of time and, more important, is generally accepted by users.
Rules Versus Principles
Another argument in favor of U.S. GAAP centers on the fact that it is “rules-based,” as opposed to the “principles-based” IFRS. The diverse socioeconomic environments in which U.S. GAAP and IFRS have emerged have created philosophical differences between the two sets of standards.
U.S. GAAP consists of a set of complex and detailed accounting rules that leave little room for individual judgment. These rules-based accounting standards ensure consistency in application. Nevertheless, rules-based standards concentrate on complying with the letter of the law, without necessarily capturing the substance of a company’s economic activities.
On the other hand, IFRS’s principles-based accounting pronouncements emphasize the spirit of the accounting standard rather than strict adherence to a written rule. Consequently, substance-over-form is the distinguishing factor between IFRS and U.S. GAAP. IFRS lends itself to the substance of the argument in that it attempts to capture the spirit and intent of an economic transaction. U.S. GAAP, on the other hand, tends to focus more on form, because following the letter of the standard is of the utmost importance, regardless of the possible differences between the reality of an economic transaction and the reporting of that transaction.
IAS 1 requires that transactions be accounted for and presented in accordance with their substance and not merely their legal form. Conspicuous by its absence is the importance of similar treatment under U.S. GAAP. Statement of Financial Accounting Concepts (SFAC) 2 states:
Substance over form is an idea that also has its proponents, but it is not included because it would be redundant. The quality of reliability and, in particular, of representational faithfulness, leaves no room for accounting representations that subordinate substance to form. Substance over form is, in any case, a rather vague idea that defies precise definition. [Appendix B, paragraph 160]
Because the concept of substance over form is not an enforceable rule under the AICPA’s Code of Professional Conduct, Rule 203, it appears to be relegated to a position of lesser importance.
Former SEC Chief Accountant Lynn Turner has opined: “When one goes to a more principles-based approach, one outcome is that you establish a basic principle and do not permit alternatives to the principle.” True, rules-based accounting principles did not stop the recent spate of accounting fraud here in the U.S. However, principles-based accounting standards probably would not have thwarted such accounting shenanigans either. In a rules-based system, unscrupulous individuals can argue: “Show me in the rules where I cannot do that.” A principles-based system however, leaves much room for interpretation and could potentially open the door for yet more accounting games.
Harmonization or Hegemony?
It has also been said that the robustness of U.S. GAAP has exerted so much pressure on the international accounting standards-setting process that the United States was effectively attempting to make its GAAP the predominant accounting influence in other countries. The continued use of U.S. GAAP is surely not aimed at creating either accounting hegemony or accounting isolation. It is simply a sovereign right to continue to use a set of national standards that not only are high in quality and robust per se, but have earned the respect and admiration of being the most stringent in the world.
One approach to convergence would be to allow the use of IFRS while not making either IFRS or U.S. GAAP mandatory. This would necessarily allow corporations to use U.S. GAAP for domestic reporting purposes, and to use IFRS should they desire to list across borders. An alternative would be for the AICPA to recognize IFRS used by private domestic companies as an Other Comprehensive Basis of Accounting (OCBOA). Used this way, IFRS would give companies added flexibility in their financial accounting reporting. Additionally, this option could narrow the familiarity gap between U. S. GAAP and IFRS.
Previous research on international accounting harmonization has taken the form of descriptive, analytical, or subjective discussions of the merits and demerits of harmonization. Some studies have shown that diversity influences international financial decision-making. Other studies suggest that harmonization is inevitable and that the mutual recognition of accounting standards with some benchmark, such as a set of international standards, could be the tool needed to harmonize accounting standards and principles.
Yet other studies do not consider the harmonization of international accounting standards as a universally acceptable goal, because accounting principles developed from the interaction of accounting practices and theory with each country’s unique social, political, and economic environments. While some authors have posited that harmonization would make sense only if the accounting systems of different countries were very similar, such as those of the United States and Canada, others have argued that because global capital markets have flourished in the absence of any uniform accounting standards, any attempt to impose such standards would be an exercise in futility. Some have asked whether innovation in disclosure occurs in the financial reporting behavior of enterprises dependent on foreign resources, and whether enterprises in the international marketplace would make disclosures contrary to the secretiveness of their home culture.
Users should be aware of convergence initiatives, especially when operating in a global economy. China, for example, has remained outside the scope of IFRS, and has been developing its own accounting standards since the 1980s. Although it does not plan to adopt IFRS in its entirety, the Chinese Ministry of Finance has set harmonization of Chinese accounting to IFRS as one of its main objectives.
The continued use of U.S. GAAP should assuage fears of U.S. accounting hegemony and dispel doubts of U.S. isolation in a global marketplace. The continued use of U.S. GAAP could provide a balance of power in the international accounting scene in general and in international accounting governance in particular.
Recently, the EU’s commissioner for internal markets pushed for a greater influence and representation on the IASB because the EU is currently the largest user of IFRS. As mentioned above, the current 25 member-states forming the EU are required to use IFRS in consolidated financial reporting. As reported in The Wall Street Journal (February 28, 2005), the request for greater input to decisions regarding IFRS was promptly rejected by the IASB on the grounds that international accounting rules should not be based on national, political, or industrial interests.
The danger here is that, in instances such as these, regional interests are often put ahead of international initiatives, thereby creating unnecessary tension and resentment among members of the international community. If, for example, greater representation is permitted to one country or region, this may lead to other countries or regions demanding equal representation, exacerbating the problem of shared and equitable governance, consensus-seeking, and decision-making.
It has also been said that one key benefit in adopting IFRS is that financial statements will be more transparent and easily comparable, leading to more-efficient capital markets. The counterargument is that international capital markets have flourished without international standards.
More than 300 SEC-listed companies are headquartered in the EU and thus required to use IFRS. These companies are still subject to the U.S. regulatory environment but have the added responsibility of complying with IFRS. It follows that non-U.S. corporations headquartered in the United States, or whose stocks are quoted on a U.S. stock exchange, should continue to present financial information in conformity with U.S. GAAP, either in its entirety, or in reconciliation form. In this respect, there is nothing wrong with U.S. regulators and accounting standards setters continuing to support international accounting convergence initiatives. This course of action will ensure that U.S. GAAP continues to evolve with IFRS.
Convergence Efforts Will Continue
Efforts to reduce accounting standards diversity have been marked by both successes and failures. The emergence of the IASB as the world’s sole international accounting standards setter, together with the acceptance of IFRS by supranational groups such as IOSCO and regional organizations such as the EU, ensure that international accounting standards will continue to play a role in international financial reporting. Nevertheless, not all countries are ready to abandon their time-proven national standards and adopt IFRS.
Efforts at accounting standards convergence will likely continue. U.S. GAAP has stood the test of time, built a high-quality reputation, and is capable of withstanding shocks such as accounting scandals. Moreover, U.S. GAAP has, in many instances, served as a model for international and national accounting standards setters outright. The author believes that the wise approach would be to allow the use of IFRS in conjunction with U.S. GAAP.
Bert J. Zarb, CPA, DBA, is an assistant professor at the college of business at Embry-Riddle University in Daytona Beach, Fla.