Consider it a gift to global investors - the ability, for the first time ever, to make "apples-to-apples" comparisons of financial numbers produced by corporations, no matter where they're headquartered. That's what the International Financial Reporting Standards (IFRS) aim to accomplish. As of July 2008, for the first time since 1973 when the London-based International Accounting Standards Committee (IASC) , now the International Accounting Standards Board, was established, the standards will be a global reality. These standards will be recognized globally and will be set for organizations large and small. This article will cover how IFRS stand to alter global accounting procedures and what their adoption means for financial statement analysis.
Setting the Stage for IFRS
The "coming of age" of IFRS is no yawn: in the past, investors had to look at financials produced by companies worldwide - particularly outside the major industrialized countries - with some or much skepticism, and question the veracity of those numbers. Could a potential stakeholder examine the financial results of a major clothing manufacturer in the United States or Canada, for instance, and compare those results with figures from competitors in China, Thailand or Brazil to decide which organization truly represents a better investment? (For related reading, see Advanced Financial Statement Analysis.)
The answer: Not necessarily, and only with great difficulty. Many investors simply decided that only the most sophisticated analysts around the world were capable of making those comparisons and deciding who was cooking the books, sloppily managing numbers or misrepresenting the relationship between theoretically privately held companies and the governments in the countries where those companies are based.
Before IFRS, true transparency in numbers among companies worldwide simply did not exist, or was deemed possible. As a result, cross-border investments were curtailed, as was the growth of the overall global economy, particularly in emerging-market countries. In the past, investors generally chose to put their money in companies and countries where they would be most comfortable with truthfulness in accounting practices and systems and the sign-off of accounting firms standing behind those numbers. With the implementation of IFRS, this is set to change. (For related reading, see Re-evaluating Emerging Markets.)
SEC Gets With the Program
Dramatically greater transparency appears within reach as IFRS is implemented. That's because the Securities and Exchange Commission (SEC) in the U.S. appears set to endorse the use of IFRS by both U.S.-based and overseas companies alike, either in conjunction with or instead of U.S.generally accepted accounting principles (GAAP).
In July 2007, the SEC voted to publish a concept release for public comment on allowing U.S. issuers, including investment companies, to prepare their financial statements in IFRS.
"Having a set of globally accepted accounting standards is critical to the rapidly accelerating global integration of the world's capital markets," SEC Chairman Christopher Cox said in a public statement in July 2007.
"Today, nearly 100 countries require or allow the use of IFRS. We will be soliciting public comment … on whether U.S. companies, like many of their competitors around the world, should be permitted to use IFRS."
In 2000, 95% of 59 countries surveyed said they had adopted international standards or expected to; 39 had a formal plan to do so, according to GAAP Convergence 2000, a report from the International Forum on Accountancy Development, a group representing the world's six largest accounting firms.
A month before that decision, the SEC proposed eliminating the requirement that foreign private issuers using IFRS reconcile statements to U.S. GAAP.
Just as important U.S. companies - without being asked for their views or input - are increasingly being required to use IFRS when reporting the financial results for their European-based subsidiaries and certain other foreign operations. That requirement is part of the European Union's decision that stated that some 7,000 publicly-held European companies had to report in IFRS by 2005.
A number of SEC commissioners have embraced IFRS, an endorsement that appears to the stanards' success. Because of the depth and breadth of the U.S. securities marketplace, the world's largest, and because of the SEC's reputation as a fierce enforcer of securities regulations in the U.S., the SEC's support and endorsement of the IFRS standards is key to ensuring that these standards become even more widespread. In fact, one of the greatest challenges facing global securities agencies is how to enforce IFRS around the world. (For background reading on the SEC, check out Policing The Securities Market: An Overview Of The SEC and How The Wild West Markets Were Tamed.)
Corporate Executives Ignore the Trend
While the SEC moves toward adopting IFRS, U.S. corporate executives have largely remained ignorant of their years-long evolution, confident that they will never replace U.S. GAAP. According to a survey completed in 2007 by accounting firm Grant Thornton LLP:
- More than 55% of those polled disagreed with the SEC's proposal to let foreign firms file financial statements in IFRS, and almost 50% opposed letting U.S. firms with extensive overseas operations adopt IFRS instead of using U.S. GAAP.
- 67.5% said they would prefer dealing with a principles-based accounting system (which IFRS is supposed to be) over the more rules-based approach of U.S. GAAP.
The study suggests that an overwhelming number of U.S. corporate executives tend to turn a blind eye to IFRS; however, the largest U.S.-based companies have spoken out in favor of these accounting principles.
"One of the friction points [in global accounting] is that we currently don't have a lingua franca, a common way of talking to each other about financial statements," said Phil Ameen, vice president and controller at General Electric and one of the few U.S. executives to become involved with IFRS from the get-go. "For that reason we're enormously excited about having to learn only one set of standards."
Adds Ken Kelly, vice president and controller of spice producer McCormick & Co., "Several years ago I would have said, ‘I don't need to look at this,' but the pace of change has been quick. World capital markets are moving closer together with electronics and the pace of global business; probably standards worldwide are lagging behind what the global corporate community is doing."
Evolution Toward IFRS
IFRS have been in development for decades - since the early 1970s, when the IASC was established in London. The IASC was started with the goal of providing a robust accounting system for countries that don't have one of their own or lack the immediate ability to develop one. The group was replaced in March 2001 by a more robust agency, the International Accounting Standards Board (IASB), also established in London. The IASB is charged with the development of IFRS, and has worked closely with national accounting standards-setting agencies like the U.S.Financial Accounting Standards Board (FASB) in a process known as "convergence."
Historically, individual countries have established their own versions of GAAP; there has been Japanese GAAP, French GAAP and so on. The problem with all of these varying generally accepted accounting principles is that they have differed not just in nuance, depending on the specific issue, but in many cases extraordinarily - so that accounting principles regarding derivatives, insurance or pension treatment in the U.S., for instance, have had almost no similarity to the accounting principles for the same issues in Europe, Asia or elsewhere.
Not all countries have had their own GAAP, particularly those in emerging market countries - in part because many haven't had the financial wherewithal or sophisticated home-grown accounting professions capable of putting together their own accounting regimes. As a result, they've adopted an accounting regime (or parts of an accounting regime) from an industrialized country. In most cases, however, those systems haven't been adopted lock, stock and barrel, but piecemeal - adding to investor confusion.
What gave a great boost to the continuing development of IFRS, virtually guaranteeing global acceptance, was a mandate from the European Union that companies in all member countries must report in IFRS by 2005.
Principles Vs. Rules
While some might consider the introduction of IFRS to be just another dull accounting concern, implementation may be anything but. That's because the IASB doesn't have the power to force adoption of IFRS by fiat: No country is under any requirement to use these standards. Indeed, the introduction of individual IFRS is being done by consensus, with accounting professionals from a broad array of countries and companies participating in discussions as each new specific accounting rule is proposed. The process can take years; once a new rule is put on the table, a "request for comment" is issued globally before it becomes adopted by the IASB.
One of the continuing points of contention surrounding IFRS is whether the principles should be more "rules-based" or "principles-based." The rules-based approach often is favored by U.S.-based corporations and accounting experts; it calls for having a specific accounting rule for each and every accounting eventuality that may come along, for fear of lawsuits. The U.S. is generally far more litigious in the corporate world than any other country, and companies have liked the idea of having specific accounting rules to refer to in court to back up their accounting treatment decisions if they're sued.
In Europe and elsewhere, by contrast, where corporate litigation is far more the exception than the norm, accounting pronouncements have been much more principles-based, giving accounting professionals far more leeway regarding how to interpret the standard. In practical terms, that means that a single U.S. accounting rule can be more than a hundred pages long (the case with derivatives accounting, for instance); elsewhere, a rule on the same issue may need no more than a handful of pages.
Other key issues of disagreement:
- When to mark to market assets and liabilities; companies all over the world are concerned with enormous volatility being introduced to their balance sheets depending when and how mark-to-market accounting is applied
- How to estimate the fair value - the true market value - of an asset and liability, particularly in the absence of a well-known, transparent market mechanism for doing so (for instance, today's value of a stock or heavily-traded commodity)
Just how contentious can these discussions be? Very. Consider some of the notes that the IASB received when it issued a request for comment on an exposure draft for International Accounting Standard (IAS) 37, which is to govern contingent assets and liabilities.
In an October 2005 letter to Henry Rees, the project manager for the IASB, Loretta V. Cangialosi, vice president of Pfizer Inc. in New York called IAS 37 "non-operational, un-auditable, representationally unfaithful, abuse-prone, costly and of limited (and perhaps negative) shareholder value."
"We believe that if this standard is issued in its current form, the gap between the expected and actual quality of financial statements will grow in a manner that will not be cured, even with extensive disclosure and information," she said. "And worse, the deterioration might be visible for years."
Other corporate executives were just as unhappy. Take sharp viewpoints like these, and the difficulty of achieving quick consensus on any single standard quickly becomes all too obvious.
For Stakeholders, It's Not Too Early To Learn
In many countries that are moving toward adopting IFRS, these won't become effective until 2012 to 2015. But as the European experience demonstrates, it's never too early to jump in.
One problem: Outside the EU, there aren't a lot of places investors and stakeholders can go for information. That's partly because - particularly in the U.S. - educating corporate financial executives is taking precedence over educating stakeholders, and the major accounting firms are just beginning to set up IFRS practices.
Nevertheless, the Big Four are training their corporate clients, and many are establishing their own newsletters/websites on the issues. Deloitte's IFRS PLUS is one of the best-known of such publications, which includes a bevy of information on how the IASB is structured, as well as detailed information about specific IAS rules and where they are in the development process.
Savvy investment professionals - and investors - will recognize that, even though there's no hurry to get caught up on IFRS, doing so may give them a leg up early on. "Like them or not, there's no turning back," says McCormick's Kelly. "It's time for all of us to grit our teeth and dig in."
For related reading, see Accounting Not Just For Nerds Anymore.