There has been a concerted convergence effort between the Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS) in order to avoid conflict and confusion, promote simplicity, streamlining, consistency and transparency, and avoid any future financial crises or meltdowns.
Despite the research-indicated evidence of a higher accounting quality being experienced by firms that either apply the IFRS standards or have switched to them from the GAAP, the convergence process has not proven to be an easy task, mostly because of the differences in approach between the two accounting bodies.
The GAAP is a rules-based methodology, while the IFRS takes a principle-based approach. The rules-based approach is comprised of a complex set of guidelines that establishes criteria for every possible contingency and provides the rules required for specified transactions, thus promoting uniformity. The principle-based methodology lays out the key objectives of good reporting in each subject area and then provides guidance, explaining the objective, and relates it to common examples, thus promoting transparency.
If these methodological differences between the two approaches cannot be resolved, they may prolong the process of compiling a true set of international accounting standards and increase the costs required to maintain two sets of books.
General Convergence Efforts
One of the main concerns in the United States business world is how the convergence process and its results will impact the future evolution of the accounting profession. This specific concern, simply stated, is about uniformity over transparency, and it has a serious impact on the standards development process. Could the goals of uniformity and transparency be achieved? Are they incompatible or mutually exclusive?
This incompatibility - real or perceived - is grounded in the conflicts existing among the constructs of rules-based and principle-based shareholder and stakeholder primacy theories, which are recognized by the Financial Accounting Standards Board (FASB), the International Accounting Standards Board (IASB) and the European and Asian Accounting Standards Boards, and which have an impact on the standards development methodology. Transparency has a direct impact on the areas of business combinations (Phase I and II), revenue recognition and financial performance of business enterprises reporting.
Convergence Efforts Made Toward the GAAP and IFRS Standards Convergence Goal on the Business Combinations Phases I and II Project.
The objective of this two-phased collaborative project between the U.S. FASB and the IFRS was to develop a single high-quality standard of accounting for business combinations that would ensure uniformity, yet promote transparency in merger and acquisitions (M&A) activities in the world’s major capital markets. Phase I of the Business Combinations Project eliminated the pooling of interest with the FASB 14. Issues excluded from Phase I were business combinations involving two or more mutual entities and business combinations where separate entities were brought together as a reporting entity without claiming an ownership interest.
Phase II of the project focused on revising IFRS 3 (Business Combinations); amended a version of International Accounting Standard 27 (IAS 27 - Consolidated and Separate Financial Statements); clarified and changed wording, aligning the GAAP with IFRS; and revised the FASB issuance of SFAS 141(R) regarding Business Combinations, and SFAS 160 regarding Non-controlling Interests in Consolidated Financial Statements. Statement of Financial Accounting Standards 141 R (SFAS 141 R) reduced the complexity of the GAAP, improved and created a greater consistency in accounting and financial reporting of business combinations, which benefited investors and other users of financial statements by providing them with more complete, comparable and relevant information.
This new standard achieved that goal by requiring the acquiring entity in a business combination to recognize all, and only, the assets acquired and the liabilities that were assumed in the transaction. It also established the acquisition-date fair value as the measurement objective for assets acquired and for all liabilities, required the acquirer to disclose to all investors and other users all of the information needed in understanding and evaluating, and the nature and financial effects of the business combination.
It included both core principles and pertinent application guidance, thus eliminating the need for numerous Emerging Issues Task Force (EITF) issues and other interpretative guidance. SFAS 160 also improved the relevance, compatibility and transparency of financial information provided to investors by requiring all entities to report subsidiaries’ minority non-controlling interests the same way as in equity-consolidated financial statements. The result eliminates the diversity in accounting transactions between an entity and non-controlling interests by treating them as equity transactions.
From the International Financial Reporting side, IFRS 3 and IAS 27 were revised and amended in the areas of partial acquisitions, step-acquisitions, acquisition-related costs, contingent consideration and transactions with non-controlling interests. In partial acquisitions, the non-controlling interests are measured either at fair value, adhering to the new GAAP requirement, or on their proportionate interest in the net-identifiable assets based on the original IFRS requirement.
In step-acquisitions, the goodwill is measured as the difference at acquisition date between the fair value of any investment held in the business before the acquisition and the transfer of consideration and acquisition of the net assets, while the former requirement of measuring every asset and liability at each step of the process when calculating a portion of the goodwill has been removed.
The acquisition-related costs are now recognized as expenses, rather than being included in the goodwill, and the contingent consideration must be recognized and measured at fair value on the date of the acquisition. For any subsequent changes in fair value, the IFRS standards will apply. Regarding transactions with non-controlling interests, no loss of control will result from changes in a parent company’s ownership interest in a subsidiary, since they are accounted as equity transactions.
The changes the FASB made to the U.S. GAAP were more fundamental than those made to the IFRS. Some of the most significant ones were: non-controlling interests classified as equity; restructuring changes required to be accounted for as they are incurred, rather than being anticipated at the time of the business combination; in-process research and development recognized as separate intangible assets, instead of being written off as an expense; alignment of the acquisition date with the date defined in the IFRS 3, instead of using the agreement date (GSSP); and gain on purchases in income is recognized instead of being allocated to the assets required.
Convergence Efforts Made Toward the GAAP and IFRS Standards Convergence Goal on the Financial Performance by Business Enterprises.
The FASB has taken steps to: consider promptly any significant areas of deficiency in financial reporting that might be addressed through the standard-setting process; promote the international convergence of accounting standards concurrent with improving the quality of financial reporting; and improve the common understanding of the nature and purposes of information contained in financial reports.
Addressing the objectives of financial reposting by business enterprises, the SFAS CON 1 states that financial reporting should provide information that is useful to current and potential investors and creditors, or any other users, in their decision-making processes regarding investments and credit, including assessing the amounts, the timing and uncertainty of prospective cash receipts or cash inflows from dividends or interest earned, the proceeds from a sale, or redemption or maturity of loans or securities. Reports should include information about a company’s economic resources, claims on those resources and the effects of those transactions, events, and circumstances that impact the resources and any claims upon them, and should be comprehensible to anyone who has a reasonable understanding of business and economic activities and who needs to examine or study the information with reasonable diligence.
Research conducted by the FASB on financial performance, reported by business enterprises and their users, found that users have a strong interest in a statement of cash flows that reports cash flows under the direct method. Users also prefer financial statements that provide greater disclosure of information with predictive value. The research indicates that there is no across-the-board dissatisfaction with, or demand for, sweeping change in the way financial statements are displayed. Users also feel that key, commonly used measures lack clarity in definition of terms such as ‘operating free cash flow,’ ‘return on invested capital,’ and adjusted, normalized or operating earnings. Although net income is frequently used as a starting point for analysis, it is not in the top three most important measures identified by users. There is also low demand for comprehensive income presentation in a single statement; however, there was no transparent opposition to providing comprehensive income items in another form.
A foreign company registered with the SEC and doing business in the U.S. may submit financial statements to either the IFRS or the GAAP, however the GAAP requires a reconciliation of earnings and net assets, which results in maintaining two sets of books (which can be counterproductive). Additionally, few companies file IFRS financial statements with the SEC and reconcile to the GAAP. The areas of reporting total comprehensive income and comparative prior-year financial statements have also received some attention. The IFRS allows, however does not require, the reporting of total comprehensive income compared to the GAAP’s requirement. This could contribute to IASB’s performance reporting project, to result in a multi-column performance statement separating current income flows from re-measurements of previously recognized items. Furthermore, the grand total, although labeled “net income” by IASB, would be similar to FASB’s total comprehensive income. As far as the comparative prior-year financial statements, the IFRS requires one year of information, compared to the two years required by the GAAP and SEC.
Convergence Efforts Made Toward the GAAP and IFRS Standards Convergence Goal on the Revenue Recognition Area
Accounting standards designed for public capital markets are burdensome, not only due to their complex nature, but also due to their adoption of the IFRS standards. This is especially apparent when applied to small and medium-sized companies, since they follow simple accounting principles that are not designed for the complexity of transactions that some small companies enter into, such as derivatives, hedging, foreign operations, business combinations, pension obligations or revenue transactions with multiple deliverables. This has forced IASB – which develops the International Financial Reporting Standards - to work on a separate standard for private entities titled, IFRS for Small and Medium-Sized Entities. The new standard will consist of a set of simplified and self-contained accounting principles that will address the needs of smaller, non-listed companies in public capital markets.
Both FASB and IASB, having acknowledged the complexity and pervasiveness of the revenue recognition area in financial reposting, are collaborating on developing a new single-revenue recognition standard for both the U.S. GAAP and the IFRS, which will streamline accounting for revenue across industries and correct any current existing inconsistencies in standards and practices. The new standard will also require businesses to disclose more information about revenue and proposes guidance to clarify accounting for contract costs.
The core principle of the new standard will recognize revenue when a company transfers goods and services to a customer equal to the amount of consideration the company expects to receive from the customer. Some of the most important differences between current practices and the new standard are that revenue would be recognized only from the transfer of goods or services to a customer. That change would affect some long-term contracts, the standard setters said. The example offered is that percentage-of-completion revenue recognition would be allowed, but only if the customer owns the work-in-progress as it is built or developed. In addition, a company would be required to account for all distinct goods or services, which could require it to separate a contract into different units of accounting from those identified in current practice.
Another change would be that collectability would affect how much revenue is recognized, rather than whether revenue is recognized or not. Also, a greater use of estimates would be required in determining both the amount to allocate and the basis for that allocation, which would better reflect the economics of a transaction. A company would follow five steps to apply the revenue recognition standard: identify the contracts with the customer; identify the separate performance obligations; identify the transaction price; allocate the transaction price to the performance obligations; and recognize revenue when a performance obligation is satisfied.
The standard would be applied to all contracts to provide goods or services to customers, except leases, insurance contracts and financial instruments. Companies would be required under the standard to disclose qualitative and quantitative information about contracts with customers, including a maturity analysis for contracts extending beyond a year, and the significant judgments and changes in judgments made in applying the proposed standard to those contracts.
The Bottom Line
Despite the philosophically and culturally based methodological differences between the GAAP and the IFRS, certain steps have been taken in the standards convergence process, and have been proven successful so far, despite its continued challenges. Both the FASB and the IFRS continue to collaborate on the development of new and convergence of existing standards, including the area of business combinations, which is an important feature and component of the capital markets, as well as the areas of revenue recognition and the financial performance of business enterprises.
Over the past decade, the average annual value of corporate acquisitions worldwide has been the equivalent of 8 to 10% of the total market capitalization of listed securities. In publishing its equivalents to IFRS 3 and IAS 27, the FASB has made fundamental changes to its accounting for business combinations, most of which bring the U.S. accounting in to line with the existing IFRS 3 and IAS 27.
It does appear that there are a lot of similarities in the principles of Revenue Recognition under IFRS and the GAAP, often resulting in the same accounting treatment. Other improvements will bring about changes in the standards for both the IFRS and GAAP, which will result in facilitating the comparison of financial statements among investors and other interested parties, such as advisors, acquirers etc., on how the acquired businesses will combine.
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