The Inevitable Move to IFRS: Getting Started

The shift to International Financial Reporting Standards (IFRS) is both appropriate and, in any event, ineluctable. It is appropriate because our markets today, more than ever before, are truly global. Investors worldwide need to be able to compare companies across the board, and disparities in accounting conventions will only create major traps for the unwary. It is ineluctable because the SEC has wisely recognized the need for a uniform global standard and has paved the way toward the achievement of such a standard.

Before we actually arrive at this promised land, however, major questions will need to be answered about the roles that the Securities and Exchange Commission, the Financial Accounting Standards Board, and, ultimately, the U.S. judiciary, will play during the transition period, and once all public companies are required to report under an IFRS regime. Given the ineptitude and generally high level of dissatisfaction with FASB, the weakened political position of the SEC and the incentive to move quickly in the waning days of the Bush administration, steps along the road to adoption of IFRS may occur more quickly than otherwise might be expected. Companies should begin to prepare for the process of abandoning U.S. GAAP and adopting IFRS within the next several years, even while bearing in mind that many details remain to be ironed out.

The Lay of the Land

IFRS is a simplified, principles-based, system of accounting standards. Instead of relying upon the rules-based approach reflected in GAAP, under which every possible type of transaction needs to be separately addressed, IFRS provides a set of principles applicable to the economic substance of various transactions, and then relies on professional and independent auditors to interpret those principles and apply them to the specific economics of each transaction. As a result of this principles-based approach, the entire IFRS canon consists of only 2,000 rules, as opposed to GAAP, which has over 25,000 rules (and still fails to address some significant issues). Concomitant with this relative regulatory simplicity come both flexibility and a potential lack of comparability. Two different reporting entities may account for comparable transactions differently under IFRS, depending upon the opinion of each entity and the professional judgment of their auditors.

IFRS has been developing and evolving since 1966, and has benefitted from inclusion of the best elements of existing accounting systems. Since 2002, FASB and IASB have worked toward convergence of IFRS and GAAP. Not surprisingly, conceptual differences have hampered the process. The initial effort proceeded rule-by-rule, and attempted to reconcile each one. Unfortunately this approach foundered on irreconcilable philosophical differences between the approaches underlying the two standards, and in any event would have taken decades to achieve (all the while new rules were being promulgated). Recently, the effort has been slimmed down and limited to several finite areas, including lease recognition, financial statement presentation, and revenue recognition. The hope is to complete these projects by 2011.

The movement toward IFRS is gaining considerable momentum in the United States. On Aug. 7, 2007, the SEC issued a concept release asking for comments on allowing U.S. companies to adopt IFRS in lieu of GAAP, and on Nov. 15, it abandoned its long-standing requirement that foreign private issuers reconcile their IFRS-based financial statements to GAAP, so long as those statements initially are prepared in accordance with IFRS. SEC Chairman Christopher Cox has made convergence one of his top priorities. Industry comments have been favorable on a conceptual level, although there has been much comment on specific issues that need to be resolved prior to the adoption of IFRS. Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson have been supportive of the concept as well. Earlier this summer John White, director of the SEC’s Division of Corporation Finance, indicated that a roadmap for convergence, possibly including a timetable for proposed rule-making, would be forthcoming once the SEC is back to its full complement of five commissioners—which has now happened—and the new commissioners have had an opportunity for input into the process.

Outstanding Issues

While generally supportive of the proposal to move to IFRS, many comment letters point out issues that need to be resolved prior to full-scale adoption. These include, predictably, the need for judicial clarity, the need to define the changed roles of the SEC and FASB, and the method by which the transition from GAAP to IFRS will be accomplished.

Switching to IFRS will require U.S. auditors to be comfortable abandoning the judicially tested, relatively well-defined, rules-based approach and entering the uncharted waters of auditors’ judgment. It is unlikely that any legislative relief will be attempted and unreasonable to expect that even if attempted, such relief would emerge expeditiously from the current quagmire bogging down tort reform. Auditors and companies will have to assume the risk that courts, in the perfect clarity of 20/20 hindsight, may decide that judgments made at the time of a transaction were incorrect, that the transaction was, therefore, improperly recorded, and, finally, that the company and the auditors should be punished for the accounting lapse. Despite the inherent uncertainty in this new approach, the missteps and near-bankruptcy of accounting firms under the current rules-based regime make for a compelling argument that pursuit of another alternative is in order. Auditors and companies may come to realize that the grass is no less green and potentially greener on the other side of the accounting standards’ fence.

Switching to IFRS will require U.S. auditors to be comfortable abandoning the judicially tested, relatively well-defined, rules-based approach and entering the uncharted waters of auditors’ judgment.

The move from detailed prescriptive rules to principles-based accounting will also change the nature of enforcement actions. Regulators will no longer be able to measure financial reporting against bright line rules. Instead, they will have to become fluent in economic reasoning and application of broad principles. It will also make after-the-fact revisions—such as the change in finite reinsurance rules—more difficult. Juries will have to make judgments based upon intent, which may be a welcome change from recent decisions, which required jurors to delve into the world of arcane accounting rules and resulted in some perverse outcomes.

If IFRS is to become and remain the international standard, the role of the SEC will need to change. The SEC presently wields considerable influence over the substantive content of GAAP, through its issuance of Staff Accounting Bulletins, initiation of enforcement proceedings, and its effective control over the membership and funding of FASB. The SEC can neither hope nor expect to have anywhere near that much influence with IASB. To be sure, the SEC will have a powerful voice, but it will be one of many, capable of being either overridden or made stronger, by other regulatory bodies. Many Europeans fear the SEC will attempt to take over IASB and move IFSR toward GAAP. While the SEC, under Chairman Cox has shown admirable worldwide cooperation, subsequent administrations might espouse a more parochial approach. A xenophobic agenda could significantly set back both international finance and the United States’ position in the international financial community.

The PCAOB will be a critical player in this evolving drama. The Sarbanes-Oxley Act created the PCAOB to oversee the auditing profession. In that role, it examines U. S. auditors and sets forth minimum standards that auditors must follow during the course of their audits. The International Auditing and Assurance Standards Board (IAASB) is the IFRS’s equivalent of the PCAOB. Will the PCAOB, which was established only six years ago, be willing to share its power so soon after its creation? The PCAOB and the IAASB could exist independently, but this would be awkward and eventually might lead to a different version of IFRS in the United States, thereby undermining one of the primary rationales for IFRS. The more pragmatic and, ultimately, more effective, approach will require cooperation, with the PCAOB acting as the U.S. representative on the IAASB. Such a limited role for the PCAOB could irritate some regulators and legislators.

FASB will clearly assume a role subsidiary to IASB. It will become the United States’ representative on IASB, but will no longer have the ability to set accounting rules by itself. To a certain extent this is an ignominious end to a rich part of U.S. financial history, but it is an end that is largely dictated by the damage self-inflicted by FASB’s consistent inability to address adequately the critical issues that have arisen during globalization of the capital markets. Bodies such as IASB, seeking to become the sole global source for regulation in a given sphere, would do well to study the history of FASB in order to avoid similar mistakes.

One final issue is the method by which the transition from GAAP to IFRS will be accomplished. Most other countries have managed the transition by providing a grace period, during which companies and their auditors had an opportunity to adjust their financial processes and to adapt to IFRS, with IFRS reporting implemented at the end of the period. Another alternative is to allow an interim period during which companies could elect to report using either IFRS or GAAP as they move toward IFRS at their own speed, but with a deadline by which the use of IFRS would be required. Under either of these approaches, full implementation of IFRS in the United States is likely in less than five years.

Critics of an interim approach complain that, during the interim, there may be disparities between companies in the same industry that utilize GAAP or IFRS. While this is regrettable, the reality is that it will likewise be possible that two companies in the same industry will report differently under IFRS. Investors and regulators will have to adjust to life under this new regime, and there is no time like the present—or at least the near future—to start getting used to it.

What Companies Should Do Now

Companies should be endeavoring to get ahead of the inevitable transition to IFRS. It will offer benefits of international consistency of approach and simplification of application. Unfortunately with these benefits there also will be upfront costs—potentially quite significant ones—as there were with Sarbanes-Oxley. This time, at least, U.S. companies are not the guinea pigs for a whole new process, but are merely adopting an approach that has already been tested in Europe and much of the rest of the world.

In order to make the transition to IFRS as smooth and painless as possible, U.S. companies should consider the following steps:

The Early Bird Catches the Worm. Companies should start planning now. International accounting firms already have in-house expertise in moving companies to IFRS. If companies act now, they can benefit from that expertise, before someone else steps in to monopolize it.

Use Outside Advisors. It is inevitable that you will need outside advisors to make the switch. Don’t be penny-wise and pound-foolish. Money spent judiciously early in the process will facilitate a smooth transition and save money in the long run.

Promote Transparency. The switch to IFRS necessarily will eliminate or change some of the key metrics that investors rely upon to track the progress of companies. To consider exactly how companies will be affected, utilization of outside advisors can help companies determine how to include these metrics in their reporting materials, introduce investors to new metrics and explain the difference between the old and the new ones, so that investors will be comfortable with, and able to anticipate, the change.

Speak Up. There will be numerous opportunities for companies to make their voices heard on the matter of IFRS and its implementation, and to influence the outcome of events. Those that actively engage in the process are likely to find the outcome far more palatable than those that make no effort to make their opinions known.

A Friend in Need Is a Pest. After the SEC finalizes its IFRS-related rules, the die will be cast. As companies offer comments or suggestions on the rules proposals, it will also be an opportune time to establish relationships with the regulators, to learn whom you can call with questions when IFRS becomes the standard. The SEC Staff needs information now, to inform its analysis and help in the formulation of specific proposals. Providing such input today will pay exponential dividends in the future.

Keep Your Equilibrium. There will be difficult times as companies transition to IFRS. For example, the recent revisions to Financial Accounting Statement 5—concerning contingent liabilities—require more expansive disclosures concerning contingent liabilities than previously required under GAAP. This was done, in part, to bring FAS 5 in line with IFRS’s requirements. Needless to say, FASB’s proposed changes are raising concerns about discovery and other issues. Unfortunately there will be many similar surprises—some good, some bad—as companies transition to IFRS. Companies would do well to bear in mind, though, that all other U.S. companies, even their competitors, are going through the same process and that this too shall pass, with IFRS eventually becoming the status quo.

Retain Flexibility. While the SEC has devoted a great deal of public comment to IFRS, there is no way of knowing when actual proposals will materialize, how long the proposals will take to move from the proposal stage to final rules, and how much might change in the interim. Companies must remain flexible and avoid going so far in one direction that it is difficult to reverse field if the lay of the regulatory landscape changes.

Be Patient and Communicate. U.S. audit partners and their teams are also learning IFRS. It will be important to have ongoing, open communications, so that companies identify key areas of uncertainty or differences in approach and develop mutually acceptable solutions. The first time through needs to be a collaborative effort, not a confrontational one.

There’s No Time Like the Present. Companies should hire or train someone in IFRS, and it isn’t too soon to start. A successful transition will depend upon the development of in-house resources that can help manage the process. This is an ideal role for cultivating junior staff with potential and initiative.

Cultivate New Investors. IFRS-based financial statements will open your company to all the world’s investors. Open a dialogue to determine what metrics they would find most useful in evaluating you and your competitors and then work to ensure that your implementation of IFRS includes those metrics.

The transition to IFRS offers exciting possibilities for U.S. companies. Abandoning rules-based GAAP in favor of principles-based IFRS should eventually simplify lives and accounting statements. In addition, comparably prepared statements should expand the worldwide investor pool for U.S. companies. There undoubtedly will be transition costs, inconsistencies, and uncertainties, to say nothing of significant dislocations, but overall it is an important step toward an integrated global financial system. Once the details work themselves out, everyone will be in a better place.