Tuesday, May 18, 2010

IFRS Risk May Be Overblown

IFRS Risk: Not What You Think

The switch from U.S. generally accepted accounting principles to international accounting standards is a hot topic. But CFOs of U.S. companies are wasting time and money managing imaginary risks while completely ignoring real ones. Article by Bruce Pounder of Leveraged Logic, from CFO.com.

Today's CFO is accustomed to managing risk. But few financial executives in the United States accurately perceive or understand the emerging risks that are associated with the global convergence of financial reporting standards (convergence). As a result, CFOs across America are wasting time and money managing imaginary risks while ignoring the real risks associated with convergence in general and International Financial Reporting Standards (IFRS) in particular.

To separate real from imagined risks, let's start by looking at some of the defining characteristics of the U.S. financial reporting environment. In the United States, as in most of the developed world, private companies outnumber public companies by a ratio of roughly 1,000 to 1. But in the United States—unlike most of the developed world—private companies have no statutory financial reporting obligations. No individual, organization, or governmental agency can unilaterally require private U.S. companies to use a particular set of financial reporting standards.

In practice, private U.S. companies frequently use U.S. generally accepted accounting principles (GAAP), and there are plenty of good reasons for doing so. But many private companies follow GAAP only up to a point, disclosing deviations in their financial statements. And other private companies use alternatives to GAAP, such as cash-basis accounting, tax-basis accounting, or some "other comprehensive basis of accounting" (OCBOA). So among private U.S. companies, diversity in financial reporting standards is the norm.

The relatively small number of public companies that exist in the United States operate in a very different environment. They are subject to statutory financial reporting obligations as determined by the Securities and Exchange Commission (SEC). The SEC has the legal authority to define the financial reporting standards that companies under its jurisdiction must or may use.

Since its inception, the SEC has relied on nongovernmental standard-setting organizations to set financial reporting standards for its regulants. Currently, the SEC looks to the Financial Accounting Standards Board (FASB) to set the financial reporting standards that the SEC requires public U.S. companies to adhere to. In some cases, the SEC has supplemented or overridden standards set by nongovernmental standard-setters, but for more than 70 years, public companies in the United States have had to use U.S. GAAP as set by the FASB and its predecessors for statutory financial reporting purposes.

IFRS and Convergence
IFRS is a specific, existing set of financial reporting standards that are developed and maintained by the International Accounting Standards Board (IASB). At the standard level, IFRS and U.S. GAAP exhibit a number of similarities-and a far greater number of differences. There are significant similarities and differences in their conceptual underpinnings as well.

As a nongovernmental organization, the IASB has no authority to compel any country to require or permit the use of IFRS. Nor does the IASB have any authority to compel any individual company to use its standards. In short, only by developing and maintaining a set of standards that at least some countries and companies perceive as being superior to alternatives (such as U.S. GAAP) has the IASB achieved widespread adoption of IFRS throughout the world.

Set-level convergence occurs when countries and/or companies stop using country-specific financial reporting standards and start using the same set of country-neutral standards, as has been the case with the adoption of IFRS outside of the United States. But standard-level convergence has also occurred in parallel with set-level convergence. Since 2002, the FASB and IASB have been working together to converge U.S. GAAP and IFRS at the standard level, and the global financial crisis has brought even greater pressure on the Boards to make further progress.

For the most part, the boards are developing new, common standards designed to replace existing standards in U.S. GAAP and IFRS. And in most cases, the standards under development differ significantly from the standards in either U.S. GAAP or IFRS today.

Imagined Risks
Many U.S. CFOs have been led to believe that their companies, at some point in the relatively near future, will be forced to switch from using U.S. GAAP, as we know it today, to using IFRS, as we know it today. On top of being concerned about the cost and effort that would likely accompany such a switch, U.S. CFOs have been bothered by the seeming uncertainty with regard to the timing of such a switch.

The responses of U.S. CFOs about their beliefs have been mixed. Some have invested time and money in voicing opposition to such a switch. Others have demanded more certainty in the timing, assuming that they'll commit resources to the switch once they get a "date certain." Still others, sensing both inevitability and imminence, have begun to study current IFRS and assess the impact of converting from current U.S. GAAP to current IFRS. But all of these represent responses to imagined risks, not real ones.

Having devoted a significant portion of my career to understanding the impact of IFRS and the phenomenon of convergence from a U.S. perspective, I am convinced that the likelihood that any U.S. company will be forced to switch from using today's version of U.S. GAAP to today's version of IFRS is absolutely zero. So to me, protesting such a switch is pointless. Insisting on knowing when the switch will take place is pointless, too. And preparing for such a switch-well, that "takes the cake" in terms of pointlessness.

What's the Evidence?
What evidence is there that U.S. companies will never be forced to switch from using U.S. GAAP as we know it today, to using IFRS as we know it today? Consider the following:
• For more than 99% of the companies in the United States (i.e., private companies), no individual, organization, or governmental agency can unilaterally require them to use any particular set of financial reporting standards. Many of those companies don't even use U.S. GAAP now. So will private U.S. companies be forced to switch from U.S. GAAP to IFRS? Absolutely not.
• For the less-than-1% of U.S. companies that fall under the jurisdiction of the SEC, the SEC has made it crystal clear that they won't even consider such a switch until there are fewer differences between U.S. GAAP and IFRS — that is, until the FASB and IASB make further substantial progress on converging the two sets of standards at the standard level. So will public U.S. companies be forced by the SEC to switch from current U.S. GAAP to current IFRS? Absolutely not. And if the SEC eventually decides to require public U.S. companies to switch from future U.S. GAAP to future IFRS, the switch will be a relatively trivial undertaking in contrast to a switch today.
•In the United States, we've generally been content to adhere to standards that everyone else in the world adheres to — as long as we set the standards. The thought of ceding global standard-setting authority to an organization that we can't "control" is, to most Americans (especially American politicians), unthinkable. So will any U.S. company be forced to follow standards set by the IASB as it is currently governed? Absolutely not.
•Investors, lenders, and other principal users of the financial statements of U.S. companies have expressed no interest in seeing those companies switch to IFRS. So are "market forces" suddenly going to compel a switch? Absolutely not.

Real Risks
Just because your company won't be forced to switch standards doesn't mean you're immune from the impact of IFRS and convergence. In fact, the real risks are far more numerous and more significant for U.S. CFOs than the imaginary risks that I've debunked. They include:

• Both U.S. GAAP and IFRS will undergo profound change as the FASB and IASB replace existing standards with common standards that bear little resemblance to current rules. Private companies that stick with U.S. GAAP, as well as public companies that are stuck with U.S. GAAP, are in for a wild ride. (If it's any consolation, so are companies that continue to use IFRS.)
• A recently formed "blue-ribbon" panel is currently examining whether it would be appropriate to decouple the standard-setting process for private U.S. companies from the standard-setting process for public U.S. companies. The likely result of the panel's efforts is that private U.S. companies will have even more and better choices of financial reporting standards beyond just future U.S. GAAP and future IFRS. A private company that fails to take advantage of new alternatives may find itself at a disadvantage to competitors that embrace them.
• With few exceptions, college accounting programs and our continuing education system for working professionals are woefully unprepared to maintain a workforce competent in U.S. GAAP given the expected pace and degree of change.
• U.S. companies subject to multiple national statutory financial reporting obligations are likely to have to adopt IFRS in addition to — not instead of — U.S. GAAP. This is a much different challenge than switching from one set of standards to the other, especially given that both U.S. GAAP and IFRS will change rapidly and profoundly in the years to come.

Bottom Line
The risk-management implications for U.S. CFOs are clear:
• Stop preparing for a switch from current U.S. GAAP to current IFRS.
• Start preparing for the roller-coaster ride that sticking with U.S. GAAP will become.
• If you work for a public company, stop worrying about when then switch from future U.S. GAAP to future IFRS will take place. If it takes place, it won't happen anytime soon and won't be nearly as big a deal as if the switch were to take place tomorrow.
• If you work for a private company, be on the lookout for additional options in financial reporting standards as they emerge.
• If your company is subject to statutory financial reporting obligations in multiple countries, get ready to start keeping a set of IFRS books in addition to keeping U.S. GAAP books.

Thursday, May 13, 2010

We Knew it All Along: Rules Based = Protection

GAAP's Lawsuit Buffer

The rules-based nature of U.S. generally accepted accounting principles may actually discourage shareholder lawsuits, says a new study

The debate over whether principles-based accounting standards are better than rules-based standards has divided many accountants, and stymied regulators who want to move U.S. accounting toward less-prescriptive guidance.

One argument against that nearly decade-long push has been that moving away from bright lines and layers upon layers of rules (as is characteristic of U.S. generally accepted accounting principles) would lead to more class-action lawsuits from shareholders second-guessing companies' accounting decisions. Because standards more reliant on principles (such as international financial reporting standards, or IFRS) give users more room to make judgment calls, observers worry that adopting such standards will open companies up to more Monday-morning quarterbacking by auditors, regulators, and the plaintiffs' bar.

Indeed, it's long been assumed that adopting principles-based standards would raise companies' litigation risk. For instance, in a 2003 report encouraging a move toward more "objectives-oriented rules," the Securities and Exchange Commission said a new system would carry with it "litigation uncertainty." At the time, the commission argued that litigation exposure could be minimized by companies and their auditors properly documenting the reasoning behind their judgment calls under a principles-based system.

Now, three university professors have gathered empirical evidence suggesting that litigation is indeed an issue in the principles-versus-rules discussion. Their study, "Rules-Based Accounting Standards and Litigation," suggests that companies that violate rules-based standards have a lower likelihood of getting sued than those that are accused of violating more-principles-based standards.

The professors looked at securities class-action suits alleging GAAP violations filed between 1996 and 2005, as well as 84 restatements made during that same time frame that did not result in litigation. Rather than judge GAAP as a whole as a rules-based system, they considered the prescriptiveness of the standards mentioned in each case, based on four characteristics: level of bright-line thresholds, exceptions, implementation guidance, and detail.

The standards were measured on a "rules-based continuum" scale running from zero to four, with zero denoting the most principles-based standards and four indicating the most rules-based standards. Accordingly, the standard for contingent liabilities, which requires judgment calls, scored zero, while accounting for leases scored four.

However, the professors shied away from concluding whether the adoption of more-principles-based standards as a whole in the United States would invite more lawsuits for American companies. The unique litigation system of this country, as well as the more litigious nature of the society, makes it difficult to directly compare the U.S. system with that of Europe or beyond, they say.

Still, over time, IFRS could become more rules-based if demands for carve-outs and additional guidance continue as they have in the United States, says study co-author John McInnis, an assistant professor at the University of Texas at Austin. "Even if we adopt a more principles-based system, I'm not sure it would stay that way," he says. Rather, the professors believe their study provides a building block for U.S. regulators and other researchers to consider as the merits of adopting IFRS continue to be weighed. (The SEC plans to decide next year whether to require U.S. companies to make a switch to the global rules, starting in 2015.)

For now, apparently, GAAP and its inherent complexity give U.S. companies a defense against lawsuits by allowing them to "shield themselves behind the rules," says McInnis. "If you follow the rules, it appears that you are protected."

Shareholders have the burden of proving that a GAAP violation was intentional, not an easy task when many layers of rules provide many opportunities for mistakes. "We find that firms are less likely to be sued when they violate standards that are more rules-based, consistent with the view that the complexity of rules-based standards provides a credible 'innocent misstatement' presumption," the professors wrote.

The professors acknowledge several limitations of their research. Among them is the fact that it's not possible to observe initial shareholder claims that lawyers drop before submitting them into the court system. Also unanswerable is whether a more principles-based system would lead to fewer restatements, which often trigger shareholder lawsuits in the United States if they affect the stock price.

article by Sarah Johnson at CFO.com

Wednesday, May 12, 2010

"Own Credit" Liability Rules Explained

What is the own credit issue?

The accounting effect of changes in the credit risk of a financial liability is referred to “own credit”.

Changes in a financial liability’s credit risk affect the fair value of that financial liability. This means that when an entity’s creditworthiness deteriorates, the fair value of its issued debt will decrease (and vice versa). For financial liabilities measured using the fair value option, this causes a gain (or loss) to be recognized in the P&L.

Many investors find this result counter-intuitive and confusing.

This was confirmed in responses to the IASB’s June 2009 discussion paper Credit Risk in Liability Measurement and in the user questionnaire on own credit that the IASB issued as part of its outreach activities.

The IASB undertook outreach on the issue of own credit in preparation for the publication of this ED, including discussions with preparers, audit firms, regulators and investors.

What did investors tell the IASB?--Extensive input was obtained from investors, including a questionnaire to which there were more than 90 responses. Whilst there was a range of responses, in general investors confirmed that:
  • P&L volatility caused by own credit does not provide useful information (except for derivatives and liabilities held for trading);
  • they did not want us to develop a new measurement method; but • information on the effects of own credit can still be useful.

In response to the input received, the ED proposes a limited change that addresses the issue of own credit for financial liabilities that an entity chooses to measure at fair value by introducing a two-step approach.

The two-step approach proposed in the ED would address the P&L volatility arising from own credit as follows:
• the fair value change of liabilities under the FVO would be recognized in P&L;
• the portion of the fair value change due to own credit would be reversed out of P&L and recognized in other comprehensive income.

Current Requirement
Income statement (P&L)

Liabilities under fair value option
100 total change in fair value

100 Profit for the year

Proposed Two-Step Approach
Income statement (P&L)
Liabilities under fair value option
100 Step 1 – Total change in fair value
(10) Step 2 – Change in fair value from own credit
90 Profit for the year


Statement of comprehensive income
Liabilities under fair value option
10 Step 2 – Change in fair value from own credit


No other changes are proposed for financial liabilities.

The current requirements for the measurement of financial liabilities would not be changed in any other way.

Importantly, the current requirements to split structured debt into a ‘vanilla’ instrument measured at amortized cost and a derivative component measured at fair value (bifurcation) would remain. As a result, those who prefer to bifurcate financial liabilities when relevant could continue to do so.

P&L volatility will no longer result from changes in own credit while information on own credit will still be available for investors.

IASB Restricts Gains form "Own Credit" Changes

Previous posts in this blog have noted that current accounting rules on financial instruments have a counter-intuitive result when a company’s credit rating is lowered. In theory, any liability should be recorded on a company’s books at the amount that is reasonably expected to be paid. If the liability is to be paid over the long-term, it should be discounted. The amount od a discounted liability on a company’s balance sheet would vary as the discount rate change. The discount rate reflects the risls associated with the liability, and as the risks increase, so does the discount rate. A higher discount rate means a lower liability. The company then reduces the liability (debit to liability) and to balance the books, requires a credit entry, which results in a gain to a company’s income statement. And that I show the counterintuitive result occurs—a drop in a company’s credit rating means a gain in earnings.

The liability treatment follows asset treatment—for example if a company thought that a debt was uncollectible, it would write the debt down to what it thought it would recover. So that the principle of fair value is maintained across the balance sheet, the same theory applies to liabilities.

The International Accounting Standards Board (IASB) has proposed changing the way banks measure their liabilities so they can no longer book the gain noted above and confuse investors after a ratings downgrade.

The IASB acknowledged that there are theoretical arguments for treating financial assets and liabilities in the same way, it is hard to defend the accounting as providing useful information when a company suffering deterioration in credit quality is able to book a corresponding gain.

The "counter intuitive" rule angered policymakers during the financial crisis when profits were being booked by banks despite ratings downgrades"

The proposal is part of an overall revamp of the IASB's fair value or marking to market rule which will be finalized by the end of this year but it is unclear when it comes into force.

HSBC Europe's biggest bank, recently reported that It had both a $5 billion hit from bad debts on U.S. home loans and asset writedowns while at the same time recording a fair value gain of $2.7 billion on its own debt during the period due to a widening in credit spreads.

Earlier in May, UBS recorded a gain of 2.1 billion Swiss francs ($2 billion) due to the widening of its own credit spread.

The debate about whether banks should allow for fair value gains on liabilities is not new, but has assumed fresh importance after a hugely volatile first quarter in credit markets, which saw bank debt trading at a discount in some cases to non-financial bonds.

Some analysts argue that if banks are taking mark-to-market losses on their assets and on hedging instruments, they should also be allowed to account for gains on their liabilities even if the underlying credit quality has not changed.

One of the practical problems with the theoretical approach noted above , however, is that a bank is unlikely to repay the debt early. A bank would usually wait until the debt matures and then buy it back at par.

Monday, May 10, 2010

AICPA Releases White Paper on Systems Impact of IFRS

The AICPA has published a white paper to provide awareness to the potential impact to an organization’s financial systems when completing an IFRS conversion project.

System Benefits of Conversion
The paper states that key benefits include opportunities to improve/ streamline business functions and processes, globally integrate the financial IT systems, and achieve consolidation/ reporting efficiency. On the other hand, there are risks associated when a company decides to convert to IFRS. Some of these risks are excessive resource spending, improper data management or migration, incomplete revisions of policies and procedures, future changes that standard setters may issue, and more.

Potential System Impacts of an IFRS Conversion
As a company prepares to convert to IFRS, the impact to information technology (IT) and financial systems should be taken into consideration during the planning phase. Representatives from the company’s IT department should be involved throughout the planning process to evaluate how the proposed accounting changes will impact the financial systems (transactional or reporting). The impact to IT and financial systems can vary depending on a company’s existing structure and environment. This may include its IT and financial systems capability/integration, industry complexity, company size, relevance of business process/transaction, internal control structure, mergers & acquisitions process, and other attributes.

If a company’s IT and financial systems are substantially integrated globally, then the degree of impact or modifications may be lower (although this is not always the case). The extent of changes may be primarily some sub-ledger configuration changes and more extensively in the general ledger and consolidation system. However, if a company has frequently acquired entities (each with unique financial systems) and has not yet integrated the acquired company systems within the organization’s infrastructure, then the degree of system impact may be quite large at the sub-ledger level as well as the internal reporting level.


Extensibility of XBRL taxonomies and the possibility to support additional reports that share the same underlying data are represented by XBRL taxonomies, either publicly available or developed internally. This provides opportunities for businesses to build on this standards-based data integration, reconciliation and convergence approach to support other key processes like internal reporting — business intelligence, tax compliance, management reporting — or internal auditing and controls. Another key consideration in this respect is that the implementation of this approach does not require the replacement of the existing systems; rather, it complements them by providing incremental functionalities that would otherwise require a substantial investment in the corporate IT environment.

Have a look at the white paper here.

Monday, May 3, 2010

Panel: Minimal Impact from IFRS

From CFO.com

If the Securities and Exchange Commission decides to force American companies to abandon U.S. generally accepted accounting principles in favor of international financial reporting standards, how will investors react? They will be "underwhelmed," says Aaron Anderson, director, IFRS policy and implementation at IBM. Anderson made the prediction on Tuesday at an accounting conference sponsored by Pace University's Lubin School of Business.

"When I look at the impact on IBM and compare it to whether investors will care, frankly, I don't think they will," said Anderson, one of four executives participating in a panel discussion on global accounting standards. He pointed out that if the company moves all of its financial reporting to IFRS — and some of its foreign subsidiaries are already reporting under the international standards — the change wouldn't be material in areas that investors "care about," such as service contracts and product backlog, which are "numbers that are not reported in GAAP, anyway."

Panelist Linda Mezon, chief accountant at The Royal Bank of Canada, said whether or not changing to IFRS will be material "depends on where you are coming from." RBC is "in the thick" of converting to IFRS, she said, as Canada has already mandated the switch. Using international standards to account for revenue, for example, won't produce any material differences at RBC, but likely will have a big effect on how the bank accounts for financial instruments, said Mezon.

Mezon recalled that when the European Union called for a switch to IFRS in 2005, the conversion caused banks to rework the way they booked derivatives, "so the balance sheet changed significantly" in terms of the transition adjustments. In some cases, those balance-sheet changes affected capital, she said, and "in the banking industry, capital is pretty much everything." Mezon said she is also keeping an eye on how adopting IFRS may change accounting for loan losses, an issue that will be dealt with in upcoming draft rules.

Jack Klingler, director of accounting research and IFRS implementation at Alcoa, agreed that the impact of IFRS would vary by industry. For his company, international standards pertaining to inventory valuation, research and development costs, and pensions may result in major adjustments, he said. In particular, Klingler said that Alcoa won't bless a conversion to IFRS until issues around inventory accounting are settled. Currently, Alcoa and other U.S. companies receive a tax benefit from using the last-in, first-out (LIFO) accounting method, which is banned by IFRS. Being forced to dump LIFO could cost those companies significant cash tax payments.

Alcoa executives are also concerned with understanding how hedging rules will change, said Klingler, since the company is a commodities supplier. However, "everything else will be small numbers" with respect to accounting adjustments, he said.

For international banking giant HSBC, which already adopted IFRS for its year-end 2005 consolidated financial statements, a major benefit of the accounting switch is cost reduction, said the bank's chief accountant, John McGinnis. Reporting U.S. results in IFRS would produce significant efficiencies for the bank, he said, because it would be able to "file under one set of standards."

IBM's Anderson noted that converting to IFRS would be an opportunity to take a new look at some old processes. He said IBM may be able to create new global shared-service centers for accounting by moving the whole company to IFRS, or perhaps institute accounting policies (such as a standard goodwill impairment test) that are currently impossible to implement, because subsidiaries are following local GAAPs. Such moves could lead to "greater efficiencies and stronger controls," he said.

The cost of conversion is another sticking point for companies opposing a move to IFRS. Anderson conceded that switching to international standards will require "a lot of work," but added that IBM, which has already started the process of preparing for a switch, knows "within a tight range" what it will cost — and in relative terms, "it won't be very much."