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.


Alter Placement Papers said...

Wow !! really nice blog. It will be very useful for me. So, thanks for sharing this post.

US Tax Abroad said...

Very informative blog! Thanks for sharing :)