Mind the GAAP: Analyzing the Proposed Switch to International Accounting Standards

The Securities and Exchange Commission (SEC), as stated in an August 2008 “roadmap proposal,” wants to set aside U.S. Generally Accepted Accounting Principles (GAAP) in favor of the international standards followed by most of the world.

The call to replace U.S. GAAP with International Financial Reporting Standards (IFRS) by 2014 would represent one of the biggest-ever accounting rule changes for public companies based in the U.S. Among other issues, it would likely displace the Financial Accounting Standards Board, or FASB, as the U.S.’s chief accounting authority, subsuming it under the London-based International Accounting Standards Board (IASB).

But there are some tough questions about the move that have yet to be answered, according to Wharton accounting professor Luzi Hail, who, with professors Christian Leuz from the University of Chicago and Peter Wysocki of MIT’s Sloan School of Management, recently conducted research on the potential impacts of the change. They present their findings in a paper titled, “Global Accounting Convergence and the Potential Adoption of IFRS by the United States: An Analysis of Economic and Policy Factors.” In March, the FASB and its parent, the Financial Accounting Foundation (FAF), sent a 132-page letter to the Securities and Exchange Commission reflecting many of the concerns raised in the research, which received funding from the FASB but, according to Hail, was conducted and reported independently.  

“Based on our study, it is not clear that such a major shift in standards would translate into large net benefits for most companies or the entire U.S. economy, as is often claimed,” says Hail.

Since 2002, when accounting standard setters from America and Europe formally agreed to harmonize their respective accounting principles as much as possible, there has been a continuing effort to merge the two sets of books in order to avoid the inherent inefficiencies caused when international companies must adhere to two separate sets of accounting rules.

Proponents of a move to IFRS say global standards can enhance the liquidity of capital markets and reduce companies’ costs of capital by providing investors with better information on corporate performance and making it easier to compare reported company numbers across industries and countries.

But that benefit accrues only if the new standards improve the quality of reporting and the comparability of reporting practices around the world, caution Hail and his collaborators. A single set of accounting standards by itself does not guarantee the comparability of firms’ reporting practices within a country or across countries, they add. In some cases, says Hail, the net result of adopting such a uniform accounting system may be negative instead of positive.

It’s the Quality That Counts

Based on their research, Hail and his coauthors conclude that the relationship between accounting standards and the quality of corporate reporting appears to be more limited than previously thought. In fact, they say, it is not even clear that the liquidity and valuation effects documented by prior studies around IFRS adoption can be attributed solely or even primarily to the adoption of new accounting standards.

“Other supporting institutions play an important role in determining reporting outcomes,” according to the paper. “Academic studies suggest that firms’ reporting incentives and enforcement of standards are at least as important as accounting standards in influencing reporting practices.”

In an earlier study, “IFRS Reporting Around the World: Early Evidence on the Economic ConsequencesHail and collaborators showed that global markets exhibit mixed results when firms are forced to adopt IFRS.,”

Hail says the benefits might be even more limited in the United States because — unlike some other countries that have adopted IFRS — it already has a system of high-quality accounting standards. The IFRS standards are unlikely to significantly improve the reporting practices of U.S. companies, he notes, especially when the underlying incentives for accurate reporting — such as market and regulatory pressures for transparency — remain constant.

Globally, different sets of reporting practices will continue to exist because influences outside of accounting standards — such as domestic regulations, competitive forces and ownership structures — are also important determinants of companies’ reporting practices, they state.

“U.S. firms typically rely heavily on publicly traded external finance that is provided in arm’s length transactions,” says Hail. “As a result, U.S. firms face intense scrutiny by the capital markets and intermediaries like financial analysts, institutional investors and the media, and market forces likely already create a strong demand for transparent reporting.” The U.S. is also unique because a large fraction of households directly or indirectly hold debt and equity securities, compared to households in most other countries.

Consequently, a robust set of securities regulations and accounting standards have developed in the U.S. They deliver high quality financial reporting that meets the needs of outside stakeholders, according to the report. It is therefore difficult to argue that a move to IFRS would bring a significant improvement of the standards within the U.S. context, Hail states.

U.S.-based multinational firms could indeed realize cost savings from using a single set of standards, since their foreign subsidiaries may now have to comply with the domestic reporting standards in place where they are operating. “This introduces duplication of reporting systems and translation costs for U.S. multinational firms,” Hail says. “U.S. subsidiaries abroad that maintain and track their primary accounts in compliance with [U.S.] GAAP may have to translate the reports to the [local] domestic GAAP … or vice versa.”

Such situations get even more complicated if a foreign subsidiary of a U.S. multinational has to maintain or reconcile three sets of accounts: U.S. GAAP for reporting to its headquarters, IFRS to comply with local regulation, and domestic GAAP for tax purposes. “In these cases, switching to IFRS reporting by the U.S. multinationals could eliminate one set of accounts and hence produce cost savings,” notes Hail.

But smaller, domestically oriented American firms, he adds, are not likely to benefit from global financial reporting compatibility, and may also find it much tougher to absorb the considerable costs of transitioning to a different set of accounting standards.

Political Issues

Over and above the accounting challenges, political concerns may emerge as the most significant argument against merging U.S. and international reporting standards, Hail and his co-authors state in the report.

In fact, the Financial Accounting Foundation’s March 11 letter to the SEC expressed concern with two measures the IASB put into place — following what the FAF described as “significant [political] pressure … and the adverse consequences such pressure can cause, such as suspension of established due process procedures” — to allow IFRS-reporting companies to defer the recognition of significant losses on certain financial instruments. The FAF also cited a newspaper report that describes Sir David Tweedie, chairman of the IASB, as acknowledging “that the IASB needs more protection from political manipulation.”

Indeed, new SEC chairman Mary Schapiro has voiced misgivings about both the roadmap — prepared during the Bush administration — and the governance of the International Accounting Standards Board, according to WebCPA.com, a site for the tax and accounting community under the umbrella of Source Media’s Professional Service group. “American investors deserve and expect high standards of financial reporting, transparency and disclosure — along with a standard-setter that is free from political interference and that has the resources to be a strong watchdog. At this time, it is not apparent that the IASB meets those criteria, and I am not prepared to delegate standard-setting or oversight responsibility to the IASB.”

A move to international standards could relegate the U.S. Congress, the SEC and FASB to secondary roles, transferring the authority to set accounting guidelines to the IASB. The international board would continue to act as an independent standard-setting body, which, theoretically, would be answerable only to the trustees of the International Accounting Standards Committee Foundation and to a recently established monitoring board.

“Such a delegation poses numerous political challenges, beyond the economic aspects,” said Hail. “It is highly unlikely, if not inconceivable, that the U.S. Congress and other legislative bodies would give up power to a foreign authority or standard setting body.”

One major concern, he adds, is the U.S. belief that European and other governments and interest groups may, in pursuit of legitimate goals for their countries, “exercise an undue influence” on the IASB and, consequently, on the formulation of IFRS.

A Smaller First Step

Hail, Leuz and Wysocki propose an alternative road map; a two-stage process that they believe could help with the decision and ease the transition. First, any company could voluntarily choose to switch to IFRS or continue to report under U.S. GAAP. “The choices that are made would provide further information on the costs and benefits of IFRS adoption,” says Hail. “In the second stage, if universal IFRS adoption is deemed to be appropriate, companies not yet reporting under IFRS would be required to switch, but this mandate could depend on the voluntary adoption patterns in the first stage.” Under this scenario, universal IFRS adoption would be required only if at least a certain portion of companies, say 50%, switched to the IFRS in the first stage.

“A two-stage process allows companies with low net costs of IFRS [adoption] to move first, giving regulators, auditors and other companies an opportunity to observe and learn from [early adopters'] efforts to switch from U.S. GAAP to IFRS,” Hail says. “It would let auditors learn how to smoothly transition to IFRS, which could reduce costs for companies that adopt the new standards at a later date. Over time, more and more companies could find it attractive to make the shift, eventually making it easier to require all other companies to do the same.”

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