Are IFRS and GAAP converging?
Richard Martin looks at the relationship between International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (GAAP) and what the future holds.
IFRS are set by the International Accounting Standards Board (IASB) and comprise around 30 standards together with official interpretations.
Who uses IFRS and US GAAP?
IFRS have been adopted by the European Union for all of their listed companies from 2005, but are also used widely as the basis for national standards in many other countries (South Africa, Malaysia, Australia, New Zealand, India, China and so on). Accountants who prepare or audit either the accounts of EU companies or the consolidation information prepared by their associates or subsidiaries will have to use IFRS.
Accountants will encounter US GAAP either with American groups or with foreign groups that have a listing on US stock markets. US GAAP are standards developed for the 12,000 or so listed companies in the USA, and required by the Securities and Exchange Commission (SEC). Foreign companies that have shares or bonds listed in the USA need not publish US GAAP accounts as such, but must in effect prepare them in order to provide a reconciliation statement. This details for their US investors the differences between net profit and net assets as reported and how they would have been stated under US GAAP.
Though there is no general filing requirement for accounts of unlisted companies in the USA it is thought that about 15,000 other companies prepare GAAP-compliant accounts as a requirement of bank borrowings or on a voluntary basis. GAAP, principally developed by the Financial Accounting Standards Board (FASB), are more extensive than IFRS - comprising hundreds of standards, interpretations, opinions and other authoritative rules.
At the time of Enron it was observed that IFRS were principle-based standards whereas US GAAP were rule driven. In reality both are based on principles, but also include rules to clarify them. It is, however, true that US GAAP have more exceptions with "bright lines" to distinguish them. The range is more extensive - there are specific standards for the forestry, movie, oil and gas industries and so on. So the standards are longer, more complex and more comprehensive than IFRS.
Not surprisingly US GAAP reflect national concerns and influences. For example the US Congress in effect prevented FASB imposing a proper standard on share-based payments (executive stock options and the like) for fear of the effect on the new economy start-ups. IFRS by contrast must be applied in varying jurisdictions, which has produced more alternative treatments to accommodate national variations, especially those in the USA and the UK. The bright lines and the extensive provision of interpretations and rules reflect the need for clarity in an environment where directors and auditors are more likely to be sued by disgruntled investors.
How do the systems differ?
The different development of the systems is reflected in the standards' details. In preparation for the 2005 transition the IASB is revising some of its existing standards and producing new ones on share-based payments and business combinations for example. Many of these changes will help to reduce the differences with US GAAP. The differences remaining after this process that are likely to give rise to reconciling items include the following.
- Development costs of new products and services - these should be capitalised as intangible assets under IFRS if conditions about recoverability are met, but must be written off in most cases under US rules.
- Impairment - the US has an initial comparison of undiscounted cash flows against carrying value, whereas IFRS use discounted cash flows and with long life assets this can produce significant differences. In US GAAP impairment produces a new cost base and so no reversals are possible, unlike IFRS.
- Inventory - Last In First Out valuation is allowed in the USA, but not under IFRS.
- Segment reporting - US rules allow more flexibility than IFRS which require analysis on two bases (by line of business and geographically).
- Definition of subsidiaries to be consolidated - the basic rules for US GAAP revolve around majority ownership, rather than the control to obtain economic benefit test in IFRS. The treatment of special purpose entities can be different.
- Business combinations - even after the IASB's new convergent standard differences will remain in the treatment of research and development and restructuring provisions on acquisitions, and in minority interests.
There remain a number of options in IFRS where one of the choices would not be compatible with US rules. These would include the following.
- Revaluation of property, plant and equipment is allowed under IFRS but not under US GAAP.
- Joint ventures - the US allow only the equity method while IFRS allow proportional consolidation.
- Investment properties - while in the US such properties have to be accounted for at depreciated historical cost, IFRS allow a fair value accounting option (at market value with changes in market value to be included in profit for the year).
- Borrowing costs on construction - interest must be capitalised along with other relevant costs in the US. IFRS permit all interest costs to be written off as incurred.
Will the systems converge?
In September 2002 the IASB and FASB concluded the Norwalk Agreement to work towards convergence and since then tangible progress has taken place:
- Major differences in the treatment of business combinations have been eliminated by IASB adopting the bulk of the US standards.
- FASB is proposing a standard on share-based payments that will be very similar to the new IFRS.
- Some existing differences will be removed by the short term convergence changes proposed by both IASB (on discontinued operations, assets held for disposal and contingent liabilities) and the FASB (including changes in accounting policy and classification of liabilities).
- IASB and FASB are working jointly on a number of new projects (for example on revenue and performance reporting) where the eventual solutions are expected to be the same. They have agreed to try to align their work programmes to ensure that this happens.
It seems realistic to expect that in the future new standards will be the same internationally as in the USA. Converging the existing standards is clearly harder to do, given the different evolution, style, length and depth of detail of the two systems. But there seems an intention to devote time and resources and, importantly, a willingness to make convergence a two-way street. It is probably realistic to hope that the reconciliation items will diminish to a level where they are exceptional or minimal. At that point it might be feasible for the SEC to allow its foreign registrants to file IFRS accounts without a reconciliation statement, which would be a major help to international companies.
Richard Martin - Head of Financial Reporting, ACCA