One of the courses I teach is Intermediate Accounting 2. This semester’s paper assignment is to take a position on whether the U.S. should adopt IFRS or retain its GAAP. To improve the quality of papers I receive, I instituted a system of peer review, requiring each paper to go though two rounds of double non-blind review. The end result was 51 pretty good papers (39 for GAAP, 11 for IFRS, 1 for both). I’ll be posting the four best. This paper is by Amber Soldenwagner, a senior in business with a concentration in accounting.
IFRS: Not Right for the U.S.
by Amber Soldenwagner
The replacement of Generally Accepted Accounting Principles (GAAP) with that of International Financial Reporting Standards (IFRS) has recently been a significant topic of discussion. There are two sides to this discussion: those that support the switch to IFRS and those that instead support the retention of GAAP in the U.S. Those who support switching from GAAP to IFRS argue that IFRS will provide a common reporting language, making financial reporting more meaningful across borders and provide consistent financial reporting for companies with global operations. Supporters also believe that one common reporting system will reduce costs for companies and make it easier for investors to compare the financial statements of companies from different countries (Diamond and Herrmann, August 2008).
I intend to explain why some of these supporting arguments for IFRS implementation are flawed. I will also present the rationale behind why the U.S. should not switch to IFRS and retain GAAP instead. From the problem that the switch to IFRS would be exceedingly costly, to the fact that IFRS leaves more room for interpretation and lacks bright line rules, I will discuss all of the reasons as to why switching to IFRS in the near future would not be the right step for the U.S. to take.
The first reason why I think that switching to IFRS would not be beneficial for the U.S. is that it will be extremely costly to convert from GAAP to IFRS. Some of these costs include workforce training, user training, and system changes. The workforce would need to be knowledgeable about IFRS, which would entail training professionals well enough to provide a smooth transition. Furthermore, new accounting curriculum for colleges and universities would need to be adopted to encompass IFRS. In addition to this, user training would need to be implemented because IFRS information would only be worthwhile if it was understood by the investment community. IFRS adoption would also lead to changes to operational procedures and information technology systems, which could likely be a transition that would take several years (Diamond and Herrmann, August 2008).
Under the Security and Exchange Commission’s (SEC) proposed timeline, all publicly traded companies would have to use IFRS within six years if the plan goes forward. Companies would be required to straddle both IFRS and GAAP for three years while making the transition and the SEC would expect to see three years worth of IFRS prepared financial statements for each filing. This would be a very costly process for U.S. companies. The SEC estimates that US companies will spend between 0.125 percent and 0.13 percent of their revenue on making the transition to IFRS from GAAP in the first year of filing alone (Johnson and Leone, November 2008).
All of the mentioned changes that will need to be made to accommodate the switch from GAAP to IFRS will not only present challenges to the industry, but they will also entail extensive time and resources. These costs are unnecessary and outweigh the benefits of switching to IFRS. Based on an incremental analysis, the only cost benefit of switching to IFRS would be reduced audit fees that would result in a cost savings of $100 billion dollars. This seems significant until one considers the additional costs that would be incurred if the U.S. switched to IFRS. Companies would end up spending about $1 trillion switching from GAAP to IFRS, education and training would cost around another $1 trillion, and if the switch was implemented, market values for stocks and bonds would go down, and the amount of this decline would be around the sum of $3 trillion (Albrecht, October 2008). Obviously, the total costs of switching to IFRS far exceed the benefits.
Comparability of Financial Statements
The fact that comparability between financial statements will not be achieved is another reason why the U.S. should not switch to IFRS. Although supporters of IFRS adoption in the U.S. argue that it will provide comparability between financial statements worldwide, I disagree with this. The reason why the goal of comparability won’t be reached is this: the differing backgrounds of people in numerous countries applying IFRS means that interpretative differences will arise because of different historical practices (Taub, September 2007). If some countries interpret IFRS differently than other countries, then how would that lead to comparability between financial statements between those countries?
SEC Chairman Cox stated that, “Securities regulations can and should be converged to a far higher degree than we have already attained. But it is unrealistic to think we could or should make them identical, because of differences in national laws, economic conditions, and objectives” (November 2008). Although Chairman Cox supports the switch from U.S. GAAP to IFRS, he blatantly admits that even if IFRS was implemented, there would still be differences in financial reporting, and financial statements would not be “identical.” Supporters argue that one of the objectives of switching to IFRS is to provide greater comparability, but Chairman Cox’s comments contradict this.
The argument that greater comparability will be reached by switching to IFRS is obviously flawed. Additionally, it has been hard enough for the Financial Accounting Standards Board (FASB) to operate only within the U.S., so it will undoubtedly be more complicated for an international body with many cultures, economies and languages. With such diverse constituents, it’s inevitable that international standards will be even more subject to compromise than U.S. GAAP and this could lead to the consequence of declined usefulness and less comparability (Bahnson and Miller, October 2008).
Why should the U.S. switch to IFRS when GAAP is one of the best systems that has ever been produced? Sure, GAAP is complex and has some of its own problems, but it works (Top Ten Reasons, September 2008). It would be irrational to implement a new system that would require a costly and painful transition when we don’t even know what the consequences of switching will be or if IFRS will even work in the U.S. In 1999, the FASB concluded that IFRS was of lower quality than GAAP (Top Ten Reasons, September 2008). Not much has changed with IFRS in the last eight or nine years to alter that conclusion, so why should the U.S. adopt a set of standards that is inferior to what it already has? GAAP has been widely used, discussed and interpreted for more than 60 years, and IFRS can’t even compare to this because it has only faced such rigors for 10 years (Diamond and Herrmann, August 2008). IFRS financial statements are just not yet up to the quality of GAAP financial statements. Strides to achieving this have yet to be made, and if IFRS is not up to par with GAAP, then switching to IFRS should at least be put on hold until this point is reached.
IFRS supporter, SEC Chairman Cox, stated that, “International agencies often are forced to regulate to the lowest common denominator. Of necessity, they must yield to the average rather than the highest standards of their members in order to achieve consensus” (November 2008). In this statement, Chairman Cox gives the impression that IFRS is the “lowest common denominator” and the “average” rather than the highest set of standards. If IFRS isn’t the highest set of standards, it doesn’t make sense for the U.S. to switch to these second-rate standards.
Principles-Based vs. Rules Based
One of the most important rationales behind why the U.S. should not switch to IFRS and should retain GAAP instead is due to the fact that IFRS is principles-based and GAAP is rules-based. This is an important distinction between IFRS and GAAP because it means that with the implementation of IFRS comes more room for interpretation in regards to financial statements, and this is not something that the U.S. needs. For principles-based accounting to work, those in charge must have the right principles. Current management is clearly lacking in that respect. Instead, they seem to have only one self-interested matter in mind, and that is to do whatever it takes to present financial statements that people want to see.
Management continually distorts the concepts behind public accountability, all in pursuit of deceiving efficient capital markets into paying too much for their securities. Giving management flexible accounting standards is the last thing the U.S. needs. The victims would end up being all of us because the markets will never bid security prices higher in response to more information uncertainty and risk, and instead, capital costs will go way up driving those prices lower (Bahnson and Miller, October 2008). The only reason why the cost of capital in the U.S. is low is due to extensive regulation (Albrecht, September 2008). With IFRS the amount of regulation will decline and financial statements will be less reliable, and the cost of capital will rise as a result of this.
IFRS is obviously open to more interpretation, but it also lacks bright line tests which are necessary for accurate and reliable financial reporting, which is another reason why the U.S. should not switch to IFRS. A change to principles-based accounting will not produce accurate and reliable results because of the shortage of ethical and economic principles in the current generation of management and auditors (Bahnson and Miller, October 2008). It can be seen from past incidents, that accounting fraud is a significant point of concern in the U.S. By allowing GAAP to be replaced with IFRS, the bright line tests that currently exist will be removed.
A lack of bright line rules will only make it easier for management to alter financial statements. Outright fraud would be replaced by more subtle means of earnings management due to the fact that interpretation will be left up to the judgment of management (Top Ten Reasons, September 2008). Bright-line accounting rules are also important in the U.S. for helping investors because companies must report all transactions in the same manner, making financial statements more comparable (Albrecht, November 2008). The loss of bright line rules is not something the U.S. needs and losing these rules would have adverse outcomes for those involved. No basis of accounting can stop fraud, but rules-based accounting can at least help to control it.
It can be seen that switching to IFRS and abandoning GAAP is not the right direction for the U.S. Many reasons support this, such as the high costs associated with converting from GAAP to IFRS, the possibility of less comparability between financial statements, the reality that IFRS is inferior to GAAP, and most importantly the fact that IFRS lacks the amount of regulation and bright line rules that are necessary in the U.S. Switching to IFRS would be an extensive and costly transition, and the overall costs of switching outweigh the benefits.
Many of those pushing for IFRS implementation in the U.S. are just pushing for it out of their own self-interests. It’s not hard to notice that a majority of those pushing for IFRS are only doing so because it will make it easier for them to make their numbers and they won’t be second-guessed by auditors, investors, or the SEC (Top Ten Reasons, September 2008). This is not the direction that financial reporting in the U.S. needs to take, and implementing IFRS in the near future in the U.S. will only lead to undesirable outcomes. That being said, GAAP is the best system for the U.S., and IFRS is just not compatible with the U.S. nor is it in the U.S.’s national interest to implement such a system.
- Albrecht, David. 1 October 2008. Benefits and Costs to U.S. Adoption of IFRS. On-line. Available from Internet, http://profalbrecht.wordpress.com/2008/10/01/benefits-and-costs-to us-adoption-of-ifrs/, accessed 17 November 2008.
- Albrecht, David. 10 November 2008. Unwarranted Politics. On-line. Available from Internet, http://profalbrecht.wordpress.com/2008/11/10/dave-albrecht-ifrs-critic/, accessed 17 November 2008.
- Albrecht, David. 26 September 2008. Why IFRS Won’t Work in the United States. On-line. Available from Internet, http://profalbrecht.wordpress.com/2008/09/26/why-ifrs-wont-work in-united-states/, accessed 17 November 2008.
- Bahnson, Paul R. and Paul B.W. Miller. 2008. The Spirit of Accounting: What Good are Principles Without Principles? Accounting Today 22 (October 6-19): 16-17. On-line. Available from Internet, http://0search.ebscohost.com.maurice.bgsu.edu/login.aspx?direct= true&db=bth&AN=34695786&loginpage=login.asp&site=ehost-live&scope=site, accessed 17 November 2008.
- Cox, Christopher. 18 November 2008. Speech by SEC Chairman: ‘The Future of International Standards and Cooperation In Light of the Credit Crisis’. On-line. Available from Internet, http://www.sec.gov/news/speech/2008/spch111808cc.htm, accessed on 23 November 2008.
- Diamond, Marc and George Herrmann. 2008. GAAP? IFRS? What you need to know. San Antonio Business Journal, 1 August. On-line. Available from Internet, http://www.bizjournals.com/sanantonio/stories/2008/08/04/editorial2.html, accessed 17 November 2008.
- Johnson, Sarah and Marie Leone. 17 November 2008. SEC: Early IFRS Adoption will Cost Firms $32M. On-line. Available from Internet, http://www.cfo.com/article.cfm/12625195, accessed 17 November 2008.
- Taub, Scott. 2007. IFRS and GAAP: The Good and the Bad. Compliance Week, 25 September. On-line. Available from Internet, http://www.complianceweek.com/article/3642/ ifrs-and-gaap-the-good-and-the-bad, accessed 17 November 2008.
- Top Ten Reasons Why U.S. Adoption of IFRS is a Terrible Idea. 16 September 2008. On-line. Available from Internet, http://accountingonion.typepad.com/theaccountingonion/2008/09/top-ten-reasons.html, accessed 17 November 2008.