Global Rules

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 some form of global accounting standards) or retain its unique GAAP. To improve the quality of papers I receive, I instituted a system of peer review, requiring each paper to go though one round of double non-blind review. The end result was 28 pretty good papers (21 for GAAP, 7 for IFRS or global accounting standards). I’ll be posting the three best. This paper is by a junior in accounting.

by Pepper Potts (pseudonym)

When over 100 different entities are bound – by choice or mandate – to a certain policy, there comes a sense of urgency for others to analyze the situation, make a decision, and take a stand. In this instance, the matter to be addressed is whether or not the United States should join the majority of other countries in adhering to International Financial Reporting Standards (IFRS), or retain Generally Accepted Accounting Principles (GAAP). Many opportunities are opened with the prospect of a global set of standards: communication, efficiency, comparability, and the advantage of working in a global market. However, caution needs to be taken when considering which global standards to use. IFRS has become popular, but it is not a suitable option because its principle-based nature sacrifices quality. Everyone needs to be involved in developing a new global system that achieves high-quality through a rules-based method. While the need for a global set of accounting standards grows, IFRS is not the solution. The United States should not abandon GAAP for IFRS, but a change to a global system needs to occur.

The global accounting system currently in progress is IFRS, but there are problems that exist with this system. The first issue is that a global system should be developed under the efforts of many, not a couple of select groups, because it concerns all; this is not the case with IFRS. The transition to a global system is a huge step, and if so much effort is to be put forth into making a change, it should be to something better designed than IFRS. There is no point in taking a huge step in the wrong direction when a high quality system can be developed to begin with. In his article, The Quest for Transparency in financial Reporting, Bert Zarb presents stipulations for maintaining a high quality system. He says, “To be useful and timely, financial information must…be reliable, comparable, consistent, and transparent” (Zarb, 2006). If a global system can maintain these elements, benefit will be gained from switching.

These elements are all achievable on a global scale; they are already being used across the United States through GAAP. One primary reason that GAAP has been so successful at incorporating all of these elements is because it is rules-based, whereas IFRS is principle-based. A rules-based system keeps all of the elements in check. The users of a global accounting system need to know it is reliable in that the information and reporting done will be useful, accurate, and available. This is not certain under IFRS due to their reduced investor focus. A successful global accounting system needs to keep an appropriate level of an investor focus; once the public trust is violated, a company (and the business market in general) will take a hard hit. In order to maintain reliability, the other three elements – comparability, transparency, and consistency – must also be fulfilled.

Using a global accounting system automatically satisfies the need for comparability. With all businesses operating under the same standards, the financial statements and reports of companies would be formatted similarly, and thus much easier to compare. Transparency is an element a bit trickier to attain, but is just as necessary as the others. It can be achieved when a high-quality system, such as GAAP, is used (Zarb, 2006). This is an area where IFRS falls short; it is just not developed enough.

As a principle-based system IFRS cannot achieve high-quality results. GAAP’s rules-based nature means that the system is developed and detailed; fit to achieve high-quality standards. Zarb writes, “US GAAP consists of a set of complex and detailed accounting rules that leave little room for individual judgment. These rules-based accounting standards ensure consistency in application” (Zarb, 2006). Thus, using a rules-based system addresses both the need for transparency and consistency in standards. Some people argue that GAAP is too complex and view individual interpretation as a benefit, thus they opt for IFRS (right step, 2007). Tom Selling is the author of The Accounting Onion blog and he has just the illustration to combat such erroneous thinking. In one of Selling’s blogs on contingent liabilities he talks about how rules-based systems are like bright lines and principles-based systems are like fuzzy lines. He uses the accounting for leases under IFRS and GAAP as an example.

As in tennis, if the present value of the minimum lease payments turns out to be even a hair over the 90% line of the leased asset’s fair value, your shot is out and you lose the point. The counterpart to FAS 13 in IFRS is IAS 17, a putative principles-based standard. It’s more a less a carbon copy of FAS 13 in its major provisions, except that bright lines are replaced with fuzzy lines: if the present value of the minimum lease payments is a “substantial portion” (whatever that means) of the leased asset’s fair value, you lose operating lease accounting. If FAS 13 is tennis, then IAS 17 is tennis-without-lines. Either way, the accounting game has another twist: the players call the balls landing on their side of the net; and the only job of the umpire – chosen and compensated by each player – is to opine on the reasonableness of their player’s call (Selling, 2008).

Selling directly demonstrates how having too flexible of standards is detrimental and how leaving room for interpretation can lead to misuse way too easily. As a race, humans do better working for the good of all under the use of strict standards than without. It doesn’t take a genius to see that humans are, by nature, self-centered creatures.

It is natural to work for one’s own benefit. As such, why open opportunity for that by allowing room for interpretation with principle-based IFRS? Self-centeredness is not just something that can be overcome, it is a terminal disease that won’t be stopped just because a policy calls for it to. Humans have had self-interest at the forefront since the beginning of time. Look back to the Garden of Eden; even Adam and Eve worked out of their own desires, against God’s specific instructions. If that is how easily humans overstep lines with specific expectations, I don’t want to know how bad things would get with fuzzy lines. Why would anyone in their right mind believe that fuzzy lines and lax rules allowed by IFRS are ok?! Using a rules-based accounting system helps to keep consistency in tact because it works to ensure accounting situations are handled the same in all cases.

While GAAP does fulfill the four qualities Zarb presents for a successful, high-quality system, the United States can’t hold out forever on switching to a global system. There is only so long it can hold out before either it succumbs to the change or disaster strikes. IFRS is not a strong option, but that does not mean that one cannot be designed. The United States has a lot to offer the world, and its efforts would be better spent helping format a system that can be used on the global level verses resisting efforts. The world system is changing and if the United States doesn’t attempt to keep up and participate, it is going to be left behind.

There are numerous benefits, for the United States and the world, involved in establishing a global accounting system. An accounting system is a means of communication involving several parties: within a business, between businesses, and between a business and other entities (investors, lenders, etc.). Communication is an important and essential element of business, and it already faces many different obstacles (i.e. language). Therefore, a change that yields a stronger and more efficient way to communication information should be considered worthwhile. With a global system, the complexity involved would be reduced because there would only be one system of communication to master; it would be a single system simplification. It would also mean that business people across the world could interact and operate on a completely new level because the accounting system is the same. This would be especially helpful because the rapid development of technology has lead to an expansion in doing business on a global scale. The more businesses connect internationally, the greater the need for a global system – it will aid in communication.

By using a global accounting system, an obstacle of communication is eliminated and that opens up many other doors of opportunity. When communication is made easier through use of a single system, businesses operate more efficiently. Only one system will need to be learned in order for everyone to understand and use the resulting information and no translation will be needed. With a single system there will be less time and money spent for companies in the United States who have foreign operations (Alcaro, 2009). One accounting system will also make learning and applying the system easier for students coming out of college into the business world; it will keep the time spent earning a degree to a minimum. There also won’t be confusion as to what policies belong to what systems.

Comparison of companies worldwide would be so much simpler with a global accounting system because the financial statements would already be prepared according to the same policy and analyzed with the same standards. It would just be a matter of looking at two companies side by side. This would be beneficial to those running the company, so that they can get a better idea of where they stand in relation to all other companies. Additionally, investors would benefit from being able to more easily analyze and compare their options. Investors would be able to look in the global market and easily make comparisons so that they can make the most of their investment. This retains the investor focus that GAAP currently works to keep in the US, except it would be expanded to a global level. With more people able to make use of the global companies, the global market will expand (Alcaro, 2009). According to an article by John Alcaro, this expansion will lead to more opportunities to use foreign capital. The move to a global accounting system would significantly simplify foreign interactions and options.

Transition to a global system is going to have its challenges, but there is much to be gained by the United States making a switch. Change in general does not carry a positive connotation, and as such it is to be expected that some people will object the change initially. Change is often tough to handle, but afterwards things will only go uphill. “The one-time cost…will vary depending on the size, diversity, and operating structure of individual companies. But the long-term benefits should be more than worth the effort” (right step, 2007). The United States can handle the transition, and someday it will; it has dealt with changes before and can do so again.

When it comes down to choosing an accounting system there is much to consider. Changes do need to be made, but it has to be to something of higher-quality than IFRS. Developing a global accounting system would be the best option for everyone because it allows for better communication worldwide, which leads to efficiency in other areas including comparability and global market growth. A global system needs to be more like GAAP, in that it is rules-based, rather than IFRS which is principles-based. By using a rules-based system, information yielded will be higher quality because it is reliable, comparable, consistent and transparent. The United States shouldn’t switch to IFRS just yet; the better option would be to help develop a global accounting system that is rules-based.

Works Cited

• Alcaro, John. 2009. “Should the U.S. switch to IFRS?” Online. Available from Internet, http://www.articlesbase.com/accounting-articles/should-the-us-switch-to-ifrs-1371025.html, accessed 17 March 2010.
• PricewaterhouceCoopers, 2007. IFRS: The right step for US business. Delaware: PricewaterhouseCoopers LLC. Online. Available from Internet, https://cfodirect.pwc.com/CFODirectWeb/download?sourcetype = contentattachment&content=MSRA-78NN47&filename=IFRS%20white%20paper-PWC.pdf, accessed February 2010.
• Selling, Tom. 2008. “Contingent Liabilities: A Troubling Signpost on the Winding Road to a Single Global Accounting Standard.” The Accounting Onion Blog. Online. Available from Internet, http://accountingonion.typepad.com/theaccountingonion/2008/05/ias-37-and-fas-5-a-troubling-signpost-on-the-road-to-a-single-global-accounting-standard.html, accessed 15 March 2010.
• Selling, Tom. 2008. “Top Ten Reasons Why U.S. Adoption of IFRS is a Terrible Idea.” The Accounting Onion Blog. Online. Available from Internet, http://accountingonion.typepad.com/theaccountingonion/2008/09/top-ten=reasons.html, accessed 15 March 2010.
• Zarb, Bert J. 2006. “The Quest for Transparency in Financial Reporting: Should International Financial Reporting Standards Replace U.S. GAAP?” Online. Available from Internet, http://www.nysscpa.org/printversions/cpaj/2006 /906/p30.htm, accessed 15 March 2010.