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 Brandon Mills, a senior in business with a concentration in accounting.
IFRS: Not the Change We Need
by Brandon Mills
With the economy and the world getting “smaller” because of advancements in technology and companies being geographically and operationally located in several countries and jurisdictions, it is only a matter of time until the “one world” mentality spreads completely into accounting rules and regulations. Also with investors and businesses increasing their examination of foreign investment options, it would be in their best interest to be comparing apples to apples and not apples to oranges. Over the past few years, there has been a strong emphasis on the convergence between Accounting Principles Generally Accepted in the United States (U.S. GAAP) and International Financial Accounting Standards (IFRS), which are currently the two most commonly used accounting standards in the world. With that mind set the International Accounting Standards Board (IASB) has been working closely with the Financial Accounting Standards Board (FASB) in the United States to level the playing field and eliminate the ambiguity between these two standards (Johnson). This movement is generally perceived to be a step in the right direction to be able to properly compare companies that operate within other countries and report to regulatory agencies other than the Securities and Exchange Commission (SEC) (Rappeport).
However, a recent decision by the SEC to consider adopting IFRS and potentially abolish U.S. GAAP has raised several concerns. There is so much concern that many professionals within the industry have formed a so-called resistance movement against the United States converting to IFRS (Vive). Tim Reason stated, in his commentary Vive la Résistance, that U.S. GAAP and the confidence that it brings has brought the most robust capital markets in the world. It would seem silly to test investors’ confidence in our financial system by switching to a less regulated set of standards that gives companies freedom to choose the accounting treatment that they want to apply in any given situation, which without a doubt would be treatment that benefits them the most (Relevante). Others, however, would say fewer regulations through a more principles-based approach wouldn’t force companies to use principles that do not appropriately reflect their financial position (Relevante). Whichever a person’s stance on the issue, it is clear that through certain accounting treatments, companies can easily manipulate financial data to give false impressions of their financial strength.
Three distinct differences between U.S. GAAP and IFRS, which are commonly used by most if not all companies, can be easily manipulated where less guidance and direction is given. First, leases can be used to effectively over’ or understate assets and can also contribute to double accounting. Second, revenue recognition, which all businesses use, must be given a set of concrete guidelines or management with room for “earnings management,” a current type of fraud, which could be a critical force behind the next accounting scandal. Finally, Research and Development is a major and necessary expenditure for certain industries. For example, the pharmaceutical industry devotes billions upon billions of dollars into projects that may never make it to market in hope to find the next big miracle drug.
When the accounting policies for these three very common transactions within businesses are studied, it is clear that fuzzy lines and the incentive to falsify data under IFRS is stronger than under U.S. GAAP. It is under these circumstances that any decision about switching to IFRS must be carefully studied so we know the full extent of our decision. I believe switching to IFRS would be detrimental to business in the United States.
Leases have quickly become one of the most common types of business transactions in the United States. Companies have been formed that devote all their efforts to leasing to other companies and consumers. Even though the accounting treatments for leases are very similar between U.S. GAAP and IFRS, there are very important differences that need to be addressed. IFRS and U.S. GAAP both have two common classifications for leases: operating and capital (financing under IFRS). The accounting treatments for operating leases are the same under both methods. Payments are expensed (revenued) when they are incurred, and the assets and liabilities generated by the leased asset remain with the lessor. In fact, the accounting treatments for capital leases (financing under IFRS) are similar as well. The lessee takes on the asset and the associated liability. Similarly, the lessor removes the asset and liability if the lease is classified as capital (financing under IFRS). The fuzziness under IFRS doesn’t lie within the method in which leases affect the financial statements; it lies within the determining criteria in which the leases are classified.
Under U.S. GAAP, the classifications for leases are given very specific guidelines that determine their treatment. For example, in order to be classified as a capital lease under U.S. GAAP, the lease term must be over 75% of the asset’s useful life, or the present value of the minimum lease payments most be greater than 90% of the asset’s fair value. Whether a person agrees or disagrees with this accounting treatment, at least the lines in the sand are clearly divided between the two classifications. In Ernst & Young, LLP’s review of the difference between IFRS and U.S. GAAP, they explain that the test is “substantially all” instead of a clear percentage for testing the treatment of leases (20). What does “substantially all” mean? Is it 90%, or more, or maybe even less? Without clear guidance companies and even accountants will be able to rationalize why a situation should be treated a certain way. Management will choose the treatment that makes them look the best financially. Not only is it in the best interest for management to make their company look financially sound, but the level of independence between an auditor and the client would diminish. It would diminish because accountants would not have to test percentages to a rule book but use more professional discernment.
I feel that when making decisions about accounting treatments, auditors would be tempted to error on the side of the client to keep the client’s business. Most SEC filing companies know the requirements and regulations required of them. So if they know that the guidelines are not clear and can be given more leeway, management would have a position to challenge the auditor on a particular decision, which could intimidate them into siding with the company. Since auditors have gotten a strong stance and power over forcing companies to comply with rules after the increased regulation of the Sarbanes Oxley Act of 2002, why would we now want to have financials governed under less regulation? With leases making up a very material amount on both the balance sheet and the income statement, companies may be able to use them to manipulate financial statement users into believing what management wants them to believe. With no clear lines drawn, companies will without a doubt choose the treatment that benefits them the most instead of the one that more accurately reflects the financial position of the company.
A company’s financial position is predominately driven by revenue that it brings in as a result of its operations. Revenues are at the top of the income statement and fuel profit from within the organization. For example, U.S. GAAP has very distinct criteria that must be fulfilled before revenue can be recognized by a business. Again, without a clear direction given by accounting rules, the temptation for management to prematurely recognize revenue or unjustly defer may become an issue with sales and budgets deadlines approaching.
As with leases, IFRS lacks the general guidance and specific rules that U.S. GAAP puts on accounting treatment. In the construction industry, the main method of revenue recognition is Percentage-of-Completion. Under IFRS, if a percentage cannot be reliably estimated, the approach to Percentage-of-Completion changes from “Revenue Cost” to “Cost-Recovery” method (IFRS vs. GAAP). This method doesn’t allow any revenue to be recognized until after the cash payments exceed the cost of the project. That would be acceptable, but with most construction jobs not paying until the project is complete or close to completion date, construction companies would record large losses that would not fairly represent their operations. Imagine a long-term contract of a building taking over three years. Most companies would incur a lot of cost in the beginning with most cash flows resulting from financing activities. The result on the financial statements would not only show less than desirable income, but would also show negative cash flows from operations, which would make it seem that the company is in financial strains. When IFRS talks about reliability of the percentage, it gives no guidance on what is reliable. Does it mean that the construction foreman gives his opinion or a general contractors’ opinion? Again, without a clear rule in place, companies and accountants will be relying on professional discernment to make these critical revenue decisions. Professional discernment by the company or accountant can be easily manipulated and influenced by actions not in the best interest of shareholders.
To some industries, the next material income statement item is Research and Development. Many industries such as pharmaceuticals, technology, and energy, invest billions of dollars into researching ways to make products more efficient and developing new products that will help shape their image in the marketplace. Currently under U.S. GAAP, companies are required to expense Research and Development costs in the period in which they are incurred. This means that if a company incurs costs researching and developing in their operations, they must expense it on income statements for that same year. For most companies, this is a very material amount, which decreases their net income substantially.
Now what if a company didn’t have to expense these costs? The company would be able to increase net income by potentially millions of dollars. Under IFRS Development, costs are capitalized as an asset and not expensed when incurred (IFRS vs. GAAP). Supporters of IFRS say that by capitalizing these costs, we are more likely to match revenues and expenses, therefore better implementing the Matching Principle. However by allowing companies to capitalize those costs, their income increases. For most public companies, having higher incomes would be perceived as a good thing. They look to be a more desirable investment to investors and give them better credit standing to creditors. Just because an accounting treatment benefits the company doesn’t mean it best represents the company’s financial position.
Imagine if a pharmaceutical company would capitalize all of their development costs. Pfizer in 2007 spent over 8 billion dollars on R&D. That is more than their entire net income for 2007. If Pfizer would be allowed to capitalize the development costs, their income could increase anywhere between 50-100%, depending on the break out of Research to Development costs (Pfizer 2007 Annual Report). Now, if fewer than 20% of Pfizer projects in development never make it to market, we are then allowing companies to defer 800 million to 1.2 billion dollars worth of loss, which will need to be recorded once the project is determined to be a failure.
This accounting treatment could lead to bad business practice and unethical behavior. Management in fear of taking large losses will not “kill” failing projects and will instead keep them going because the dollars spent are being reported as assets and not an expense. There is no incentive for management to put a project to rest even when it is clear the costs outweigh the benefits. Also, it may be appealing for management to classify other expenses as Development costs to avoid the income statement. Supplies and labor may be classified as development but may actually be in another department.
Besides the change in business practices, companies will incur thousands of dollars in bookkeeping costs as a result of capitalizing these costs. With thousands of projects being in development, companies will have to spend money keeping track of which costs are with what product. The costs will eventually have to be amortized once the project makes it to market, so in order to amortize the correct number, companies will have to use advanced cost records to keep track of projects over several years. Maintaining these records will further force companies to incur extra costs that will ultimately flow to the consumer.
Unclear guidance is the common trend under IFRS. With all the advances the U.S. GAAP has gone through over the past 50 years, it would seem IFRS would be a step backwards for the Untied States. Not only do we have the most robust capital markets in the world with the lowest cost of capital, but we also have the toughest regulations on business that help sustain the strong degree of confidence that investors have in U.S. GAAP. I believe the SEC would be serving investors, that rely on financial statements, an injustice by destroying the safe guards that the FASB fought so hard to achieve. Even though the world does need one set of accounting standards, the costs of IFRS far outweighs the benefits that it offers.
- Epstein, Barry J. CPA. IFRS vs. GAAP. A service of Dr. Barry J. Epstein, CPA.
- Ernst & Young, LLP. US GAAP vs. IFRS: The Basic. April 2008 update.
- Johnson, Sarah. Goodbye GAAP. April 1, 2008 CFO Magazine.
- Rappeport Alan, Regulator’s Quandary: Which IFRS to use?. September 27, 2007.
- Reason, Tim. Vive la Resistance (to IFRS)?. Tim Reason September 11, 2008.
- Relevante: A Comparison: IRFS vs. US GAAP. November 2007