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 by R. J. Segovia, a senior in business with a concentration in accounting.
Missing The Target:
Convergence Replaces Improvement
by R. J. Segovia
“The appraisers are still in the old world,” (Aflalo, 2008) remarked Rozanski, Chief Executive Officer (CEO) of Delek Real Estate. Apparently the “old world” is anything except for the International Financial Reporting Standards (IFRS); which includes United States (US) Generally Accepted Accounting Principles (GAAP). So it seems now that the “Old World” is in the “new world” and the “New World,” or at least the US financial sector of the “New World,” is in the “old world.” While many would state that the US should not retain GAAP but instead switch to IFRS in efforts to join this new world, I completely disagree with this stance. The US should retain GAAP and not switch to IFRS because the lack of acknowledgment that IFRS and GAAP are more different than similar will negatively affect companies immediately. It is well known that US GAAP has extensive guidance and this is exactly what US companies need. The recent focus and push for convergence rather than the improvement of accounting standards departs from moral and ethical logic (which has faded away and been forgotten) while inferior financial reporting standards are creeping their way into the US financial system. The analysis of such statements must be thorough so that CEOs in the US are not found repeating the words of Mr. Rozanski who said, “we do not know what the company’s [net] profits are” (Aflalo, 2008).
While Mr. Rozanski may not know what the company’s net profits are, I doubt that he and many other CEO’s would agree with me that publicly traded companies will be negatively affected immediately and significantly if IFRS is adopted. Part of this disagreement stems from misinformation provided by large accounting firms that sugar-coat the differences between US GAAP and IFRS. In fact, according to a report released by Ernst & Young, there are eight significant differences in accounting related to financial statement presentation, seven for consolidations, joint venture accounting and equity method investees, three for intangible assets, three for inventory, six for long-lived assets, seven for impairment of assets, three for leases, nine for financial instruments, three for foreign currency matters, four related to provisions and contingencies, four related to share-based payments, nine for employee benefits other than share-based payments, four related to segment reporting, three for earnings per share, and two for subsequent events. It appears to me after finding this out that IFRS is, in no way, shape, or form, similar to US GAAP and will greatly change the numbers seen on the financial statements. These “significant differences” are termed to be “significant” by Ernst & Young themselves and do not even begin to embody the totality of just how different IFRS is from US GAAP.
However, Ernst & Young maintains, “We believe that any discussion on this topic should not lose sight of the fact that the two sets of standards are generally more alike than different for most commonly encountered transactions” (Ernst & Young, 2008). In contrast, PriceWaterhouseCoopers seems to take a more “realistic view” and openly admits, “Adopting IFRS will likely impact key performance metrics, requiring thoughtful communications plans for the Board of Directors, shareholders and other key stakeholders. Internally, IFRS could have a broad impact on a company’s infrastructure, including underlying processes, systems, controls, and even customer contracts and interactions” (PriceWaterhouseCoopers, 2008). This seems to fit well with a self-contradictory statement made by Ernst & Young regarding revenue recognition which reiterates, “There is extensive guidance under US GAAP which can be very prescriptive and often applies only to specific industry transactions” (Ernst & Young, 2008).
I call this statement self contradictory because it concurs with the statement made by PriceWaterhouseCoopers in that it brings to light the underlying truth: US GAAP is vastly different from IFRS. Regardless of the percentage of principles and rules which are similar, the differences that do exist and the severity of them are to an extent which makes any similarities pale in comparison. Even if it is true as Ernst & Young stated that “the two sets of standards are generally more alike than different for most commonly encountered transactions,” that statement appears to be completely irrelevant in light of the fact that financial statements and businesses will be so heavily impacted. Even if we assumed that those “significant differences” stated earlier were not applied to the most commonly occurring transactions, that assumption would bear no weight either. The differences between US GAAP and IFRS are in the details, and the detailed differences would be multiplied and expanded on a wide scope when implemented nationwide. Accounting firms such as Ernst & Young have a civil duty to not “beat around the bush” and just “tell it like it is” to businesses, investors, and the general public in big, black, bold letters: US GAAP ≠IFRS. It is illogical in one breath to term so many differences as “significant” but then attempt to justify that IFRS and GAAP more similar due to related underlying principles. Equal weights and measures must be used.
The weightier matters of financial reporting standards are the results those standards yield. If the end result application of two standards yields significantly different financial statements, then they are, overall, significantly more different than alike. More specifically, here is a logical and fair assessment: if two separate financial reporting standards produce financial statements that contain material differences, then they are materially different. If they are materially different then they are more different than similar. It is illogical to state that they are more similar than different while they produce financial statements with material differences. While the principles of the standards may appear to be similar, that bears no weight if the application of those standards yields different results. Ernst & Young, as well as many other public company accounting firms, has failed to perform their civil duty with due diligence by putting more weight on matters that are less important and less weight on matters that tip the scale. It comes down to a simple, logical thought process: if the financial statements from two standards are significantly different, then the standards are significantly different; period.
If the statements from two standards are not significantly different, then one would beg to ask, “Why do we need to switch at all if IFRS and GAAP are already comparable?” Some proponents of IFRS attempt to say that we need IFRS so that financial statements are universally comparable, but in the same breath also attempt to justify their stance by saying IFRS and GAAP are similar in principle. However, this is illogical. If IFRS and GAAP are similar, then comparability between financial statements cannot then, logically, be a material issue. As established previously, similar standards will produce financial statements which do not contain material differences. This leads to the logical conclusion that if IFRS and GAAP are similar, there will be no material differences. If there are no material differences, then the financial statements currently produced by IFRS and GAAP are already comparable and the “need for universal comparability between financial statements” becomes a moot point.
The basis for deciding if standards are similar should be by examining the resulting financial statements. Similar standards will result in similar financial statements and similar financial statements are easily comparable. It’s almost like saying, “The shoes in the store are just as good as the shoes I have on so I’m going to buy them.” There is no logic in that statement. If the two standards were that similar, then the issue of being able to compare financial statements universally is not an issue. It can only be possible for comparability to be an issue if you are looking at financial statements created through use of standards which are different enough to affect the financial statements in a material manner. If a financial statement is affected in a material manner, then clearly the standards are materially different. If financial statements are materially different, then they are more different than similar and to say anything otherwise is illogical and shows a lack of judgment.
The lack of foresight and honesty observed through the lack of a logical analysis and open admission to businesses, investors, and the general public will cause many immediate problems for companies. As stated before, “Adopting IFRS will likely impact key performance metrics, requiring thoughtful communications plans for the Board of Directors, shareholders and other key stakeholders. Internally, IFRS could have a broad impact on a company’s infrastructure, including underlying processes, systems, controls, and even customer contracts and interactions” (PriceWaterhouseCoopers, 2008). If the US switches from GAAP to IFRS companies will immediately have to begin restructuring all of these aspects of their business. They will have to make large expenditures initially and large changes in many areas. This would be acceptable under the right circumstances, but otherwise these changes will be completely negative with no silver lining.
The link between these thoughts exists in this: the failure to accurately analyze GAAP in comparison to IFRS stems from a lack of recognition that they are more different than similar. This lack of understanding and acknowledgement leads to poor decision making, poor advice, poor implementation, and inaccurate forecasts. Failure to recognize that significant differences exist to an extent that IFRS and GAAP are, in fact, more different than similar will cause companies to overestimate the benefits received from IFRS and underestimate the costs. When examining these underlying forces, it becomes clear that the lack of acknowledgement that IFRS and GAAP are more different than similar will negatively affect companies immediately.
In recognizing these differences, we must also remember that “There is extensive guidance under US GAAP which can be very prescriptive and often applies only to specific industry transactions” (Ernst & Young, 2008). In this statement, we find a few important key factors to expound upon. First and foremost: US GAAP has extensive guidance. Extensive guidance is necessary for US businesses to ensure investors that companies are abiding by the underlying principles so that another Enron or WorldCom doesn’t occur. As Ernst & Young so correctly stated, US GAAP is “very prescriptive.” When we get sick we go to a doctor and he prescribes a medicine for us. He doesn’t tell us the principles of healthy living because a principle is not going to help us recover or show us the steps we must take to be healthy; it will only give us an “idea” of what would be good for us to do. No; instead, our doctors prescribe what exactly we need to do. In the same way, US GAAP is like our friendly doctor who gives us the specific instructions packed with do’s and don’ts which ensure financial statement numbers remain healthy. Moreover, the fact that US GAAP has rules which often apply “only to specific industry transactions” is a positive note for investors.
Industries are different and these differences should be respected. Applying one broad principle the same way across industries for the sake of the principle itself is defeating the very purpose for which accounting exists: to communicate the financial position of an entity. If an entity exists within a specific industry or industries, it makes sense to have specific rules. It does not make sense to apply a broad principle to environments that function differently. In summary, businesses will be heavily impacted especially if they exist within a niche market or industry because they will no longer have specific rules but be permitted to instead disregard specifics and only concern themselves with the underlying principles which may prove to encourage inaccurate communication of specific financial conditions for various publicly traded companies.
Companies and industries are not cookie-cutter carbon copies of one another and applying principles without also providing an intricate web of rules to accompany those principles leaves more room for human error. This increased margin of human error increases the risk for management in a company to make poor decisions due to less accurate information provided via faulty financial reports. We mustn’t forget that investors are not the only users of the financial statements. Managers are users as well. Upon the increased possibility of human error and, thus, poor decisions come poor financial performance. Companies may skate through a few poor decisions if their assets and quick thinking of management permit, but other companies who would have otherwise made better decisions under the intricate understandings of financial performance provided by the US GAAP framework may find themselves overestimating their resources and underestimating their uses of resources. Unless the Securities and Exchange Commission (SEC) and US investors are confident that IFRS will more accurately portray the financial position of entities, the universal comparison of statements which report financial position of entities is irrelevant and useless.
In fact, it is logically impossible for companies to maintain their current level of potential financial performance if the financial statements are less representative of the true underlying economic realities. The logic is as follows: accurate statements of financial position lead to well-informed decisions which in turn are better decisions; and these better decisions are multiplied to permit optimal performance by an entity which ensures optimal financial gain and return to shareholders. Based upon that logic, if any set of accounting standards are adopted which do not result in businesses reporting their financial position more accurately than under the currently held standards, it is impossible for all businesses to benefit equally in the long run from that change in accounting standards. In fact, it is inevitable that certain businesses will fail in the long run that otherwise would not have, unless of course there is a motivating factor put in place to cause businesses to actually report their financial position more accurately under IFRS.
However, based upon recent events, I doubt that having less rules will somehow, magically, motivate businesses to be more accurate. I fail to see how IFRS will improve the accuracy for which financial performance is reported. I fail to see the logic in removing guidelines specific to industries that can benefit management or provide more accurate information to improve their ability to make profitable decisions. It seems there is a lack of recognition for the underlying logic of financial and business concepts which clearly indicate that the focus to increase return to shareholders should be on how to improve the information managers use so that they can, in turn, make improved decisions.
In focusing on these basic, logical, underlying concepts and not getting lost in ideas based on nothing, it becomes clear that US GAAP has extensive guidance which is exactly what US companies need. This extensive guidance acts as a hedge that aids in minimizing human error by eliminating some of the “guess work” that must inherently be done and is unavoidable when preparing financial statements. To remove such a hedge shows a lack of acknowledgment for these underlying concepts which do explain the true realities of how businesses function and how the numbers on the financial statements are determined. We must not forget that these numbers are not “cut and dry” calculations, but many done through human estimation which is not an exact science. Our hedge around the processes involved in such “guess work,” that being the US GAAP, is healthy and necessary for US companies. To say otherwise is illogical and requires one to redefine the very nature of businesses and the underlying concepts which govern them.
Now some would read my previous statements in what I fail to see and criticize me quite quickly. For example, in failing to see how IFRS will improve the accuracy for which financial performance is reported, McGladrey & Pullen, a leading national CPA firm, could be quoted in rebuttal, “A consistent financial reporting basis would allow a multinational company to apply common accounting standards with its subsidiaries worldwide, which would improve internal communications, quality of reporting and group decision-making” (McGladrey & Pullen, 2008). This statement is true if you assume that IFRS will lead businesses to report their financial position more accurately. However, until it is established that IFRS will lead to more accurate financial reporting on the part of businesses then the ability to have consistent financial reporting is irrelevant and it is illogical to link it to quality of “reporting and group decision-making.” I say that it is irrelevant because no matter how consistent statements are, if they are less accurate then it is illogical to state that decisions would be more accurate as a result.
These positive statements about IFRS all hinge on the assumption that businesses will report their true economic and financial position more accurately as a result of IFRS. If that assumption is wrong, then all the statements are wrong as well. If the reporting quality does not improve, then it is illogical to state decision making on any level would be improved. Certainly decision making can be improved by a consistent standard insofar as the comparability factor of statements is concerned. However, at all levels, even under a consistent reporting standard, decision making improvement is contingent on the ability of the standard to cause businesses to report their financial condition more accurately. In fact, because there would only be one standard, the scrutiny under which the proposed standard is examined should be fine-tuned and put under a microscope not just blindly followed for the sake of consistency alone.
It seems, however, that all of Europe is “following along” and the US seems to be an outlier. According to ifrsaccounting.com, IFRS is a required as part of the European Union (EU) initiative and a number of countries are already using or plan to implement IFRS in the next few coming years. This seems to explain the statements made by Deloitte which establish, “the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) have been working together to achieve convergence of International Financial Reporting Standards (IFRSs) and generally accepted accounting principles in the United States (US GAAP)” (Deloitte, 2008) for the past few years now. Regarding the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB), David M. Katz of CFO.com confirms Deloitte’s words in support, “[they] have worked closely to eliminate major differences between the two standards” (Katz, 2007). These close talks between the FASB and IASB precede the news of ifrs.org on the current condition, elaborating, “Accountancy Age reports that the Securities and Exchange Commission is expected to publish its IFRS roadmap today or tomorrow” (ifrs.org, 2008) Talks of convergence, road maps, and IFRS “How-To” guides have reached the market before the justification has caught up to the general public or investors. With years and years of talking, the sole purpose appears to have been to “converge” standards not “improve” the ability of the standards to result in accurate portrayal of financial position for entities.
When the goal is “convergence” and not “improvement,” the bigger moral and ethical picture is left to fade away and forgotten. The underlying fundamental purposes for which accounting exists have been placed on the back-burner and other issues have taken precedence. This is unethical and illogical behavior. Before trying to converge standards the FASB should have sought the support of the SEC and investors as well as the general public.
Instead of doing this, it seems as though major decision makers have been rearing ahead full power without considering the deeper issues such as the condition of and requirements for appropriate social, political, private, moral, and ethical infrastructures necessary to support such a change. There appears to actually be no measuring rod in existence because those making decisions are not interested in measuring the two systems and comparing them to one anothertheir decision has already been made. The measuring rod determined by the appropriate partiessociety, investors, publicly traded companies, and the US governmentwould point towards implementation of not only the various necessary infrastructures, but also the various underemphasized intricacies within. These intricacies include: the accuracy of financial statements under IFRS, the ability of international enforcement of auditing standards to a level that is consistent enough to justify implementation of a single accounting standard, and desperately needed government agencies.
Such government agencies need to first be established in order to aid in the re-education of the many professionals across the nation whom have the potential to negatively impact, however indirectly, various business operations after a switch from US GAAP to IFRS. This statement is made clear by revisiting where we began with the words of Mr. Rozanski: “The appraisers are still in the old world” (Aflalo, 2008). Surely he was pointing towards the lack of infrastructure. From appraisers to credit agencies and banks to other various external entities (all of which businesses rely on and interact with), a tightly-knit initiative to establish appropriate infrastructures and related webbings within must precede any change in accounting standards. In addition, prior to even considering the expenditures required for such a large task, it would be appropriate to re-examine the purpose of the switch.
Unfortunately, the purpose of the switch is not being questioned. We are only asked, “should the United States switch from US GAAP to IFRS?” In answering this, make no mistake: switching to IFRS would be a mistake. The differences are significant in that they are clearly material and they cannot be ignored or sugar-coated. Ignoring these material differences will negatively affect companies immediately. Companies do not have a strong recent history of ethical behavior and the moral compass in the United States is best guided by prescriptive rules that mimic the routines of our friendly doctor. The financial statements must remain healthy and vigorously exercised by the backing of the Public Company Accounting Oversight Board, which ensures auditors have a spine. The underlying similarities in concepts and principles will not ensure that those underlying principles will be followed let alone result in improved accuracy of financial statement reporting upon a switch to IFRS. Companies in niche markets would no longer have niche standards applied to them. Perhaps more statements could be compared, but there is no guarantee that the statements would be more accurate.
These inaccuracies would lead to worse decision making and ultimately harm society and investors as well as various publicly traded companies. Prescriptive rules in US GAAP are exactly what US companies need. The goal we should have is that of improvement of accounting standards, not convergence. A move to IFRS from US GAAP is not only a bad decision, it is completely illogical and perhaps even a form of de-evolution as the global society seeks to be one massive melting pot for the sake of melting alone. Melting together in harmony is wonderful but I would hate to hear, “we do not know what the company’s [net] profits are” (Aflalo, 2008). I, for one, would definitely not want to invest in a company with a CEO who says those words. I doubt many other investors would feel comfortable taking that risk either.
- Aflalo, Eti. 2008. Values change as real estate firms switch to IFRS accounting. Israel: Haaretz. On-line. Available from Internet, http://www.haaretz.com/hasen/pages/ShArtStEngPE.jhtml?itemNo=949016&contrassID=2&subContrassID=2&title=%27Values%20change%20as%20real%20estate%20firms%20switch%20to%20IFRS%20accounting%20%27&dyn_server=172.20.5.5, accessed 16 November 2008.
- Ernst & Young. 2008. US GAAP vs. IFRS: The basics. Cayman Islands: Ernst & Young. On-line. Available from Internet, http://www.ey.com/Global/assets.nsf/US/Assurance_US_GAAP_v_IFRS/$file/US_GAAP_v_IFRS.pdf, accessed 16 November 2008.
- PriceWaterhouseCoopers. 2008. IFRS and US GAAP similarities and differences. USA: PriceWaterhouseCoopers. On-line. Available from Internet, http://www.pwc.com/extweb/pwcpublications.nsf/docid/598E9D7EDF5239A0852574AB00659431/$File/IFRS_USGAAPSep08.pdf, accessed 16 November 2008.
- McGladrey & Pullen. 2008. Considering IFRS?. Bloomington, MN: McGladrey & Pullen. On-line. Available from Internet, http://www.mcgladrey.com/Resource_Center/Audit/Articles/ConsideringIFRS.html, accessed 16 November 2008.
- Deloitte. Year. IFRSs and US GAAP: A pocket comparison: An IAS Plus guide. USA: Deloitte. On-line. Available from Internet, http://www.iasplus.com/dttpubs/0809ifrsusgaap.pdf, accessed 16 November 2008.
- Katz, David M.. 2007. IFRS or GAAP: Take Your Pick?. USA: CFO.com. On-line. Available from Internet, http://www.cfo.com/article.cfm/9133180?f=related, accessed 16 November 2008.
- ifrs.org. 2008. SEC Set to Publish IFRS Roadmap. USA: ifrs.org. On-line. Available fromInternet, http://www.ifrs.org/, accessed 16 November 2008.