New England Biz Law Update
The Securities and Exchange Commission last November proposed a road map leading to the possible mandatory adoption of International Financial Reporting Standards (or IFRS) for all reporting U.S. issuers. Not many things could be more revolutionary than a complete revision of accounting systems that scraps all Generally Accepted Accounting Principles (GAAP, for short), long mandated by the SEC, and not many proposals could present more significant impediments. Nonetheless, few commentators doubt that IFRS is inevitable, and the ultimate questions appear to be of timing, not result.
The SEC premises its road map on the desirability of a single financial reporting regime for worldwide business. The SEC Release (Securities Act Release No. 8982 at www.sec.gov) lists numerous jurisdictions — 113 countries and counting — that have already opted into IFRS. The benefits of being able to compare financial information among entities on a global basis, where shareholders are not located in the jurisdictions of their companies and where companies operate in many places, are self-evident.
The SEC acknowledges that much of the world’s market capitalization trades over non-US exchanges (the European Union, Australia, Israel, Brazil and Canada alone account for 31 percent). The subtext here is one of inevitability, spiced with the melancholy if implicit realization that the United States no longer is able to define the ground rules of world business.
This loss of primacy is not just psychological, although it is that, too. The road map itself observes: “Due to the IASB’s (the governing body for IFRS) need to develop standards with a wider variety of constituents in mind, US capital market participants will have a lesser degree of input into the standard setting process including fewer members of the IASB and fewer participants on roundtables and advisory and other groups than they currently have in the US standard setting process.”
In one sense, IFRS is a leading indicator of the decline of American hegemony over the world business stage. And in that sense, it is hard to imagine that this country will be able to resist IFRS for very long, regardless of the problems identified by the SEC in the road map.
Timetable
The road map contemplates that the SEC will decide in 2011 whether or not to mandate IFRS for all Securities Act filings. If it does so, large accelerated filers would be required to comply for years ended after Dec. 15, 2014; regular accelerated filers one year later; and all other reporting companies one year after that.
The SEC proposes that certain larger companies may elect to comply for years ending after Dec. 15, 2009, provided that they are among the largest 20 companies in their industries worldwide; that IFRS is the accounting regime most used by such 20 companies; and that the SEC, upon application, issues a letter of authorization.
There are two different suggestions, upon which the SEC solicits comment, for reconciliation with GAAP, basically requiring either a single initial reconciliation or a three-year process. The SEC estimates that up to 110 U.S. companies might qualify to apply, incurring an aggregate transitional cost of $3.5 billion.
Issues of substance
First, the SEC sets forth several pre-conditions to any declaration of IFRS on a mandatory basis, a couple of which seem startling: In addition to seeking assurance that the international foundation controlling IFRS is properly funded and that the system will be interactive with the SEC’s mandated XBRL language, which allows tagging of financial data in a uniform and comparable manner, the SEC will evaluate the ability of the U.S. professionals to educate and train themselves to actually perform the services required and will review the improvement of the substance of IFRS as a reporting regime (noting that US GAAP presently is more robust) — this notwithstanding the 113 countries already using it.
The SEC sees the question of building requisite expertise as multi-dimensional. Not only certified public accountants but also actuaries, valuation experts and members of industry groups would need to integrate IFRS into training materials; colleges and universities would need to teach it; and the Uniform CPA Examination would need to address it. The SEC itself, and the PCAOB, would have to become conversant. CPAs also would have to become expert enough to render requisite opinions.
Numerous GAAP-dependent aspects of the U.S. economy also must be considered. GAAP determines capital requirements for financial institutions. GAAP is the basis of many tax-related determinations, and, for example, IFRS presently does not even permit LIFO accounting. Many of our U.S. contracts, particularly though not exclusively in the lending area, contain GAAP covenants or GAAP accounting calculations.
Current IFRS standards for P&L recognition of litigation liability might have significant impact on a given reporting company and, in turn, place substantial pressure on counsel (inside and outside) to evaluate litigation risk differently.
An issuer, required to use the equity method of valuing investment in another company, would require specific information about the investee for each reporting period, and that information in turn may prove elusive if the investee itself is not using IFRS accounting.
IFRS is more principles-based, less driven by specific hard-and-fast rules. While counsel may look forward to the day when rational discourse with outside auditors will be the norm, the opportunity for greater dispute between issuer and CPA presents itself when accounting treatment is made more judgmental, particularly in the context of the litigious business climate in this country wherein accounting judgment is easily challenged in subsequent legal actions.
Finally, interesting issues of application of IFRS to the U.S. system are suggested by the road map. It is clear that all SEC financial reporting by issuers subject to IFRS must only utilize the IFRS regime, not only under the ’33 act but also in proxy and tender offer applications and in meeting disclosure obligations wherein an issuer is effecting an unregistered sale of securities (private placement). It is also clear that at present the SEC is not proposing IFRS for either investment companies (funds) or broker-dealers. Further, the road map speculates as to the difficulty of complying with mandatory IFRS by companies in an initial public offering.
The public comments
As this article goes to press, the period for SEC public comment on the road map is about to expire. Already, the volume of comment is substantial. (Many larger multi-national companies have asked for an extension of the comment period, some until the end of April, so that key personnel will have enough time to reply; by the time you read this, the SEC may have acceded to this request.)
Substantive comments run the gamut:
• Don’t do it. IFRS is principles-based, will thus increase audit costs; let the marketplace control a gradual convergence to one international standard.
• Do it, but don’t mandate precise IFRS compliance as some countries are moving toward IFRS by convergence of practices.
• Do it now. Uncertainty about the final decision, scheduled by the SEC for 2011, will cause foot-dragging, then a mad dash toward compliance.
• Do it our way: Have the world adopt this country’s GAAP. There will be less cost to a battered U.S. economy.
Encouraging early adoption is silly; it is expensive. And what if the SEC does not adopt IFRS?
IFRS pricing of balance-sheet assets, based on original cost, is inconsistent with the U.S. trend toward fair value/mark-to-market accounting.
Treatment of depreciation, whether by group or individual assets, and the choice of applicable depreciable lives appear fundamentally inconsistent between GAAP and IFRS.
If IFRS is mandated in 2014, there will be great cost and mass confusion; rather than forcing change, we should allow the systems more time to converge so it will be unnecessary to prepare three years of comparative financials based on two different accounting systems.
The prestigious FEI (Financial Executives International) wants to eliminate any reconciliation of GAAP and IFRS.
Who cares? We are a big company, and no one (investors, shareholders, creditors, analysts, banks) has ever expressed a need for IFRS.
Final thoughts
Is it not inevitable that the accounting regime of the public market will dictate accounting for all U.S. enterprises? Will accounting firms forever maintain practices using two complex, robust and inconsistent systems? Will the accounting profession bifurcate, with firms doing public company work operating under IFRS and firms doing all other company accounting adhering to GAAP? Not likely.
And if comparability of financial results internationally is important, why is it not equally as important, or more important, in comparing domestic U.S. companies, some of which may not be public issuers?
And what private company, looking to an exit through acquisition, or IPO, is going to want to handicap itself with an accounting regime that is inconsistent with the accounting requirements of the vast bulk of its potential acquirers — or of the SEC?
If IFRS is coming, and many commentators are sure that it is, it will come with all pistons firing, and the IFRS engine soon will occupy the entire roadway of U.S. financial reporting. General counsel should closely monitor the process, to be sure that his or her company, board and audit committee are taking requisite planning steps along the way.
