Advantages and Disadvantages of switching from U.S.

GAAP to IFRS
Nara Yoon
Charles Center Summer 2009

2 Advantages and Disadvantages of switching from U.S.GAAP to IFRS

In todays business, markets are demanding increasing conformity. Many countries have converted to and implemented the International Accounting Standards Board (IASB)s accounting standards. The United States, however, still maintains its own Financial Accounting Standards Board (FASB). Both IASB and FASB have created International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles (U.S.GAAP) respectively. These accounting standards are rules of measurements for financial statements that companies issuing stock to the public must provide to stockholders (Libby, 21). There are various advantages and disadvantages of the U.S. companies changing their systems from U.S.GAAP to IFRS. As the markets have grown to become more complex and global, the disparities between the two standards have been a significant issue as consumers and producers call for reform. The current differences between U.S.GAAP and IFRS affect many aspects of business. There seems to be some future losses but the U.S. is continuing to move toward conversion. The primary benefits U.S. hopes to get are comparability, and thus, greater market liquidity and lower cost of capital. They also hope to see cost savings for multinational companies who keep record of several accounting standards. Most importantly, U.S. businesses wish to take advantage of the global accounting network. At a closer view, these assumed benefits are not nearly as influential as many people suggest. The first benefit of the conversion is comparability. Switching to IFRS would allow people to see various companies from different parts of world on the same plane. As willingness to trade increases, cross-border investment and integration of capital markets are easier with greater market liquidity and lower cost of capital (Hail, 12). Investor bases would increase as the financial reports are becoming comparable. With better information, companies would be able to more effectively allocate their capital. Having one standard, however, does not guarantee comparability. With the same standard, practices and enforcement can differ considerably across firms and countries. It is only natural because diversity in accounting standards would result from diversity of the countries institutional infrastructures. Although there are currently more than 113 countries on IFRS, an estimated 29 countries using IFRS added their own exceptions, defeating the purpose of a global standard (IOMA, 6 ) (Henry). Although comparability in general is a difficult goal in an international setting, the nature of IFRS itself also seems to hinder the process of becoming a global standard. The major difference between IFRS and U.S.GAAP is that IFRS requires more discretion and that U.S.GAAP is more principles-based and detailed (Hail, 7). IFRS has wider rules and less specific guidance applications, giving more room to interpretation. Thus, IFRS incorporates the value judgment of an accountant in its financial report. These value judgments can easily be influenced by incentives a company may have, causing a variety of ways to implement IFRS. This further interferes with creating a global standard. Although U.S.GAAP is moving toward convergence with IFRS to make them more similar, the differences have considerable influence in representing the companys economic performance. Differences do matter. The five principal areas where there are disparities are fair values, revenue recognition, share-based payment, financial liabilities and equity, and consolidation. One of the most debated issues is the use of fair values in IFRS and U.S. GAAP (Hail,53). IFRS had allowed fair-value accounting, which is incompatible with the current legal,

3 Advantages and Disadvantages of switching from U.S.GAAP to IFRS

institutional, and political environment in the U.S. (Hail,53) The use of fair value is congruous with increasing the amount of discretion given to managers (Watts, 2003a, 2003b). In addition to more discretion, the differences also affect the numbers the companies choose to represent themselves. The area of financial liabilities and equity gives rise to differences that could affect how a firm chooses to raise capital (Hail,54). Reclassification of certain instruments as equity and debt will affect reported net assets and debt to equity ratios (De Jong, 2006).These changes will affect firms borrowing activities, debt covenants, ratings, and other contracts (Hail,54). In the area of consolidation, one of the specific differences is the order of the inventory. U.S.GAAP uses the Last-In-First-Out (LIFO) method, which assumes that goods purchased most recently are sold first and that the remaining items have been purchased at earlier periods (Libby, 2007). Using the LIFO method results in lower gross profit, which allows a company to be taxed less. Under IFRS, however, the LIFO method is prohibited. Implementing IFRS would trigger a big tax hike for U.S. companies (Bogoslaw). This would probably diminish a companys position because of a higher tax burden. Thus, the differences between the standards in the various areas affect a firm holistically. The switch of numbers effect more than just the financial report but also the companys financial standing and its bargaining power. The second benefit of the conversion is cost savings, primarily for multinational companies. Before companies can realize cost savings, transition costs are considerable. They include preparation, certification, dissemination of reports, and opportunity costs (Hail,13). Businesses will be adjusting their computer systems and processes, updating documentation, training employees, and hiring outside specialists and consultants (Hail,40). Based on survey data for 2005 mandatory transition to IFRS in the European Union, it was possible to construct an estimate of the first-time preparation costs of IFRS consolidated financial statements for publicly traded firms (Hail,41). Using the surveys measurements, the transition costs estimate to be at least 8 billion dollars for the entire U.S. economy(Hail,41). The average one-time cost of $420,000 will be difficult to absorb for local and small firms (Hail,41). The main beneficiaries would be multinational corporations. Despite the average one-time cost of $3.24 million dollars, these companies will still be saving money when they cut down from three to two or one financial reports (Hail,41). Those only on U.S. GAAP, however, will reap no benefits in the short run. Although in the long run, there may be cost savings, the small companies will probably have trouble surviving until that time. Interestingly, the one of the benefits U.S. would not assume is better quality and enforcement. It is little disputed that U.S. already has a high quality set of standards and superior enforcement. There was an instance in the 1990s when European firms adopted U.S. GAAP. These European firms had the similar goals that some U.S. firms today have to convert to international standards. They all wanted to reduce asymmetry and lower the cost of capital. (Wu,1) This would allow them to access capital markets, in which companies get most of their money. The European firms believed that by switching to U.S.GAAP, they would convey their economic conditions more credibly (Wu,2). They hoped to gain more trust from their capital providers and stakeholders by producing more accurate financial statements. One of the major reasons why U.S.GAAP was thought to be more transparent was that U.S.GAAP prohibits the practice of hidden reserves. Hidden reserves used to be widespread

4 Advantages and Disadvantages of switching from U.S.GAAP to IFRS

in Continental Europe. It is a bundle of money that a company creates by increasing an expense account (Wu,6). This bundle is supposed to be stored in case of potential future losses. These reserves can be accessed later to cover up poor performances. Since these companies were allowed to create hidden reserves for unspecified potential future losses, people would not know how much money a company would have stowed elsewhere and whether the performance the company is claiming to have is legitimate. This was why the accounting processes in Continental Europe were viewed as opaque (Wu,9). Thus, using U.S.GAAP, which prohibits this practice, resulted in more honest and truthful reports of a companys economic performance. European companies voluntary disclosure of economic losses under U.S.GAAP showed their commitment to more transparency (Wu,9). Their willingness brought more credibility to their reports, increasing their bargaining power. This curious case shows that U.S.GAAP is also a high quality set of standards. U.S.GAAP has its advantages in its transparency with clear-cut rules and application guidance. The European companies in the 1990s had switched to U.S.GAAP because U.S.GAAP had more credibly and accurately portrayed their true economic performances. This instance shows that U.S.s movement toward IFRS is not because IFRS is a set of standards of higher quality. In fact, U.S. is believed to have unparalleled public enforcement of their high quality standards because of its institutional infrastructure and its detailed rules. FASB can maintain and had maintained its high quality standards and public enforcement but whether IASB would be able to do same brings doubt to U.S. businesses. A major drawback to switching to IFRS is giving monopoly status to London-based IASB (Hail,7). This switching may signal willingness by US to cooperate internationally (Hail,8). However, U.S. would be ceding power to IASB which would pose several problems. Firstly, IASB would be a step closer to being a potentially dangerous monopolist. Since monopolist does not face competition, IASB standards may slip and still would not be corrected. In fact, Ashwinpaul Sondhi, a member of FASB, said that many analysts in the U.S. and overseas found the differences between GAAP and foreign standards very useful (Bogoslaw). He agrees that competition between different sets of standards might result in better information (Bogoslaw). Secondly, U.S.s power over accounting would diminish. Currently, the authority to set accounting standards in U.S. rests not only with FASB, but also with the Congress, the Securities and Exchange Commission (SEC) and the court precedents. Ceding power to IASB would not only diminish the control of FASB but also that of other authoritative bodies. Even though U.S. has seats on IASB, there are concerns of underrepresentation (Economist.com). Some firms want to have influence in accordance to Americas equity markets, which account for almost half of global market capitalization(Economist.com). In general, U.S. companies worry that U.S.s interests will not be served as well as they were under FASB. Thirdly, IASB does not a stable funding source. Its finances derive primarily from corporate contributions from various countries (Bogoslaw). This unfortunately compromises its independence (Bogoslaw). For example, in October 2008, IASB had bowed to pressure from European regulators on the issue of fair value accounting. It had allowed a certain transfer of assets which FASB only allowed on rare circumstances. (Bogoslaw) That would not be the last time when European and other governments would continuously try to interfere. Even the chairman of IASB, Sir David Tweedie, acknowledges, IASB needs more protection from

5 Advantages and Disadvantages of switching from U.S.GAAP to IFRS

political manipulation (Knowledge@Wharton, Mind the GAAP). IASBs susceptibility to outside influence may hamper the boards duties in setting standards and overseeing practices fairly. This brings U.S. to question whether IASB is even ready take charge of a global accounting network. In addition to studied political and economic implications to the transition, there are some unknown risks that not even specialists can predict. Adopting IFRS has had mixed evidence around the world. As it has been established that U.S. already has superior quality and unparalleled public enforcement (Hail,30) and that there are many similarities between U.S.GAAP and IFRS, benefits themselves may be limited (Hail,5), in which case the costs of transitioning would outweigh the benefits. In a country like U.S. which has one of the largest economies in the world, it is rather difficult to know what the transition will do. IFRS has not been tested in such an environment (Hail,8), whereas U.S.GAAP has been proved through time. U.S.GAAP has been customized, evolving with the changes in the U.S.s institutional framework (Hail,7). U.S. GAAP has become more rules-based according to the demands of the changes (Hail,47). It has been tested through various incidents such as Enron and Tyco International. Therefore, switching to a new standard from an accepted dependable standard may be apprehensive, creating unknown complications. Although an initial look at the conversion would seem favorable, at closer detail, there are far more complexities to the situation. The goal of the global standard still seems difficult with IFRS. It is also uncertain whether the benefits of joining the IFRS accounting network will overcome the transition costs. Aside from the multinational companies, smaller companies will find these costs significantly heavy and they see little benefit of switching when U.S.GAAP has already proven itself to be of high quality. They also wonder whether the quality will be maintained when they switch to IFRS and whether IASB has resources to do so. In addition to the known complexities, there are some unknown risks, which raise hesitation and doubt among the American companies. As U.S. continues to converge to IFRS, however, it should continually monitor the process to bring the best for its businesses.

6 Advantages and Disadvantages of switching from U.S.GAAP to IFRS

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7 Advantages and Disadvantages of switching from U.S.GAAP to IFRS

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8 Advantages and Disadvantages of switching from U.S.GAAP to IFRS

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9 Advantages and Disadvantages of switching from U.S.GAAP to IFRS

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