GAAP and IFRS convergence pros and cons

In 2016, the chief accountant of the SEC, James Schnurr, announced that he would not recommend that the SEC should mandate, or even offer the choice, for US companies to use International Financial Reporting Standards (IFRS). This announcement was believed to be the "death knell" for the convergence between GAAP and IFRS, a project that had already stretched more than a decade with only moderate success (Katz, 2015).

When the convergence project was originally proposed, there were several benefits cited that made the case for regulators to pursue the project. The biggest argument was that capital markets are becoming increasingly global, therefore it was valuable to converge all major accounting standards. If every nation in every country used the same accounting standards, that would reduce the transaction costs associated with the flow of capital. In theory, this would spark an increase in cross-border investment, and that in turn would provide greater opportunity for all companies, by reducing the friction associated with translating and understanding financial statements produced under different standards. While there were over 100 nations using IFRS, the US, Canada, and a few other major industrial nations still used their own set of accounting standards. The US decided that convergence with IFRS would be a positive for the US economy, and began the project.

Yet, there were fundamental differences that made convergence more difficult than was perhaps originally anticipated. Fundamentally, the two systems are different in their cultural foundations. Ding, Jeanjean & Stolowy (2005) note that GAAP is a set of principles, while IFRS is a set of standards. An example would be a situation where in one there was a prescribed rule for handling, but in the other there was merely guidance, the latter being much more open-ended. Cultural differences are theorized to account for some of the differences, but each instance where there was such a difference presented challenges for accountants, and for anybody else seeking to interpret the financial statements.

What this means is that GAAP have developed in line with US cultural norms, and have become ingrained in the accounting culture and norms in the profession. The IFRS would represent not just a shift in guidance, but a shift in the norms and expectations for accountants and investors alike. That is not to say that the two systems are fully different – indeed, there is considerable overlap at the fundamental level in terms of embracing conservatism, matching, materiality, historical cost and consistency (Ampofo & Sellani, 2005).

As a result, one of the issues that was central to the debate about the merits of convergence was that of weighing the costs and benefits. The costs were generally understood as confusion in the markets and in the accounting professional whenever a rule changed, and certainly when fundamental beliefs changed. The entire point of convergence was that it would make it easier for everybody the world over to understand financial statements, and reduce friction, yet the convergence process clearly was causing confusion, and going to cause confusion.

One of the underlying issues that spurred the move to convergence was the fact that foreign companies that wanted to list on US exchanges had to publish financial statements that conformed to US GAAP. The need to create statements that conformed to home country standards, and then other statements that conformed to US GAAP was clearly a transaction cost, and it was believed that this cost was resulting in competitive advantage for exchanges that conformed to IFRS. The US could attract more foreign listings, the theory went, if it converged with IFRS. Companies would appreciate having to only produce a single set of statements, and investors would not be confused when a company's statements were different depending on which report the investor happened to be reading. Reducing the friction associated with cross-listing was clearly going to be a benefit (US Fed News Service, 2007).

In 2007, the move was made to address this by allowing foreign companies to list without reconciling their financial statements (US Fed New Agency, 2007). Thus did not solve the issue of investors having to understand multiple different accounting systems, but it did reduce some of the friction that was preventing companies from cross-listing. It is understood that most investing is done at the institutional level, and institutions can if they so desire have people on staff to handle reconciliations or translations of IFRS, or any other foreign accounting system.

To understand whether convergence is a good thing or not, not only is it necessary to examine the benefits of convergence, but to weigh them against the status quo. The status quo allows the US to maintain its own accounting system. This system is governed independently of international influence, and therefore can be specifically tailored to the needs of US companies and US investors. The GAAP still need to be robust and transparent – and they are – but this is where the role of culture comes into play. Securities law is the provenance of the SEC and it is easier for the SEC to adjudicate the financial system if its values and systems are aligned with the rules by which companies report their financial condition. Convergence was in part a slow process because it wasn't just the rules that needed to be converged – it was the culture and the entire system for implementing the rules that needed to be changed. By allowing GAAP to remain, there will be no need to make those other changes, which could have been substantial in nature.

There is also the impact on foreign listers that has to be taken into consideration, since one of the main arguments in favor of convergence was that it would reduce transaction costs for foreign issuers to list on US exchanges. First, US exchanges tap into the deepest capital pool in the world, and therefore they are attractive despite added costs. One view holds that higher transaction costs are unlikely to dissuade firms that have a genuine benefit to tapping into US markets. It is known that firms that specifically want to trade in the US are typically willing to utilize GAAP, and those that are not as interested in trading in the US are more inclined to international standards, should they need to choose a second standard (Tarca, 2004).

It should also be taken in account that the nature of the differences between IFRS and GAAP might be significant in how investors and companies operate. As Ding et al (2005) note, some differences are divergences between the systems, and some are absences, where one system addresses an issue that the other system does not. Nobes (2009) notes that while some of these differences may not be particularly significant, some of the differences are significant, and for accounting practice this matters (Nobes, 2009).