Long-Term Impacts of IFRS and GAAP Convergence on Reporting

Introduction

In the world of accounting, there has been a sustained focus on creating a workable standard for firms to utilize around the world. This effort is driven by the need for greater transparency and more consistent financial reporting. To determine the overall scope of what is happening requires carefully examining the convergence of International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP). These elements offer specific insights that highlight the scope of these changes and the way they are affecting different stakeholders.

Globalization is having a positive impact on corporations by giving them access to new markets and clientele. Technology is improving and the world is becoming more interconnected, thanks in part to advancements in communication. As a result, accounting standards are converging to provide greater transparency to investors and regulators. However, a significant problem is that the new standards are often confusing and create uncertainty in understanding the financial information provided by organizations. To address these challenges, regulators have focused on creating a universal standard: the International Financial Reporting Standards (IFRS). These are guidelines designed to address the differences between countries and the practices most commonly utilized (Bragg, 2010).

One of the biggest challenges facing firms that list on multiple stock exchanges concerns how they account for revenues. In some countries, standards are more lax and give personnel greater flexibility, while in others certain practices are discouraged due to the confusion and misrepresentations they can produce. For example, under Generally Accepted Accounting Principles (GAAP), some countries allow reverse entries to improve financial results, including reporting revenues on potential sales in the quarter a transaction is completed. However, there is a probability these projections will prove inaccurate, because the customer could cancel the contract or alter the size of their purchases. When this happens, the firm must restate earnings, having taken an overly optimistic perspective on revenues. This is problematic, as it can cause regulators and investors to question the validity of the information they receive and may make it appear as though financial improprieties are taking place—even when actuaries had no control over the impact of outside events (Bragg, 2010).

The problem with this approach is that it is permitted under GAAP standards inside the United States. However, other countries—including Canada, Australia, and those in Europe—do not recognize these methods, because their figures make it harder to project earnings or gauge the impact on forecasts. At the same time, some firms want to use this approach in order to take immediate write-offs and inform investors about the impact of various events on their bottom-line results. These differences vary from one company to the next and are based upon the management and accounting philosophies embraced by each organization (Bragg, 2010).

To address these issues, there has been a focus on integrating all of the different standards under the IFRS protocol. According to a study conducted by Barth (2012), these shifts are creating changes in practices and attitudes, yet also underscore significant challenges that remain. Barth states: "IFRS firms have greater accounting system and value relevance comparability with U.S. firms when IFRS firms apply IFRS than when they applied domestic standards. Comparability is greater for firms that adopt IFRS mandatorily, firms in common law and high enforcement countries, and in more recent years. Earnings smoothing, accrual quality, and timeliness are potential sources of the greater comparability. Although application of IFRS has enhanced financial reporting comparability with U.S. firms, significant differences remain" (Barth, 2012). These insights reveal the potential long-term benefits and drawbacks of convergence. To fully understand what is taking place requires carefully examining these shifts and their lasting impacts through a literature review, an examination of research methods, and an analysis and discussion.

Literature Review: The Pros and Cons of Integration

Since the 1950s, there has been a focus on creating a single standard that integrates American guidelines with those used around the world. This effort began when various oversight boards sought to improve transparency and make it easier for companies to list on multiple stock exchanges. The basic idea is to create standards that improve transparency and ensure that everyone is following the most widely accepted guidelines (Ball, 2006).

However, many countries—including the United States—have been slow to adopt these kinds of standards, because economic and political forces are influencing the process. According to a study conducted by Ball (2006), these shifts are forcing firms to accept universal principles and standards, yet at the same time there are issues with many older systems continuing to influence which standards are utilized. These factors are shaped by economic and political forces following worldwide integration of both markets and politics, making the integration of financial reporting standards ultimately inevitable. The pros and cons are reflected in the unbridled enthusiasm of allegedly altruistic proponents. On the benefits side, there are extraordinary successes in developing a comprehensive set of high-quality IFRS standards, which has proved successful in persuading over 100 countries to adopt them. On the negative side, there are problems with the fascination of the IASB (and the FASB) regarding fair value accounting. A much larger concern is that there will be substantial differences between countries in the implementation of these guidelines (Ball, 2006).

These insights show how the convergence of accounting standards is a logical process to simplify and streamline reporting procedures. The problem is that certain practices which the old systems continue to support conflict with the one-size-fits-all approach of the new IFRS standards. This makes it harder for universal guidelines to be accepted, in part due to an inability to adjust to the needs of firms in specific regions. The result is that there are obvious gains and limitations arising from these challenges.

Furthermore, Daske (2008) determined that IFRS guidelines are effective when there is an incentive for organizations to embrace them; however, in countries where adoption is voluntary, many organizations often choose to retain the old standards. Daske examined the economic consequences of mandatory IFRS adoption around the world, focusing on the effects on market liquidity and the cost of capital using a sample of firms mandated to adopt IFRS. He found that market liquidity increases around the time of IFRS introduction and documented a decrease in firms' cost of capital along with an increase in equity valuations—but only when accounting for the possibility that these effects occur prior to the official adoption date. Partitioning the sample, he found that capital-market benefits occur only in countries where firms have incentives to be transparent and where legal enforcement is strong, underscoring the central importance of firms' reporting incentives and countries' enforcement regimes for the quality of financial reporting. Comparing mandatory and voluntary adopters, he found that capital-market effects are most pronounced for firms that voluntarily switch to IFRS, both in the year they switch and again when IFRS become mandatory. While the former result is likely due to self-selection, the latter result cautions against attributing capital-market effects for mandatory adopters solely or even primarily to the IFRS mandate. Many adopting countries make concurrent efforts to improve enforcement and governance regimes, which likely contribute to these findings (Daske, 2008).

This illustrates the motivating factors that encourage firms to embrace IFRS standards. Higher levels of liquidity result, and firms function more effectively in these environments. Yet a larger number of organizations will not embrace IFRS if there is no incentive to do so—in those situations, they will rely on old methods based on lower costs and convenience. This is something many integration efforts fail to account for when taking a one-size-fits-all approach.

Key Differences Between IFRS and GAAP Standards

The biggest differences between the two standards concern the way various assets are accounted for. Under GAAP protocols, an asset is recognized using its current or fair market value, whereas IFRS guidelines focus on what the asset is worth in the future. This makes it difficult for accountants to report the value of different assets, given the separate views about what assets are worth and how they are applied to the organization's balance sheet (Bellandi, 2012).

For instance, intangible assets are reported under GAAP using their current market value, which creates contention about future valuation by taking a here-and-now approach. Under IFRS standards, this is seen as failing to reflect the nature of how firms actually operate. In many situations, GAAP will record increases or write-offs without considering factors such as the current state of the economy, revenue trends, or other intangible factors that can affect value—whereas IFRS looks at an asset's net worth in the future using unrealized events (Bellandi, 2012).

According to a study conducted by Van der Meulen (2007), there are challenges in encouraging firms to switch to GAAP standards when they do not see the broader benefits. Examining different German-based organizations embracing one standard or the other, the results indicate that many choose GAAP. The study explored attribute differences between U.S. GAAP and IFRS earnings, testing two market-based earnings attributes—value relevance and timeliness—as well as two accounting-based earnings attributes: predictability and accrual quality. These attributes were tested for German New Market firms, which were allowed to choose between IFRS and U.S. GAAP for financial reporting purposes. Overall, the study found that U.S. GAAP and IFRS differ only with regard to predictive ability. The finding that U.S. GAAP accounting information outperforms IFRS holds even after controlling for differences in firm characteristics such as size, leverage, and audit firm. However, the results also suggest that these differences are not fully valued by investors, as no significant and consistent differences were observed for the value-relevance attribute (Van der Meulen, 2007). This illustrates that there are not enormous differences between the two systems; the challenge is encouraging firms to recognize the benefits of IFRS and become motivated to embrace it.

The types of businesses most affected are large multinational entities with operations in different parts of the world. This is problematic for these firms, as they must change how they report and release financial information to investors and regulators. Some of the most notable sectors include: airlines, technology companies, manufacturers, oil and gas producers, service organizations, financial institutions, and transportation organizations.

A good example can be seen in a study conducted by Bao (2010), which examined the effect of differences related to reporting inventory, property, plant, and equipment, intangible assets, and development costs between IFRS and U.S. GAAP companies. Both univariate tests (t-tests) and multivariate tests (ANOVA, probit, and logit analyses) were used to compare ratios between IFRS and U.S. GAAP companies. The results consistently show that IFRS-country firms have a significantly higher current ratio, a significantly lower asset turnover ratio, and a significantly lower debt-to-asset ratio (Bao, 2010). These insights show how differences in reporting standards can have a dramatic impact on the way various ratios are calculated, and consequently on the firm's balance sheet and the value of its assets—including common stock and bonds.

Henry (2009) determined that these shifts will have varying effects depending upon the industry and business model of the firm. He evaluated the extent to which the FASB and IASB convergence projects and the EU-wide adoption of IFRS have impacted the differences between firms' financial results under U.S. GAAP and IFRS. Using 2004 to 2006 reconciliation disclosures of 75 EU cross-listed firms, he found that the average gap between U.S. GAAP and IFRS income and between U.S. GAAP and IFRS shareholders' equity declined from 2004 to 2006, consistent with convergence, though the net income gap remains significant. Although both pensions and goodwill are included in the convergence projects, these adjustments appear to be the dominant reconciliation items. Across the EU, net income and shareholders' equity reconciliation amounts differ significantly by industry and by legal origin of the firm's home country, raising questions about the homogeneity of IFRS as implemented. Furthermore, most firms report IFRS net income and shareholders' equity higher and lower, respectively, than U.S. GAAP equivalents; as a result, 28% of the sample firms' 2006 return on equity (ROE) under IFRS is more than 5 percentage points higher than under U.S. GAAP, whereas fewer than 10% report ROE more than 5 percentage points lower. Finally, shareholders' equity reconciliations and income reconciliations appear value-relevant, although results are somewhat sensitive to model specification. Overall, significant numerical differences still exist between results under IFRS and U.S. GAAP, despite convergence. In light of the SEC's elimination of the requirement for reconciliations between the two sets of standards and the potential adoption of provisions allowing U.S. firms to choose between them, investors and other financial statement users should be aware of these significant numerical differences (Henry, 2009).

These insights show that certain firms benefit from integration while others—particularly those with a domestic rather than international focus—experience a negative impact. This underscores how differences in reporting standards will influence the preferences of accountants and actuaries.

Convergence will change how firms report financial information, particularly through a focus on the future value of certain assets and on understanding the worth of different kinds of inventory and assets. These variables affect the firm's ability to report financial information to various stakeholders. Notable areas impacted include: intangible assets, the way write-offs are reported, and how inventory is valued and what procedures are used. This will require managers to transform the way they report financial information to regulators and investors (Shamrock, 2012).

Another area of difference involves inventory reporting. Under GAAP, inventory is estimated on a first-in, first-out (FIFO) or last-in, first-out (LIFO) basis to control costs and determine value. IFRS provisions, by contrast, do not allow the LIFO inventory approach (Shamrock, 2012).

These methods will be affected by any convergence through changes in how different items are reported, transforming the information on the balance sheet and income statement. This is based upon how assets are valued and the assumptions made. In the future, this will require a shift in the procedures utilized by firms (Shamrock, 2012).

The biggest obstacle to convergence is that many firms are accustomed to their current practices and are reluctant to switch. Doing so would cost them millions of dollars and require updating previous financial information over several years to reflect the new standards. At the same time, there is the possibility that executives will not fully understand what is happening internally, increasing the risk of under- or over-reporting earnings to investors—which could lead to greater stock price volatility (Larson, 2004; Bellandi, 2012).

Moreover, various countries have different tax systems that are not aligned with other accounting methods. Integrating a new standard will make it more costly for firms to take write-offs and report total revenues generated. These factors require firms to spend more money and increase the likelihood of paying more in taxes, which will affect earnings per share and long-term returns (Larson, 2004; Bellandi, 2012).

The differences between the standards illustrate the benefits and drawbacks of each. These distinctions are important in highlighting the possible challenges with convergence and explaining why it has taken so long to achieve broader objectives. They also illustrate why a one-size-fits-all approach is ineffective in encouraging larger shifts—since each business and industry is different, firms need greater flexibility. This has created controversy, with various researchers holding contrasting ideas and theories about how to achieve these larger goals.

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