International Financial Reporting Standards – A Paradigm Shift in Financial Reporting
By D.J. Gannon

We’ve seen an evolution in the financial reporting environment over the past several years – a paradigm shift of sorts. The globalization of the world’s capital markets has caused a shift toward global standards and benchmarks that are based more so on “principles” or “objectives” versus detailed “rules”. Ultimately, these trends are impacting how standards are developed, written and applied. This will involve looking at accounting and financial reporting in a new way.

Historically, the focus of financial reporting was on compliance with an accepted standard (i.e., U.S. generally accepted accounting principles, or GAAP). The assumption was that if compliant with the accepted standard, then the accounting result in the financial statements was adequate. Now the focus of financial reporting and, in particular, of International Financial Reporting Standards (IFRS) is on “transparency”. That is, do the financial statements represent the economic reality underlying the transactions and events accounted for in the financial statements?

The reality is that every country around the globe is moving toward IFRS in some way, shape or form. In many countries there has been a clear trend toward IFRS as a required basis for financial reporting. This has been driven in large part by changes in public listing requirements. In Europe, approximately 7,000 companies have made the transition to IFRS and have completed their “first IFRS financial statements”. Of these companies, approximately 250 are “foreign private issuers” that have filing requirements in the United States. The change in public listing requirements also has had an effect on other reporting requirements such as statutory reporting.

On the other hand, some countries (like the United States and Japan) have taken a convergence approach. That is, they have decided to maintain their local standard-setting process and change local GAAP to converge (at least on some level) with IFRS. Ultimately, this means that local standards become global standards.

The SEC — Moving Forward With IFRS

In the United States, the “acceptance” of IFRS has almost always been debated in the context of cross-border offerings and listings involving “foreign private issuers.” Current Securities and Exchange Commission rules allow a foreign private issuer to prepare its financial statements using either local accounting standards or IFRS, as long as a “reconciliation” to U.S. GAAP is included in the financial statements filed with the SEC.

A recent flurry of activity by the SEC has made it almost certain that the reconciliation requirement will be eliminated — a wake-up call for many involved in financial reporting, including foreign and domestic companies, analysts,
standard setters, and accountants. Of greater relevance to U.S. companies, the SEC is considering letting U.S. issuers use either IFRS or U.S. GAAP when reporting their financial statements.

Recently the SEC and its counterparts in Europe have been discussing the mutual recognition of financial reporting frameworks. This would result in an “acceptance” of both IFRS and U.S. GAAP in each others markets. To accomplish this, the EU has embarked on an initiative involving“equivalence” of standards, while the SEC has developed
its “IFRS Roadmap”. Ultimately, these efforts will result in U.S. companies the ability to continue to use U.S. GAAP in Europe and EU companies the ability to use IFRS in the U.S. (without reconciliation to U.S. GAAP).

On June 20, the SEC agreed to issue a “proposing release” that would eliminate the requirement to reconcile
financial statements to U.S. GAAP if the financial statements are prepared using IFRS as published by the International Accounting Standards Board (IASB). This proposed approach would give foreign private issuers a choice of using U.S. GAAP, local GAAP reconciled to U.S. GAAP, or IFRS in preparing financial statements that are filed with the SEC. The change, which awaits formal adoption after a 75-day public comment period, would apply to 2008 annual reports, which are filed in 2009.

Later this summer, the SEC also is expected to issue a “concept release” targeted at U.S. domestic issuers. The release will request comment on whether U.S. issuers should be permitted to use IFRS in preparing their financial statements. On the basis of the feedback it receives, the Commission will consider whether to issue a proposing release changing the requirements for domestic companies. It’s conceivable that by 2010 or 2011 U.S. companies may have a choice of using either IFRS or U.S. GAAP.

Ongoing Convergence Efforts

Complications stemming from the coexistence of IFRS and U.S. GAAP can be lessened if the IASB and FASB are
successful in their continuing efforts to converge the two sets of standards. In the past, differing views concerning the role of financial reporting made it difficult to achieve convergence of accounting standards. Now, with the
growing international consensus that financial reporting should provide high-quality financial information to serve
the needs of investors everywhere the IASB and FASB have coordinated their agendas and have taken steps to amend
current standards.

In 2002 the FASB and IASB entered into an agreement (dubbed the “Norwalk Agreement”) that set forth each
board’s commitment to converging U.S. GAAP and IFRS. That agreement was updated in 2006 and includes a specific work plan targeted at converging a number of major topical areas. Under this plan, the FASB will amend certain U.S. GAAP standards to conform with IFRS and the IASB will amend IFRS to conform with U.S. GAAP. There are ten
“short-term” projects that are targeted toward completion by 2009. There are several other projects, which are longer term in nature and involve major topics (such as revenues, liabilities, consolidation, leasing). Most of these are “joint” projects.

It’s important to keep in mind that convergence is really a process – the result of which is standards that are similar, but not necessarily identical. The major focus of the standard-setters has been on converging the objectives and general principles versus detailed guidance. “Principlesbased” standards are ultimately about simplifying accounting standards, with the focus on understanding the economics underlying a transaction or event and applying qualitative factors, rather than adherence to strict criteria, when accounting for that transaction.

No longer will accounting and financial reporting standards be developed in the vacuum of the domestic environment only. It also means that the standards that will be written differently than in the past. Emphasis will now be on underlying objectives and principles versus a set of arbitrary rules. As a result, the application of those standards will require more judgment than what we are used to. Because the approach to global reporting will be more conceptual, there will be greater emphasis on application. Now more than ever the focus will be on understanding a company’s accounting policies and areas where judgment exists. This means adopting a new way of thinking.

Not Just About Accounting

In order for “principles-based” standards to work, it is necessary for all the elements of a financial reporting scheme to be operating efficiently, including all of the objectives and reforms contemplated in the Sarbanes-Oxley Act. In its Concept Release, International Accounting Standards, the SEC emphasized the importance of supporting high-quality accounting standards with an infrastructure that ensures that those standards are rigorously interpreted and effectively applied. The SEC noted that the primary elements for this infrastructure would include:

• Effective, independent and high quality accounting and auditing standard-setters;
• High quality auditing standards;
• Audit firms with effective quality controls worldwide;
• Profession-wide quality assurance; and
• Active regulatory oversight.

Each of the items noted above have been or are being addressed. In addition, the Sarbanes-Oxley Act requires
changes in many facets of the financial reporting by and analysis of companies.

Perhaps the most significant obstacle to having a single set of high quality global accounting standards is divergent views on how those standards should be applied. It’s important that convergence efforts also be made at the interpretive and enforcement levels. It is critical that all participants concur that accounting done under international standards also conforms to the “spirit of the standard”. Clearly, this can create tensions over interpretation and threaten consistent application. While there is some evidence of differential regulatory approaches to IFRS by regulatory agencies, the SEC and European regulators have agreed on a “work plan” to facilitate resolution of practice issues across borders. This work plan, in conjunction with individual country Memorandums of Understanding, will allow all parties to share information in order to resolve issues. The challenge for the regulators, companies and auditors is making sure that consistency exists within the conceptual parameters of the standard.

Now that the initial adoption of IFRS in Europe is complete, regulators and others are assessing practice. Regulators such as the SEC will continue to scrutinize IFRS, but have committed to work together in resolving divergent practices. It is expected that there will be an evolution of practice over the next several years as regulators, auditors, and companies continue to scrutinize practice. This likely will result in more detailed disclosures in financial statements as much of the focus has been on making the financial statements more “transparent”. Other areas where there may be an evolution of practice include presentation formats, and industry issues (for example, accounting for loan loss reserves).

Implications for U.S. companies

The most significant impact IFRS adoption may have on a company is the impact on its culture. IFRS typically results in changing the company’s perspective on financial reporting. In addition, companies shouldn’t underestimate the impact IFRS may have – it’s not just about changing accounting policies. IFRS adoption typically impacts all aspects of a company, including financial reporting systems and internal controls, taxes, treasury and cash management, legal and debt covenants.

To a certain degree, IFRS already has had an impact on many U.S. companies. For example, when a U.S. company has a parent or investor located outside the U.S. that is required to report on an IFRS basis, at a minimum, it will have to gather IFRS information. In some cases, it may be required to prepare IFRS-compliant financial statements. This would be the case with EU domiciled parent or investor companies. In addition, U.S. companies that have subsidiaries with local or statutory reporting requirements in another country may have to comply with IFRS for those local or statutory reporting purposes. Further, U.S. companies that have or are looking to establish operations in another country may now be required by local regulators or lenders to prepare IFRS-compliant financial statements.

Ultimately, companies should identify countries that may now have a local IFRS reporting requirement and consider where it has securities listed internationally (don’t forget to include in that analysis equity investees, and joint ventures). Companies also should consider where they may have complex cross-border structures and whether there is an IFRS requirement.

It’s also worth noting that U.S. companies may benefit from voluntarily distributing financial information on an
IFRS basis, particularly where they operate in an industry that has significant competition from outside the United
States; for example, the banking, insurance, motor vehicle manufacturing, pharmaceutical, and telecommunications industries, to name a few. Companies should understand what the competition is doing – many industries are now dominated by companies outside the U.S. that now have an IFRS reporting requirement. Having comparable financial reporting evens the playing field and allows investors to have an “apples-to-apples” perspective when comparing results.

In addition, we’re seeing cases where U.S. companies are giving greater consideration to the accounting under IFRS when undertaking transactions such as business combinations, leases, and asset securitizations, among others.

Final thoughts

The time has come for a single body of internationally accepted accounting standards. And with that a fundamental shift in how we approach accounting. Accountants must understand base principles and objectives, how judgments are made, and how they are applied in relation to the base principles and objectives. The test is does the financial reporting make sense? Does it follow the underlying economics? How does it compare to other companies that assemble financial reports under similar circumstances? Accountants ultimately must impose a kind of “reasonableness” test. Such an approach to accounting requires changes in behavior. Accountants now will have to rely on their ability to understand the economics and substance underlying a transaction or event.

About the Authors

D.J. Gannon is a partner with Deloitte & Touche LLP where he specializes in global accounting, financial reporting, regulatory and professional issues. Mr. Gannon leads the firm’s IFRS Centre of Excellence – Americas, which provides
technical assistance, including consultation and training, on matters involving IFRS to clients in the region. He also is chairman of the U.S. Center for Audit Quality’s International Practices Task Force. Mr. Gannon previously served as
a Professional Accounting Fellow in the Office of the Chief Accountant of the U.S. Securities and Exchange Commission where he worked as a liaison with international accounting and auditing standard-setting bodies, and assisted in the development of the SEC’s Concept Release, International Accounting Standards. While at the Commission, he also participated in the activities of the International Organization of Securities Commissions (IOSCO). Contact: dgannon@deloitte.com.