In December 2007, the Securities and Exchange Commission ("SEC") released a final rule allowing foreign private issuers to use financial statements prepared in accordance with International Financial Reporting Standards ("IFRS") as issued by the International Accounting Standards Board ("IASB") without reconciliation to US generally accepted accounting principles ("US GAAP").1 The release not only underscored the SEC's recognition that use of IFRS has increased among foreign private issuers,2 but also illustrated that IFRS represents a proven, high-quality financial reporting framework. IFRS provides a principles-based framework, whereas US GAAP represents a more rules-oriented approach to financial reporting. Unlike US GAAP, IFRS allows greater exercise of professional judgment because there are fewer cumbersome rules and exceptions to apply. Experts at the Big Four accounting firms have indicated that an SEC mandate for all US public companies to use IFRS is inevitable.3 Although the SEC has eliminated the requirement to reconcile to US GAAP for foreign private issuers that use IFRS, it has yet to decide whether to mandate adoption of IFRS by all US companies by a date certain.
Benefits of IFRS
The globalization of business and finance has led to the adoption of IFRS by more than 12,000 companies in over 100 countries. A conversion from US GAAP to IFRS would enhance the competitiveness of US capital markets by eliminating certain barriers to entry. However, not all foreign issuers fall within the definition of a "foreign private issuer," and hence not all foreign issuers can presently use IFRS. IFRS would likely reduce the costly requirements to report in, or reconcile to, US GAAP for foreign issuers that do not qualify as foreign private issuers. US public companies would be able to access capital in markets where foreign competitors currently report under IFRS. Where a certain industry sector or market reports in accordance with IFRS, conversion to IFRS would increase comparability for investment analysis between US public companies and foreign competitors, allowing for better investor information and understanding.
Furthermore, US-based multinational companies that previously used more than one accounting system for regulatory purposes here and abroad would no longer be required to adhere to US GAAP as well as another country's accounting rules. The elimination of the burden of complying with multiple accounting standards should reduce costs for US-based multinational companies because the conversion to IFRS would generate process and cost efficiencies for preparers, investors, auditors and others by allowing them to operate in essentially a single accounting environment.
Challenges in Transitioning to IFRS
Although a shift to IFRS would enhance comparability and transparency for US-based multinational companies, the transition may still pose certain challenges.
Unlike US-based multinational companies, smaller US companies with no foreign subsidiaries or competitors may not benefit from such transition because they might not have financial reporting obligations abroad. For companies with no cross-border operations, a transition to IFRS might prove costly, possibly prohibitively so for some. Certain US companies not only will need to evaluate their disclosure controls and procedures and internal control over financial reporting, but also will be required to train individuals in new accounting standards even though they do not operate abroad. However, some commentators have suggested that domestically focused companies and smaller US companies that may have less depth in accounting resources will benefit from the simplification that IFRS brings over US GAAP, once initial implementation costs are overcome.
The conversion from US GAAP to IFRS could also raise certain tax-related issues, as differences exist in the measurement of pre-tax income and the principles governing accounting for income taxes under US GAAP and IFRS. The impact of various international tax implications will vary by company and by industry.
In addition, US companies using last-in, first-out method ("LIFO") of inventory valuation may face a possible tax cost in the conversion from US GAAP to IFRS because IFRS does not recognize the use of LIFO. Currently, US companies can use LIFO in their tax reporting to reduce taxes paid to the government, but must then also use it in their financial statements. Robert Herz, Chairman of the Financial Accounting Standards Board ("FASB"), indicated that the cost of "coming off LIFO . . . could cost them hundreds of millions or billions of dollars."4
One should also consider the IFRS implications for debt covenants. Transitioning to IFRS could raise debt covenant issues for loan agreements with a "frozen GAAP" provision.5 Debt covenants containing a frozen GAAP provision, absent a waiver, would prove problematic because compliance would require dual bookkeeping. Issues also arise where no frozen GAAP provision exists; the requirement will usually be to provide financial reports in accordance with GAAP as it changes from time to time. In these few cases, if it is likely that calculations based on IFRS-compliant accounts may result in breach of covenants, it will be necessary to negotiate a change in the terms of the agreement with new covenants adapted to IFRS.
Securitization transactions may also represent a potential challenge because current IFRS standards result in very different reporting for such transactions. Under US GAAP, trillions of dollars in securitized financial assets and liabilities are allowed to stay off the books of originating financial services institutions, while IFRS would show most of those assets and liabilities on the balance sheet. Although the conversion to IFRS might result in different financial reporting, the underlying economics and cash flow should remain the same.
FASB and IASB
In 2002, the aim of the FASB and the IASB was to make their existing financial reporting standards fully compatible with one another. By 2005, the focus shifted from the compatibility of the two reporting standards to that of convergence, with the goal of developing high-quality, common standards over time. The current landscape of convergence is best summarized by Herz: "Both of our standards [the US and the IASB] are in some desperate need of overhaul. If the US is going to adopt IFRS in the future, we have to make sure it makes sense for everyone rather than just adopt it."6 In addition to the initiatives of both standard-setting bodies, the SEC also appears committed to moving toward IFRS. In addition to eliminating the reconciliation requirement to US GAAP for foreign private issuers reporting under IFRS, the SEC issued a concept release in August 2007,7 soliciting comments on a rule to allow US issuers to prepare financial statements in accordance with IFRS. How the US moves from US GAAP continues to remain unclear; however, SEC Chairman Christopher Cox has indicated that he would like a "public policy oversight body" that would oversee the trustees of the IASB consisting of national securities regulators that would help ensure that IASB's governance is consistent with the requirements of Sarbanes-Oxley corporate governance rules.
How long and what form of IFRS the US adopts remains to be seen. Sir David Tweedie, head of the IASB, indicates that "the IASB is making some adoptions of US standards; the US is making some adoptions of IFRS," suggesting that concessions have been made from both standard-setting bodies in the path to convergence. When asked of a realistic time frame for convergence of US GAAP and IFRS, Herz replied, "[I]f everything went absolutely right, it's a minimum of five years. But things never go absolutely right. Most countries have allowed for four or five years. And in the US, we have probably more issues and more complicated issues than almost anybody else."8
Around the world most major markets have moved to IFRS on an all-at-once, mandatory basis for domestic companies in that market.9 Although which approach the US takes in converting from US GAAP to IFRS is yet to be determined, it seems clear that the US is moving toward IFRS. Even if the conversion from US GAAP to IFRS is not immediate, US companies would best be served in considering and preparing for the conversion to IFRS.
For Further Information
If you have any questions regarding the new rules, including how they may affect your company, please contact Charles E. Harrell, P.C., Shelton M. Vaughan, P.C., Joel N. Ephross, T. John Lin or any of the other members of the Securities Law Practice Group.
1Acceptance from Foreign Private Issuers of Financial Statements Prepared in Accordance with International Financial Reporting Standards without Reconciliation to US GAAP, Securities Act Release No. 33-8879, Exchange Act Release No. 34-57026 (December 21, 2007).
2A foreign private issuer, as defined in Rule 3b-4(c) under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), is any foreign issuer (other than a foreign government) unless more than 50% of the issuer's outstanding voting securities are directly or indirectly held of record by residents of the US and any one of the following three conditions is satisfied: (i) the majority of the executive officers or directors are US citizens or residents; (ii) more than 50% of the assets of the issuer are located in the US; or (iii) the business of the issuer is administered principally in the US.
5In a typical "frozen GAAP" provision, the borrower undertakes to ensure that either (i) all financial statements provided to the lenders apply the same GAAP as were used in the financial statements delivered at or prior to signing of the loan agreement or, (ii) if a change in the GAAP occurs (such as adoption of IFRS), to identify to the banks the changes necessary for the financial statements to reflect the original GAAP, and to provide lenders with sufficient information to enable them to test compliance with the financial covenants.
7Concept Release on Allowing US Issuers to Prepare Financial Statements in Accordance with International Financial Reporting Standards, Securities Act Release No. 33-8831; Exchange Act Release No. 34-56217.
9One possible model for the US transition to IFRS would be to emulate Canada in its conversion to IFRS. In Canada, IFRS will replace current Canadian standards and interpretations as Canadian generally accepted accounting principles ("Canadian GAAP") on January 1, 2011 for publicly accountable enterprises. In preparation for the changeover date, the Canadian Securities Administrators ("CSA") has taken an incremental approach. The CSA has issued guidance regarding the preparation of interim and annual Management's Discussion & Analysis (MD&A) for each year of the three years preceding the changeover date. For example, for the annual MD&A three years before changeover to IFRS, the CSA has indicated that an issuer should discuss the key elements and time frame of its changeover plan. For the annual MD&A two years before the changeover date, the CSA has suggested that an issuer describe the major identified differences between its current accounting policies and those it expects to apply in preparing IFRS statements. By the final year preceding the changeover date, an issuer should generally be able to discuss in detail the key decisions and changes the issuer has made, or will make, relating to the conversion to IFRS.
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