2008 Oxford Business &Economics Conference Program ISBN : 978-0-9742114-7-3

INTERNATIONALIZATION OF THE U.S. FINANCIAL REPORTING SYSTEM: PREREQUISITES AND IMPLICATIONS

Sylwia Gornik-Tomaszewski, DBA, CMA, CFM

Associate Professor

Department of Accounting and Taxation

The Peter J. Tobin College of Business

St. John’s University

8000 Utopia Parkway

Queens, NY 11439

Phone: 718-990-2499

E-mail address:

February 25, 2008

Submitted for the 2008 Oxford Business & Economics Conference (OBEC)

Proceedings CD

June 22-24, 2008

Oxford University, UK

Internationalization of the U.S. Financial Reporting System: Prerequisites and Implications

ABSTRACT

For the past six years U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have cooperated on gradual convergence to a single set of financial reporting standards. The process was originally envisioned to continue until U.S. Generally Accepted Accounting Principles (U.S. GAAP) and International Financial Reporting Standards (IFRS) achieve practical equivalence. Although the convergence process produced some results, it has also proven to be slow and complicated. Therefore, most recently consensus in the United States has shifted from the convergence towards adoption of IFRS, and U.S. companies may soon be allowed or required to report under the IFRS. The SEC 2007 Concept Release on Allowing U.S. Issuers to Prepare Financial Statements in Accordance with IFRS, presents a dramatic new idea the implementation of which must be carefully considered. In the short term, the transition to IFRS in the United States will require significant cost and effort. Long-term benefits, however, of a single set of high-quality, globally-accepted financial reporting standards should outweigh the cost. Such a set of standards would serve to increase comparability of financial information among all companies worldwide, and would promote efficient and more cost-effective access to capital markets. This paper discusses a current status of the convergence between IFRS and U.S. GAAP, possible modes of transition to IFRS, prerequisites for adoption of IFRS in the United States, and implications for various stakeholders. This paper should be of interest to accounting practitioners and academicians, as well as to anybody having an interest in the capital markets.

INTRODUCTION

Recent progress towards a single set of high quality global accounting standards has been unprecedented. As of 2007, over 100 countries either require or allow the use of International Financial Reporting Standards (IFRS)[a], issued by the International Accounting Standards Board (IASB) based in London, U.K., for financial reporting by listed companies. Some of those countries extended the use of IFRS for local regulatory or statutory financial reporting by non-listed companies. Several other countries with significant capital markets plan to require or permit the use of IFRS in the near future. This movement towards IFRS has started to affect U.S. companies, in particular those with a significant global presence.

For the past six years, accounting standard setting authorities in the United States have been on the path of gradual convergence to a single set of high-quality accounting standards via joint standard-setting by the U.S. Financial Accounting Standards Board (FASB) and the IASB. The process, which started in 2002 with the Norwalk Agreement between the two Boards, was envisioned to continue until the point when U.S. Generally Accepted Accounting Principles (U.S. GAAP) and IFRS achieve practical equivalence (FASB, 2002). Although the convergence process produced some results, it occurred to be slower and more difficult than expected. Consequently, the progress on convergence has been limited. Therefore, most recently the consensus in the United States has shifted from the convergence towards adoption of IFRS.

Over the summer 2007 the U.S. Securities and Exchange Commission (SEC) issued two very important documents. First, in June 2007, the SEC proposed to eliminate the requirement to reconcile financial statements prepared by foreign private issuers under IFRS, as issued by the IASB, to U.S. GAAP. The SEC voted in favor of the proposal on November 15, 2007. The new rule is effective immediately for fiscal years ending after November 15, 2007. It should be emphasized that the Commission insisted that foreign financial statements must fully comply with the IASB’s version of IFRS and jurisdictional versions of IFRS would not be accepted. One exception was granted though. The Commission voted to make temporary transition relief available to registrants from the European Union (EU) who file their financial statements prepared in compliance with IFRS “as endorsed by the EU.” Specifically, for a two-year period those registrants who have taken advantage of the EU’s “carve out” from IAS 39, Financial Instruments: Recognition and Measurement with respect to hedge accounting for certain financial instruments, but otherwise complied with IFRS as issued by the IASB, will be able to file their reports with the SEC without reconciliation to U.S. GAAP, as long as a reconciliation to the IASB’s version of IFRS is provided. After the two-year period, those issuers will either have to use the IASB’s version of IFRS or provide reconciliation to U.S. GAAP.[b]

Second, to level the playing field, in August 2007 the SEC issued Concept Release on Allowing U.S. Issuers to Prepare Financial Statements in Accordance with IFRS (SEC, 2007). The 2007 Concept Release is an information-seeking document that describes the policy issues and, in the form of 35 questions, seeks public input regarding the possibility of allowing U.S. issuers to report under IFRS. The 2007 Concept Release requests comments with respect to a number of matters, including the establishment and oversight of IFRS, the practical implications that would arise for U.S. issuers applying IFRS, and the possible impact on the U.S. capital markets.

The SEC’s 2007 Concept Release presents a dramatic new idea the implications of which, for U.S. companies and the U.S. capital markets, must be carefully considered. It has forced an important conversation about complex issues that must be addressed before application of IFRS in the United States would be possible. Some serious questions have been raised about the readiness of the U.S. financial community to adopt IFRS. Transition to IFRS would require significant investments in the financial reporting infrastructure, and the mode and scope of transition would affect the resources needed.

This paper proceeds as follows: after a brief overview of the convergence process, IFRS implementation modes currently considered in the United States are compared. Next, prerequisites for adoption of IFRS in the United States are discussed, and implications for various constituencies are explored. The final section offers some concluding remarks. This paper should be of interest to accounting practitioners and academicians, as well as to anybody having an interest in the capital markets. We may soon witness the most significant and comprehensive change in U.S. financial reporting practice and education in recent decades.

THE FASB-IASB CONVERGENCE PROCESS

The U.S. SEC has long advocated international harmonization and convergence of accounting and financial reporting practices. As part of its 1988 Policy Statement, the Commission explicitly supported the establishment of mutually acceptable international accounting standards to facilitate cross-border capital formation while providing adequate disclosure for the protection of investors and the promotion of fair, orderly and efficient markets (SEC, 1988). Since the mid-1990s the Commission, as a member of the International Organization of Securities Commissions (IOSCO), encouraged the efforts of the International Accounting Standards Committee (IASC), the international accounting standard setting body at the time, to develop a core set of accounting standards that could serve as a framework for financial reporting in cross-border listings and offerings (Epstein and Jermakowicz, 2007).

In February 2000 the SEC issued a Concept Release on International Accounting Standards seeking input on convergence to high quality global financial reporting standards. Specifically, the Commission sought comments as to the conditions under which it should accept financial statements of foreign private issuers that are prepared using IAS, and the use of the U.S. GAAP reconciliation of IAS financial statements (SEC, 2000). This SEC’s inquiry was undoubtedly influenced by the new financial reporting strategy in the EU, as formulated in June 2000 Communication to the Council and the European Parliament entitled “EU Financial Reporting Strategy: the Way Forward.” In this Communication the European Commission (EC) stated its intention to submit legislation to the European Parliament that would make it mandatory for all EU listed companies to prepare consolidated financial statements in accordance with IAS. It was expected that this requirement would enter into effect, at the latest, from 2005 onwards (EC, 2000).[c]

Although the development of core-standards significantly improved the IAS, their endorsement by the IOSCO fell short of expectations. At the annual meeting in May 2000, IOSCO recommended that its members allow companies to use core IAS for cross-border listings and offerings, but at the same time members were still permitted to require reconciliation, call for supplementary information, or eliminate some of the options that existed in IAS (IOSCO, 2000). Based on this decision, the SEC did not wave the reconciliation requirement, but encouraged the restructuring of IASC into the IASB,[d] and strongly supported the FASB-IASB convergence process, described below.

The FASB has been one of the strongest and most important partners of the IASB. The IASB has been modeled after FASB and many personal connections exist between the two Boards. For example, current FASB chairman, Robert H. Herz, served as the IASB part-time member from the Board’s inception in 2001 to his promotion to the FASB chairmanship in 2002[e]. James J. Leisenring, a former FASB Board member and the first director of international activities at the FASB, was appointed to the IASB in 2001. He is the IASB member currently filling the role of liaison Board member to the FASB. The role was created to facilitate information exchange and increase cooperation between the FASB and the IASB.

In the Memorandum of Understanding called “The Norwalk Agreement,” issued at their joint meeting in Norwalk, Connecticut on September 18, 2002, both the FASB and IASB pledged to use their best efforts to make existing international and U.S. accounting standards fully compatible as soon as practicable. The Boards also made a commitment to coordinate their future agendas to ensure that once achieved, compatibility is maintained (FASB, 2002). On October 29, 2002, the FASB and IASB jointly announced their commitment to achieving real convergence between their respective accounting standards by 2005. The goal has not been achieved by 2005 and in February 2006, the Boards published a new Memorandum of Understanding, in which they reaffirmed their shared objective of developing high quality common accounting standards for use in the world’s capital markets. This new Memorandum includes a 2006-2008 ‘roadmap,’ which identified short- and long-term convergence projects (FASB, 2006).

The scope of the series of short-term convergence projects is limited to those differences between U.S. GAAP and IFRS in which convergence around a high-quality solution appears relatively easy to achieve. Because of the nature of these differences, it has been expected that a high-quality solution could usually be achieved by selecting between existing U.S. GAAP and IFRS. Several new standards resulted from this effort

Some of the projects, however, have at time been delayed, as the underlying issues occur to be more complex and significant.[f]

Long-term projects are those that the Boards have agreed to conduct simultaneously in a coordinated manner and which involve the sharing of staff resources. The Boards have simultaneously focused on the development of new common standards where their respective standards are each regarded as candidates for improvement. The long-term projects consisted of the following: business combinations, consolidations, conceptual framework, fair value measurement guidance, liability and equity distinctions, financial performance reporting, postretirement benefits, revenue recognition, derecognition, financial instruments, intangible assets and leases (FASB, 2007).

Both Boards, as a result of the convergence project, have issued several standards. Differences between U.S. GAAP and IFRS have been eliminated or reduced in areas such as inventory, nonmonetary transactions, share-based payments, segment reporting, and the use of a fair value option to simplify the accounting for financial instruments. Both Boards have recently issued a common standard that improved, simplified, and converged the accounting for business combinations and noncontrolling interests.[g] Furthermore, during the convergence process the Boards identified and studied many differences between the two sets of standards. The progress, however, can only be described as limited. Convergence has advanced at a slower pace than originally expected and produced standards that still follow different style and wording that could result in unintended differences in interpretation and implementation by preparers and auditors (Ernst & Young, 2007). Some doubt whether a complete convergence may ever be achieved because of differing cultural, legal, regulatory and economic environments (PricewaterhouseCoopers, 2007).

IFRS IN THE UNITED STATES: CONSIDERATION OF ALTERNATIVE IMPLEMENTATION MODES

As of 2007, over 100 countries required or allowed the use of IFRS for the preparation of financial statements by listed companies, including the Member States of the EU, Hong Kong, Australia and New Zealand[h]. Countries that require or allow the use of IFRS by listed companies may also allow the use of IFRS for local regulatory or statutory financial reporting by non-listed companies.

The modes of transition to IFRS differ by jurisdiction. The European Commission (EC), for example, issued a Regulation in 2002, which required companies incorporated in the Member States and whose securities are listed on an EU-regulated market to report their consolidated financial statements using endorsed[i] IFRS beginning 2005 (EC, 2002).[j] Unlike a Directive, which must be incorporated into national law before it becomes effective in practice, a Regulation is directly applicable in all Member States and does not require the intervention of national legislation. Member States are no longer allowed to restrict accounting options available under IFRS, nor can they issue new accounting standards (Van Hulle, 2004). In other countries, such as Australia and New Zealand, national accounting standards became word-for-word equivalents of IFRS. In the jurisdictions described above, all or almost all of the listed companies transitioned to IFRS at the same time. Recently, more countries have announced their commitment to join the IFRS club. Canada, Israel, Korea and Japan are among countries with plans to adopt IFRS as their national accounting standards (FASB, 2007).

This movement to IFRS has begun to affect U.S. companies, in particular those with a significant global operations. Gannon and Ashwal (2004) identified four possible scenarios in which a U.S. company would be required to use IFRS. If the U.S. company’s international parent uses IFRS, the subsidiary will have to prepare IFRS financial statements for inclusion in the parent’s consolidated financial statements. Publicly listed European subsidiary of U.S.–headquartered multinational corporations must comply with IFRS. Consequently, the U.S. parent may have to convert subsidiary’s financial statements to U.S. GAAP for consolidation purposes. In this situation, U.S. parent company may simplify its financial reporting by implementing IFRS for all its foreign subsidiaries around the world. The U.S. company that has foreign operations and is seeking to enter new markets and expand operations to a foreign country may need to report under IFRS in order to obtain an operating license or raise capital. If a foreign investor in a U.S. company uses IFRS, the U.S. company may also be required to report under IFRS.