Future of Accounting – IFRS Vs GAAP

The actions of Bernie Madoff and Kenneth Lay (Enron Co.) made quite an impact on business America. While thousands lost everything they had, the U.S economy lost something far greater; their ethical backbone and credibility. Since then, many consumers, corporations, and world economies put the U.S. economy under a microscope. GAAP and industry standards have been scrutinized, revised, and reformed. Despite the recent changes and strengthening of U.S. GAPP, the adoption of the International Financial Reporting Standards (IFRS) has become a potential possibility.

The adoption of IFRS has several positive attributes, with its greatest being the improvement of financial reporting to global investors, the facilitation of cross-border investments, and the integration of capital markets. Given that the global “IFRS network” has already reached a significant scale, the United States would benefit greatly by conforming, rather than remaining in the smaller underdeveloped IFRS network. It is difficult to gauge the magnitude of the effects but several studies and beliefs exist regarding the various effects of adopting IFRS.

There are U.S firms that already have a global presence with international operation that would realize significant cost savings from the use of a single set of financial reporting standards. Being a foreign subsidiary of the U.S requires compliance with the domestic reporting standards of their domicile and U.S GAAP. Additional costs arise from the duplication and translation of financial reporting information.

Empirical studies show that the costs and benefits of IFRS adoption vary amongst firms. Evidence shows that voluntary IFRS adoption typically results in benefits exceeding costs. Voluntary adopters tend to have similar characteristics; larger in size, more likely to have international dispersed operations, more diffused ownership, and rely more on outside funding. In some respects, GAAP creates barriers for many U.S. companies limiting both expansion and growth. Consistent with the notion of comparability benefits, the primary beneficiaries of IFRS adoption would be the U.S. multinational firms, as well as their investors.

Several other patterns have emerged from studying foreign nations that primarily use or have already adopted IFRS. All accounting standards use discretion, since several figures stem from evaluations and approximations (such as the useful life of an asset, the value of company goodwill, etc). IFRS is no exception, and whether firms implement IFRS in ways that make the numbers more informative (such as footnotes and recognition) still poses a threat to the reliability of information. A single set of accounting standards does not guarantee the comparability of firms’ reporting practices, since enforcement is not the sole influence in achieving successful results. Ethics and other variables will always play a factor in the exercise of any accounting standards. It is essential to realize that the key elements of an institutional infrastructure fit and reinforce each other.

The best results have been seen in countries with strict enforcement regimes and institutional structures that provide strong reporting incentives. These countries are more likely to have discernable capital-market effects when using IFRS reporting. A “serious” commitment to IFRS has shown larger cost of capital and market liquidity benefits compared to adopting IFRS as a “label”. The comparison of accounting numbers under German GAAP against the use International Accounting Standards (IAS) for the same years reveal greater total assets, and book value of equity under IAS.

Mixed results including the benefit of mandatory IAS, do exist however between various industries. Regardless, a study spanning 26 different countries, with strict enforcement regimes and strong reporting incentives consistently showed an increase in market liquidity of 3-6%, a decrease in firms’ costs of capital, and a corresponding increase in equity valuations. Voluntary adopters of IFRS have better initial reporting incentives and are more responsive to institutional changes (switching to IFRS), resulting in greater benefits over the mandatory adopters. This raises the question whether the benefits received reside in the type of accounting practices and standards used or instead the incentives and changes that lie in other institutional factors. Perhaps creating standard incentives for strict adherence to the current GAAP would have a similar effect as adopting IFRS.

The intensity of public enforcement efforts in the U.S is unparalleled not just in terms of rules and regulations but also the staffing levels and budgets, actual enforcement actions, and sanctions imposed. The primarily enforcement agencies are the Securities Exchange Commission (SEC), U.S Congress, and the courts. In this aspect, the U.S stands as one of the greatest potential beneficiaries of IFRS.

In comparison, U.S. GAAP and IFRS are based on the same underlying philosophy, roots used in common law tradition, and capital-market orientation. In fact, U.S. GAAP constitutes a set of high-quality standards that is fairly similar to IFRS and expected to be even closer by the time the U.S may adopt IFRS. The IFRS adoption would be an easy transition insuring the same quality and benefits already enjoyed with GAAP. The comparability benefits and network effects of IFRS, however, provide a strong rationale to make the switch. Even if these benefits are modest, they are recurring in nature and accrue in the long run.

The U.S. uses GAAP that already mimics IFRS, has a large number of international operations, and monitors business through a strict enforcement regime. When considering the switch we must evaluate the cost-benefit trade off. The cost of IFRS would be the initial transition and the shift of accounting authority to the FASB. In return, America would benefit from the comparability benefits previously discussed, which are modest but accrue over a long term basis, and the recurring cost savings of reporting, which mainly effect multinational U.S. companies. Regardless, U.S. GAAP is slowly evolving through its adoption of various standards and practices of the IFRS. Others, including myself feel that the capitalist nature of a free market society will eventually meld the two standards together pushing the global economy to a new level of success.

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