CHAPTER TWO

How important are IFRS to business and global acceptance?

FOR YEARS, LEADERS IN WORLDWIDE CAPITAL MARKETS as well as the US capital markets were anxious to develop a global set of financial reporting standards to improve the comparison of international financial data. In recent years, this effort has accelerated as investments by US investors increased significantly. The US capital markets include thousands of US firms that invest in non-US companies, either through acquisition or direct investment. As such, millions of individuals and trust funds invest in non-US companies, either directly or indirectly, through investments in mutual funds. Generally, hedge funds are made up of international investments. Furthermore, there are approximately 1,000 foreign private issuers that file with the Securities and Exchange Commission (SEC).

In the so-called preface to IFRS, the IASB sets out its mission and objectives, the scope of IFRS due process for developing IFRS and interpretations, and policies on effective dates, format and language for IFRS. In particular, the IASB's objectives are:

Thus it should be clear that IFRS will become important for business reporting and that convergence will happen in one form or another. No doubt convergence will be achieved using technology instead of integrating conceptual standards. Examples are the US codification process of US GAAP and the use of XBRL industry-specific taxonomies.

From a legal objectives standpoint, it will be important to watch the convergence process through the eyes of the reconciliation process. However, since foreign filers and Canadian companies are now allowed to file their 20F in IFRS, this will be a less important tool than in the past. More interesting will be the coordination and work of regulators, as well as the progress of worldwide adoption of IFRS.

2.1 IFRS AND LEGAL OBJECTIVES

The transition from US GAAP, and other accounting principles, to IFRS is much more than an accounting exercise. Examples in other countries have shown far-reaching implications in various areas, such as regulatory, tax, organisation (compensation, cash management, etc.) and legal consequences.

Many companies have contractual agreements that contain financial covenants and other financial provisions. The calculation of ratios under IFRS might be different and could force the entity to keep dual accounting systems until contracts are renegotiated. Areas that require a critical review would include real-estate contracts (including property leases), business combinations and accounting for financial instruments. From a legal viewpoint, IAS 37 (Provisions, Contingent Liabilities, and Contingent Assets) is probably one of the most important standards to comprehend.

Tax issues are another area of concern. IFRS does not allow the last-in/first-out (LIFO) method of accounting for inventories. Unless the conformity requirement is changed by legislation, entities face a tax cost due to a realised gain on reserves in inventories.

There are a large number of references to US GAAP in contracts, legislation and the Internal Revenue Code. To make the Code compatible with IFRS reporting, either the Internal Revenue Service must revise its interpretations of the Code or other legislation has to be enacted.

The various US laws require much more, or different, disclosures than what is required under IFRS. This might include Form 10-K, its proxy information statements or very specific requirements for certain industries. Last, but not least, the transition from US GAAP to IFRS will impact the internal control system and touch on requirements of the Sarbanes – Oxley Act of 2002.

IFRS reporting requires added disclosure through more forward-looking statements and different accounting for provisions. Needless to say, the extent of potential litigation problems will be the most difficult to judge in advance. The IASB has issued an exposure draft ‘management commentary' that will not be issued as a standard but includes a large amount of guidance on additional business disclosure.

Literacy of IFRS in the governance function (board of directors, top management) of an entity is probably one of the most overlooked aspects of successful adoption of IFRS. If this knowledge is not available in the upper echelon of business, legal objectives cannot be accomplished.

2.2 CONVERGENCE OF IFRS AND US GAAP

Discussions on applying one set of financial reporting standards have focused on the words adopting, converging, endorsing and implementing. Lately, a new word, ‘condorsement', was created and is in use. By merging the ideas of convergence and endorsement, IFRS would be incorporated into US GAAP through a lead by the FASB instead of the IASB, that is, condorsement. The SEC has had numerous positions on this issue in the past and even issued a roadmap to convergence. For an update see ‘Commission Statement in Support of Convergence and Global Accounting', 2010, as per www.sec.gov/rules/other/2010/­33-9109.pdf.

The most successful implementations call for a fixed timetable for the various stages of adoption. A good example is Canada's move to IFRS. It includes all aspects of conversion, such as education and training, changing legislation and other legal and tax considerations, translation (into French) of the standards and building an extended XBRL taxonomy.

The US SEC and jointly the IASB and the FASB have issued numerous releases and agreements relating to convergence. Timetables on the understandings were never adhered to and are constantly pushed forward. In 2010 the FASB and IASB again reaffirmed their commitment to improving IFRS and US GAAP and achieving their convergence. They committed to providing transparency and accountability regarding projects by reporting quarterly on progress and making those reports available on their respective websites.

However, as mentioned in other parts in this section, the authors believe that convergence between IFRS and US GAAP will be achieved through technology and not by wording individual standards, unless the US is adopting the full set of IFRS similar to Canada.

In September 2011, the Private Sector Taskforce of Regulated Professions and Industries (PSTF) issued its final report to the G-20 called ‘Regulatory Convergence in Financial Professions and Industries'. Establishment of the PSTF was coordinated by the IFAC. It comprises representatives from private sector organisations of professions and industries that are subject to regulation, and operate within the financial sector.

In addition to IFAC, the membership of the taskforce is comprised of:

• CFA Institute (CFA I)
• INSOL International
• Institute of International Finance (IIF)
• International Accounting Standards Board (IASB)
• International Actuarial Association (IAA)
• International Corporate Governance Network (ICGN)
• International Insurance Society (IIS)
• International Valuation Standards Council (IVSC).

The report includes 15 recommendations on the financial service industry and identifies gaps in regulatory convergence by industry, as summarised by the following topics:

• Accounting Profession – Financial Reporting
• Accounting Profession – Auditing and Public Sector Accounting
• Actuarial Profession and Insurance Industry
• Corporate Governance
• Financial Services Industry
• Investment Management and Analysis Profession
• Restructuring and Insolvency Profession
• Valuation Profession.

Some major economies have yet to commit fully to IFRS for domestic companies but have processes under way (e.g. China, India, Japan, the US). In India some ‘carve-outs' from standards are being proposed, which means the IFRS will not be fully adopted. Japan has deferred its decision on convergence with IFRS, while the process of convergence between IFRS and US GAAP has been ongoing for several years. The IASB and the FASB have made significant progress towards convergence and have completed most of the projects on their Memorandum of Understanding (MoU). However, the boards had not completed the remaining three projects, including financial instruments, as initially anticipated by the end of 2011. In addition, the US SEC has yet to confirm its decision on the adoption of IFRS, which in turn may be impacting or delaying convergence plans in some other countries.

Some notable differences remain between the reporting requirements of IFRS and US GAAP. One example that creates considerable concern for financial institutions relates to netting or offsetting arrangements. In 2011 the IASB and the FASB attempted to align the financial reporting requirements relating to the offsetting of financial assets and liabilities. The boards were not successful, partly because the existing differences have been institutionalised in their respective jurisdictions. It would be beneficial to have the offsetting requirements aligned for both financial reporting and prudential reporting purposes.An example of differences resulting from an existing relationship between financial reporting and regulations relates to taxation. In the US a particular basis for measuring inventory (called LIFO) is permitted for taxation purposes if an entity also uses that basis for financial reporting purposes. LIFO generally reduces the tax base, which is why entities elect to use this approach. LIFO is permitted in US GAAP but not in IFRS. There is limited support for LIFO as a financial reporting basis. However, eliminating LIFO from US GAAP would change the tax basis for those companies and create potentially significant tax liabilities for them. This is widely perceived to be an impediment to removing LIFO from US GAAP. Yet it is an impediment that could be removed easily, by decoupling or changing the link between the financial reporting and taxation requirements.

IFRS were originally developed for industrial companies, not for the financial service sector. There is still no complete standard for insurance companies. Object tracking, due to securitisation of financial instruments and other supply chain factors, is complicated and the use of different currencies for valuation makes accounting very difficult.

2.3 RECONCILIATION TO US GAAP

Approximately 1,000–1,150 (down from prior numbers, as there is a de-listing trend) of the 12,000 companies registered with the SEC are non-US companies. A foreign registrant may submit financial statements that conform to US GAAP or financial statements that conform to International Financial Reporting Standards as adopted by the IASB (that is, not jurisdictional adaptations of IFRS) without needing to provide reconciliation to US GAAP. Alternatively, a foreign registrant may submit financial statements prepared using its national GAAP or using a jurisdictional adaptation of IFRS (such as IFRS as adopted by the EU). Then, however, a reconciliation of earnings and net assets to US GAAP figures is required. This is normally done on Form 20F.

Current major differences between IFRS and US GAAP are presented in Table 2.1 for ease of comparison.

Taxes (deferred taxes, IAS 12) will nearly always be a reconciliation item since book-to-tax differences have a flow-through effect on taxes.

A difficult and very technical area of reconciliation exists for financial instruments and derivatives (IAS 39, IFRS 9 and others). Detailed literature on identifying IFRS/US GAAP differences for financial institutions is available from the large accounting firms.

Over the last several years the FASB has worked on a project codifying the US financial reporting literature. The codification reorganises the thousands of US GAAP pronouncements into roughly 90 accounting topics and displays all topics using a consistent structure. It includes relevant SEC guidance that follows the same topical structure in separate sections in the codification. This again is aligned to the US XBRL taxonomy (see the relevant section in Part III).

Unfortunately, IFRS to this date have not been codified. Once this is completed, US GAAP and IFRS financial statements will be much easier to reconcile and compare.

Note that, as we go to press, there is considerable discussion arising from the release of a less than positive Staff Report issued by the SEC, with this being Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. Issuers – Final Staff Report, Office of the Chief Accountant, United States Securities and Exchange ­Commission, 13 July 2012. For additional information, see www.sec.gov­/spotlight/globalaccountingstandards.shtml, as well as www.sec.gov/spotlight/globalaccountingstandards/ifrs-work-plan-final-report.pdf for the actual report.

Table 2.1 Major differences between IFRS and US GAAP.

2.4 IOSCO, REGULATORS AND ENFORCEMENT

Due to pressure as a result of the financial crises, independence questions and to secure future funding, the IFRSF created a monitoring board consisting of public regulators. The International Organisation of Securities Commissions, based in Madrid, is the worldwide association of national securities regulatory commissions, such as the Securities and Exchange Commission in the United States, the Financial Services Authority in the United Kingdom, and 100 or so other similar bodies. IOSCO is recognised as the leading international policy forum for securities regulators.

IOSCO looks to the IASB to develop International Financial Reporting Standards that IOSCO members can rely on for use in their jurisdictions. IOSCO has consistently supported the further development of IFRS through recommendations, endorsements and agreements. Accounting issues are dealt with through IOSCO's Technical Committee, a specialised working group established by IOSCO's Executive Committee. It is made up of 15 agencies that regulate some of the world's larger, more developed and internationalised markets. Its objective is to review major regulatory issues related to international securities and futures transactions and to coordinate practical responses to these concerns.

On 22 February 2010, the IOSCO Technical Committee published a report entitled ‘Principles for Periodic Disclosure by Listed Entities'. The report includes a set of recommendations for disclosures that could be provided in the periodic reports, particularly annual reports, of entities whose securities are listed or admitted to trading on a regulated market in which retail investors participate. The disclosure principles also cover other issues related to periodic disclosure, such as the timeliness of disclosures, disclosure criteria and storage of information. The principles are intended to provide a useful framework for securities regulators that are reviewing or revising their regulatory disclosure regime for periodic reports.

The report identifies the following principles as essential for any periodic disclosure regime:

• Periodic reports should contain relevant information (the IOSCO report elaborates on this principle in considerable detail).
• For those periodic reports in which financial statements are included, the persons responsible for the financial statements provided should be clearly identified, and should state that the financial information provided in the report is fairly presented.
• The issuer's internal control over financial reporting should be assessed or reviewed.
• Information should be available to the public on a timely basis.
• Periodic reports should be filed with the relevant regulator.
• The information should be stored to facilitate public access to the information.
• There should be disclosure criteria (including fair presentation, not misleading, no material omissions, clear and concise language).
• There should be equal access to disclosure by all investors at the same time.
• There should be equivalence of disclosure in all markets in which the entity is listed.

IOSCO's wide membership regulates more than 90 per cent of the world's securities markets and IOSCO is the world's most important international cooperative forum for securities regulatory agencies.

IOSCO aims, through its permanent structures, to:

• cooperate to promote high standards of regulation in order to maintain just, efficient and sound markets;
• exchange information on their respective experiences in order to promote the development of domestic markets;
• unite efforts to establish standards and an effective surveillance of international securities transactions;
• provide mutual assistance to promote the integrity of the markets by a rigorous application of the standards and by effective enforcement against offences.

Worldwide enforcement is still an emerging area. Progress was made by signing a multilateral MoU concerning Consultation, Cooperation and the Exchange of Information in January 2010. For further information, see www.fsa.gov.uk/pubs/mou/fsa_sec.pdf.

At this point, it is worthwhile understanding something of the governance and accountability of the IFRS foundation, outlined in the next chapter.