Countries like the United States are feeling the pressure to eliminate the gap between the International Financial Reporting Standards (IFRS) and the U.S. generally accepted accounting principles (GAAP). This pressure is coming from globalization, the Sarbanes-Oxley Act (SOX), and the Securities and Exchange Commission's (SEC)adoption of international standards.
Such initiatives have consequences on the world of accounting diversity. The convergence of GAAP along with the IFRS largely impacts corporate management, investors, stock markets, accounting professionals, and accounting standards setters. It also changes the attitudes of certified public accountants (CPAs) and chief financial officers (CFOs) toward the harmonization of international accounting, affecting the quality of the international accounting standards and the efforts made toward the goal of convergence of GAAP and IFRS standards.
Key Takeaways
- One major difference between GAAP and IFRS is their methodology, with GAAP being rules-based and the latter being principles-based.
- This difference has posed a challenge in areas such as consolidation, the income statement, inventory, the earnings-per-share calculation, and development costs.
- IFRS favors a control model whereas the U.S. GAAP prefers a risk-and-reward model.
- It could be difficult for GAAP users to try another format, especially when the change could require learning a whole new system of financial accounting.
GAAP vs. IFRS: An Overview
The main difference between the GAAP and the IFRS is one of approach:
- GAAP is rule-based and consists of a complex set of guidelines attempting to establish rules and criteria for any contingency.
- IFRS is a principles-based methodology that begins with the objectives of good reporting and then provides guidance on how the specific objective relates to a given situation.
Not every country uses the same accounting and reporting standards. For instance, the U.S. is the only country that uses GAAP while countries that use IFRS include. Canada, China, India, and the United Kingdom, among others.
This creates inconsistencies for both investors and lenders. Investorsmay come across issues when they consider funding capital-seeking companies that follow the accounting standards and financial reporting of the country in which they do business. Similarly, lenders may find it hard to determine a company's financial health and well-being of two companies that don't follow the same standards.
The main issues with convergence lie with the difference in the approach of the U.S. GAAP and IFRS. The IFRS is more dynamic and is continuously being revised in response to an ever-changing financial environment.
SEC'S Goals for Convergence
The Securities and Exchange Commission's goals and efforts have been to consistently pursue the achievement of fair, liquid, and efficient capital markets. The aim is to provide investors with information that is accurate, timely, comparable, and reliable. One of the ways the SEC has pursued these goals is by upholding the domestic quality of financial reporting as well as encouraging the convergence of the U.S. and IFRS standards.
Research indicates that firms that apply the international standards show the following:
- A higher variance of net income changes
- A higher change in cash flows
- A significantly lower negative correlation between accruals and cash flows
- A lower frequency of small positive income
- A higher frequency of large negative income
- A higher value relevance in accounting amounts
They also have fewer earnings management, more timely loss recognition, and more value relevance in accounting amounts compared to domestic firms following the GAAP. Therefore, firms adhering to the IFRS generally exhibit higher accounting quality than when they previously followed the GAAP.
Financial Accounting Standards Board (FASB)'s Role in Convergence
The Financial Accounting Standards Board (FASB) states that the Sarbanes-Oxley Act's requirement of the SEC to investigate the feasibility of implementing a more principles-based approach to accounting means that the U.S. needs to continue its compliance with the SOX as part of the process of the convergence of the GAAP and IFRS standards.
Both FASB and IFRS have identified short- and long-term convergence projects, including 20 reporting areas where differences have been resolved and completed. The FASB also provides clarification on the GAAP by categorizing it in descending order of authority.
The appeal of convergence is based on the fact that the convergence of accounting standards can best be achieved over time through the development of high-quality, common standards. It is also attractive because eliminating standards on either side is counterproductive. Therefore, new common standards that improve the financial information reported to stakeholders should be developed.
Despite the research-indicated evidence of a higher accounting quality being experienced by firms that either apply the IFRS standards or have switched to them from the GAAP, theconvergence process has not proven to be an easy task, mostly because of the differences in approach between the two accounting bodies. A solution may be that the IFRS should accept some FASB standards to accommodate the needs of the U.S. constituents and stakeholders.
The Financial Accounting Standards Board's original mission has always been to establish the U.S. GAAP (which FASB oversees) and standards for accounting and financial reporting; however, the mission has been enhanced to include the convergence and harmonization of U.S. standards with international ones (IFRS).
Attitudes on Convergence
There is some opposition to the convergence from all stakeholders involved, including accounting professionals and corporations' top management. There are various reasons for such resistance to change, and some are pertinent to the accounting profession, some to corporate management and some are shared by both.
Certified Public Accountant (CPA)
Some reasons for the U.S. not embracing the standards convergence are: U.S. firms are already familiar with the existing standards; the inability or low ability to culturally relate to other countries' accounting systems; and a lack of good understanding of the international principles.
Culture in this context is defined as "the collective programming of the mind which distinguishes the members of one human group from another." Each nation and culture shares its own societal norms consisting of common characteristics, such as a value system—a broad tendency to prefer certain states of affairs over others—which is adopted by the majority of constituents.
The accounting value dimensions used to define a country's accounting system, based on the country's culture, consist of the following:
- Professionalism versus statutory control
- Uniformity versus conformity
- Conservatism versus optimism
- Secrecy versus transparency
The first two relate to authority and enforcement of accounting practice at a country level, while the last two relate to the measurement and disclosure of accounting information at a country level. Examining those dimensions and factors that impact an accounting system, it becomes evident that cultural differences have a strong impact on the accounting standards of another nation, thus complicating the standards convergence.
Another reason why U.S. companies are resistant to converging the GAAP with the IFRS is the prevailing opinion that the principles-based IFRS fails to offer guidance compared to the rules-based U.S. standards.As a result, U.S. accounting professionals and corporate management perceive the IFRS to be lower quality than the GAAP.
Chief Financial Officer (CFO)
CFOs are not embracing this change because of the costs involved. There are specifically two areas that are directly impacted: a company's financial reporting and its internal control systems. Another cost involved in the transition and change to the IFRS is the public's perception of the integrity of the new converged set of standards. The SEC reporting requirements will also have to be adjusted to reflect changes in the converged system.
IFRS does not segregate extraordinary items in the income statement, but U.S. GAAP shows them as net income. IFRS does not allow LIFO for inventory valuation whereas the U.S. GAAP provides the option of either LIFO, average cost, or FIFO.Under the IFRS the EPS calculation does not average the individual interim period calculations, but the U.S. GAAP does. Regarding developmental costs, IFRS capitalizes them if certain criteria are met while the U.S. GAAP considers them expenses.
It has been agreed to "(a) undertake a short-term project aimed at removing a variety of individual differences between U.S. GAAP and International Financial Reporting Standards' (IFRS), which include International Accounting Standards (IAS), (b) remove other differences between IFRSs and U.S. GAAP through coordination of their future work programs, (c) continue progress on the joint projects that they are undertaking, and (d) encourage their respective interpretative bodies to coordinate their activities"
The new set of standards that will be adopted will need to provide transparency and full disclosure similar to the U.S. standards, and it should also ensure broad acceptance.
Impact of Convergence
The convergence and subsequent change of accounting and reporting standards at the international level impact a number of constituents. The International Accounting Standards Board (IASB) seeks a workable solution to alleviate the existing complexity, conflict, and confusion created by inconsistency and the lack of streamlined accounting standards in financial reporting.
- Corporate Management: Corporate management will benefit from simpler, streamlined standards, rules, and practices that apply to all countries and are followed worldwide. The change will afford corporate management the opportunity to raise capital via lower interest rates while lowering risk and the cost of doing business.
- Investors: Investors will have to re-educate themselves in reading and understanding accounting reports and financial statements following the new internationally accepted standards. At the same time, the process will provide more credible information and will be simplified without the need for conversion to the standards of the country. Further, the new standards will increase the international flow of capital.
- Stock Markets: Stock markets will see a reduction in the costs that accompany entering foreign exchanges, and all markets adhering to the same rules and standards will further allow markets to compete internationally for global investment opportunities.
- Accounting Professionals: The shift and convergence of the current standards to internationally accepted ones will force accounting professionals to learn the new standard and will lead to consistency in accounting practices.
- Accounting Standards Setters: The development of standards involves a number of boards and entities that make the process longer, more time-consuming, and frustrating for all parties involved. Once standards have converged, the actual process of developing and implementing new international standards will be simpler and will eliminate the reliance on agencies to develop and ratify a decision on any specific standard.
Advantages and Disadvantages of Convergence
Advantages
Arguments for the convergence are:
- Renewed clarity
- Possible simplification
- Transparency
- Comparability between different countries on accounting and financial reporting
This will result in an increase in capital flow and international investments, which will further reduce interest rates and lead to economic growth for a specific nation and the firms with which the country conducts business.
Timeliness and the availability of uniform information to all concerned stakeholders will also conceptually make for a smoother and more efficient process. Additionally, new safeguards will be in place to prevent another national or international economic and financial meltdown.
Disadvantages
Arguments against accounting standards convergence are the unwillingness of the different nations involved in the process to collaborate. This is based on different cultures, ethics, standards, beliefs, types of economies, political systems, and preconceived notions for specific countries, systems, and religions.
Another key drawback of convergence, though, lies in time. This means that it could take a great deal of time to implement a new system of accounting rules and standards across the board.
Pros
Can lead to clarity, simplification, transparency, and comparability
Increased capital flow in international markets
Potential for free flow of information and on a timely basis
Cons
Some countries may not want to collaborate
Could take a long time to implement a new combined system
What Does Convergence of GAAP and IFRS Entail?
Converging GAAP and IFRS involves the establishment of a single set of accounting and reporting standards. This new set of principles would be used across the board from country to country. Combining the two would require a great deal of cooperation between international accounting bodies, as well as a lot of time in order to ensure a smooth transition.
Why Is There Opposition to Converging GAAP and IFRS?
Converging GAAP and IFRS may make it easier to conduct business and investments on an international level. But, there is a great deal of opposition from certain stakeholders. For instance, corporate leaders would have to learn a brand new set of rules. There is also a chance that there would be general unwillingness when it comes to relating to international standards. Adopting a new, uniform set of standards also comes at a cost—notably making changes to existing records in order to meet the new requirements.
What Is the Purpose of Reporting Standards?
Reporting standards are put in place to provide companies with a set of uniform principles so they can all inform the public (investors, analysts, and financial institutions) about their financial health and well-being. This includes the completion of financial statements in a fair, accurate, and transparent manner on a timely basis. With reporting standards in place, investors, lenders, and others can make informed decisions about different companies.
The Bottom Line
It's anyone's guess how this convergence will evolve and impact the corporate financial accounting in the U.S. From a legal perspective, companies will be required to disclose qualitative and quantitative information about contracts with customers, including a maturity analysis for contracts extending beyond a year, as well as the inclusion of any significant judgments and changes in judgments made in applying the proposed standard to those contracts.
Maybe the answer lies in the need to consider a more in-depth study and an examination of the factors influencing the molding or development of a country's accounting system. But company boards, in an effort to best serve their investors' needs, should contribute to the convergence process by replacing old standards with the new jointly developed ones.
