Chapter 20

Creating a Global Financial Reporting Standard

In This Chapter

Developing uniform global financial reporting standards

Seeing who benefits from standardization

Examining the differences between reporting systems

As more companies operate globally, the need grows for common financial reporting rules. Today many global companies must prepare financial statements in every country in which they operate, to meet each country's reporting requirements. They also must keep the books according to U.S. generally accepted accounting principles (GAAP) rules (see Chapter 18), if the company is a U.S. company, and must meet the standards of the International Financial Reporting Standards (IFRS), or possibly other standards set by government officials in the country in which they're based.

Financial regulatory institutions plan to meld the standards at some point in the future. Today more than 100 countries use the IFRS as the public reporting standard. The IFRS may be used in almost every country, including the U.S, if the company is based in another country. In this chapter, I explore why a move to develop a global public reporting standard is underway, and I introduce you to the key players who are creating this standard. I also discuss the primary benefits of a worldwide standard and talk about some key differences between the U.S. GAAP and the IFRS.

Why Develop a Worldwide Financial Standard?

Have you ever tried to compare a U.S. company to a company in another country and been frustrated with how difficult it is to be looking at apples to oranges? Financial reporting rules differ from country to country, so you can never be certain you're comparing the same information about assets, liabilities, equity, revenue, or expenses. These differences in reporting can make trying to decide which company's stock to buy very difficult.

Companies that operate in more than one country have bigger problems than ones that operate in only one country because they must report results to each country in which they operate, as well as to the country in which they're based. This can result in numerous different accounting systems that must constantly be translated to match the rules for each set of financial reports.

For example, a global U.S. company operating in Canada can report results using the U.S. GAAP, but Canada is moving toward full adoption of IFRS. If the firm is listed on the London exchange, it must also prepare statements to meet the IFRS, and it needs to prepare another set of statements under the rules of the U.S. GAAP. Imagine doing that for every country in which the business operates. Fortunately for U.S. companies, most countries are now accepting the IFRS standards. At some point in the future, the U.S. may also accept IFRS standards, but that point seems to be getting farther away as the work continues. Anything that can simplify this process benefits both the companies that must prepare the statements and the investors trying to interpret the differences.

Key Moves to Reshape Global Financial Reporting

So how did the process get started to reshape the global financial road map, and who are the key players?

In 2002, the U.S. Financial Accounting Standards Board (or FASB, which issues GAAP rules) and the London-based International Accounting Standards Board (or IASB, which issues the IFRS) entered into the Norwalk Agreement, which lays out a plan to undertake efforts to converge the U.S. GAAP and the IFRS. The primary difference between the two is that the IFRS is more focused on objectives and principles and less reliant on detailed rules than the GAAP.

After much discussion and negotiation, the European Commission began its project on the equivalence of national GAAP and the IFRS and issued a draft report in 2005. The U.S. Securities and Exchange Commission (SEC) followed with its development of the IFRS Road Map in 2005.

In 2006, the FASB and IASB reaffirmed their commitment to converge the two reporting systems and updated the Norwalk Agreement based on findings in the 2005 reports. In 2007, the SEC eliminated the requirement for foreign companies that use the IFRS to reconcile to the GAAP. The first major step in accepting the IFRS in financial reports circulated to U.S. investors.

In 2007, in another major step to accept IFRS reporting requirements by U.S. companies, the SEC issued a “concept release” on the topic of giving U.S. companies a choice between filing their reports based on IFRS or GAAP requirements. A concept release opens up the question and seeks comments. The SEC has not yet permitted U.S. companies to use IFRS reporting requirements for SEC reports, but it did move a step closer in May 2008 when it released a “proposing release” on the matter. The proposing release proposes the change and asks for comments.

In July 2012, the SEC issued a report entitled “Work Plan for Consideration of Incorporating International Reporting Standards into the Financial Reporting System for U.S. Issuers,” but it did not make any recommendations for a time frame in which to adopt IFRS. The staff concluded that more analysis and consideration was needed before IFRS could be incorporated into U.S. financial reporting.

The U.S. will be one of the last countries to jump on this bandwagon. Israel adopted the IFRS in 2008, Chile and Korea adopted it in 2009, Brazil adopted it in 2010, and Canada did so in 2011.

So global corporations will be able to adopt IFRS for almost all their reporting, unless they are a U.S.–based corporation.

Who Benefits from a Global Standard and How?

Companies that must prepare the reports, and investors, government agencies, and vendors that must use the reports, all benefit from a global standard. Making an informed decision is hard when companies use varying regulations for reporting their finances.

Investors

Every day, investors seek ways to get high-quality financial information that accurately reflects a company's true financial results. Any investor burned by the mortgage mess in 2007, when key financial institutions kept major holdings off the books, knows how critical accurate financial reporting can be to decision making.

Although the IFRS wouldn't fix all the problems that cropped up in 2007 and 2008 as financial institutions fessed up to their reporting shenanigans, a global standard would make it harder to hide problems across country borders. As U.S. investors become aware that they no longer have to massage the numbers to compare the results of U.S. companies to companies based outside the U.S., they'll push for IFRS alignment so they can compare apples to apples.

Companies that use IFRS standards tend to have longer annual reports than companies that use GAAP guidelines, and the reports are more transparent. A U.S. report based on GAAP principles may be 60 to 70 pages; a report using the IFRS guidelines may be closer to 110 pages. That difference may seem even more overwhelming to you, but you'll have more information with which to make your decisions.

Capital Markets

Capital markets would benefit from the IFRS because if all companies operate under one set of accounting standards, investors can more easily access multiple foreign markets as they build their investment portfolios. This move would stimulate investment and enable capital flows across borders.

Companies

Companies stand to gain the most from this rule change because it would simplify the financial reporting requirements for companies that operate in more than one country. Allowing U.S. companies who operate globally to use IFRS would have these benefits:

• Standardized and improved accounting and financial policies: Companies would no longer have to maintain two or more sets of books to prepare financial statements based on varying rules.
• More efficient use of resources: Companies would be able to more easily centralize their accounting processes and simplify the training required for employees if only one set of standards for reporting were required to meet governmental regulations.
• Improved controls: The IFRS gives companies more control over statutory reporting, which would reduce the risks related to penalties and compliance problems to meet the regulations of each country in which the company operates.
• Better cash management: By having more consistent rules across borders, companies could manage their cash more efficiently.

Key Differences between GAAP and the IFRS

Major reports have been written about the key differences between the GAAP and IFRS standards. I don't have the space to do a comprehensive breakdown of the differences, but I do give you a quick peek at some of the key differences in this section.

If you want a full comparison, you can download excellent reports from PricewaterhouseCoopers (a major global accounting firm) at www.pwc.com/us/en/issues/ifrs-reporting/index.jhtml.

Accounting framework

A significant difference between IFRS and GAAP standards is that the IFRS guidelines permit the revaluation of intangible assets; property, plant and equipment; and investment property. GAAP prohibits revaluations except for certain categories of financial instruments that are carried at fair value.

Many analysts believe that assets are undervalued on the balance sheets of major U.S. corporations that compile their reports based on GAAP, especially when it comes to the value of property and plants. Corporate headquarters and factories that were built 20 to 30 years ago are valued on the balance sheets at cost. These assets likely have appreciated greatly even though the buildings have been depreciated to near zero on the balance sheets.

If U.S. corporations do decide to switch to IFRS standards, you may see a dramatic increase in the value of assets held by some companies as they revalue their property and plants.

Financial statements

The key financial statements required by both the IFRS and GAAP are similar, but the ways in which the numbers are calculated sometimes differ. Also, IFRS standards require only two years of data for the income statements, changes in equity, and cash flow statements, whereas GAAP requires three years of data for SEC registrants.

I discuss some key differences in the following sections, but if your company is considering a switch to the IFRS, or if you're an investor who really wants to understand how the differences may impact the compilation of numbers for the financial statements, I highly recommend that you download the report from PricewaterhouseCoopers mentioned earlier in the chapter.

Balance sheet

GAAP standards require assets, liabilities, and equity to be presented in decreasing order of liquidity. The balance sheet is generally presented with total assets equaling total liabilities and shareholders’ equity. For more details on how the balance sheet is presented, review Chapter 6.

IFRS guidelines don't require any specific format, but entities are expected to present current and noncurrent assets and current and noncurrent liabilities as separate classifications on their balance sheets, except when liquidity presentation provides more relevant and reliable information.

I did review several balance sheets of European companies and didn't find any significant differences in the way the balance sheet was presented. The basic format of the GAAP balance sheet seems to be pretty well accepted globally. In Chapter 6, I include a financial position format, which is sometimes used by companies not based in the U.S.

Income statement

The IFRS guidelines don't prescribe a standard format, but GAAP does require the use of a single-step or multistep format, as shown in Chapter 7. The IFRS prohibits the use of the category “extraordinary items,” but GAAP allows an extraordinary line item on the income statement.

Extraordinary items are defined as being both infrequent and unusual. For example, when goodwill is shown as a negative item, it's listed as an extraordinary item on the income statement. In 2007 and 2008, as financial institutions put goodwill in this category from acquisitions gone bad because of the mortgage mess, they usually put it down as an extraordinary item. By separating these items from operating income results, a company can make its net income look better.

Writing down goodwill doesn't involve the use of cash. Cash is used when a company buys another company for more than the value of its assets. If this happened many years ago, it doesn't impact the current year's operating results.

Statement of recognised income and expense (SoRIE)

The SoRIE is unique to IFRS, but the information is commonly shown at the bottom of the income statement in companies filing reports under the rules of GAAP, or it's presented on a separate document called the statement of changes in shareholders' equity. In either case, the information presents the total income and accumulated income over time.

Note: Note that recognised is spelled with an s instead of a z. I use the common British spelling because U.S. corporations don't use this statement; it's primarily for companies in Europe that use a British spelling.

Statement of changes in shareholders’ equity

This statement is similar in both the IFRS and GAAP standards, unless a non-U.S. company files a SoRIE. This statement isn't required as a separate document under GAAP rules. A company can choose to present the information about changes in shareholders’ equity as part of the notes to the financial statements.

Cash flow statement

In both IFRS and GAAP rules, this statement is presented with similar headings. The IFRS gives limited guidance on what information the statement must include.

GAAP gives more specific guidance for which categories must be included in each section of the statement. Statements can be prepared using the direct or indirect method under either the IFRS or GAAP. I discuss the differences between the direct and indirect methods in Chapter 8.

Revenue recognition

Both the IFRS and GAAP require the recognition of revenue when an item's ownership is transferred to the buyer of the goods, but GAAP gives much more detailed guidance for specific types of transactions. In Chapter 23, I detail the games some companies play with revenue recognition, even under the more detailed GAAP rules. I certainly hope that as the international financial regulators converge the requirements of the two systems, they improve the rules related to the recognition of revenue.

Assets

One key difference between the IFRS and GAAP rules is that assets can be revalued under the IFRS, as discussed earlier in the “Accounting framework” section. Another key difference is that only research is expensed as a cost of doing business under the IFRS, but both research and development are expensed under the GAAP rules. Under the IFRS, development costs are capitalized and amortized (or written off) over several years.

This policy can have a major impact on a company's bottom line. For example, suppose a company determines that, of the $5 million it spent on bringing a new product to market, $1 million was for research and $4 million was for development of the product after research was concluded. Under the GAAP rules, the $5 million would be expensed in each year of the development, based on when the expenses are recognized (I talk about expense recognition in Chapters 7 and 16). Those expenses would decrease net income significantly.

A company operating under the requirements of the IFRS would report this same scenario differently. It would need to expense the $1 million spent on research only as it was spent, but it could capitalize the $4 million and write it off more slowly as an amortization. Depending on the life span given the value of the development, it could be written off over 10 to 15 years or more, to reduce the impact of development on the bottom line.

If you're trying to determine which company makes the better investment, you must look carefully at this key difference in research and development. When all global firms use IFRS to file their financial statements, this difference will no longer be a factor when comparing U.S. companies to companies based outside the U.S.

Inventory

Another key difference between IFRS and GAAP standards is the way inventory is valued. All companies that file reports under the IFRS must use FIFO or weighted-average inventory valuation methods (I discuss inventory valuation methods in Chapter 15). Companies filing under GAAP rules can also use LIFO.

FIFO stands for “first in, first out.” This type of inventory valuation assumes that the first item in the door is the first item sold. Because prices of goods are usually increasing, the item with the lowest cost likely sells first. LIFO stands for “last in, first out.” When this inventory valuation method is used, the last item bought is the first item sold. In this case, the most expensive item is likely sold, and the older, cheaper items remain on the shelf.

LIFO can increase the cost of goods sold and decrease net income, making it look like a company made less money and, therefore, reducing the company's taxes. FIFO results in a lower cost of goods sold and higher net income.

When comparing companies using two different inventory valuation methods, determining the actual costs of doing business can be difficult. If all companies were required to use either FIFO or the weighted-average inventory valuation methods, comparing apples to apples would be easier. When the two systems are merged in the future, the IFRS requirements on inventory valuation will hopefully be adopted. In fact, the LIFO option may be discontinued under GAAP rules.

Related-party transactions disclosures

In related-party transactions — transactions between, say, a corporation and one of its affiliates — companies filing under IFRS regulations must disclose the compensation of key management personnel in the financial statements. GAAP doesn't require such disclosure.

Hopefully, the IFRS rules will be adopted when the systems converge. Shareholders need to know the compensation of management personnel, and this information should be made visible in the financial statements. U.S. investors will definitely benefit from fuller disclosure in this area.

Discontinued operations

Under the IFRS, if operations are discontinued, the operations and cash flows must be clearly distinguished for financial reporting and must represent a separate line of business or geographical area of operations, including whether a subsidiary is acquired exclusively for the purpose of being sold. That scenario happens often when a company buys another company for a specific purpose and isn't interested in continuing every area of the bought company's operations.

Under GAAP, the lines are more blurred for discontinued operations. A segment, operating segment, reporting unit, subsidiary, or asset group can be shown as separate losses for discontinued operations.

Some analysts believe that companies filing under GAAP use this loophole to hide significant problems. I talk more about how discontinued operations are used to clear out deadwood on a balance sheet in Chapter 23. U.S. investors will benefit if clear IFRS lines are drawn for U.S. companies, and fewer problems will be swept under the rug.

Impairment charges

Sometimes an asset loses value. For example, a computer manufacturer may have inventory of older models that can no longer be sold at full price because newer, more advanced models are now available. Their values become impaired and must be written down.

Under GAAP, when an impairment charge is recorded in inventory, the company can't reverse the impairment charge if assets subsequently increase in value. Under the IFRS, however, the company is allowed to reverse the impairment charge if assets subsequently go back up in value.

Both the income statement and the balance sheet can be impacted, as assets whose values have been impaired are adjusted in later years. Investors need to watch the ups and downs of assets, which can impact the profit or loss of a company without a change in operations.