Future of Accounting – IFRS vs. GAAP

The actions of Bernie Madoff and Kenneth Lay (Enron Co.) had a major impact on the American economy. While thousands lost everything they had, the US economy lost something much bigger; their ethical backbone and credibility. Since then, many consumers, businesses and the global economy have scrutinized the US economy. GAAP and industry standards have been reviewed, revised and reformed. Despite recent changes and strengthening of US GAPP, adoption of International Financial Reporting Standards (IFRS) has become a potential opportunity.

The adoption of IFRS has several positive attributes, the biggest being improving financial reporting for global investors, facilitating cross-border investment and integrating capital markets. Given that the global “IFRS network” has already reached a significant size, the United States would benefit greatly from alignment rather than remaining in the smaller, underdeveloped IFRS network. It is difficult to estimate the extent of the impact, but there are several studies and opinions on the various impacts of adopting IFRS.

There are US firms that already have a global footprint with international operations that would realize significant cost savings by using a single set of accounting standards. Being a foreign subsidiary of the US requires compliance with the domestic reporting standards of your domicile and US GAAP. Additional costs arise from the duplication and translation of financial report information.

Empirical studies show that the costs and benefits of adopting IFRS vary from company to company. There is evidence that the voluntary adoption of IFRS usually results in benefits that outweigh the costs. Voluntary adopters tend to have similar characteristics; Larger, more likely internationally dispersed operations, more dispersed ownership, and more reliant on outside funding. In some respects, GAAP creates barriers for many US companies that limit both expansion and growth. In line with the notion of comparability benefits, the main beneficiaries of the adoption of IFRS would be US multinational corporations and their investors.

Several other patterns have emerged from examining foreign nations that primarily use or have already adopted IFRS. All accounting standards use judgment as some numbers are based on estimates and approximations (e.g. the useful life of an asset, the value of goodwill, etc.). IFRS is no exception, and whether companies implement IFRS in a way that makes the figures more informative (such as footnotes and recognition) still poses a threat to the reliability of the information. A single set of accounting standards does not guarantee the comparability of companies’ reporting practices, as enforcement is not the only influence in achieving successful outcomes. Ethics and other variables always play a role in the application of accounting standards. It is important to recognize that the key elements of an institutional infrastructure fit together and are mutually reinforcing.

The best results have been achieved in countries with strong enforcement regimes and institutional structures that provide strong incentives for reporting. These countries are more likely to have recognizable capital market effects when applying IFRS reporting. A ‘serious’ commitment to IFRS has demonstrated higher capital costs and market liquidity benefits compared to adopting IFRS as a ‘label’. A comparison of the accounting figures according to German GAAP with those of the International Accounting Standards (IAS) for the same years shows a higher balance sheet total and a higher book value of equity according to IAS.

However, there are mixed results across different industries, including the benefit of mandatory IAS. Separately, a 26-country study with strong enforcement regimes and strong reporting incentives consistently showed a 3-6% increase in market liquidity, a reduction in companies’ cost of capital and a corresponding increase in stock valuations. Voluntary adopters of IFRS have better incentives for initial reporting and are more responsive to institutional changes (transition to IFRS), resulting in greater advantages over mandatory adopters. This raises the question of whether the benefits received lie in the types of accounting practices and standards used, or instead in the incentives and changes that lie in other institutional factors. Perhaps creating standard incentives for strict compliance with current GAAP would have a similar effect as adopting IFRS.

The intensity of public enforcement efforts in the US is unprecedented, not only in terms of rules and regulations, but also in terms of staffing levels and budgets, actual enforcement actions, and sanctions imposed. The principal law enforcement agencies are the Securities Exchange Commission (SEC), the US Congress and the courts. In this regard, the US is one of the biggest potential beneficiaries of IFRS.

In comparison, US GAAP and IFRS are based on the same underlying philosophy, roots in the common law tradition and capital markets orientation. In fact, US GAAP is a set of high quality standards that are quite similar to IFRS and are expected to be even more closely aligned when the US adopts IFRS. Adoption of IFRS would be an easy transition, ensuring the same quality and benefits already enjoyed with GAAP. However, the comparability benefits and network effects of IFRS provide a strong rationale for the switch. While these benefits are modest, they are recurring in nature and accrue over the long term.

The US uses GAAP, which already mimics IFRS, has a large number of international offices and oversees business through a strict enforcement regime. When considering the switch, we need to evaluate the cost-benefit trade-off. The cost of IFRS would be the initial transition and shift of accounting authority to the FASB. In turn, America would benefit from the comparability benefits discussed earlier, which are modest but accrue over the long term, and the recurring cost savings of reporting, which primarily affect US multinationals. Regardless, US GAAP is slowly evolving by adopting various standards and practices from IFRS. Others, including myself, believe that the capitalist nature of a free-market society will eventually merge the two standards to propel the global economy to new levels of success.