Advantages and Disadvantages of U.S. Convergence Between GAAP and IFRS

For over the past decade, there has been a growing demand in the corporate world for U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) to converge to form one set of universal accounting standards. In 2002, members of the Financial Accounting Standards Board (FASB) and members of the International Accounting Standards Board (IASB) met and issued a memorandum laying out framework for the adoption of IFRS by the U.S. Known as the Norwalk Agreement, the two boards agreed to make “existing financial reporting standards fully compatible as soon as practicable”, and to “coordinate future work programs to ensure compatibility is maintained” (Kieso, 2012, p. EP-2).

Critics against the adoption of IFRS in the United States argue principle based accounting standards leave too much of a judgment call in the hands of the preparer. In other words, IFRS is open to more interpretation than rules based GAAP, and can lead companies to release fraudulent representations. Additionally, disadvantages include an increased ability to manipulate transactional accounting, increased variations in accounting approaches for similar transactions, and fewer rules to consider in determining how to account for a transaction (“Which is Better — Principles or Rules?”, 2011). According to a global fraud report issued by Kroll Inc. for 2012-2013, American and European companies have a higher rate of fraud (60% and 63%, respectively) compared to global averages (“Global Fraud Report”, 2013). Changing accounting standards to be open to greater interpretation may attract higher cases of internal, or company fraud.

Another disadvantage to IFRS is the cost expected to be associated with transitioning from GAAP based standards and accounting information systems to IFRS based accounting information systems. However, while these costs may be high, they are short-term in nature and it is estimated companies will save money in the long term. “Studies suggest that a major impact will be the cost of transition to IFRS. According to research, the benefits to U.S. investors may not exceed costs. Additionally, due to U.S. GAAP’s high standards, financial reporting improvements will be minor. Research also suggests that these costs and benefits will vary across firms and will be difficult to trace upon adoption” (Bolt-Lee, 2009). These costs will burden small to medium sized companies that lack the capital and resources that large MNCs possess. And, according to KMPG, the largest component of IFRS conversion costs are IT costs, estimating that 50 percent to 70 percent of a typical conversion effort’s costs relates to IT (Krell, 2009).

A major holdup in the convergence of IFRS and GAAP rests with control. In the U.S. the Security and Exchange Commission (SEC) has the power when it comes to accounting standards. Although the FASB sets the standards, the SEC oversees and ensures public companies are complying with laws, practices and acting in a manner that facilitates ethical behavior and decision making. “Under the present system, the SEC attempts to ensure uniformity and consistency in financial reporting. However, regulators cannot enforce uniformity in a principles-based system” (Thompson, 2009). If the U.S. converts, the SEC is sure to lose a great deal of control and influence over the accounting and reporting practices.

One benefit to IFRS is standards that are based on principles, unlike GAAP which relies on rules-based standards. Principles-based standards allow more leeway as to how corporations can portray their financial performance (Galuszka, 2008). According to a survey of corporate executives, many of them listed IFRS and principles-based standards as “more intuitive” and “easier to use” than their GAAP counterpart.

The distinction between the two approaches lies precisely where their respective descriptions suggest: principles-based standards are based on a clear hierarchy of overarching principles, contain few or no provisions and rely heavily on the exercise of judgment as to what constitutes fair presentation; rules-based standards are characterized by several anti-abuse provisions and allow relatively less scope for the exercise of judgment in their application. (International GAAP, 2010)

Under rules based accounting, it is sometimes the case that a “transaction must be accounted for in accordance with the rule even if the applied accounting is misleading” (“Which is Better — Principles or Rules?”, 2011). Using IFRS allows a company to use judgment to best represent financial performance, and increase comparability among companies with similar transactions over different industries. “Rules-based accounting has not worked in practice. Critics argue that the present U.S. system does not produce accurate reporting. It focuses on “checking the boxes” more than portraying an underlying economic reality” (Thompson, 2009). IFRS tries to curb this problem through greater interpretation of the accounting principles.

Replacing GAAP standards with IFRS accounting standards will enable interested users of financial statements to make more informed decisions. Currently, “over 115 countries have adopted IFRS, plus the European Union now requires all listed companies in Europe (over 7,000 companies) to use it” (Kieso, 2012, p. EP-2). Most of the developed nations, especially those members of the EU currently practicing international standards, have a higher degree of transparency and reliability amongst financial information. Working towards convergence of accounting standards will make international investing easier, as well as make it easier for users to dissect financial information if located in foreign regions.

Adopting IFRS will, in the long-term, help to reduce cost. Many firms such as Nike, Microsoft, IBM and Apple have operations in several different countries, and therefore must prepare several different accounting books and records under each set of standards. In addition, users of financial statements must be knowledgeable in both GAAP and IFRS to completely dissect the financial information reported by multi-national corporations (MNCs).

Adopting IFRS will open the doors for firms across the globe to hire new talent. According to Matthew Birney, a manager in the financial reporting department responsible for International Financial Reporting Standards at United Technologies says some of the positives to IFRS is access to a wider talent pool (Krell, 2009). In an increasing globalized economy and workforce, hiring may no longer be restricted to hiring new applicants within the country’s borders.

As the world continues to shrink and business becomes even more globalized, a universal set of accounting standards is desired to help harmonize global accounting practices. The benefits of increasing comprehension and creating one set of accounting standards will help facilitate the flow of assets and increase overseas investment. Adopting a principles based approach to accounting will allow preparers of financial information to more accurately portray financial performance relative to the operations of the company. As global business environments improve, it is inevitable that one set of accounting standards is needed.

References

Bolt-Lee, C., & Smith, L. (2009, November 1). Highlights of IFRS Research. Retrieved September 20, 2014.

Galuszka, P. (2008, August 28). Pros and Cons of IFRS. Retrieved September 18, 2014.

International GAAP. (2010, January 1). Retrieved September 18, 2014, from http://www.wiley.com/WileyCDA/Section/id-403632.html

Kieso, D., Weygandt, J., & Warfield, T. (2012). Intermediate accounting (14th ed.). Hoboken, NJ: Wiley.

Krell, E. (2009, April 2). Biggest IFRS Cost? IT. Retrieved September 18, 2014.

Krell, E. (2009, April 6). IFRS Pros and Cons. Retrieved September 19, 2014.

Thompson, R. (2009, September 14). Principles- vs. Rules-Based Accounting. Retrieved September 19, 2014.

Which is Better — Principles or Rules? (2011, April 5). Retrieved September 18, 2014.

2012 / 2013 KROLL GLOBAL FRAUD REPORT SURVEY. (2013, January 1). Retrieved September 19, 2014.