Over the years we have moved closer and closer to globalisation and globalised economies. Those in doubt just need to look no further than the current global economic collapse. Many countries initially felt they were unaffected by the effect of subprime mortgages in the United States. That was until they realised they had invested in someone who had invested in someone who had invested in someone who had invested in subprime mortgages.
As increasing globalisation of the world’s capital markets took place, the need for a common language for commerce and financial reporting came about. The International Accounting Standards Committee (IASC) was formed in 1973 and charged with harmonising the world’s accounting standards. As trade and investment across borders increased, it becomes more and more important for financial information to be reliable, transparent and comparable.
But the IASC met with limited success. Though many countries were members of the IASC, these same countries were not willing to drop their own country’s standards in favour of international standards. The goal of a single set of internationally accepted accounting standards seemed unattainable. In 2001, the IASC re-imaged itself after the Financial Accounting Standards Board (FASB) into an independent standard setting body and became the International Accounting Standards Board (IASB).
Then Enron, WorldCom, Adelphia and many others came along. While there are many reasons why the accounting and investor communities took notice of these failures, a prime reason was the fact that almost everyone is an investor. While we may not actively buy and sell stocks, our mutual funds or pension fund investments do. So all of us are impacted by shifts in the stock markets.
The above noted collapses resulted in many looking more closely at the US-based standards, which many felt facilitated the collapses. They argue the collapse exposed the greatest weakness of US GAAP; an emphasis on compliance with the rules rather than the spirit of the standards. They felt rules-based systems had too many complex standards and were not principle-based. It was also argued rules-based standards were overly influenced by public accounting (auditing) concerns and not the users’ concerns.
Others argued that the world is becoming more litigious and accordingly rules-based standards were necessary. The prevailing US view was that international accounting standards were not as rigorous as US standards.
The fact is, all principle-based systems use rules to operationalise their standards, and all rule-based systems must rely on principles in order to derive the rules. The real issue is where you ought to be on the continuum.
Post-Enron we started to see change. In 2002 FASB in the US and the IASB entered into the Norwalk agreement. The FASB and the IASB agreed to make their existing financial reporting standards fully compatible as soon as possible and to coordinate their future work programmes to ensure that once achieved, compatibility was maintained.
In 2005 The European Union and Australia adopted International Financial Reporting Standards. In 2006 New Zealand joined. Brazil adopts IFRS in 2010 and Canada in 2011, Ecuador is phasing them in between 2010 and 2012 and the list goes on. In the Caribbean counties, IFRS are required for all domestically listed companies in Antigua and Barbuda, Bahamas and Barbados and they are permitted in the Cayman Islands. More than 100 countries have adopted the single global standard for accounting. The large emerging economies of China and India as well as Japan have signalled very clearly that they are on track to do so. In the US, the Securities and Exchange Commission issued a rule change to accept filings from foreign issuers that comply fully with IFRS, without the need for reconciliation to US GAAP, and is even considering the possibility of allowing US companies to choose to adopt IFRS.
The reasons given by these countries vary and include:
- that they are too small to have their own national standards
- that national accounts based on tax rules are not market-orientated
- the need to create a single capital market to rival the US
- the need to access international markets
- that most of the world does this and cost savings are in sight
So what are some of the ‘unique’ features of the IFRS? There are far too many to cover in this short article so we will cover just a few.
The IFRS state that the objective of financial statements is to provide information for economic decisions. Now think back to your economics courses and ask yourself, if you need to make an economic decision, aren’t opportunity cost concepts an economic decision? Is income measured differently in an economic model than it is under an accounting model?
There is no prescribed standard format for the financial statements under the IFRS, although examples and guidance are usually provided. There are minimum disclosures to be made on the face of the financial statements as well as in the notes.
Historical cost is the main accounting convention. Items are usually accounted for at their historical cost. However, IFRS permits the revaluation of intangible assets, property, plant and equipment (PPE) and investment property to their fair value. IFRS also requires certain categories of financial instruments and certain biological assets to be valued at their fair value. All items, other than those carried at fair value through profit or loss, are subject to impairment.
The IFRS are principle-based standards and the principles require more professional judgement than many accountants might be used to. It is less clear when the ‘right answer’ has been obtained and there are fewer ‘bright lines’. There is also significantly more disclosure
Some standards of note:
IFRS 1– First-time Adoption of IFRS: The objective of IFRS 1 is to provide guidance to financial statement preparers as to how to establish a starting point for accounting under IFRS. This is done through an opening balance sheet where opening balance sheet entries generally flow through equity to record adjustments necessary on first-time adoption. In order to arrive at a consistent starting point for all first-time adopters the IASB included in the standard a fairly prescriptive list of ‘dos’ and ‘don’ts’ that are applicable when initially adopting IFRS. This could cause some significant differences for retained earnings on the financial statements.
You may no longer have a ‘cost of goods sold’ section. An entity must present an analysis of expenses using a classification based on whichever of the following provides information that is reliable and more relevant:
- the nature of expenses (for example, depreciation, purchases of materials, transport costs, employee benefits and advertising costs); or
- their function within the entity (for example costs of sales, selling and administrative expenses)
IAS 16 – Property, Plant and Equipment: you can use historical cost or you can elect to use a fair value model. This allows you to revalue each year – but with one caveat. You must be able to reasonably and justifiably estimate fair value. Tangible assets need to be estimated with ‘reasonable certainty’, but the exercise associated with obtaining a fair value can become a challenge for intangible assets that do not have an active market. These gains and losses may affect income or comprehensive income depending on the circumstances. Now think of how depreciation expense or accumulated depreciation could be affected if the fair value model is chosen.
Significant changes in accounting in the real estate industry can be anticipated upon convergence to IFRS. These changes come courtesy of IAS 40 – Investment property – a standard which provides certain companies owning qualifying real estate properties with the option to record this property at fair value. If you choose the re-valued model, there is no requirement for depreciation on the investment property.
IAS 23 – Borrowing costs, under which the capitalisation of certain types of interest will become mandatory. In the past this was optional for firms following US or international rules.
Under IAS 11 – Construction contracts, the completed contract method is no longer allowed. Only the percentage of completion or the rarely used cost-plus methods are now permitted.
But accountants and business entities adapting the IFRS should recognise it is far from just being a technical accounting exercise. You need to consider a much wider perspective. Areas to consider in an implementation plan include:
- your accounting resources and capabilities. The move to IFRS will require a significant amount of training and education, especially for corporate accountants responsible for maintaining financial records, those preparing the financial statements and those responsible for auditing them.
- the effects on debt covenants and financing. For example, some long-term debt under a non-IFRS standard may constitute a current liability under the IFRS and hence debt covenant ratios could be affected.
- budgets and forecasts may now be based on different measurement models. The financial statements emphasise the external user while the budgets focus on the internal user.
- income and capital tax bases may change. How will taxing authorities treat items such as fair value increases?
- compensation plans will be affected. Often they are based on income but under the IFRS income may be different. Do you really want to reward or penalise someone for something they have no control over?
- internal controls, general ledgers, chart of accounts and systems are likely going to undergo significant change.
Countries moving to the IFRS have a number of challenges ahead of them. While not all are in agreement, many are of the opinion that international accounting and auditing standards are seen as a way of ensuring reliability and comparability in financial statements across regions and jurisdictions. They are also seen as a way to restore confidence in the accounting profession as a whole and in capital markets.