Small World

Over the last several years, the world’s capital markets have undergone tremendous expansion, diversification, and integration. Accompanying these changes has been a movement away from local financial reporting standards toward global standards. In 2005, the 25 member states of the European Union (EU) met and decided to establish a common set of financial reporting standards: the International Financial Reporting Standards (IFRS). Today, the IFRS standards are used for public reporting in more than 100 countries throughout the world. Other countries, namely Argentina, Brazil, Canada, Chile, India, Japan, Korea, and Mexico will be following suit over the next couple of years.

The leaders of the G-20 countries recently reiterated their desire for a single set of global standards in response to the current financial crisis. In addition, the International Organization of Securities Commission (IOSCO, the leading international policy forum for securities regulators) recently indicated in a letter to the G-20 that it “supports the development and use of robust, internationally accepted and consistently applied financial reporting standards,” and it therefore supports IFRS.

The discussion has now turned to the U.S. domestic environment. Last year the SEC issued for comment its “IFRS roadmap” that proposes an eventual adoption of IFRS, beginning in 2014, for U.S. public companies. In determining how to move forward with the proposed IFRS roadmap, the SEC will most likely consider recent developments related to the financial crisis, including the loss in confidence in the U.S. capital markets, the development of capital market alternatives outside the United States, and the impact on global competitiveness.

This movement toward a single set of global accounting standards is particularly important for investment advisors who rely on the quality and transparency of company financial statements in order to provide investment advice to their clients.

Rethinking Reporting

While some may argue that in light of recent market and economic events this is not the time to make fundamental changes in financial reporting requirements, these very events may actually have reinforced the need to rethink the approach to financial reporting. After all:

1) With the rise in global markets, we can no longer think just locally.

In a CFA Institute member poll on the IFRS Roadmap conducted in March 2009, 91% of respondents indicated they supported having all companies throughout the world use a single set of accounting standards.

Evidence from the recent adoption of IFRS in the European Union also corroborates the need for a single set of global accounting standards and reinforces the importance of cross-border comparison. In a report commissioned by the European Commission in October 2007, the Institute of Chartered Accountants in England and Wales (ICAEW) studied the impact of the conversion to IFRS in the EU. The ICAEW’s report (EU Implementation of IFRS and the Fair Value Directive), noted that “there was widespread agreement that IFRS has made financial statements easier to compare across countries, across competitors within the same industry sector, and across industry sectors.”

In a study compiled by the Institute of Chartered Accountants of Scotland, more than 150 preparers, auditors, analysts, and regulators in the UK, Ireland, and Italy were surveyed. The study, The Implementation of IFRS in the UK, Italy and Ireland, indicated “that some putative benefits may arise from the adoption of international standards including: access to capital; enhancing cross-border listings; providing better investment opportunities; increasing transparency; comparability.”

2) The increased complexity of financial reporting and accounting for the economics of transaction.

Since the late 1990s, there have been ongoing questions about U.S. financial reporting, including the complexity of U.S. generally accepted accounting principles (U.S. GAAP) and the need for standards that are less reliant on detailed rules and bright lines. Recently, the SEC’s Advisory Committee for Improvements to Financial Reporting (CIFiR) noted in its recommendations (//www.sec.gov/about/offices/oca/acifr.shtml), that less industry-specific guidance and less reliance on mechanical rules would help reduce unnecessary complexity in financial reporting.

Complex financial reporting often makes financial statements less transparent and, as a result, the investment advisor’s job more difficult. Accounting standards that rely more on judgment make it less likely that a transaction can be structured to achieve a less transparent accounting result. Without detailed examples and rules, preparers are more inclined to focus on understanding the economic purpose of a transaction to properly account for it than on researching the accounting literature for a similar transaction.

3) A greater focus on principles and use of judgment versus detailed rules.

The CIFiR recommendations highlight the need to simplify the level of detailed guidance in U.S. GAAP, which is often conflicting, and move toward a more “principles-based” approach in which judgment is paramount. A “principles-based” approach is generally designed to (1) reflect economic substance more than legal form; (2) reflect economic gains and losses in a more timely fashion; (3) make earnings more informative; (4) provide more useful balance sheets; and (5) curtail the historical discretion afforded managers to manipulate provisions, create hidden reserves, “smooth” earnings, and hide economic losses from public view.

Critics of IFRS often associate more detailed guidance with increased rigor in financial reporting. This association has not proven true and is, in fact, arguably entirely false, particularly given recent events. A recent academic study (“Principles-based versus rules-based accounting standards: the influence of standard precision and audit committee strength on financial reporting decisions” (January 2009) by Tsaksumas, Agoglia, and Doupnik) found that financial statement preparers are less likely to report aggressively under a less precise (i.e., more principles-based) standard than under a more precise or rules-based standard. The researchers also found significantly less variability in application among preparers that used a less precise standard, suggesting that the application of more principles-based standards such as IFRSs need not result in less comparability than the application of more precise standards such as U.S. GAAP.