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.
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 (http://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.
4) A greater focus on transparency versus uniformity.
Investment advisors are increasingly focused on the transparency of financial statements. More generally, user groups such as the Corporate Reporting User Forum have stressed the importance of transparency in financial statements and focus less on a single measure.
With greater transparency comes greater comparability. The ICAEW report on EU implementation of IFRS notes that most investors, preparers, and auditors believe that IFRS has increased the comparability of financial reporting in the EU. In a November 2008 Duke/Oxford survey of financial executives for companies listed on major stock exchanges in the United States, Germany, France, and the United Kingdom, U.S. respondents indicated that while IFRS results in information that is less uniform, the standards are more transparent.
A Moody’s commentary in November 2008, “Are We Better Off Under IFRS,” noted that adoption of IFRS has brought more comprehensive reporting globally, including requiring cash flow statements, better information on pensions, leases, and disclosures about judgments used (revenues and provisions). The Moody’s commentary also noted that IFRS better reflects the economics of transactions, including financing transactions, minority interest, put options, depreciation, revenues, and consolidation policy. This is consistent with a Mazars survey (IFRS 2005 European Survey of 550 listed companies in 12 European countries) in which the majority of respondents indicated that IFRS brings accounting practices closer to economic substance.
The Advantages of a Single Set of Standards
The potential benefits of a single set of global accounting standards are real and significant. Ultimately, having a single set of global accounting standards is a win for all market participants, including investment advisors, because they will yield:
Greater transparency and better, more relevant information.
Transparency has become a benchmark for evaluating financial statements and financial reporting standards. In the context of financial reporting, transparency refers to the ability of the user to understand the underlying transaction and how it was accounted for in the financial statements. High-quality financial reporting standards should not only include guidance on the principles supporting accounting for various types of transactions, but also guidance on disclosing such transactions.
Because they consist of overriding principles for accounting, rather than more detailed, specific guidance, IFRS, by design, requires in-depth disclosures. These disclosures enhance the ability of a user who is mindful of the general principles to compare financial statements of different entities, even if the user accounted for a similar transaction differently. A user who focuses on the economic substance of a transaction, along with enhanced disclosures, should gain a more in-depth understanding of an underlying transaction. Having more relevant financial information about companies, regardless of where they are located, should allow investment advisors to provide better advice on investment decisions.
Less Risk and Lower Costs in the Long Run
In the results of a March 2009 study conducted by Accenture, CFOs and other executives of U.S.-listed companies cited reducing the risk of inconsistent financial reporting as one of the main benefits of adopting IFRS. Various studies in Europe have indicated that the transition to IFRS increased confidence in markets in which IFRS have been adopted. Because information quality is improved under IFRS as a result of increased transparency, risk to all investors from owning shares should be reduced–not just the risk to less-informed investors as a result of adverse selection. In theory, this risk reduction should lead to a reduction in firms’ costs of equity capital, which would increase share prices and make new investments by firms more attractive, all other things being equal. Academic studies (e.g. “Market Reaction to the Adoption of IFRS in Europe” by Chris S. Armstrong, Mary E. Barth, Alan D. Jagolinzer, and Edward J. Riedl, Edward in 2007 [revised April 20, 2009 Accounting Review, Forthcoming]) have shown that the decision to impose mandatory IFRS in the EU had on average a positive effect on the value of companies and suggested an overall reduction in the cost of capital.
By eliminating many international differences in accounting standards and standardizing reporting formats, IFRS will eliminate many of the adjustments investment advisors historically have made to allow companies’ financials to be more comparable internationally. IFRS adoptions, therefore, could reduce not only compliance costs for companies, but also the cost to investment advisors of processing financial information.
No Arbitrage Between Different Standards
A risk of having multiple sets of financial standards that are broadly used and accepted is that they will offset each other or that accounting arbitrage will result. For example, the recent financial crisis has shown that “technical differences” between U.S. GAAP and IFRS that were previously considered harmless have become the source of much politicization. Unfortunately, some of the recent rulemaking related to fair value accounting was motivated by the desire of certain interested parties to “level the playing field.” Instead of focusing on the best approach to dealing with the accounting issue on a global basis, the rules addressed the potential advantage or disadvantage to companies being forced to apply either U.S. GAAP or IFRS. A single set of global standards would create a level playing field worldwide and eliminate accounting arbitrage that may lead to a decline in the overall quality of financial reporting.
We are now in a world where investors are increasingly looking for global investment opportunities. This means understanding the financial reporting of companies regardless of where they are domiciled. The movement toward a single set of global accounting standards should be welcome news for investment advisors, who are increasingly looking for global investment opportunities.
D.J. Gannon is a partner with Deloitte & Touche LLP and is based in Washington, D.C. Gannon focuses on international accounting and financial reporting as well as global regulatory and professional issues. His responsibilities include consulting on matters involving International Financial Reporting Standards (IFRS) and working with Securities and Exchange Commission (SEC) registrants that are foreign private issuers. He leads Deloitte’s IFRS Center of Excellence in the U.S. He can be reached at [email protected]. For more information on IFRS please go to http://www.deloitte.com/us/ifrs.