What a Switch from GAAP to IFRS May Mean for Investors
International trade and cross-border investing is becoming more complex with new emerging market economies and global investment opportunities. The Securities and Exchange Commission, Federal Accounting Standards Board (FASB), and International Accounting Standards Board (IASB), are continuously seeking way to converge U.S. and international corporate financial reporting requirements.
The SEC recently released two staff papers examining the implications of a global standard. The first paper compares U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), while the second paper takes a closer look at how some foreign companies have used IFRS with SEC filings. By the end of this year, the SEC’s staff is expected to recommend whether or not to move closer toward IFRS standards and away from U.S. GAAP. But what would a shift in reporting standards mean for investors?
Dr. Barry Epstein, a CPA with Russell Novak & Company in Chicago, says a universal reporting standard would greatly benefit investors.
“We’re taught to diversify investments beyond just U.S. companies, but often there are added taxes and fees when reporting standards are different, and this discourages people from investing. This hardly serves the purpose of diversification,” Epstein says.
Along those same lines, Joel Osnoss, global leader of IFRS Clients and Markets at Deloitte and Touche, says that because investors aren’t investing solely in U.S. companies, there is a critical need for convergence.
“A global standard will result in higher quality,” he says. “It will give investors the ability to have a meaningful comparison of companies around the world, will raise the disclosure standard and provide more consistency within industries and worldwide.”
Collaboration between global regulators who monitor financial reporting standards would be a direct result of convergence. “Ongoing dialogue among regulators would raise the global standard and improve the quality of company financial statements overall,” Osnoss says.
More than 100 countries use IFRS. And, while the U.S. uses its own standards under GAAP, IFRS still affects U.S. companies due to cross-border mergers and acquisitions. But one expert argues that IFRS standards aren’t as mature as U.S. GAAP, and that convergence should be considered very carefully.
“There is much flexibility in IFRS standards,” says Charles Mulford, a professor at Georgia Tech’s School of Business and Director of the Financial Reporting & Analysis Lab. “I think investors would have a hard time comparing results across companies, because there is a lack of comparability between IFRS and GAAP standards.”
Mulford points out that where there are specific rules outlined by U.S. GAAP, IFRS offers silence or some flexibility. “I think U.S. investors would lose something if we gave up GAAP.” He says a longer convergence timeline, allowing more work to be done to identify where specific rules are lacking, would be most beneficial for investors.
The LIFO Effect
Total convergence will affect financial instruments, revenue reporting, leasing, and insurance, along with contract terms, tax policy, financial planning, systems requirements, credit agreements, and compensation strategies. Dr. Epstein contends that most of these are relatively minor, or are already in the process of being converged, but that a major effect of full IFRS implementation would be the elimination of LIFO.
LIFO, or the Last-in-First-Out inventory costing method, is widely used by U.S. companies for tax purposes. Under LIFO, a company assumes that the last product added to inventory is the first unit sold, matching current economic costs with current revenues. This method tends to result in reduced levels of taxable income, allowing companies to conserve cash. An immediate switch to IFRS, and the elimination of LIFO, would cause many companies to have to pay the tax effect of inventory differences known as “LIFO Reserve.”
For example, if there is $50 million in a company’s LIFO reserve, and the company must suddenly stop using LIFO in favor of FIFO (First-in-First-Out inventory costing), they’d have to pay 35% of that $50 million in “catch-up” taxes.
“This would result in a crisis for companies that don’t have the liquidity,” says Dr. Epstein. “This would be very detrimental for businesses that are still struggling in this post-recessionary world.”