Origins and Rationale for IFRS Convergence

Table of contents

* Executive Summary
* Introduction
* Why Convergence Is Necessary
* The Development of Global Standards
* Use in International Capital Markets
* Convergence on a Worldwide Standard
* Conclusion
* Case Study
* Making It Happen

Executive Summary

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Worldwide convergence on international standards for financial reporting will make investment and financial reporting more efficient.
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Investors gain access to more investment opportunities and the cost of capital comes down.
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As more countries use International Financial Reporting Standards (IFRS), so international groups can use them for subsidiary reporting and group reporting.
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The International Accounting Standards Committee, the international standard-setter, came into existence in 1973 as an initiative by the accounting profession to address the emerging needs of cross-border business.
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The standard-setter negotiated a role with the international co-ordinator of stock exchange regulators as a supplier of rules for secondary listings.
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The International Accounting Standards Board, the successor body, was created in 2000 at the time when the European Union announced it would adopt IFRS for listed companies.
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IFRS are now mandatory or permitted in more than 100 countries. China, Japan, India, Canada, Brazil, and South Korea are set to adopt IFRS in 2011.
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Companies using IFRS can list in the United States without preparing a costly reconciliation of their numbers to US GAAP.

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Introduction

How did an internal phone call in a Sydney hotel in 1972 lead 40 years later to a worldwide movement that is changing financial reporting radically and opening up international investment?

Thanks to that conversation, companies can more and more easily access different stock markets, and investors can step across national and cultural boundaries. Investment should be getting more efficient. Since 2001, International Financial Reporting Standards (IFRS) have been set in London by the International Accounting Standards Board (IASB), a privately financed independent body. Their standards are used for listed companies within the European Union and in many other places. In 2011 China, Japan, India, Brazil, and South Korea will start using them. Even the United States is considering abandoning its rules in favor of the international ones.

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Why Convergence Is Necessary

Evidently, having different national accounting systems is costly for companies and investors. Companies have to keep duplicate accounting systems, and investors are wary about buying shares of companies whose accounts they do not understand. The problem arises because accounting regulation has developed over a couple of centuries in national economies whose needs have differed from each other, and whose ways of regulating people’s activities have also differed. What people are looking for from accounting is often different.

Much accounting regulation is contingent: you get an accounting failure, then you get rules to shut the stable door; so, for example, the Enron debacle was followed by the Sarbanes–Oxley Act. This has been going on ever since there were accounting rules. The first government requirements were developed because of a spate of bankruptcies in Paris in the seventeenth century. Consequently, while much of the basic methodology (double entry bookkeeping, balance sheet, etc.) is the same everywhere, the details can differ—especially when it comes to the more complex situations where there is no obvious best solution.

This has a number of consequences, which in turn bring costs. Internally within a multinational group there is usually a network of national subsidiaries (e.g. Nestlé has more than a thousand) spread across the world. They have to report nationally using their national GAAP (Generally Accepted Accounting Principles) and also have to report to the parent, which has to prepare consolidated statements using parent company GAAP. This means that either the subsidiary has dual accounting systems, or the parent has to maintain a special team to adjust the accounts of subsidiaries to parent GAAP. This is costly, and it also means that it is not that easy to transfer accounting staff around the world because of the different local requirements, and it is more expensive to train them.

The group consolidated financial statements are then used to communicate to present and potential shareholders. If the company is listed on several stock exchanges, this means the possibility of having to provide information adjusted to the requirements of the individual foreign stock exchanges—as in the case of the SEC reconciliation to US GAAP. Investors are not comfortable with financial statements that are not prepared under the GAAP they are used to. Consequently they either do not invest, or they will require a higher risk premium to do so.

This situation has the effect of limiting the extent to which international capital markets are truly international. A company may choose not to list in a major market because of the reporting costs, and therefore cuts itself off from investors based there who for legal, cultural, and other reasons will not invest outside that market. Equally there is a cost for investors because their choice is restricted. The US investor cannot directly compare Whirlpool with Electrolux or Siemens. If they could directly compare all washing machine manufacturers around the globe, they could choose the most efficient, and global wealth would increase.

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The Development of Global Standards

The 1972 phone call that launched what are now the International Financial Reporting Standards, or IFRS, was made by Douglas Morpeth, then a partner in the international audit firm Touche Ross (now Deloitte) and also president of the Institute of Chartered Accountants in England and Wales, to Henry Benson, a partner in Coopers & Lybrand (now part of PricewaterhouseCoopers). They were at a conference of the international accounting profession. Benson had just made a presentation about the future international organization of the profession. Morpeth asked why Benson’s committee had not also suggested setting up an international standard-setter.

They called a meeting with representatives of the US and Canadian professional bodies, and by June the next year the board of the International Accounting Standards Committee (IASC), comprising representatives of nine national professional bodies, was holding its first meeting in London.

The initiative should be seen in context: international trade started to grow significantly from the 1960s, and by the early 1970s was starting to register as an issue that needed to be addressed. People were staring to transact more frequently across borders and would need a common accounting language, or at least Morpeth and Benson thought so. The second current was the development of standard-setters. The present US standard-setter, the Financial Accounting Standards Board (FASB) also started work in 1973. The United Kingdom’s first standard-setter started to appear in 1969. Douglas Morpeth was deputy chairman of the Accounting Standards Committee as the UK body was eventually called. He thought that the United Kingdom’s new standards could be usefully recycled for international use.

Benson was the first chairman of the IASC. It was a very small organization with a single employee based in London and a voluntary chairman and board members supported by professional accounting associations. After the initial enthusiasm for doing something international, two problems emerged. It became clear that the national bodies were doing very little about getting International Accounting Standards (IAS) adopted in their home countries, so no one was actually using these standards. Second, as standards were being developed, individuals were reluctant to see their national practices banned or ignored, and so IAS were written that included options within them. Two companies could adopt radically different stances on an issue and both be in compliance with the same standard.

By the 1980s the IASC’s standards were being voluntarily adopted by multinationals in countries such as Switzerland, France, and Italy (e.g. Nestlé, Roche, Aérospatiale, Cap Gemini) to make up for a lack of detailed rules for consolidated financial statements. They were also being used as a model in developing countries that were members of the British Commonwealth to build on to the model they had inherited from the British Empire. Outside that use, they were much cited in debates about standards, but very rarely directly applied. When they were used voluntarily by individual companies, often those companies followed some but not all of the standards.

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Use in International Capital Markets

However, change was on its way. From 1985 a new secretary general, David Cairns, set about transforming the situation. He initiated an agreement with the International Organization of Securities Commissions (IOSCO), a body that links national stock exchange regulators, for the IASC to supply standards to be used in conjunction with secondary listings. At the time, most stock exchanges required foreign issuers either to provide financial statements according to local generally accepted accounting principles (GAAP) or to provide reconciliations to them. IOSCO’s idea was that all stock exchanges would sign up to a single set of listing requirements for foreign issuers, so dramatically cutting the costs of a secondary listing.

At the same time Cairns set out to widen the funding base of the body so that he could expand its work, and to try to involve national standard-setters as well as professional bodies. The idea that the accounting profession should set its own standards was disappearing and standards were increasingly being set by dedicated independent committees. He agreed with IOSCO a program to improve International Accounting Standards by removing options and also by extending the range.

The road proved to be rocky, and took more than ten years. Cairns resigned in 1994, to be replaced by Bryan Carsberg, an accounting practitioner turned academic turned government regulator (he had been director-general of fair trading in the United Kingdom). Under Carsberg the program was finally completed, including the difficult standard on financial instruments, IAS 39. A strategy committee was also established to recommend how the future standard-setter should be organized.

The year 2000 was pivotal. In May IOSCO voted to approve the body on International Accounting Standards (if with some reservations). In June, the European Commission announced that it was going to propose legislation to require the use of the standards by EU listed companies from 2005, and in July the international accounting profession, meeting in Edinburgh, agreed to relinquish its control of the IASC and let the IASB be set up in its place.

The IASB is a small committee of professional standard-setters. It has a large technical team, based in London still, and is funded through voluntary contributions from companies, audit firms, and various institutions, both national and international. It adopted the predecessor body’s standards, but used a different name (IFRS instead of IAS) for its own standards. IFRS is also the generic term for all the standards together with the interpretations issued by the International Financial Reporting Interpretations Committee (IFRIC).

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Convergence on a Worldwide Standard

Where the IASC was part of a world of “harmonization”—or movement toward each other—the IASB is firmly committed “to develop, in the public interest, a single set of high quality, understandable and enforceable global accounting standards” and “to bring about convergence of national accounting standards and IFRSs to high quality solutions” (Preface to IFRS, London: IASC Foundation). Though it has not focused exclusively on the United States, the IASB’s main driver is convergence with US GAAP. It entered into an agreement with the FASB in 2002 to pursue convergence through a joint program of removing differences and developing new standards together.

This program yielded a big prize in 2007. The Securities and Exchange Commission decided that it would recognize financial statements prepared under IFRS as issued by the IASB as equivalent to US GAAP. Until then, foreign registrants with the SEC were obliged to file annually either a set of accounts using US GAAP, or a reconciliation of annual earnings and equity at balance sheet date with how they would have been measured under US GAAP. This was a big burden to companies listed on the New York Stock Exchange or NASDAQ and a major disincentive to foreign companies to list there. In 2007 the chief financial officer of AXA told the SEC at a round table that the company budgeted $20 million a year to produce the reconciliation. Another part of the cost is that the companies end up publishing two, or even three, sets of figures (see the Cadbury case study) and then having to discuss with analysts and journalists which is the “correct” profit.

The removal of the reconciliation requirement means that, for example, European companies that are using IFRS can simply file with the SEC the same accounts that they file with their primary stock exchange. Of course the SEC has other requirements that still have to be complied with, including management’s discussion and analysis of results. However, companies no longer have to be able to restate their figures to US GAAP, nor retain teams to monitor US GAAP.

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Conclusion

Convergence on IFRS is taking us to a bright new world where investors can indeed take their pick from around the globe, and where companies maintain a single accounting basis throughout their network. IFRS are already either compulsory or permitted for listed companies in more than 100 countries around the world. When the next wave of adopters joins in 2011, a large slice of the world economy will be IFRS conversant.

It will take time for investors to become confident about reading IFRS accounts—although that happened quickly within the European Union. But multinational companies should quickly reap the benefits of having uniform systems across the globe and will be able to exploit the opportunities of being listed on several stock exchanges at much lower cost.

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Case Study
Cadbury Changes to IFRS from UK GAAP

In common with all companies listed on EU stock exchanges, Cadbury PLC (at the time Cadbury Schweppes PLC) officially switched to IFRS in 2005, as required by the EU IAS Regulation. In practice, the real transition moment was the beginning the 2004 financial year: IFRS require that a company provides previous-year comparative figures with the annual financial statements. Consequently, when reporting the 2005 results, the company had also to provide 2004 figures according to IFRS. However, the company had also had to report 2004 under local GAAP (in Cadbury’s case, UK GAAP), and IFRS 1, the standard dealing with transition, requires that a company also provide a reconciliation between the local GAAP figures for 2004 and the IFRS figures for 2004. From an investor’s perspective, therefore, every company provides a statement comparing its pretransition figures with the same transactions reported under IFRS.

Cadbury is also listed in the US and therefore is registered with the Securities and Exchange Commission. Consequently, at that time it was also obliged to provide a reconciliation of its annual earnings and its equity to US GAAP. This means that, for 2004, an investor could observe the earnings and net assets of Cadbury under three different sets of GAAP: UK GAAP, IFRS, and US GAAP. The figures show that—despite the fact that all three sets of accounting rules belong to the same underlying tradition of Anglo-Saxon accounting, with financial reporting oriented toward informing investors—there still remain significant differences of measurement at a detailed level. This illustrates how difficult it is to compare the results of companies that are using different comprehensive bases of accounting, and why investors and international companies are keen to move to a different global standard.

If we take equity—the net worth of the group after deducting all liabilities from assets—the Cadbury figures at the end of 2004 were:
£ million
UK GAAP 3,088
IFRS 2,300
US GAAP 3,998

There is a presentational difference in that the US definition of “equity” at the time excluded minority interests. For comparative purposes I have added these to the US GAAP number in the above table.

It is not particularly productive to make a detailed analysis of why the differences occur. Basically, they reflect different ways of accounting for business combinations that had occurred in the past, different treatment of pension liabilities, and the significantly different treatment of deferred tax in the United Kingdom from that under IFRS and US GAAP. There is a detailed analysis in the notes to the 2005 Cadbury (Cadbury Schweppes) annual report.

If we take net earnings, the numbers are:
£ million
UK GAAP 453
IFRS 547
US GAAP 484

We can see that in 2003 investors had two sets of figures to choose from, while in 2004 the convergence initiative meant that in the transitional phase they had three different measures of the same performance. However, in 2007, when the SEC removed the US GAAP reconciliation requirement, they would have come down to a single view of performance which was comparable to that used in 100 countries.

It should be emphasized that, of course, the company’s cash flows do not change with the different accounting bases: what drives the differences is different timing assumptions, different measurement rules for some transactions, and different allocations across time periods.

You can only know absolutely how much profit a company has made when it has stopped trading and all its assets and liabilities have been liquidated. The only profit that is irrefutable is the lifetime’s net increase or net decrease in cash.

This is not much help for investors, and financial reporting is a means of estimating what part of the lifetime profit has been earned in a particular year, in order to help investors decide whether to buy, sell, or hold the company’s securities. However, the annual profit is only an estimate, it is not a fact. All estimates are based on assumptions—change the assumptions and you have a different profit.

So none of the three sets of figures Cadbury published for 2004 is “correct” or “incorrect”—they are all justifiable estimates. It is not surprising that investors ask for a single agreed accounting standard.

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Making It Happen

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Using IFRS at group level is mandatory in many countries, but is voluntary in some. It is often voluntary at subsidiary level: both parent and subsidiaries need to choose this option to access the benefits.
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Using IFRS makes access to capital markets outside the country where the group has its primary listing much easier and cheaper. In what markets would there be special benefits for your company? Remember that a secondary listing is not just about access to foreign investors, it is about credibility and flexibility in that market.
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Are your group accounting and internal audit professionals able to move easily from one foreign subsidiary to another? Using IFRS would facilitate their work and potentially improve internal control.
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Do professional fund managers and analysts that you deal with understand IFRS? Talk to them about whether they are IFRS literate and ask if they see benefits in switching.
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What do your group auditors think? The large international firms are fully geared up for IFRS. They will help you switch.

Scrap mark-to-market accounting or face further crisis, warn investors

The interrogation of Barclays' newly-installed chief executive Bob Diamond by the Treasury committee of the House of Commons last Tuesday was an unsatisfactory affair.

The two and half hour session gave the politicians the opportunity to “grandstand” and channel popular anger about bankers’ bonuses, tax avoidance and reluctance to lend to SMEs.

But the politicians on the panel seemed keener on venting their spleens than on getting their heads around more complex issues such as addressing the flawed structures and accounting standards that continue to jeopardize the banking sector.

This brings me on to a more productive parliamentary session in the UK - the meeting of the House of Lords Economic Affairs Committee on January 11th.

During this session a group of leading UK-based fund managers told the Lords what they thought of the audit profession. There was near unanimity that revising accounting rules and auditing standards would be a good starting point if further crisis is to be avoided.

The fund managers told the committee that International Financial Reporting Standards (IFRS) had enabled banks to live in a fool's paradise where risk could be buried and profits and bonuses inflated. In a report in Financial News, the financial journalist Mike Foster explained:

"The devastating assessment of the accounting rules was articulated for the first time by some of Britain's biggest institutional investors."

Iain Richards, head of corporate governance at Aviva Investors, told the lords that IFRS, or mark-to-market accounting, was a distorting prism through which to look at bank performance. He said this was because it legitimized giving fantastically high valuations to assets at the peak of the credit bubble - even though the market for such assets was thin or non-existent.

Richards was also concerned that the use of IFRS meant that banks made very light provisioning for bad debts ahead of the crisis.

Instead of highlighting problems, IFRS had exacerbated them, enabling banks to deceive their investors - enabling them to portray themselves as massively profitable when in fact they weren't.

This enabled the banks to make imprudent payouts to both executives (in the shape of bonuses) and to shareholders (in the shape of dividends) which in reality they could ill afford to make. This cavalier approach to their own finances is one reason they ended up costing taxpayers such a fortune to bailout. Richard said:

“IFRS is extremely pro-cyclical.It facilitated and exacerbated the credit bubble ...There were some very clear risks inherent (in the banks)...the risks were extremely material."

It was only once the banking and financial crisis struck and liquidity froze in 2007 that the distortions became apparent, said Richards. He added:

"The double-digit billions pumped into the banks went to plug the gap created by both bonus distribution and dividend distributions that were made just preceding the crisis."

His assessment was backed up by other senior fund managers in the session, including David Pitt-Watson of Hermes; Guy Jubb of Standard Life Investments; and Robert Talbut of Royal London Asset Management.

Pitt-Watson said "we as investors and society" need to see the re-introduction of a principle-based accounting system that includes prudential and on-going assessments of risks.

As Telegraph financial journalist Louise Armitstead points out, Tim Bush, a City veteran and a former fund manager at Hermes, last year warned the government that IFRS amounted to a "regulatory fiasco" that had contributed to the crisis and continued to pose a severe danger to the system.

As I mentioned in an earlier blog post, Bush believes that the use of IFRS may even have obliged the boards of UK banks to commit illegal acts. He said following IFRS, as applied in the UK, was:

“...positively contrary to the objective of directors discharging their duties properly. False profits, hidden losses and hidden gearing (note: hidden losses are also hidden gearing as capital is overstated) are possible with IFRS.”

Richards and the other investors on the panel argued that auditors ought to be allowed to speak directly to shareholders and that the lack of competition in the audit market must be addressed.

Currently the “Big Four” firms - PWC, Deloitte, KPMG and Ernst & Young - have the market sewn up, which commentators such as Re: The Auditors' Francine McKenna argue makes them unassailable and more prone to audit sloppily.

The panel of investors said the dominance of the Big Four ought to be broken up, perhaps with the help of mandatory retendering. “Eight seems to be a credible number,” Jubb said.

Robert Talbut, chief investment officer at Royal London Asset Management, summed up the problem:

“Prudence has been considerably lost in the way accounting standards has been operating.”

The AICPA Talks to Going Concern About the New CPA Exam

By Adrienne Gonzalez

Because I genuinely care about the well-being of you little CPA exam candidates out there, I recently put aside the inflammatory nonsense for a moment and took some time out of my busy schedule to chat with the AICPA about the new CPA exam that they were proud to say launched early this month without a hitch. We’re pretty excited about that too, mostly because it means we can finally stop talking about 2011 changes and get back to talking CPA exam strategy, which is largely unchanged as a result of CBT-e.

We here at Going Concern value reader input (even if we do value chastising said reader just as equally) and therefore reached out to get your input on the sorts of questions we should ask. You spoke and we listened so let’s cut right to the chase and give you some answers.


John Mattar, Ed.D., Director of Psychometrics and Research and Mike Decker, Director of Operations and Development, both of the AICPA Examinations Team, were kind and brave enough to speak with me and give me plenty of insight on the brain behind the new CPA exam.

First of all, we need to talk scoring as that’s the one thing you guys have complained about consistently since the exam went computerized in 2004 (except for written communication but that is an entirely different issue). We’re proud to tell you that we can finally say with certainty that the AICPA will not be changing the passing score from 75 moving forward. That’s right, put down your flaming pitchforks, all you 74s who were ready to flip should the score have been lowered to 70. “In terms of the score reported to candidates, right now the passing score on that reported scale is a 75 and it’s going to remain there because we want to have consistency over time,” John told us.

That means a 75 last year might not necessarily be the same as a 75 this year but a 75 is still passing and that’s what matters. As we all know, the AICPA uses a complicated and mysterious psychometric formula to determine weights for each question and bases a candidate’s score on this formula. It isn’t for you, little candidate, to worry about how they come up with their numbers nor should you feel as though the AICPA gets some sick thrill out of seeing you get a 74. Believe it or not, they’re neutral. They don’t care if you pass or fail, they only care about overseeing a professional examination that successfully tests the knowledge base of entry-level CPAs in the United States. That’s it.

Second, while the AICPA will be using a single score release formula for at least the first three testing windows of the year, candidates can anticipate a new and improved score release system that will hopefully be introduced by the end of the year. This means all candidates who test early in their window will be eligible to receive their scores in the first release and all other candidates can expect to receive their scores in more frequent batches through the end of that window’s blackout month. So forget the Wave 1/Wave 2 nonsense. “Due to a lot of the work we’re doing on the backend, we’re going to be able to release scores faster. We’re not actually going to be able to release the scores earlier until the 4th quarter because we need to do a greater analysis in the first three quarters,” Mike said. So while you guys see the new simulations and international content on the frontend, it’s important to remember that a lot of time and effort went into improving the backend of the CPA exam and faster scoring is one such improvement that we can expect to see by the end of the year. But these changes come at a price so be patient while the AICPA works through the first three windows of this year to finalize their new scoring process.

If you haven’t already, I recommend you check out How the CPA Exam is Scored for more details on this process. Expect an update to that document when new scoring takes effect later in the year.

As for CBT-e content, I initially congratulated the AICPA for finally streamlining some questionable areas of the exam (especially BEC) in the updated CSOs/SSOs but forgot that they don’t actually come up with content on their own. You can thank an extensive practice analysis and subsequent input from practicing CPAs for the CPA exam you know and love today, a process that takes into account input from the profession on what entry-level CPAs should know. That means the introduction of international financial reporting and auditing standards is entirely independent of the SEC’s do-we-or-do-we-not IFRS roadmap. This should be a comfort to some of you who are wondering just how much IFRS will appear on the exam in coming windows as it means the exam will most likely continue to test remedial international content and will mostly focus on major differences between IFRS and GAAP. Entry-level CPAs in the U.S. are not expected to be experts in IFRS, just as they are not expected to be experts in cost accounting, government accounting, non-profit accounting or any number of areas that have been consistently tested on the CPA exam for years now.

The best news is that though the e in CBT-e stands for evolution, those expecting to take the exam in 2012 or beyond shouldn’t expect such a large overhaul as we just saw any time soon. “We don’t plan to change the exam,” John said. “What we plan to do is keep the exam current with the profession to protect the public interest. If we do have significant changes in test content we would have to let candidates know in advance.”

That being said, the largest takeaway I got from my conversation with the AICPA was that they are simply interested in providing a consistent examination that continues to evolve to meet the needs of the profession. I swear to you that they really don’t get a sick thrill out of torturing you guys with changes, scoring delays and new content though it may appear that way sometimes, especially if you’re in the 74 x 3 club. It’s their job to make sure that the CPA exam represents the best interests of the profession, which means revising their strategy to keep up with the evolution of the industry.

We applaud the AICPA on a job well done and congratulate them for a successful CBT-e launch. So far, candidate feedback I have gotten on the new exam format has been mostly positive, which means that their hard work was totally worth it.

IFRS ordinance may be issued early next month: Govt Sources

An ordinance to formalise International Financial Reporting Standards (IFRS) converged standards or what will now be called IndAS is expected by early next month. Sources tell us that while companies will have to prepare financial statements based on IFRS for investors, dividend and tax liability is likely to be computed based on Indian GAAP, reports CNBC-TV18’s Malvika Jain.

That’s right an ordinance to notify IFRS is likely to be promulgated by early next month. Sources tell us that IFRS convergence standards, what will now be called IndAS have been vetted by the ministry of law. Infact the changes which need to be made to the companies act for IFRS convergence have also been approved by the law ministry.

We are picking up that these new standards will be notified under the Companies Act 1956. As you probably know these are based on the concepts of fair valuation and time value of money. These two concepts have been used in India for the purpose of financial decision making, but are very new for purposes of accounting.

What we have also learnt is that now all companies whether they are listed or unlisted will have to prepare consolidated financial statements for the purpose of being more investor friendly as is required by IFRS. But the dividends and the tax liabilities will be computed on the basis of financial statements prepared as per Indian GAAP which practically means that the companies will have to prepare two sets of accounts.