Can Investors Determine If A Cash Flow Has Been Manipulated Advantages and Disadvantages of U.S. Convergence Between GAAP and IFRS

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Advantages and Disadvantages of U.S. Convergence Between GAAP and IFRS

Over the past decade, there has been a growing demand in the corporate world for US Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) to be unified into one set of universal accounting standards. In 2002, members of the Financial Accounting Standards Board (FASB) and members of the International Accounting Standards Board (IASB) met and issued a memorandum setting out the framework for the adoption of IFRS in the United States. Known as the Norwal Agreement, the two committees agreed to make “existing financial reporting standards fully compatible as soon as practicable” and to “coordinate future work programs to ensure that compatibility is maintained” (Kieso, 2012, p. EP-2).

Critics of IFRS adoption in the United States argue that principles-based accounting standards leave too much discretion to the preparer. In other words, IFRS is open to more interpretation than rules-based GAAP and can lead companies to publish fraudulent statements. In addition, disadvantages include the increased manipulation potential of transaction accounting, increased differences in accounting approaches for similar transactions, and fewer rules to follow when determining how to account for a transaction (“Which is better – principles or rules?”, 2011). According to the Global Fraud Report by Kroll Inc. for 2012-2013, US and European companies have higher fraud rates (60% and 63% respectively) compared to global averages (“Global Fraud Report”, 2013). Changing accounting standards to make them open to more interpretation can attract more cases of internal fraud or corporate fraud.

Another disadvantage of IFRS is the expected cost associated with the transition from GAAP-based standards and accounting information systems to IFRS-based accounting information systems. Although these costs may be high, they are short-term in nature and are estimated to save companies money in the long run. “Studies show that the costs of transitioning to IFRS will have a major impact. According to research, the benefits to US investors may not exceed the costs. In addition, due to the high standards of US GAAP, the improvements in financial reporting will be smaller. Research also shows that these costs and benefits will differentiate between companies and be difficult to trace after adoption” (Bolt-Lee, 2009). These costs will burden small and medium-sized companies, which lack the capital and resources that large multinational companies have. And according to the KMPG, they are the largest component part of the costs of transition to IFRS are IT costs, with estimates that 50 to 70 percent of normal transition costs relate to IT (Krell, 2009).

The main obstacle in converging IFRS and GAAP is control. In the US, the Security and Exchange Commission (SEC) has the power when it comes to accounting standards. Although the FASB sets standards, the SEC oversees and ensures that public companies follow laws, practices, and operate in a manner that facilitates ethical behavior and decision-making. “Under the current system, the SEC attempts to ensure uniformity and consistency in financial reporting. However, regulators cannot enforce uniformity in a principles-based system” (Thompson, 2009). If the US converts, the SEC will certainly lose much of its control and influence over accounting and reporting practices.

One of the advantages of IFRS is that it is principles-based standards, as opposed to GAAP, which is based on rules-based standards. Principles-based standards allow more room for maneuver in how corporations can present their financial performance (Galuszka, 2008). According to a survey of corporate executives, many of them cited IFRS and principles-based standards as “more intuitive” and “easier to use” than their GAAP counterparts.

The difference between the two approaches is exactly where their descriptions suggest: principles-based standards are based on a clear hierarchy of overarching principles, contain few or no provisions, and rely heavily on judgment about what constitutes fair representation; rule-based standards are characterized by more anti-abuse provisions and allow relatively less discretion in their application. (International GAAP, 2010)

In rules-based accounting, it is sometimes the case that “a transaction must be accounted for according to the rule, even if the accounting used is misleading” (“Which is better – principles or rules?”, 2011). The use of IFRS allows a company to best present financial performance based on judgment and increase comparability between companies with similar transactions in different industries. “Rules-based accounting has not worked in practice. Critics argue that the current US system does not provide accurate reporting. It focuses on ‘checking the boxes’ rather than reflecting underlying economic reality” (Thompson, 2009). IFRS attempts to limit this problem by providing greater interpretation of accounting principles.

The replacement of GAAP standards with IFRS accounting standards will enable interested users of financial statements to make more informed decisions. Currently, “more than 115 countries have adopted IFRS, and the European Union now requires all listed companies in Europe (more than 7,000 companies) to use them” (Kieso, 2012, p. EP-2). Most developed countries, especially those EU members that currently implement international standards, have a higher level of transparency and reliability of financial information. The pursuit of convergence in accounting standards will facilitate international investment, as well as make it easier for users to dissect financial information when located in foreign regions.

The adoption of IFRS will help reduce costs in the long term. Many companies, such as Nike, Microsoft, IBM, and Apple, do business in several different countries, so they must prepare several different accounting books and records in accordance with each set of standards. In addition, users of financial statements must be familiar with both GAAP and IFRS in order to fully analyze the financial information reported by multinational corporations (MNCs).

The adoption of IFRS will open the door for companies around the world to recruit new talent. According to Matthew Birney, head of financial reporting responsible for international financial reporting standards at United Technologies, some of the positives of IFRS are access to a wider pool of talent (Krell, 2009). In an increasingly globalized economy and workforce, recruitment may no longer be limited to recruiting new applicants within national borders.

As the world continues to shrink and business becomes even more globalized, a universal set of accounting standards is desirable to help harmonize global accounting practices. The benefits of greater understanding and the creation of a single set of accounting standards will help facilitate the flow of funds and increase investment abroad. Adopting a principles-based approach to accounting will allow preparers of financial information to more accurately represent financial performance relative to the company’s operations. As the global business environment improves, one set of accounting standards is inevitably needed.

References

Bolt-Lee, C., & Smith, L. (2009, November 1). IFRS research highlights. Retrieved September 20, 2014.

Galuszka, P. (2008, August 28). Advantages and disadvantages of IFRS. Retrieved September 18, 2014.

International GAAP. (2010, January 1). Retrieved September 18, 2014, from http://www.wiley.com/WileyCDA/Section/id-403632.html

Kieso, D., Weygandt, J., & Warfield, T. (2012). Intermediate accounting (14th ed.). Hoboken, NJ: Wiley.

Krell, E. (2009, April 2). The biggest MSRP expense? IT. Retrieved September 18, 2014.

Krell, E. (2009, April 6). Advantages and disadvantages of IFRS. Retrieved September 19, 2014.

Thompson, R. (2009, September 14). Principles-Based Accounting vs. Rules-Based Accounting. Retrieved September 19, 2014.

Which is better – principles or rules? (2011, April 5). Retrieved September 18, 2014.

2012 / 2013 KROLL GLOBAL FRAUD REPORT. (2013, January 1). Retrieved September 19, 2014.

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