The joint project between the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) in developing a common accounting language for the world has gained much attention after the Securities and Exchange Commission (SEC) in United States (U.S.) announced its plans to adopt the International Financial Reporting Standards (IFRS). As investments by U.S. investors in foreign public corporations have grown drastically, it is timely for the U.S. to adopt a uniform set of accounting standards to facilitate comparative analyses of foreign and U.S. corporate financial statements.
Pros and Cons of U.S.-GAAP and IFRS
The broad conceptual difference between GAAP and IFRS is that GAAP is rules-based and IFRS is principles-based. As such, the IFRS is considered more thoughtful, transparent and reflective of the true nature of each transaction.
IFRS is less detailed than U.S. GAAP [i] , thus reducing complexity that masks economic reality
IFRS is easier to use (principles-based) and will result in better reporting (substance over legal form)
IFRS is a “global” approach;comparability to financial statements from other countries that have already adopted IFRS [ii]
Reduce costs for companies and smooth cross-border investing for investors
Management is given more discretion in the interpretation of economic events due to the lack of specific rules
Enforcement and cultural interpretations vary (risk of comparability) when individual countries added their own exceptions to the rules, defeating the purpose of a global standard
Accounting under IFRS tends to lead to higher earnings [iii] , thus inflating earnings of U.S. companies and misleading investors
More extensive audit procedures are required to test the reasonableness of financial reporting determinations made by management
IFRS on relevance, reliability and decision usefulness
IFRS places more emphasis on relevance than reliability. Reliability is associated with accuracy but faithful representation simply means to capture the economic substance, thus giving management the opportunity to reflect the true economic phenomena that the transaction purports to represent rather than be constrained by its accuracy of information.
The adoption of ‘fair value accounting’ in IFRS will incorporate more timely information about economic gains and losses. Incorporating more information in the financial statements will typically make them more informative and improve decision usefulness for users. However, for fair value accounting to be relevant, there must be an active market with observable market prices where managers cannot materially influence. When an active market is not available, fair value accounting becomes ‘mark to model’ [iv] accounting and firms report estimates of market prices, which may not be a faithful representation [v] of the underlying asset or liability.
In my view, reliability is a necessary precondition that must be met for information to be relevant. Fair value measures can be considered reliable only if the variability in the range of reasonable fair value estimates is not significant.
Therefore, there is the risk that speculative future income may be used to justify reporting the asset at a higher carrying amount, which, in turn, would result in reporting a speculative gain. It also means that a significant proportion of a company’s reported income could well be represented by calculated net present value growth, not the results of real transactions.
In addition, powerful local economic and political forces will lead to an uneven implementation of the IFRS, thereby leading to increased information processing costs, by burying accounting inconsistencies at a deeper and less transparent level than more readily observable differences in standards. Hence, investors may be misled into believing that there is more uniformity in practice than it actually is.
Therefore, only when there is balance between relevance and reliability, decision usefulness of financial statements to report on stewardship and provide useful information to present and potential investors can be achieved.
Improvement in accounting quality and valuation of firms
Although the adoption of the IFRS in the U.S. will inevitably impose hefty transition costs [vi] , the move will presumably improve accounting quality and the valuation of firms as it: reflects economic gains and losses in a more timely fashion than U.S. GAAP, makes earnings more informative and provides more useful balance sheets (with fair value accounting)
With improved financial statement information, this should lead to more-informed valuation in the equity markets and consequently, lower risk to investors. Small investors are less likely than institutional investors to be able to anticipate financial statement information from other sources so improved financial reporting quality allows them to compete better with professionals and reduces the risk of adverse selection [vii] .
Reducing the cost of processing financial information will also increase the efficiency in which the stock market incorporates it in prices and thus, with better firm valuation, investors can be expected to gain from increased market efficiency. Corporations might also benefit from a reduction of its cost of capital with increased market depth [viii] and lower bid-ask spread [ix] .
With fair value accounting, reported earnings are less noisy and hence, accounting information are more accurate and more ‘value relevant.’ However, investors in the U.S. will need to be more discerning in distinguishing between objective andsubjective figures, between realised gains and losses, and gains and losses based on hypothetical calculations.
With the adoption of IFRS, the balance sheet becomes the primary vehicle for conveying financial information to investors. As all assets and liabilities are recorded at fair value on balance sheet date, the Price/Book ratio will be equal to 1.0.
Consequently, accounting quality is improved as the balance sheet satisfies the valuation objective while the income statement provides information about the risk exposure [x] and management’s performance.