U.S. companies are navigating rough waters to prepare for what many say is an inevitable drift towards IFRS, Ng I-ching reports from New York
When Alcoa, the U.S. aluminium giant, bought the Norwegian smelting company Elkem Aluminium ANS in March last year, the acquisition was complicated by the fact that the two companies use different accounting standards, says Jack Klingler, director of accounting research and IFRS implementation at Alcoa.
Translating Elkem’s financial reports prepared under the international financial reporting standards into U.S. GAAP, which Alcoa uses, became an important step in closing the transaction.
“You need to make sure you understood the numbers correctly and that requires a familiarity with IFRS, which many folks do not have,” says Klingler.
Accounting’s holygrail, a single global financial reporting standard, would have made the transaction easier. Like many listed U.S. multinational corporations, Alcoa is caught up in a debate on whether it should adopt IFRS, now in use in 117 countries, or stick to U.S. GAAP. More and more of Alcoa’s foreign subsidiaries report using IFRS, but they need to keep a separate set of books in U.S. GAAP because that’s what the Pittsburgh based parent is handcuffed to.
Klingler says if the United States’ move towards IFRS succeeds, many of Alcoa’s global subsidiaries will no longer need to keep two sets of books and can thus save costs. Investors can also “more readily compare financial statements within an industry with global competitors, without having to reconcile results under different GAAPs,” he says.
All eyes are now on the U.S. Securities and Exchange Commission, which will decide next year on mandatory IFRS adoption. If it says yes, the soonest U.S. companies could use the standards will be in 2015. At the same time, the International Accounting Standards Board and the U.S. Financial Accounting Standards Board are pressing towards convergence of U.S. GAAP and IFRS by June next year, and are trying to resolve major differences between the two standards that impede IFRS adoption in the United States.
“The potential benefits to investors of a single set of high-quality global standards are real, including having greater transparency in financial reporting within and across jurisdictions,” says John Veihmeyer, chief executive of KPMG LLP and KPMG International’s Americas chairman. “It will eliminate arbitrage opportunities that now exist between sets of standards.”
However, U.S. companies are divided over IFRS because of concerns that it would be complex, expensive and operationally disruptive.
A KPMG survey in March of 2,500 U.S. executives showed 41 percent are in favour of IFRS adoption, 22 percent are against it and the remaining 36 percent are undecided.
“The client community is largely reluctant to get moving,” says Robert J. Kueppers, deputy chief executive of Deloitte LLP. “They feel that these (the standards) are going to change once or twice before they get finished and they do not want to be spending money to prepare or begin a lengthy conversion process or adoption process. They are still suspicious as to whether we will come to pass [IFRS adoption].”
Devil in the details
Indeed, according to a PricewaterhouseCoopers survey released in December of more than 100 chief financial officers and managing directors of U.S. multinationals, 53 percent said they place moderate to high priority on IFRS conversion, while 44 percent said it is low priority or not a priority at all. When asked which actions their companies have taken, most say they are still gathering information and learning about the standards.
That lack of preparedness could bite them. Depending on the industry, IFRS conversion could entail upgrading accounting software systems, retraining staff and even changing business strategy.
For Alcoa, preparing for an IFRS conversion has been “time consuming,” says Klingler. He cites as an example how the company tried to analyze the various options in IFRS 1, which sets out procedures for first time adoption. Among other things, IFRS 1 allows Alcoa to take its unrecognized actuarial gains or losses for pensions and its currency translation adjustments to retained earnings upon adoption.
“These changes are generally very large numbers that have major impacts on your financial statements,” explains Klingler. “However, keep in mind that the devil is in the details in many other areas.”
Another hurdle for Alcoa was asset impairment standards, since the test in IFRS is based on discounted cash flows as opposed to undiscounted cash flows under U.S. GAAP. In addition, IFRS prohibits companies from using LIFO (last in, first out) inventory accounting, which impacts tax reporting. The Internal Revenue Service requires companies that use LIFO inventory accounting to also use the same accounting for their financial reporting. Converting from LIFO to FIFO (first in, first out) might result in a higher tax bill because LIFO reserves could be taxable.
In the financial industry, Linda Mezon, Royal Bank of Canada’s chief accountant, says banks are mindful of the impact that accounting for financial instruments under IFRS has on capital.
She cites the example of how banks’ capital was affected when they had to change the way they booked derivatives after the European Union adopted IFRS in 2005. “Some European banks were coming from their home country GAAPs, and didn’t actually officially account for derivatives, so the balance sheet changed significantly,” she says.
The Royal Bank of Canada is in the middle of an IFRS transition from Canadian GAAP, while its U.S. operation still uses U.S. GAAP for its filings.
The cost factor
In the same PwC survey cited above, 49 percent of executives said the expense is an important factor in the success of IFRS convergence. The SEC estimated that U.S. companies would spend on average 0.125 percent to 0.13 percent of revenues on the transition during the first year.
For a company like Alcoa with US$18.4 billion in revenues, that is as much as US$23.9 million. But Klingler says Alcoa may not need to spend this much.
“Our cost for now is generally limited to anywhere from two to four full-time people working on this for two to three years. Our systems are very well-developed, so we do not see major systems costs,” he says.
Unlike Alcoa, which has a dedicated team to deal with IFRS issues, smaller companies worry about the costs, especially since the economy is only starting to emerge from its worst recession in a century.
“Small businesses will resist adoption and will adopt only when it becomes mandatory,” says Wei Liren, managing partner of Wei, Wei & Co. LLP, the largest Chinese-owned accounting firm in the United States. “The switch is an extra burden when the costs outweigh the benefits.”
Wei, who is vice president of the New York State Society of CPAs, says he expects more delays in the U.S. adoption of IFRS, but his firm has started offering IFRS training to its around 75 staff accountants.
What does IFRS mean?
Many small and medium enterprises in the U.S. barely know what IFRS entails.
Mike Chang, vice president of CP Language Institute Inc., a New York translation agency, says he is aware some form of standards change is afoot, but he’s leaving it to his CPA. “Accounting standard preferences will be left to the recommendations of our CPA,” he says. “Small business owners would rather focus on their businesses and growing them.”
D.J. Gannon, a Deloitte partner who heads up his firm’s IFRS research and adoption, says the cost of converting to IFRS will vary depending on the size of the company, the nature of its accounting systems, its degree of centralization and how convergence affects it.
“Many of the new standards will result in significant changes to U.S. GAAP, so U.S. companies also will need to determine the cost of adopting the ‘new’ U.S. GAAP and then any incremental cost to adopt IFRS,” he says.
U.S. private companies will also have to consider whether they should go for full IFRS or IFRS for SMEs, a decision that will alter, on a basic level, their intercompany financing, tax planning and reporting, and on a macro level, decisions about whether to stay private, Gannon says.
“Private companies should carefully consider their capital requirements to support their growth strategies,” he says. “If the ultimate goal is to go public, companies may consider full IFRS. If the goal is not going public, private companies may want to understand if their lending institutions and creditors are comfortable with IFRS for SMEs.”
It’s not all pain
Some multinational companies that have already invested in IFRS conversion say the benefits outweigh costs. Since 2005, HSBC USA Inc. has reconciled its SEC filings prepared in U.S. GAAP to IFRS and submitted them to its global parent in Britain. “It’ll be big cost saving for us to move to one set of common books for both U.S. and global purposes,” says Jack McGinnis, executive vice president and chief accounting officer of HSBC North America Holdings.
Besides saving time, McGinnis says it will save questions from global analysts and investors who want to understand how the bank’s U.S. GAAP reconciliation works.
“So I think from their perspective they would see this as a big benefit if they can just look at a comparable set of information,” he says.
For Charles Huang, vice president of business development at Sundia MediTech Company Ltd., one of China’s top drug contractors, one set of standards would help avoid misunderstandings such as one the company faced prior to its initial public offering.
One of Sundia’s clients, a U.S. multinational drug maker, questioned the company’s venture capital funding for its pre-IPO projects, which were booked under long-term liability under IFRS.
“The CFO of our client thought we took on a debt with huge liability, but in fact it was a cash investment with relatively low risk, which would have been accounted for as investment equity under U.S. GAAP,” says Huang, whose company has operations in Shanghai and the United States.
Although software giant IBM Corp. adopts IFRS only for its statutory reporting – it still reports in U.S. GAAP for its regulatory filings – the company is able to create standardized solutions to common transactions through the IFRS convergence projects it started in 2004, which result in “greater efficiencies and stronger controls,” says Aaron Anderson, IBM’s director of IFRS policy and implementation.
Alcoa’s Klingler says that in countries where IFRS is used, the company can centralize and share certain accounting tasks, such as impairment testing and sharebased payments, letting one IFRS team handle them. “In the past, subsidiaries generally prepared their local financial statements on their own without any support,” he says.
The rules culture
Gannon of Deloitte says one big IFRS implementation challenge is a cultural one: Accountants accustomed to the U.S. GAAP’s rules-based approach may find it hard to adapt to the principles-based IFRS.
“There must be a greater acceptance of judgment, which is something that is difficult for most people in the U.S. In practical terms, this means spending more time on transaction analysis, understanding the substance, and less time on researching accounting literature,” he says. “In many respects, we’re really talking about a fundamental shift in how we approach accounting and financial reporting.”
Even if the SEC doesn’t mandate adoption next year, accounting experts say corporate America’s embrace of IFRS is inevitable as their foreign subsidiaries, customers and vendors working from important trading jurisdictions like Japan, Britain, Brazil, the European Union, Canada and India are all making the switch. Consider Alcoa, which conducts half of its business outside the United States: Its Jamaica unit took up IFRS in 2003, followed by its Australian operations in 2005 and this year, its Brazilian unit.
“When we are all on IFRS, it will be much easier,” says Klingler.
The IASB and the FASB are racing to complete an ambitious project started in 2006 to converge IFRS and U.S. GAAP by next year. The SEC says its decision on IFRS adoption would depend in part on the project’s progress.
In March, the two boards said they have agreed to publish a series of exposure drafts covering those areas that have to be aligned before IFRS can be used in the United States – for example, presentation of financial statements, derecognition, leasing and revenue recognition.
“The idea is to get the proposal and exposure drafts out over the next months in the hopes that as we get feedback from them in the fall and in the winter, we will be able to redeliberate and issue final standards during the next year,” said FASB board member Marc Siegel in a webcast last month.
James Kroeker, chief accountant of the SEC, which oversees the FASB, says the two standard setters may have their differences, but they “are closer to alignment.”
One contentious issue is fair value accounting, which has been partly blamed for torturing banks during the credit crunch. Last November, the IASB issued IFRS 9, which narrows down the types of financial assets that can be measured at fair value. The FASB favours a wider application and was supposed to publish its own comprehensive proposals last month.
Kroeker expects the FASB to work towards a proposal in which “fair value information ought to be reported on the balance sheet, but you still report those effectively on an amortized cost model in the income statement.”
Tom Jones, director of Pace University’s Centre for the Study of International Accounting Standards and a former IASB vice chairman, says he is optimistic that many U.S. companies would warm to the IASB’s view of limiting fair value accounting.
“The banking industry and its regulators have historically been opposed to full fair value for all instruments and probably are still of that view,” explains Jones, now an advisor to the IASB. “My guess is that they would probably favour the IASB decision.”
John Veihmeyer, chief executive of KPMG LLP and KPMG International’s Americas chairman, says: “I hope that when we step back in a year’s time that the focus will be qualitative – looking at what improvements were achieved – and not just focusing on trying to tick the box on the deadline of the memorandum of understanding between the IASB and the FASB.”
Veihmeyer also warns U.S. companies that their financial reporting is about to change a great deal very soon because as projects between the two standard setters are completed, they will trigger adjustments.
“The potential completion of these projects between now and June 2011 could mean that many U.S. companies will have to make significant changes in systems, processes, and controls to address this standard setting, even looking solely from a U.S. GAAP perspective,” he says.
Arleen R. Thomas, senior vice president of member competency and development at the American Institute of Certified Public Accountants, says the SEC needs to allow U.S. companies enough time to make the adjustment – possibly five years from the time it announces the adoption.
“If the U.S. were to adopt IFRS today, it’s safe to say the U.S. [accounting] profession is not adequately prepared,” says William Roberts, spokesman for the AICPA. In a survey conducted from 20 April to 7 May, only 1 percent of AICPA members said they have “expert knowledge” of IFRS today.
To meet demand, the AICPA started training CPAs on IFRS reporting in November 2008. Its board of examiners will include questions on IFRS in three out of four sections of the Uniform CPA exam beginning next year.
KPMG’s Veihmeyer sees this as a positive offshoot of switching to IFRS. “One of the more important opportunities in the move toward a global set of accounting standards is the training and education that would be required for stakeholders in the capital markets, including company executives, investors and the academic community,” he says.