IS IFRS a better Accounting Standard than US GAAP for achieving good financial reports? This research paper delivers an analysis of determining whether the International Financial Reporting Standards, hereafter known as IFRS, is a better reporting standard than the US Generally Accepted Accounting Principle (GAAP). Financial Statements have to provide high quality financial reporting information with regards to economic entities, primarily financial in nature, which are useful for economic decision making (FASB, 1999; IASB, 2008).
International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) have been extremely involved in making IFRS the international Accounting Standard. The Securities and Exchange Commission (SEC) has been working on evaluating the implications of incorporating IFRS into the US financial reporting system, currently known as US GAAP. More than one hundred countries have moved to IFRS reporting, or have decided to require the use of these standards in the near future. (SEC,).
Financial reports are a combination of four different key statements. They are balance sheets, income statements, cash flow statements and the statements of shareholders equity. Currently, the FASB is the highest authority in establishing generally accepted accounting for public and private companies in the United States. Financial reports are a necessary tool used by current and prospective investors to see how a company function and stands financially. It is also used to analyze and assess a company’s potential areas of growth as well as its areas of weakness.
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US GAAP has many guidelines and rules to follow whereas IFRS is more based on basic principle. Comparing the US Generally Accepted Accounting Principle (GAAP) and IFRS might help to understand which standards will better serve the Goal of achieving good financial reports. Both IFRS and US GAAP have many rules in common and are significantly similar due to the conjunction efforts of both officials over the years. Despite this, numerous differences between US GAAP and IFRS also exist. The big four audit firms have been instrumental in developing a difference between the standards.
The followings are the comparisons of rules between IFRS and US GAAP to remotely see the difference between two accounting standards in three different areas. The areas are A) Revenue Recognition, B) Business Combination and C) Inventories. A) Revenue Recognition: US GAAP revenue recognition guidance is extensive and includes a significant number of standards issued by the Financial Accounting Standard Board (FASB) and the US Securities and Exchange Commission. The guidance tends to be highly detailed and is often industry-specific.
One of the most common general revenue recognition issues has to do with the determination of when transaction with multiple deliverables should be separated into components and how the revenue gets allocated to the different components. Under US GAAP, detailed separation and allocation criteria is focused whereas IFRS focus on the economic substance of the transactions (Ernst & Young, 2011). Revenues are likely to increase with less detailed guidance under IFRS. B) Inventory Valuation: The US GAAP permits last in first out (LIFO), first in first out (FIFO), and weighted average cost.
The inventories carried are recorded at the lower of the cost or market price. According to IFRS, first in first out and weighted average cost are only permitted. Companies that use last in first out must revalue inventory, which could result in tax liabilities due to the IRS’s last in first out conformity rule. C) Business combination: Business combination refers to the takeover of one enterprise by another. Business combinations are one of the important business activities carried out in current capital market (Bohusova, 2009). More than 13000 M&A transactions were carried out worldwide in 2006 (IASB, 2006).
Although US GAAP has largely converged with IFRS in this area, certain important differences have remained. The business combination standards under US GAAP and IFRS have two major differences: (1) Full goodwill and (2) the requirements regarding recognition of contingent assets and contingent liabilities. Different requirements for impairment testing and accounting for deferred taxes are among the most significant. The Business combination project has contributed to Mergers and Acquisition recording harmonization and to comparability of financial statement in the area of business combination (Svoboda, 2009).
Importance of Good Financial Reporting: Financial reporting and disclosure quality are very important because it is linked with various economic consequences such as market liquidity, firms’ cost of capital, and corporate decision making (Daske, 2006). It is relatively impossible to compute all of the economic consequences that may have cause due to corporate decision. Additionally, all the effects are not properly understood nor will there be supportive evidence. Investors depend upon the financial reports provided by the companies for investment opportunities.
Financial reports provided by the companies are the only evidence of the effectiveness of reporting quality. Less informed investors are worried about the better informed investors. This causes less informed investors to lower the price of the security to protect against the losses from trading with better informed financiers. The unwillingness of the less informed investors reduces the liquidity of the securities market. Corporate disclosure can alleviate the problem and increase market liquidity by leveling information among investors (Verracchia, 2001).
Good reporting and disclosure can affect the cost of capital. Better disclosure can improve risk sharing in the economy, either by making investors aware of certain securities or by making them more willing to hold them, which again reduces the cost of capital (Diamond and Verrecchia, 1991). It is also very likely that better reporting improves corporate decision making. For instance the efficiency of firm’s investment decision would improve. There have been a number of studies conducted suggesting that better reporting leads to higher investment efficiency.
However, the evidence on the effects of reporting quality on corporate decisions is still in its early stages (Biddle et al, 2008). The disclosure of one firm can be very useful to other firms for decision-making purpose but it can also help reduce agency problems in other firms. The disclosure of operating performance and governance engagements provides useful standards that help outside investors to evaluate other firm’s managerial efficiency or potential agency conflicts and doing so lowers the cost of monitoring. Another very important element of corporate reporting is its comparability among firms.
Corporate reporting can be precisely useful to the investors and other stakeholders if they are using similar accounting standards. More comparable reporting makes it easier to differentiate between less and more profitable firms, which in turn reduces information asymmetries among investors and provides lower risk to the investors. These improvement resulting from greater comparability can also increase market liquidity and reduce firms cost of capital (Daske, 2006). Better comparability can also have positive effects on corporate decision making.
More comparable reports allow firms to make better informed investment choices due to a better understanding of competing firms, both within a country and across countries. Growing numbers of firms with comparable financial reports increases the number of two ways communication linkages in the “Financial reporting” network. This enhances the value of the overall network to both the investors and firms (Meeks and Swann, 2008). Although there are many benefits of more comparable reporting and disclosure, there are also costs to improving corporate reporting.
The reporting and disclosure costs include the preparation and certification. Regulators should carefully weigh the convergence of costs and benefits to firms, investors, and other parties in the economy. The benefit of high quality and more comparable reporting may also vary significantly across industries and markets. Impact of IFRS in Foreign Countries: Financial reporting quality is affected by many factors other than just the accounting principle adopted. These include legal and political systems, reporting incentives and other market incentives. Ball, Robin, & Wu, 2003). The quality of financial reporting also depends on the relevance and reliability of the financial and non-financial information recognized and disclosed (Ferrari, Momente, and Reggiani, 2011). Empirical research conducted by Ferrari, Momente and Reggiani studied the earning quality in relation between the German companies practicing IFRS and German companies practicing German accounting standards (HGB). This research has been conducted based on German companies, excluding financials and utilities listed on the Frankfurt stock exchange.
German is the only large country in Europe with a strong set of local GAAP where a substantial quantity of firms applied IFRS on a voluntary basis before 2005. Out of 746 German companies 368 were following IRFS and 378 companies were following HGB (SEE APPENDEX 1). The mathematical finding articulates that the analyses supports the idea that the IFRS adopter are generally characterized by a level of earnings management lower than or equal to the HGB adopters. Another study conducted by Daske, Hall, Leuz and Verdi looked for evidence on economic consequences after mandatory IFRS Reporting.
The analyses were based on market liquidity and cost of capital in 26 different countries. Their research provides us with the synopsis on the capital market effects after introducing the IFRS in 26 countries around the world. The study analyzes the effects in stock market liquidity, cost of equity capital, and equity valuations. The results propose that the mandatory adopters experience statistically significant increases in market liquidity after IFRS reporting becomes compulsory. These research and results indicate that results have mixed results on quality changes after the adaption of IFRS in different countries.
Whether IFRS can work properly in markets that are disciplined mainly by regulators rather than the market mechanism can be verified by observing the adoption of IFRS by China (DING & SU, 2008). What’s more, a single set of standards may not be suitable for all settings and thus may not improve reliability due to differences among countries (Soderstrom & Sun, 2007). The adoption of IFRS in the Chinese economy has significantly improved the quality of accounting and reported earnings (Liu el at, 2001).
Evidence also reveals that value significance of reported earnings increased while earning leveling decreased with the standard change. Empirical evidence showed by Daske et al. ’s (2008) claim that quality improvement from IFRS adoption is expected to be higher for adopters with poorer quality as firms audited by the Big Four before the standard change. This clearly shows that IFRS has been the preferable accounting standards for foreign countries. Is Conversion to IFRS economically advantage? Quality reporting and more comparable reporting and disclosure can create economy-wide benefits.
Therefore it is safe to say that it makes economic sense for regulators to access the current reporting environment within a market or country to determine if any changes to the reporting environment could move reporting quality and comparability closer to the peak. My question is, what role the accounting standards play in achieving good quality and comparable reporting practices? How will policymaker achieve these goals? The capital markets and investors appreciate higher transparency and high quality reporting.
However, the evidence from academic studies suggests a limited role of standards in influencing reporting practices (Daske, 2006). To further support this point, we need to highlight the role of reporting incentives and institutional frameworks in shaping firms’ reporting practices. We can also assume that changing the accounting standards can also lead to undesirable effects depending upon the economy. Studies steered by Ball and Shivakumar (2005) illustrated the importance of firms reporting incentives, rather than accounting standards, as key drivers of observed reporting quality.
The studies identify that accounting standards give firms considerable reporting choice because the application of the standards involves considerable judgment since accounting measurements rely on management’s private information and involve an assessment of the future, making them subjective demonstration of management’s evidence set. Firms reporting inducements are molded by many factors which includes the capital market forces, the law of the nation and a firm’s compensation on performance to the management.
It is relevant for the IFRS debater that the studies show that even the firms with the same accounting standards, reporting practices fluctuate considerably across firms and countries (Ball and Shivakumar, 2005). Studies also shows that even if these standards are strictly enforced and implemented, moving to a single set of accounting standards is not enough to produce comparability of reporting and disclosure practices (Ball and Shivakumar, 2005). This proves that accounting standards are more limited than often thought.
They are just one of many factors which help shape actual reporting and disclosure practices. Accounting standards are a very important organized element that affects financial reporting practices in a country. In a good economy, these elements are most likely to help one another because accounting information plays an important role in financial contracting (Ball, 2001). Investors in public equity markets use financial statements to witness their entitlements, make speculations, or use their rights at shareholder meetings.
Therefore, it is practical to think that corporate reporting improvements in conjunction with other institutional factors to enable financial transaction and contracting (Ball, 2001). IFRS is favored because of the idea behind its effects on capital market and investors. Another thing to consider is that the adoption of IFRS can also improve financial reporting to outside investors. We can conclude that IFRS leans more toward capital markets which is more relevant to investors. Tightening the accounting standard can reduce the level of earning management and improve reporting quality (Soderstrom, 2007).
Hence, IFRS helps to lower the quantity of reporting discretion comparative to many local GAAP. However reducing the level of reporting discretion can also makes it more difficult for management to track their private information through the financial statements. Using a similar accounting standard across the world likely improves foreigner’s ability to notice earnings management and accounting manipulations. Hence, a shift to IFRS does in fact increase the comparability of a firm’s report, and it can also improve market liquidity. In contrary, Daske et al. 2008) verifies that the capital market effects around the mandatory IFRS reporting are not evenly distributed across countries because countries with weak law enforcement and reporting incentives are most susceptible to remain substantially unaffected by the IFRS mandate. There is evidence of constructive capital market outcome by the IFRS mandate in several countries. However, there is significant variance in the effects across firms and countries. IFRS adoptions in the US economy rests on whether the quality of US firms reporting fluctuate in the capital market.
Therefore, it is necessary to acknowledge such changes in reporting quality are likely to occur. IFRS is now similarly compared with US GAAP and the remaining differences are minor (Krishnan el at 2012). Both standards have a similar fundamental viewpoint and capital market positioning. In 2002, the two standard setting bodies issued a Memorandum of Understanding (“Norwalk Agreement”), agreeing to make the two financial reporting standards more compatible and to coordinate their future work program in order to maintain compatibility (FASB (1999).
IFRS and US GAAP have converged in many areas bringing both standards closer to each other. The US is one of the largest economies in the world. The institutional framework of the US economy is very unique. US firms typically rely heavily on publicly traded external finance (Juang el at, 2012). Directly or indirectly, a larger portion of US household hold debt and equity securities through mutual funds compare to other countries. Retirement savings represents a substantial amount of those securities. Hence, the regulators have a great responsibility to support this financial system.
Therefore, the current securities laws and the US GAAP primarily are geared towards supporting public debt and equity markets. The US economy and its capital market are diverse. Reporting outcomes under US GAAP are generally considered to be high quality because of its ability to reflect economic events in a timely manner (Ball et al, 2001). The public enforcement system is supplemented by robust private administration, intimidating lawsuit, and potentially substantial financial consequences for managers, directors, and corporations that engage in reporting crimes.
FASB standards and additional SEC filing rules requires a more substantial amount of disclosure than in any other countries (SEC). Hence, a switch to IFRS can bring a dilemma weather to maintain disclosure requirements mandated by the SEC or stick to IFRS limited disclosure (SEC). Cost Analysis of Adopting IFRS-From the preceding discussion, the capital market benefits of IFRS and the effects on U. S reporting practices are likely to be small. However, let’s take a look at the cost consequences of adopting IFRS.
In the first year of publishing IFRS reports, companies will have to train their employees in the preparation of IFRS financial statements. Hiring outside specialists and consultants and upgrading the software are other major expenses companies will have to bear. It should be noted that there will be additional revenue for the firms who does the advisory and auditing of those firms. Not surprisingly, many of the accounting firms take very optimistic attitude regarding the potential adoption of IFRS by the US. The cost for US firms would be substantial.
According to ICAEW, 2007 per firm estimates ranging from 0. 31% of total sales for firms with sales below $700 million to . 05% of total sales for larger firms. This amounts to an average onetime cost of $430,000 for small firms and $3. 24 million for large firms. Based on these estimates, the US economy as a whole could cost up to $8 billion. The cost might go up if SEC requires firms to provide reports under both standards. Although the one-time conversion costs are likely to be substantial, there is no guarantee for any recurring cost.
There might be periodic costs associated with inconsistencies within the US legal and institutional system (ICAEW, 2007). To my understanding issues like this wouldn’t be easily to fixed. One can argue that there are also many reasons to believe that adoption of IFRS could also save money because of a single global reporting system in the long run. The foreign US holdings multinationals often have to fulfill with the domestic reporting standards of their residence which is most likely to be IFRS. If foreign multinationals that use IFRS no longer have to maintain US GAAP reporting then they will save money on the conversion.
The adoption of IFRS could save money to many US firms indirectly. Effect on Education System due to conversion: The accounting professionals and educators need to be brought up to speed in an adequately time frame in order for smooth conversion to IFRS. As mentioned earlier, China and Germany were able to convert the standard smoothly; the same should be possible in the U. S. The big four accounting firms have been releasing a number of reports that IFRS education is lagging behind. The big four accounting firm have reported that U.
S. investors and issuers are not yet appropriately educated with IFRS, and that at present college curriculums, text books and other instructional tools do not adequately train students and other interested parties in IFRS proficiencies (Ernst & Young, 2007b; KPMG, 2008b). Writers Point of View: This research paper has mentioned a few times about the issues related to the compatibility of IFRS with the US institutional framework. The country’s financial reporting system is a very important determinant of aggregate economic effects.
Hence, the financial reporting system is one of the basics of country’s organized framework which is likely to detect the performance of a country’s financial and economic system. A switch to IFRS by US regulators can cause unwanted concerns for the US economy if there are any incompatibilities with other elements of the organizational framework, even when IFRS are thought to be high quality and perform well in other countries. Financial markets are a network where one is reliant upon others’ financial reports. It is difficult to ascertain and quantify the complexity that can caused due to the adoption of IFRS.
As countries institutional frameworks play a key role in determining manager’s reporting inducements and the use of discretion, it is significant to know whether the amount of reporting preference in IFRS creates a problem for the US litigation system since it is moderately exclusive. Because IFRS has less specific standards and guidance, executives have to apply more judgment in interpreting IFRS. IFRS could lead to uncertainty about litigation outcomes which could even induce executives to make conservative accounting decisions.
A vital issue is whether a single set of accounting standards is necessary and would benefit firms, investors, and additional stakeholders. Striving for a single set of accounting standards can generate some cost savings and comparability supports, but the adoption of IFRS in the US would also eliminate the existing competition between IFRS and US GAAP. This could also mean the monopoly of IFRS. Monopoly has never been a good sign in the business world for a consumer. As I have mentioned earlier in my paper, US GAAP and IFRS have very small differences.
Hence, it makes perfect logic that comparability of US GAAP is likely to increase globally because additional countries plan on adopting IFRS. US investors will be in better position if they are capable of understanding the IFRS due to growing adoption around the globe. Alternatively, FASB could keep up with the work on adapting the favorable principles of IFRS into the US GAAP yet not converting completely into IFRS. U. S investors and executives will have sufficient time to adapt with the change if U. S GAAP is slowly modified to converge with IFRS.
This could possibly be the most inexpensive and least disruptive option for the US economy. A vital role of accounting standards is to cut back the transactions cost of communicating data among various shareholders, permitting them to make more effective judgments and to undertake transactions within, outside, and among firms. There are pros and cons for adopting IFRS. Comparability could be seen as pros whereas higher initial cost for convergence and monopoly of IFRS could be seen as cons. Since US economy is very complex, the effect of IFRS could not be forecasted in its eternity. It is better for US regulator to slowly convert the favorable principle of IFRS into US GAAP.
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