On November 14, 2008, the US Securities and Exchange Commission (the “SEC”) published a “roadmap” (the “Roadmap”) for the possible transition by US domestic reporting companies from US generally accepted accounting principles (“US GAAP”) to International Financial Reporting Standards (“IFRS”). The proposed transition is largely based on the SEC’s desire to reduce the disparity between US and non-US accounting and disclosure practices in order to facilitate cross-border capital formation while providing adequate disclosure for the protection of investors and the promotion of fair, orderly and efficient markets. In setting this goal, the SEC acknowledged that a large number of non-US jurisdictions have already transitioned to IFRS, and that US investors are increasingly using IFRS financial statements to assess their investments in non-US companies.1 While not the sole factor being considered by the SEC, widespread adoption of IFRS outside of the United States is an important factor being weighed by the SEC in considering the transition to IFRS.
Under the Roadmap, the SEC will determine in 2011 whether it is in the public interest and would enhance investor protection to proceed with rulemaking to require US domestic reporting companies to use IFRS beginning in 2014. Comments on the Roadmap, including responses to any of 70 specific questions posed by the SEC, are due on or before February 19, 2009; however, publication of the Roadmap after the comment period will not result in a final rule with an effective date. Rather, the Roadmap contains the SEC’s key considerations for mandatory IFRS reporting. In particular, the SEC’s decision in 2011 will be based on four milestones that it has stated must be satisfied and three milestones that it believes should be satisfied before IFRS becomes mandatory for US domestic reporting companies.
The following chart sets forth the first year for which US domestic reporting companies would be required to adopt IFRS if the SEC proceeds with rulemaking in 2011: (see original document)
A limited number of large US domestic reporting companies may be permitted to adopt IFRS for fiscal years ending on or after December 15, 2009. This limited exception would apply only to a US domestic reporting company that is among the 20 largest companies in its industry worldwide based on market capitalization, provided that the most commonly used reporting standard in that industry group is IFRS. The SEC estimates that approximately 110 US domestic reporting companies across 34 industries would qualify. The SEC has not indicated whether early adopters of IFRS would be required to return to reporting in accordance with US GAAP if it determines in 2011 not to proceed with rulemaking requiring all US domestic reporting companies to use IFRS.
Background to IFRS
IFRS, issued by the International Accounting Standards Board (“IASB”), is widely used outside of the United States for the preparation of financial statements. More than 110 countries, including all members of the European Union, Australia, Brazil, Hong Kong, India, Russia and South Africa, permit or require the use of IFRS in the preparation of financial statements of listed companies. The extent of adoption of IFRS in these countries varies. In some countries, IFRS as issued by the IASB is stated to be the national standard or the national standard is identical to IFRS as issued by the IASB. In other countries, the national standard is consistent with, but not identical to, IFRS as issued by the IASB. Finally, in some countries, the national standard permits deviation from IFRS as issued by the IASB.
The SEC has undertaken a series of initiatives to foster convergence between US GAAP and IFRS. In addition, in August 2007, the SEC issued a Concept Release on whether US domestic reporting companies should be permitted to prepare financial statements in accordance with IFRS.3 Subsequently, in December 2007, the SEC adopted rules allowing foreign private issuers to file financial statements with the SEC prepared in accordance with IFRS issued by the IASB without reconciliation to US GAAP.4
Switching to IFRS Voluntarily
As part of the Roadmap, the SEC proposes to allow US domestic reporting companies that meet specific criteria to file financial statements in accordance with IFRS as issued by the IASB, rather than US GAAP, for use in their annual and other reports under Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), proxy statements and information statements under Schedules 14A and 14C under the Exchange Act, and registration statements under the Securities Act of 1933, as amended (the “Securities Act”), and the Exchange Act.
The SEC offers three primary reasons for permitting qualifying US companies to adopt IFRS prior to 2010:
- affording investors a more consistent presentation of financial information to enhance comparability of the financial statements of qualifying US companies with non-US competitors;
- providing assistance in the transition to mandatory IFRS financial reporting by creating additional, but manageable, demand for IFRS-related services; and
- presenting the SEC with an opportunity to learn from investors and US capital market participants regarding their thoughts about US domestic reporting companies filing financial information using IFRS.
In order to determine which US domestic reporting companies are eligible to elect to make their filings using IFRS, the SEC is proposing to adopt a two-pronged test, requiring that:
- the candidate company is one of the 20 largest companies based on market capitalization in its industry group worldwide (using a single, published, widely-accepted industry classification system); and
- more companies within the 20 largest listed companies of that industry group use IFRS as the basis of financial reporting than any other basis for financial reporting.
The SEC estimates that approximately 110 US domestic reporting companies across 34 industries would meet these requirements and be eligible for early adoption of IFRS.
Letter of No Objection
A US domestic reporting company that believes it meets the above eligibility requirements and wishes to use IFRS for its financial reporting will also need to obtain a letter of no objection from the SEC Staff. Under the proposed definition of “IFRS Issuer” in Rule 1-02(cc) of Regulation S-X, which contains the eligibility criteria that must be provided in request to the Staff, certain companies are automatically excluded, including: investment companies; employee stock purchase, savings and similar plans; and smaller reporting companies. Assuming a company is not in an excluded category, upon receipt of a request for a letter of no objection, the SEC Staff will review the US domestic reporting company’s analysis of its eligibility in order to determine whether to issue a letter of no objection. Once the SEC Staff issues a letter of no objection, the candidate company may elect to adopt IFRS at any time during the three-year period following issuance of the letter. A qualifying US domestic reporting company need not reassess its eligibility during this three-year period.
Reporting Requirements for Early Adopters— Two Options
An eligible US domestic reporting company that elects to file IFRS financial statements may begin to file financial statements prepared in accordance with IFRS for fiscal years ending on or after December 15, 2009. The Roadmap requires each eligible company that elects to file IFRS financial statements with the SEC to do so first in its annual report on Form 10-K containing three years of audited financial statements.5 A company would not be permitted to file IFRS financial statements for the first time in a quarterly report, in a Securities Act or Exchange Act registration statement, or in a proxy statement or information statement. A company would be required to explain in its Form 10-K its reasons for adopting IFRS, the corporate governance processes followed by the company during its transition to IFRS (including whether a shareholder vote was held and whether the board or audit committee considered the matter), and details regarding the SEC Staff’s no objection letter.
The SEC is considering two alternatives for the disclosure of US GAAP financial information by US domestic reporting companies that elect to use IFRS financial statements in their SEC filings:
Proposal A—One Time Reconciliation
Under Proposal A, a US domestic reporting company that elects to file IFRS financial statements would provide an audited reconciliation of its US GAAP results to IFRS in a footnote to its first audited financial statements based on IFRS. The information required in the financial statements is referred to by the SEC as “IFRS 1.” IFRS 1 requires a company electing to file under IFRS to provide: (1) a reconciliation of (i) its equity previously reported under US GAAP for the date of transition to IFRS and the end of the latest period presented in the most recent audited financial statements to IFRS, and (ii) its profit and loss, and cash flows, as previously reported under US GAAP for the latest period in the most recent audited financial statements to its profit and loss, and cash flows, under IFRS for the same period and (2) disclosure of how the transition from US GAAP to IFRS affects its reported financial position, financial performance and cash flows. After the initial reconciliation, the eligible company would no longer be required to provide any reconciliation in subsequent filings with the SEC.
Proposal B—Ongoing Reconciliation
Under Proposal B, a US domestic reporting company that elects to file IFRS financial statements would be required to provide (i) the information required by IFRS 1 in a footnote to its first audited financial statements based on IFRS and (ii) on an annual basis, certain unaudited supplemental US GAAP financial information, covering a three-year period in the form of a reconciliation of US GAAP to IFRS. The reconciliation would cover balance sheets, income statements, cash flow statements, statements of changes in shareholders’ equity and statements of comprehensive income. Under Proposal B, the reconciliation would relate to all annual periods covered by IFRS audited financial statements (usually the three most recent fiscal years). A US domestic reporting company, under Proposal B, would disclose its unaudited information on an annual basis in its Form 10-K. If the SEC determines in 2011 not to continue to permit or require US domestic reporting companies to use IFRS, Proposal B would allow US domestic reporting companies that had elected to report under IFRS to return more easily to reporting under US GAAP.
The unaudited supplemental US GAAP financial information would be subject to the certification under Sections 302 and 906 of the Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act”), which relate to disclosure controls and procedures; however, such financial information would not be subject to management’s assessment of, and the independent auditor’s report relating to, a company’s internal controls over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act.
Milestones for Implementation in 2011
The Roadmap identifies seven milestones that the SEC will consider in determining whether to engage in rulemaking requiring US domestic reporting companies to report financial information in accordance with IFRS. The following four milestones must be satisfied by 2011 before the SEC will engage in such rulemaking:
- Improvements in accounting standards. In 2002, the US Financial Accounting Standards Board (“FASB”) and the IASB made a joint commitment to develop high quality, compatible accounting standards to be used for both domestic and cross-border financial reporting. In 2011, the SEC will review the progress that the FASB and the IASB have made in order to determine whether the accounting standards are of high quality and sufficiently comprehensive. In addition, the SEC notes its belief that accounting standards should be established under a robust and independent process that includes consideration of alternative approaches. It is the SEC’s belief that standards should be current and reflect emerging accounting issues and changing business practices—all with the stated goal of improving the accuracy and effectiveness of financial reporting and protecting investors. In determining whether to require financial reporting using IFRS, the SEC will assess whether the IASB will be able to continue to develop its standards in line with such criteria.
- Accountability and funding of the IASC Foundation. National accounting standard setters have traditionally been accountable to a national securities regulator or other government authority. The SEC currently oversees the Financial Accounting Foundation (“FAF”), the overseer of the FASB. The International Accounting Standards Committee Foundation (the “IASC Foundation”), which oversees the IASB, does not have a similar relationship with any national regulator and is looking to establish a monitoring group consisting of national securities authorities. The effectiveness of this oversight will be one of the key elements in deciding whether the SEC proceeds with the mandatory adoption of IFRS.
The IASC Foundation is funded through voluntary contributions from capital markets participants around the globe, including accounting firms, companies, international organizations, central banks and governments. The SEC will consider whether the IASC Foundation has established a stable funding mechanism to enable it to continue operating independently, thereby ensuring there are no external influences on it or its rulemaking activities.
- Improvement in the ability to use interactive data for IFRS reporting. In May 2008, the SEC proposed rules requiring companies to provide their financial statements in interactive data format using eXtensible Business Reporting Language (“XBRL”).6 This requirement applies to both US domestic reporting companies that use US GAAP and foreign companies that use IFRS as issued by the IASB. The ability to provide IFRS financial statements through XBRL is currently limited. The SEC will consider the development of an IFRS list of tags for interactive data reporting before determining whether to require US domestic reporting companies to use IFRS.
- Education and training. Switching to IFRS would increase the need for effective education and training in IFRS by accountants, auditors, investors and others involved in preparing and using financial statements. While the SEC Staff has developed familiarity with IFRS, the private sector predominantly focuses on the application and usage of US GAAP and is therefore not proficient in IFRS. Professional associations and industry groups, as well as colleges and universities, would need to include IFRS in their training materials, publications, testing and certification programs and curricula. In addition, IFRS would need to be included in the Uniform CPA Examination. In 2011, the SEC will consider the overall status of education, training and readiness of accountants, auditors, investors and others before proceeding with rulemaking and implementation of IFRS for US domestic reporting companies.
In addition to the four mandatory milestones discussed above, the following three factors, while not prerequisites to the SEC rulemaking in 2011, are deemed to be important considerations by the SEC to facilitate mandatory IFRS reporting.
- Limited early use of IFRS where this would enhance comparability for US investors. As described above, the Roadmap would allow limited early adoption of IFRS by certain large US domestic reporting companies where usage of IFRS would enhance comparability between such companies and their non-US counterparts within the same industry. Because there is some risk that this would result in a dual system of reporting by some US companies if the SEC did not take further action to expand IFRS to all US companies, the SEC is limiting those companies that can participate in early adoption of IFRS to only a small group.
- Anticipated timing of future SEC rulemaking. In 2011, the SEC will review the status of the milestones and determine whether requiring the use of IFRS by US domestic reporting companies would be in the public interest and would enhance investor protection. A rulemaking decision in 2011 would give sufficient advance notice to those US domestic reporting companies that would be required to use IFRS for their publicly filed financial statements in 2014. Since the SEC would continue to require three years of audited annual financial statements using the same accounting standard, a company adopting IFRS in 2014 would need to prepare IFRS audits for 2012 and 2013, even though its public filings for those years would still be presented in US GAAP.
- Staged transition to mandatory IFRS. The SEC is considering a staged transition to IFRS reporting. Large accelerated filers would begin reporting in IFRS for the fiscal year ending on or after December 15, 2014. Accelerated filers would begin reporting in IFRS for the fiscal year ending on or after December 15, 2015. Non-accelerated filers would begin reporting in IFRS for the fiscal year ending on or after December 15, 2016. The SEC would also consider expanding the eligibility criteria for US domestic reporting companies that may adopt IFRS early since some companies may wish to do so, for example, in order to maintain comparability with their competitors.
Impact of IFRS on Filings and Disclosure Requirements
A transition to financial reporting under IFRS for SEC filings would require changes to the form and content of certain existing SEC rules and regulations.
The SEC has proposed amendments to Regulation S-X to include a new Article 13 that would set out requirements governing the application of SEC rules and regulations that apply to any issuer that prepares financial statements in accordance with IFRS as issued by the IASB for filings with the SEC. New Article 13 would apply to financial statements filed by a US domestic reporting company or a foreign private issuer, and to financial statements filed pursuant to Rules 3-05, 3-09 and 3-14 of Regulation S-X. These financial statements would be required to contain a note in which the issuer unreservedly and explicitly states compliance with IFRS as issued by the IASB. In addition, the applicable accountant’s report must include an opinion on whether the issuer’s financial statements comply with IFRS as issued by the IASB. Finally, financial statements which are not prepared in accordance with IFRS as issued by the IASB will be presumed to be misleading or inaccurate, despite footnote or other disclosures, unless the SEC has otherwise provided.
The SEC has also proposed amendments that would impact exempt offerings, Form 8-K, tender offers and going-private transactions. If adopted, in the context of an exempt offering requiring a company to deliver financial statements to investors, for example, under Rule 701 or Regulation D under the Securities Act, eligible companies using IFRS would be allowed to deliver IFRS financial statements to investors. In addition, in applying the proposed amendments to Form 8-K, the SEC proposes to add instructions to certain items that contain references to specific standards included in US GAAP, in order to provide references to specific IFRS standards to which an IFRS issuer would refer instead of the US GAAP standard. Finally, certain specific references exist under Schedule TO and Schedule 13E-3 relating to tender offers and going-private transactions, which require, among other things, a reconciliation to US GAAP. Under the proposed rules, the SEC proposed to amend the instructions to Schedule TO and Schedule 13E-3 to clarify that IFRS eligible issuers may use financial statements filed in accordance with IFRS when conducting a tender offer or goingprivate transaction, without needing to reconcile such financial statements to US GAAP.
Other Considerations for the Potential Transition to IFRS
Uses of financial information
A change from US GAAP to IFRS may skew a company’s portrayal of its reported results of operations when used for different purposes or otherwise be inconsistent with a company’s reporting obligations. The following are examples of possible issues:
- The US Internal Revenue Code is conformed to US GAAP standards, for example, by accounting for inventory for tax purposes using a last-in, first-out (LIFO) methodology. IFRS, however, does not permit the use of LIFO and requires issuers to use a first-in, first-out (FIFO) methodology to account for inventory. Companies may experience a change in taxable income based on this difference.
- Many companies may be contractually committed to using US GAAP when calculating financial measurements or ratios in connection with their credit or other agreements. Amending these agreements may not only be costly and complex, but in some circumstances may result in less favorable outcomes for companies than exist under US GAAP.
- Some market indices, such as the S&P 500, only include issuers that report in accordance with US GAAP. Early adoption of IFRS may cause an issuer to be removed from these indices until the indices make the necessary adjustments.
Accounting systems, controls and procedures
Transitioning to IFRS reporting will require numerous changes to companies’ internal policies and procedures, with some changes being more complicated and costly than others. For example:
- Many issuers hold investments in other companies that are accounted for using the equity method. IFRS does not recognize the equity method and instead uses the proportional consolidation method. Therefore, to properly record such investments, the issuer would need to obtain IFRS-based information from the investee for each applicable period. This would be potentially difficult for an investee still using a US GAAP recording system.
- Private companies, which are not required by the SEC to present financial statements using IFRS, could incur added costs and be subject to delays if they are required to convert to IFRS before going public.
- Companies may face challenges in maintaining adequate internal control over financial reporting during the initial periods of adopting IFRS. One challenge may be a lack of personnel with experience applying IFRS in general or specific IFRS policies in particular.
US audit firms in general, and smaller firms in particular, which have fewer resources to help their personnel adjust to the transition, may find the transition to IFRS extremely challenging. Since US audit firms generally have less experience with IFRS than with US GAAP, many firms may find it challenging to establish new policies and procedures, as well as hire and train personnel, to provide reasonable assurance that they possess the knowledge to perform IFRS audits.
Consideration of IFRS and the IASB’s standardsetting process
IFRS is not as developed as US GAAP in many areas. As a result, there is less literature and a greater number of alternatives permitted in certain areas. Without sufficient authoritative guidance, comparability of reported financial information between different issuers may become difficult, as different issuers account for disclosure of similar transactions in different ways. The IASB and its related organizations consist of members from numerous countries, representing a range of economic, social and political interests. The US capital markets will have less input into IFRS standards than they do currently into US GAAP standards. Additionally, the SEC will have less direct oversight over the IASC Foundation and the IASB than it currently does with respect to the FAF and the FASB.
At the SEC’s August 2008 roundtable to discuss the proposed transition to IFRS, participants, consisting of auditors, accountants, investors and others who deal with financial statements, agreed on the following points:
- it is desirable for a single set of global accounting standards to be established;
- while US GAAP could be such a global standard, worldwide momentum is continuing towards the adoption of IFRS; and
- the detailed Roadmap, including specific dates for transitioning, and ongoing FASB/IASB projects will support the transition to IFRS.
Many participants thought that IFRS compared well to US GAAP in its performance during the current market turmoil, attributing this in part to IFRS generally reflecting a more accurate analysis of the underlying economics of a transaction, resulting in more transparent disclosure. Nevertheless, panelists were concerned that the range of options available under IFRS would require more judgment and could result in confusion among investors, because accounting treatment may not be uniform among companies. Finally, some investors noted that, in light of current economic conditions, now is not the appropriate time to begin a complex and potentially expensive transition.7 It remains to be seen how these and other concerns are addressed in the course of discussions on the Roadmap.