The SEC has published its roadmap (the “Roadmap”) for the eventual adoption of International Financial Reporting Standards (“IFRS”) as issued by the International Accounting Standards Board (“IASB”) as the required standards of accounting for all U.S. public companies. The Roadmap sets forth a series of milestones that, if achieved, could result in the mandatory use of IFRS, rather than U.S. GAAP, in financial statements filed by U.S. reporting companies with the SEC beginning in 2014, 2015 or 2016, depending on the size of the company. The Roadmap also includes proposals that would allow a limited number of U.S. reporting companies to voluntarily adopt IFRS for fiscal years ending on or after December 15, 2009.
The SEC voted to publish the Roadmap on August 27, 2008, but the text was only released on the SEC website on November 14, 2008. The period for public comment will end February 19, 2009.
The convergence of international accounting standards has accelerated dramatically in recent years. In 2002, the European Union (“EU”) adopted regulations that require all EU listed companies to use IFRS as adopted by the EU beginning with their 2005 financial year. Other countries, including Brazil, Israel, Australia and Canada, have followed suit, and currently over 100 countries either have adopted or have made plans to adopt IFRS. Last year, the SEC approved rules allowing foreign private issuers to present their financial statements in accordance with IFRS as issued by the IASB without reconciliation to U.S. GAAP. Since that time, the Commission has published a concept release and held several roundtables to consider the possibility of permitting or requiring U.S. issuers to use IFRS.
The SEC has consistently supported the goal of international convergence to a single set of high-quality global accounting standards as a means of enhancing the comparability of financial statements and facilitating cross-border capital formation. In the SEC’s view, IFRS has the greatest potential to be that truly global accounting standard, and it is in the best interests of U.S. investors, U.S. reporting companies and the U.S. capital markets to move to IFRS, and to do so on a mandatory, not elective, basis.
It is noteworthy that during the past few years, the convergence of U.S. GAAP and IFRS, and more recently the possible move to a single accounting standard, has been held up as the model for a broader initiative to reduce the barriers to the development of a truly global capital market. The reduction of these barriers would be accomplished through global convergence of the regulations governing access to the capital markets, whether through harmonization, mutual recognition or exemption. The need for such convergence was highlighted most recently by the leaders of the Group of Twenty in their November 15th declaration on responses to the credit crisis. The decision to move forward with the Roadmap in light of the current credit crisis suggests that we should expect to see far more in the way of global initiatives towards convergence.
The SEC will determine in 2011 whether to mandate use of IFRS for all domestic SEC reporting companies. Reporting companies would be required to provide three years of financial statements under IFRS. Implementation would be phased-in between 2014 and 2016.
The move to IFRS would affect financial statements included in period reports, proxy statements and information statements, registration statements filed under the Securities Act of 1933 (“Securities Act”) and Form 10 registration statements filed under the U.S. Securities Exchange Act of 1934 (“Exchange Act”) by all domestic SEC reporting companies (or those seeking to become such), other than investment companies. The Roadmap does not apply to reports required of regulated entities (such as FOCUS Reports).
Comments on the Roadmap are likely to focus on the implication of a final decision in 2011 only and whether companies are likely to delay preparation for use of IFRS for fear that the SEC will ultimately retain U.S. GAAP. (One of the alternatives for voluntary filers contemplates a reconciliation during the transition period, but some are concerned that may deter early adoption.) Another possible source of concern will be the requirement for three years versus two years of statements. Given the potential benefits of IFRS reporting in light of the move by much of the rest of the world already or shortly to IFRS, some reporting companies may seek the flexibility to adopt IFRS earlier than the proposed scheduled, and some commentators may even suggest an acceleration of the mandatory adoption deadlines.
If the Roadmap is adopted, the SEC will include it in its Codification of Financial Reporting Policies. If new circumstances arise, the SEC may update or revise the Roadmap accordingly.
Roadmap to IFRS Reporting by U.S. Reporting Companies
We set forth below the proposed milestones that, if achieved, would lead to the mandatory use of IFRS in SEC filings by U.S. reporting companies.
Improvements in accounting standards. In 2011, the SEC will make a determination whether the IFRS accounting standards are of high enough quality and are sufficiently comprehensive for adoption by U.S. issuers. The SEC will also consider whether IFRS standards have been developed through a robust, independent process. In the course of this evaluation, the SEC will consider the degree of progress made by the Financial Accounting Standards Board (“FASB”) and the IASB to improve financial reporting and develop accounting standards through their joint “conversion” projects.
Accountability and funding of the IASC Foundation. The SEC believes that effective oversight is critical to mandating that U.S. reporting companies prepare financial statements in accordance with IFRS. Currently, the oversight mechanism of the IASB is governed by the International Accounting Standards Committee (“IASC”) Foundation, which is a stand-alone, notfor- profit organization. The SEC will monitor various developments of the IASC Foundation prior to mandating the use of IFRS for U.S. reporting companies.
Improvement in the ability of issuers to use interactive data for IFRS reporting. In May 2008, the SEC proposed rules to require companies to provide their financial statements to the SEC and on their corporate websites in interactive data format using the eXtensible Business Reporting Language (“XBRL”). The rules, if adopted, would apply to U.S. and foreign public companies preparing their financial statements in U.S. GAAP, and foreign private issuers that prepare their financial statements using IFRS (in the latter case, with a deadline to provide such financial statements starting with fiscal periods ending on or after December 15, 2010). The SEC believes that, in order to realize the benefits of the use of interactive data, it will be necessary to increase the development of an IFRS list of tags for interactive data reporting.
Education and training relating to IFRS. The SEC believes that effective training and education about IFRS for those market participants involved in the preparation and use of financial statements is critical to realizing the benefits of a single set of high-quality globally accepted accounting standards, and it will take into account the status of the overall education, training and readiness of such market participants prior to proceeding with rulemaking on IFRS.
Limited early adoption. The Roadmap sets forth proposed amendments that would allow a limited number of U.S. reporting companies to file IFRS financial statements prior to any mandated use of IFRS in SEC filings. This is intended in part to help inform the SEC’s decision of whether to mandate the use of IFRS for all U.S. reporting companies and to ease the comparability of financial statements among such issuers.
After reviewing the status of the milestones and a study undertaken by the Office of the Chief Accountant, in consultation with the other Divisions and Offices of the SEC, on the implications for investors and other market participants of the implementation of IFRS for U.S. reporting companies, the SEC will determine in 2011 whether to proceed with rules mandating the use of IFRS for all U.S. reporting companies. The SEC believes that this timing provides reporting companies with sufficiently early notice of the transition to IFRS to permit them to prepare financial statements in accordance with IFRS. The year 2012 would be the earliest possible fiscal year that would be covered under the earliest anticipated phase-in for IFRS reporting in 2014, as the SEC will continue to require three years of audited financial statements, and will require all three years to be reported in accordance with IFRS in the first year of IFRS reporting.1
The SEC is considering a staged transition for IFRS filings, which it believes may help manage resource demands on auditors, consultants and other market participants. In recognition of the fact that larger issuers will be better able to allocate resources to the transition to IFRS more quickly than smaller issuers, large accelerated filers would be the first to phase in IFRS reporting. IFRS reporting would begin for large accelerated filers for fiscal years ending on or after December 15, 2014. Accelerated filers would begin IFRS reporting for years ending on or after December 15, 2015. Non-accelerated filers, including smaller reporting companies, would begin IFRS reporting for years ending on or after December 15, 2016. The SEC acknowledges, however, that a staged transition would create a temporary dual system of reporting, which would require investors to be familiar with both reporting systems (U.S. GAAP and IFRS).
In addition, the SEC may consider expanding the universe of reporting companies eligible to adopt IFRS prior to the mandatory implementation date.
The Roadmap does not indicate how the SEC would mandate the use of IFRS. It does acknowledge that one approach would be for the FASB to continue to set the standards for accounting principles used by reporting companies for purposes of their SEC filings. In this case, IFRS, at transition and all future changes, would be incorporated directly into U.S. GAAP.
Voluntary Early Adoption of IFRS by Certain Reporting Companies
Eligibility requirements. Reporting companies that are among the 20 largest companies globally in a particular industry where IFRS is used as the basis of financial reporting more often than any other basis of financial reporting among those companies worldwide would be eligible to “early adopt” IFRS by requesting a letter of no-objection from the SEC staff.
The SEC estimates that at least 110 U.S. companies in 34 different “IFRS industries” would be eligible (based on the proposed two-part test) to elect to use IFRS, representing approximately 12% (as of December 2007) of total U.S. market capitalization. It observes that, because it used only one of several industry classification methods, the actual number of eligible companies is certainly higher and may increase over time.
No-Objection SEC Letter. The no-objection letter would not bind the reporting company to use IFRS, but would give it the ability to commence filing reports using IFRS for a period of three years (without the eligibility criteria being recalculated during those three years).
Transition. The option to use IFRS for eligible reporting companies would apply to filings for fiscal years ending on or after December 15, 2009. An eligible reporting company would be required to first report under IFRS in an annual report containing three years of audited financial statements, and to disclose information related to its decision to change to IFRS in the first Form 10-K that includes IFRS financial information.
Alternative Proposals for U.S. GAAP Information. Aware of the disadvantages to the market of a dual system of reporting during the transition period, the SEC has proposed the following two alternatives under which U.S. reporting companies that elect to use IFRS on a voluntary basis would disclose U.S. GAAP information (for comparability purposes with the balance of the U.S. market that will still be using U.S. GAAP):
Proposal A—Reconciled Information Pursuant to IFRS 1. A reporting company could provide a one-time reconciliation from certain U.S. GAAP financial statements to IFRS pursuant to IFRS 1, First-time Adoption of International Financial Reporting Standards in a footnote to its financial statements.
Specifically, IFRS 1 requires an explanation of how the transition from previous GAAP (U.S. GAAP) to IFRS impacts the issuer’s reported financial position, financial performance and cash flows. The reporting company would have to include reconciliations of its equity (reported under U.S. GAAP and under current IFRS) for the date of transition to IFRS and the end of the latest period presented in the most recent annual financial statements prepared under U.S. GAAP. Similarly, the reporting company would have to include a reconciliation of its profit and loss, and cash flows, as reported under U.S. GAAP for the latest period in the most recent annual financial statements to its profit and loss, and cash flows, under IFRS for the same period. After the initial reconciliation, the reporting company would not be required to provide any reconciliation in future filings with the SEC. A U.S. reporting company could, in any event, disclose U.S. GAAP information if it decides it is useful for U.S. investors.
Proposal B—Supplemental U.S. GAAP Information. A reporting company that elects to file IFRS financial statements could provide the reconciling information from U.S. GAAP to IFRS required under IFRS 1 and disclose, on an annual basis, certain unaudited supplemental U.S. GAAP financial information covering a three-year period (in the form of a reconciliation from IFRS to U.S. GAAP).
To implement Proposal B, the SEC would amend Item 101 “Business” of Regulation S-K. Under proposed Item 101(j), an IFRS issuer would provide reconciliations from its IFRS financial statements to U.S. GAAP for each of the three fiscal years covered by the audited IFRS financial statements included elsewhere in the Form 10-K. The reconciliations would cover all of the financial statements required to be presented under IFRS: balance sheets, statements of income (loss), statements of cash flow, statements of changes in shareholders’ equity, and statements of comprehensive income. Reporting companies would need to maintain sufficient records and controls to prepare this U.S. GAAP information. No such disclosure would be required in 10-Q reports.
Under Proposal B, the information disclosed pursuant to proposed Item 101(j) would be contained in the body of the annual report on Form 10-K and, therefore, would be deemed “filed” for purposes of the Exchange Act, would be subject to the certifications by the principal executive and financial officers and would be subject to the disclosures and certifications relating to disclosure controls and procedures. The supplemental U.S. GAAP information would not be required to be audited or reviewed by the company’s independent auditors.
The SEC noted that Proposal A would not promote the ability of U.S. reporting companies to revert back to U.S. GAAP, since U.S. GAAP information would not have been required to be accumulated or disclosed beyond the last year that the company previously reported under U.S. GAAP. In contrast, the Proposal B requirement to provide a U.S. GAAP reconciliation on an annual and on-going basis would likely allow U.S. reporting companies to revert back to U.S. GAAP with greater ease (for example if the Roadmap did not culminate in the mandatory or elective use of IFRS).
Conforming amendments. The SEC has identified a number of conforming amendments that would be needed for voluntary IFRS filers. We list them in Annex A.
Other Considerations for Reporting Companies
Due to the pervasive role that financial information plays for reporting companies and in the markets more generally, investors, reporting companies and other market participants that use financial statements or have a role in the capital markets or the financial reporting infrastructure would need a fundamental reorientation before IFRS becomes an accepted, let alone mandated, accounting standard in the United States.
Training. A move to IFRS would require training of accountants as well as the accounting staffs at reporting companies. Although it may be overstating the comparison to say that U.S. GAAP is rules-based, and IFRS is principles-based, IFRS does require application of broader principles and is far less rules-based than U.S. GAAP. Applying IFRS can result in different judgments and different analyses. There is less interpretive guidance in respect of IFRS, which places a greater premium on judgments, and in large organizations in particular, consistency in making those judgments would be important.
In addition to the preparers of the financial statements, members of boards of directors and, in particular, audit committee members, and internal audit staff, would need to become conversant with IFRS.
Cost. For all the reasons described in this section, first-time adoption would trigger transition costs.
Tax implications. IFRS filers could experience a change in reportable income due to the interaction between accounting standards and income tax requirements. In the Roadmap, the SEC notes that the Internal Revenue Code has “conformity provisions” tying the method of accounting of inventory for tax purposes to the method used for financial reporting purposes. IFRS does not allow for the use of the Last-in, First-out (“LIFO”) method of accounting for inventory. If IFRS filers were required to shift to First-in, First-out (“FIFO”), as recognized under IFRS, they may experience a change in taxable income based on the difference in applying LIFO and FIFO.
Covenants. Bank credit facilities typically contain financial ratios and other maintenance covenants that are measured on the basis of results as calculated in accordance with accounting principles High yield indentures will contain incurrence-based covenants tied to ratios calculated in accordance with indenture-based accounting conventions that use as their starting point GAAP concepts and will have been negotiated based on GAAP standards. These facilities and indentures are likely to specify that the calculations are to be made in accordance with U.S. GAAP (either as in effect on the date of the facility or indenture, or as then in effect), while others may refer to accounting standards as then in effect. In either case, consideration should be given in the period leading up to 2011 to the implications of a shift to IFRS.
Compensation arrangements. Compensation plans that set bonus targets based on financial statement results would need to be reviewed to determine the impact of the transition on various thresholds of performance-based compensation. Similarly, sales commission arrangements may be impacted as a result of differences in revenue recognition.
Other contracts. To the extent that contracts and other agreements outside the lending context contain provisions tied to accounting concepts, to the extent that the treatment would be different under IFRS, consideration needs to be given to the potential impact.
Systems and procedures. The transition by reporting companies to IFRS would require numerous changes in the policies and procedures and system of internal controls of reporting companies as well as other users of financial information, such as analysts, credit rating agencies and regulators. IT infrastructures would need to be modified too, as every system that uses financial information may be affected by the transition and the full range of data compilation processes would need to be analyzed against what they need to “produce” under IFRS. While companies are in transition, they would need to consider how to capture information for U.S. GAAP as well as for IFRS purposes.
Compliance issues. Internal control processes would also be affected, which in turn will impact the audit of internal control and CEO/CFO certifications. Disclosure controls and procedures would also need to take account of any changes in reporting procedures occasioned by the transition. Staff tasked with monitoring covenant compliance will need to be trained to assess compliance under IFRS.
Equity investees. Reporting companies would need to consider the implication of equity method investment in other companies that are not required to have IFRS financial information (e.g., private U.S. companies). This issue exists today for U.S. companies making an investment in non-U.S. companies and vice versa.
Going public. Private companies using U.S. GAAP would need to consider the implications of going public, as was the case in the European Union for companies that were able to retain local GAAP financial statements until such time as they listed on EU exchanges.
Contingencies. Under IFRS, the recognition threshold for legal contingencies is lower than under U.S. GAAP, potentially resulting in earlier income statement recognition of litigation costs. Concerns have been raised about the ability of an auditor to corroborate the information furnished by management relating to litigation, claims and assessments. This may require changes to the “audit letter” process governed by the American Bar Association’s “Treaty” on lawyers’ responses to auditors’ requests.
Educating the market. Finally, market participants will be analyzing different financial statement results and companies would need to plan for a process of educating the market by reason of a potential list of differences, whether arising from timing of revenue recognition, pension fund accounting, benefit plan accounting, segment and management reporting groupings and classification, and tax implications, among others.
Early adoption. IFRS is mandated, or permitted, in an increasing number of countries. It will become increasingly important for U.S. companies to present financial information on a comparable basis to their competitors. And, to the extent that the capital markets do move towards are more global model, U.S. companies may find it easier to access the markets if they can present IFRS financial information. Accordingly, there may be significant incentives to move as quickly as possible, either when the voluntary program become effective, or earlier if the SEC decides to accelerate the effective date of the transition.
The SEC noted the impact that a move to mandating the use of IFRS for U.S. reporting companies might have on the relationship between the U.S. capital markets and the accounting standard setting process. In particular, the interaction, and potentially the relevance and influence, of U.S. capital market participants, including the SEC and its staff, might be reduced. The IASB will consider worldwide constituencies during the deliberative process for issuing new or revised accounting standards.
For the SEC to achieve its stated objective, the world does need to embrace a single standard that is consistently applied. We will need to avoid “multiplicity of divergent standards.” Regulators will need to make accommodations, and will need to respond uniformly to the pressures of industry to revise accounting concepts.
Experience with the transition in the EU to IFRS suggests that convergence can occur in a period that is far shorter than the timetable laid out in the Roadmap. It is possible that the schedule could be accelerated. It will also be important to consider the implications of a phased implementation and whether it would not be easier if the entire market were to move at once (for reasons ranging from comparability and ease of market analysis and research to the implications for acquisitions between IFRS issuers and U.S. GAAP issuers).
Please click here to view Annex A.