On Friday, November 21, 2008, the Securities and Exchange Commission (the “Commission”) published in the Federal Register1 for public comment a Roadmap (the “Roadmap”) that could lead to the phasing out of United States Generally Accepted Accounting Principles (U.S. GAAP) in favor of International Financial Reporting Standards (IFRS), as issued by the International Accounting Standards Board (IASB).2 If seven key milestones are met by 2011, the Commission would make a determination regarding whether or not to require U.S. issuers to use IFRS, as issued by the IASB, for purposes of their filings with the Commission, beginning in the year 2014. The proposed rule also contemplates the early election of IFRS by a small class of eligible U.S. issuers, beginning with Commission filings in 2010, as well as several amendments to the current rules and regulations under U.S. federal securities laws.
The Commission held an open meeting proposing the Roadmap on August 27, 2008.3 Although it is unclear why the Commission did not publish the release until November 14, more than two months after the meeting, it is possible that the declaration issued at the G-20 summit hosted in Washington earlier this month may have prompted the Commission to move forward, as one of the medium-term actions agreed upon was to support the global accounting standards bodies’ work toward “the objective of creating a single high-quality global standard.”4 At the meeting, newly appointed Commissioner Walter emphasized that there were significant milestones to be met before adopting rules requiring implementation by U.S. issuers. Whether a different Commission under a new administration will adopt the Roadmap substantially as proposed is far from certain, and the adopting release discusses the fact that, even if adopted, the Roadmap could change over time.
Presently, approximately 113 countries around the world require or permit publicly listed domestic companies to use IFRS. In 2005, the European Union adopted IFRS for all publicly held companies. The Commission recently eliminated the requirement for foreign private issuers using IFRS to provide a reconciliation with U.S. GAAP in their financial statements.5
In proposing the Roadmap, the Commission states that “the use of a single, widely accepted set of high-quality accounting standards would benefit both the global markets and U.S. investors by providing a common basis for investors, issuers and others to evaluate investment opportunities and prospects in different jurisdictions.”6 Further, the Commission notes that, within the context of the growing interdependence of the global capital market system, adopting IFRS would permit U.S. investors “to make better-informed investment decisions if they were to obtain high-quality financial information from U.S. companies that is more comparable to the presently available information from non-U.S. companies operating in the same industry or line of business.”7
The earliest that a U.S. issuer could be required to use IFRS is in Commission filings for the fiscal year ending in 2014. With the Roadmap, the Commission has requested comments on whether or not it should stagger the transition from U.S. GAAP to IFRS, as opposed to requiring all U.S. issuers to transition at once, which was more akin to the European experience. If the staggered approach were to be adopted, mandatory IFRS filings would begin for large accelerated filers for fiscal years ending on or after December 15, 2014, for accelerated filers for years ending on or after December 15, 2015, and for non-accelerated filers, which include smaller reporting companies, for years ending on or after December 15, 2016. The Roadmap would apply only to U.S. issuers that file periodic reports pursuant to the requirements outlined under Section 13 and 15(d) of the Exchange Act, proxy and information statements under Section 14 of the Exchange Act and registration statements under Section 12 of the Exchange Act and Section 7 of the Securities Act. The Roadmap would not apply to other types of financial reports that are filed with the Commission by regulated entities, including registered broker dealers and investment companies, as defined under the Investment Company Act of 1940.
The proposed Roadmap outlines seven key milestones that, if met by 2011, could lead to a determination by the Commission to proceed with appropriate rulemaking to require U.S. issuers to adopt IFRS beginning in 2014.
The seven milestones would be
- improvements in accounting standards;
- the accountability and funding of the IASC Foundation (IASC), which is the oversight body of the IASB;
- improvement in the ability to use interactive data for IFRS reporting;
- education and training relating to IFRS;
- limited early use of IFRS where it would enhance comparability for U.S. investors;
- the anticipated timing of future rulemaking by the Commission; and
- status of certain marketplace and business practice considerations regarding the implementation of the mandatory use of IFRS by U.S. issuers.
Improvements in Accounting Standards
Over the past six years, IASB and the U.S. Financial Accounting Standards Board (FASB) have been working jointly to develop “high-quality, compatible accounting standards that could be used for both domestic and cross-border financial reporting.”8 The two standard-setters have most recently worked together on financial reporting issues in the context of the present global financial crisis.9 The Commission states that it intends to closely monitor the activities outlined in the joint work plan of the FASB and IASB, set to be completed in 2011. One important consideration for the Commission is determining whether IFRS accounting standards, as issued by IASB, can continue to be developed under an independent standard-setting process, and whether IASB can respond to changes in market practices by issuing appropriate guidance.
Accountability and Funding of the IASC Foundation
The Commission has flexibility to recognize accounting standard-setters, but the Sarbanes-Oxley Act of 2002 (“S-Ox”) imposes boundaries on this Commission authority. One of these requirements is that the standard setting body must be funded as provided in section 109 of S-Ox, which means by congressionally levied fees. IASC, which presently is comprised of 22 trustees, maintains IASB’s operations largely through voluntary donations from a diverse group of market participants. The Commission addresses this concern by stating that it must carefully “consider the degree to which the IASC Foundation has a secure, stable funding mechanism that permits it to function independently and that enhances the IASB’s standard setting process.”10
Another important consideration that the Commission acknowledges is whether IASB will be accountable to the Commission in the same capacity as the Financial Accounting Foundation (FAF), the oversight body for FASB. The Commission noted in its proposed Roadmap that improving the IASC Foundation’s accountability “is critical to mandating that U.S. issuers prepare financial statements in accordance with IFRS.”11
Improvement in the Ability to Use Interactive Data for IFRS Reporting
The Commission has recently proposed rules requiring companies “to provide their financial statements to the Commission on their corporate web sites in interactive data format using eXtensible Business Reporting Language (XBRL) in order to improve their usefulness to investors.”12 Going forward, the rules, if adopted, would permit both domestic and foreign public companies that prepare their financial statements in accordance with U.S. GAAP, and private issuers that prepare their financial statements with IFRS starting with their fiscal period ending on or after December 15, 2010, to submit their Commission filings in interactive data format. If the Commission permits a limited class of U.S. issuers to adopt the application of IFRS as early as 2010, these issuers would also be permitted to file IFRS financial statements in interactive data format. However, the IFRS list of tags needs to be continuously updated. The Commission is presently working with IASC’s XBRL Advisory Council to improve and monitor the present IFRS taxonomies, so that it will be able to remain current with future changes in XBRL technical standards and be able to accommodate a larger class of issuers.
Education and Training Relating to IFRS
The Roadmap highlights the importance of adopting and supporting effective training and educational initiatives for market participants and users of financial statements if the IFRS is adopted. This includes training and education for auditors, specialists, valuation experts, professional associations, industry groups, accountants and colleges and universities. Within the regulatory context, the Commission staff is committed to developing its familiarity with IFRS if and when the Roadmap moves forward. This is a significant undertaking, particularly given that U.S. schools do not currently teach IFRS.
Limited Early Use of IFRS Where This Would Enhance Comparability for U.S. Investors
Another important aspect of the Roadmap is a proposal to permit a small number of eligible U.S. issuers to prepare their filings using IFRS for fiscal years ending on or after December 15, 2009.13 The purpose of permitting the early adoption of IFRS by certain issuers would be to enhance the comparability of financial reporting to U.S. investors, at least for purposes of comparing the largest U.S. issuers with the largest non-U.S. companies in the same industry. In determining whether they qualify to elect to use IFRS early, U.S. issuers would have to
- ascertain their industry group according to the North American Industry Classification • System (NAICS) code at the three-digit level, Standard Industrial Classification (SIC) codes at the two-digit level or the International Standard Industrial Classification (ISIC) codes at the “Division” level (the proposed Roadmap does provide, however, that an issuer could alternatively use a privately published, but widely accepted, industry classification scheme); and
- determine whether IFRS is used as a basis of financial reporting more than any other financial reporting standard by the 20 largest listed companies worldwide within its industry group.
U.S. issuers that are deemed eligible for early adoption of IFRS would have to submit a request to the Division of Corporation Finance’s Office of the Chief Accountant, outlining its eligibility for early adoption. After reviewing the issuer’s request, the staff would then issue a letter of no objection if the issuer is deemed eligible.
The letter of no objection and the issuer’s request would be made readily available on the Commission’s web site. Only after an issuer received a letter of no objection could it choose to adopt IFRS any time for a period of up to three years.
Using SIC codes, the Commission believes that approximately 110 U.S. issuers in 34 IFRS industries would be eligible to receive a letter of no objection from the Commission staff.
Anticipated Timing of Future Rulemaking by the Commission
If the milestones outlined above are met by 2011, the Commission would determine whether to proceed with appropriate rulemaking to require U.S. issuers to file financial statements prepared in accordance with IFRS by 2014 “if it is in the public interest and promotes investor protection.”14 The Commission has already begun substantive review of its present regulatory framework related to financial reporting. The Commission has tasked the Office of the Chief Accountant “to undertake a study and report back to the Commission on the implications for investors and other market participants of the implications of IFRS for U.S. issuers.”15
The Roadmap proposes two alternatives for treatment of the disclosure of U.S. GAAP information by U.S. issuers that elect to use IFRS in their Commission filings. Under Proposal 1, “U.S. issuers would provide a one-time reconciliation from certain U.S. GAAP financial statements to IFRS in accordance with IFRS 1. Under the second proposal, U.S. issuers also would provide on an annual basis a reconciliation from IFRS financial statements to U.S. GAAP covering a three-year period.” The Commission is soliciting public comments as to which proposal should be adopted.
Key Considerations Regarding the Implementation of the Mandatory Use of IFRS by U.S. Issuers
The Roadmap would substantially change the present accounting framework within the United States. Converting from U.S. GAAP to IFRS would have the following immediate implications for the use of financial statements and business practices affected by accounting:
- Cost: Transitioning from U.S. GAAP to IFRS would require users to change controls and systems relating to the production of financial statements and related costs, and also require resources to be allocated for IFRS-related education and training.
- Federal and State law implications: Converting from U.S. GAAP to IFRS may have other implications outside the context of Commission filed reports. For instance, various federal and state regulators receive periodic financial information prepared according to U.S. GAAP standards. Changes from U.S. GAAP to IFRS may also have federal and state income tax implications; for example, the Internal Revenue Code “has conformity provisions related to the method of accounting for inventory for tax reporting purposes and the method used for reporting to shareholders (and other owners or beneficiaries) or for credit purposes.”16
- Inventory Accounting: IFRS only allows use of the first-in, first out, or FIFO, method of accounting and does not permit the use of the last-in, first-out, or LIFO, method of accounting, which is the cornerstone of U.S. GAAP accounting. One tangible affect of this change in accounting would be taxable income based on the difference between inventory valued on a LIFO basis and on a FIFO basis.
- Debt Covenants: Indentures that govern debt securities and loan agreements, as well as other contractual arrangements, may contain provisions that are tied to U.S. GAAP. Other provisions may subject issuers to the periodic reporting of financial information or contain covenants based upon financial measurements—for example, stated minimum net worth. If IFRS were adopted, these issuers may have to revisit and amend these agreements to implement IFRS as the governing accounting standard.
- Market indices: Some market indices, for example S&P 500, only list issuers that prepare their financial statements in accordance with U.S. GAAP. Converting from U.S. GAAP to IFRS reporting might affect an issuer’s ability to be listed in such indices or included in financial instruments based on those indices, unless the applicable indices and/or financial instruments make appropriate changes in the near future to include issuers that report using IFRS.
- Accounting Systems, Controls and Procedures: Converting to IFRS will require substantial changes to an issuer’s internal financial reporting systems and procedures used to identify, collect, analyze and report financial information and the corresponding changes related to the issuer’s internal policies and internal controls.
- An Issuer’s Method of Investment in Another Company and IPOs: Issuers that hold investments in other entities, which are accounted for under the equity method, under IFRS would need IFRS-based information about the investee for each reporting period. If the investee entity used U.S. GAAP in preparing its own financial statements, it may be costly—or impossible—for the investor to obtain the required IFRS information. In addition, under IFRS accounting, any private company whose financial statements were prepared in accordance with U.S. GAAP, and that was planning an initial public offering, would be required to prepare new financial statements in accordance with IFRS for purposes of its initial registration with the Commission.
In transitioning from U.S. GAAP to IFRS, the Commission would be giving up its institutional familiarity with a standard of accounting that is intrinsic to U.S. financial reporting. IFRS, as a fairly new accounting standard, is not as developed as U.S. GAAP, and its application requires management to exercise significantly more judgment. Further, there is not a deep reservoir of authoritative guidance to assist users in the preparation of their financial statements, and IASB has yet to develop practice guidelines related to certain industries. The Commission’s adoption of IFRS would substantially change the relationship between the U.S. capital markets and the standard-setting process, as the role of FASB will diminish. Unlike FASB, which is the arbiter of accounting standards in the United States, IASB’s membership body includes representatives from different countries, and its organization is expected to be responsive to a broad demographic of market participants. If IFRS is adopted, the involvement of the Commission in the standard-setting process would be significantly reduced and the U.S. capital market would stand to have less input in the development of high-quality accounting standards.
The Commission has posed more than 60 nuanced questions for public comment. These questions are included within the release and all public comments will be made electronically available on the Commission web site. Some of the questions posed include the following:
- Is the timeline proposed reasonable?
- Is it appropriate under the proposed scheme to exclude investment companies and other regulated entities from preparing financial statements for the purposes of Commission filings in accordance with IFRS?
- Should early adoption of IFRS be limited to the largest 20 competitors by market capitalization?
- Should the Commission limit the first filing after transitioning to IFRS to an annual report on a Form 10-K?
- Should there be additional considerations that may pose difficulty for a U.S. issuer to file financial statements prepared in accordance with IFRS?
The Commission has acknowledged that unforeseeable events or trends may require it to revise and/or update the Roadmap. Comments on the proposed rule are due February 19, 2009.