THIS WAY PLEASE
Private companies point the way to IFRS adoption.
By Nadira M. Saafir, CPA and Barry Jay Epstein, Ph.D./CPA
In recent years, the IASB (International Accounting Standards Board) and the FASB (Financial Accounting Standards Board) have made strides towards eliminating, or at least minimizing, remaining differences between International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (GAAP). While there are only a handful of significant distinctions between them, neither can truly be said to offer a clearly “simplified” financial reporting alternative.
The unstoppable trend has been towards worldwide adoption of IFRS, now mandated in over 100 nations and permitted or encouraged in many others. By 2011, it’s predicted that there will be 150 national adopters.
Three developments make the continuation—and even acceleration—of this trend likely. First is the SEC’s landmark decision to allow foreign private issuers to file fully compliant IFRS-based financial statements without the previously required reconciliations to US GAAP. Second is the SEC’s subsequent decision to permit and, perhaps, require all domestic issuers to file under IFRS. And third is the AICPA’s May 2008 action to recognize IFRS as a legitimate basis for US financial reporting.
Notwithstanding these favorable developments, the appeal of IFRS adoption among domestic companies may be dampened by the fact that its application isn’t necessarily less onerous than that of US GAAP—even discounting the inevitable learning curve and conversion costs of IFRS adoption. This, however, may soon change.
US-based private companies have tilted the playing field in favor of IFRS adoption, thanks to the July 2009 AICPA publication of IFRS for Small and Medium-Sized Entities (IFRS for SMEs).
Coupled with the AICPA governing council’s recognition of the IASB as an international accounting standard-setter, this abbreviated financial reporting rule book is expected to have great appeal. (IFRS for SMEs has only 230 pages versus approximately 2,500 pages of full IFRS and 25,000 pages of US GAAP guidance.)
US private companies and not-for-profit organizations now have the option of employing either full IFRS or IFRS for SMEs when preparing their general-purpose financial statements. This potentially places smaller entities in the vanguard of US businesses abandoning US GAAP for IFRS, providing the impetus for public companies—which were expected to be the first to adopt—to then follow suit.
IFRS for SMEs was developed to provide a simplified, self-contained set of accounting principles derived from the full IFRS, but with a reduced range of acceptable alternative accounting methods and less onerous disclosure requirements. It is intended for entities that don’t have public accountability; namely those entities that fail to meet either of two conditions: Having issued debt or equity securities in a public market, or holding assets in a fiduciary capacity for a broad group of outsiders as their primary purpose of business. This means that banks, insurance companies, securities broker/dealers, pension funds, mutual funds and investment banks, as well as publicly traded companies, cannot employ IFRS for SMEs. Although created with a focus on the needs of a typical mid-sized company, IFRS for SMEs may be used by a nonpublicly accountable entity of any size.
There are many reasons why a US private company or not-forprofit might prefer IFRS and, in particular, IFRS for SMEs over US GAAP. For one, the enterprise might be owned by a foreign parent, be a supplier to foreign companies, or have a foreign investor, which means it is involved in international commerce.
What’s more, as business activities become ever more global, it’s increasingly important for smaller, private entities to have a cost-effective and efficient means of facilitating cross-border business development, including capital flows. Using IFRS for SMEs may enable companies to present financial statements comparable to those of foreign companies that are competing for the same customers, vendors and capital. Electing IFRS for SMEs would reduce the volume of disclosures versus full IFRS or US GAAP.
Perhaps the paramount consideration, however, is that IFRS for SMEs offers a significantly simplified financial statement preparation process. Features include:
Accounting for investments in financial assets, a particularly complicated area, has fewer categories and therefore fewer specific accounting requirements under IFRS for SMEs. It allows only for accounting at fair value through profit or loss and amortized cost. There is no available-for-sale classification, and therefore no option to display unrealized gains or losses directly in equity, which many users find ambiguous and confusing
Intangible assets and goodwill are to be amortized over their useful lives, unless reliable estimates of useful lives cannot be determined, in which case an arbitrary period of 10 years is prescribed. By contrast, indefinite-lived intangibles and goodwill are not amortized under US GAAP, making it necessary to use cumbersome annual impairment testing. Under IFRS for SMEs, impairment testing is only performed when certain indicators are present.
There is no requirement to account for embedded derivatives separately from the host contract. Accounting for compound financial instruments, including derivatives, has been challenging for preparers, auditors and users alike, often resisting obvious explanations.
Under the IFRS for SMEs standard, the impairment of a financial instrument measured at amortized cost is defined by the difference between the asset’s carrying amount and the present value of estimated cash flows, with required reversal in future periods if the impairment is ameliorated. US GAAP pre scribes several different impairment models for instruments measured at amortized cost, depending on whether they are classified as loans held for investment, held-to-maturity securities, or available-for-sale securities.
IFRS for SMEs offers simplified revenue recognition criteria. For example, it has limited industry specific guidance, unlike US GAAP, which has specific guidance related to software revenue recognition, sales of real estate, and many other types of transaction. Also, detailed prescriptive guidance on the separation and allocation consideration in multiple-element arrangements is not included in IFRS for SMEs, in contrast to US GAAP.
For financial assets and liabilities measured at fair value, the entity applying IFRS for SMEs must disclose only the basis for determining fair value, the carrying amount of each category of financial assets and liabilities, and information that enables financial statement users to evaluate the significance of financial instruments for their financial positions and performances. US GAAP, on the other hand, requires numerous quantitative and qualitative disclosures regarding the fair value of financial assets and liabilities, including a comprehensive analysis of the inputs used to determine fair value, as well as their classification into a three-level hierarchy.
Not only does IFRS for SMEs imply a more cost-effective and efficient alternative to US GAAP—and to the full IFRS—but it also promises the preparer relative stability compared to other GAAP. The IASB plans to update the SME standard approximately every three years, which means users will have a moderately stable platform of requirements to stand on. New IFRS and US GAAP rules are issued irregularly but often, typically with many new pronouncements each year.
While the benefits of converting to IFRS for SMEs are apparently many, qualifying US companies should cautiously evaluate the conversion’s impact. In particular, consider:
The financial statement users’ willingness to accept financial statements prepared in accordance with IFRS for SMEs.
The availability of information needed for conversion, as well as the best timing for the conversion.
The conversion’s impact on any subsidiary or parent company. For example, if the parent company is a public entity whose financial statements are based on full IFRS or US GAAP, then the parent would have to convert the subsidiary’s results from IFRS for SMEs to full IFRS or US GAAP for consolidation purposes.
The cost and time needed to make the conversion.
The conversion’s impact on some categories, such as fixed assets. For instance, smaller private companies and not-forprofits don’t always maintain the best records. IFRS requires component-level fixed asset depreciation, and this level of detail may not have been maintained under earlier standards.
How the conversion will affect the entity’s reporting systems and controls.
The availability of outside professionals (such as auditors) who can assist in the transition and have the knowledge and expertise necessary to provide ongoing service.
If, as seems quite possible, private businesses and other entities do find IFRS for SMEs an attractive financial reporting alternative, these entities may well lead US adoption of IFRS, with broad implications for expansion of trade and reduced barriers for crossborder capital flows. This could propel a rising economic tide that would indeed raise all business boats, and reinforce the already widely accepted fact that small businesses do serve as the essential engines for domestic fiscal growth.
Nadira M. Saafir, CPA is a member of the IFRS consulting team at Russell Novak & Company LLP [rnco.com]. ICPAS member Barry Jay Epstein, Ph.D./CPA is a partner at Russell Novak & Company LLP, and co-author of Wiley IFRS 2010 and Wiley IFRS for SMEs. He is a consulting expert on GAAP, auditing standards and financial reporting matters.