Potential Effects of the Move from US GAAP to IFRS
US companies have used a set of “generally accepted accounting principles” — called US GAAP — to determine their earnings and value their assets for the past 75 years. Many companies outside the US use a different set of global standards called the international financial reporting standards, or IFRS. The United States may be moving to adopt these global standards.
Sherif Sakr, a partner in the New York office of Deloitte, spoke to Chadbourne lawyers on a video conference call in late September about what the shift in accounting methods means for US companies and for project finance and corporate transactions. Mr. Sakr worked with Deloitte in Europe and the Middle East before moving to New York. His areas of expertise include financial instruments, structured transactions, fair value measurements and IFRS. He received an award from President Bush in 2007 for working with the US Agency for International Development on training local standard setters, exchange commissioners and central bankers in developing countries about IFRS. The Chadbourne lawyers asking questions are Keith Martin in Washington, Charles Hord, Edouard Markson and George Zeitlin in New York, Irina Skidan in St. Petersburg, Anthony Girolami in Mexico City and Noam Ayali in Washington.
MR. MARTIN: What is IFRS and how does it differ from US GAAP?
MR. SAKR: The international financial reporting standards are standards issued by the International Accounting Standards Board in London. The board was established in 2001 to replace a predecessor committee called the International Accounting Standards Committee that was established in 1973. IFRS is the equivalent of GAAP here in the United States, but international standards differ from GAAP. US GAAP generally tends to be more form driven or rules based. IFRS relies more on concepts and broad principles. It generally focuses more on the underlying substance of the transaction than on its legal form.
IFRS really started gaining momentum in 2002 when the European Union required the use of IFRS by all European-listed companies. More than 7,000 companies went through a transition to IFRS between 2003 and 2005. Today, more than 100 countries use IFRS, and we are now thinking about moving to IFRS in the United States.
MR. MARTIN: So there is more room for argument about how to account for transactions under IFRS than under US GAAP because lines are not drawn as clearly under IFRS as under GAAP.
MR. SAKR: Generally, that is correct.
MR. MARTIN: The US Securities and Exchange Commission indicated in August that it intends to move the US to IFRS. What is the timetable?
MR. SAKR: The current timetable provides an option for early adoption by certain companies as early as fiscal years starting after December 15, 2009. There is a roadmap to be released and there are certain milestones that need to be met before all public companies are required to move to IFRS. Large accelerated filers will be expected to move by fiscal years ending on or after December 15, 2014, accelerated filers by fiscal years ending on or after December 15, 2015 and non-accelerated filers by fiscal years ending on or after December 15, 2016.
MR. MARTIN: What does “accelerated filer” mean?
MR. SAKR: An accelerated filer is basically a company with a global market capitalization of between $75 and $700 million, as further defined by SEC Rule 12b-2. Accelerated filers must file their periodic reports with the SEC faster than smaller public companies have to file.
Let me spend a minute talking about which entities qualify for early adoption. The SEC wants to implement IFRS on a limited scale initially to see how it will fit in our existing environment. The SEC decided to provide for early adoption as early as next year for US companies that are among the 20 largest companies globally in their industries based on market capitalization, but only if IFRS is used more often than any other method of accounting by those 20 companies. These are generally multinational corporations. Examples are pharmaceutical and manufacturing companies and large financial institutions.
MR. MARTIN: So those early adopters are companies that may switch as early as next year if they choose. Can others switch before 2014?
MR. SAKR: Only if certain milestones are met. The window period of 2014 through 2016 for conversion of all US public companies is contingent on certain milestones being met. There are basically four such milestones. One is the International Accounting Standards Board in London must obtain sustainable financing. The IASB is funded currently through contributions from corporations and “big four” accounting firms. The second milestone is improvements to IFRS. That is ongoing. The third milestone is improvement in the ability to use interactive data for IFRS reporting. The SEC has adopted a new filing system called XBRL that replaces the current Edgar system. The last milestone is companies need to have been educated about what IFRS requires. The process of educating everyone is already underway. This session is an example. Universities will start to include IFRS in their curricula within the next year or so. The CPA exam will include IFRS questions within the next two years.
MR. MARTIN: Help me understand something. If a European utility owns a subsidiary in the US — let’s say it owns a US utility — would that US utility already be reporting on IFRS?
MR. SAKR: Not necessarily. The US utility probably has to turn in accounts to its regulators using US GAAP, but it probably also has internal IFRS reporting to file with the parent in Europe. It is a good example of how the US move to IFRS would make things easier for companies that are part of groups operating in more than one country.
MR. MARTIN: So the largest impact of the switch is on companies that are purely domestic concerns. They will have the most work to do to change.
MR. SAKR: That is probably a fair characterization. I would agree with that.
MR. MARTIN: What transition issues does the switch create?
MR. SAKR: There are a lot of transition issues. Companies will basically be changing how they calculate income and loss and other items on their balance sheets and income statements in more than one area. The shift in accounting systems will require some reprogramming of systems that collect data for preparing financial reports. Different data may have to be collected. Data that is already collected may have to be analyzed differently. This may lead, in turn, to organizational changes within and beyond corporate accounting departments.
Stock-based compensation plans may be affected and could have to be restructured. The change to IFRS is a very broad exercise that will touch upon every group or department within an organization.
MR. MARTIN: One change is that many companies in the US use something called last-in-first-out accounting. Companies that use this method tend to be in industries where costs increase over time. There is an advantage in such industries to treat the last goods added to inventory as the first ones sold. LIFO cannot be used under IFRS. These companies will have to switch to treating the first goods in as the first ones sold. That will tend to reduce their earnings in the future, correct? That’s the first question. The second question is which industries are big users of LIFO?
MR. SAKR: LIFO is common among manufacturers and retailers.
MR. MARTIN: If a company switches from LIFO to FIFO, would you expect its earnings to go up or down?
MR. SAKR: It depends on the direction in prices of the particular inventory item. If the company is acquiring inventory at escalating prices, and the most recently-acquired inventory is considered sold first, then you would expect to see a higher cost associated with that from a cost-of-goods sold perspective versus what would occur if the trend was for falling costs-of-goods sold. I don’t think one can make a simple statement about how the change will affect earnings. The most one can say is the change will definitely have an impact, and that impact is broader than just the accounting impact and the result on earnings.
MR. MARTIN: According to news reports, IFRS will allow US companies to report roughly 20% more income. Is this true across sectors or does the impact vary by sector? And I should tell you most of the lawyers in our project finance group work with power companies, so we are keenly interested in the potential effects on them.
MR. SAKR: I have seen the same news reports, but don’t see any support for the numbers. We have been discussing IFRS with many clients across multiple industries. We are trying to look at their competitors in Europe who have been through the conversion to see the impact of the transition from local GAAP — whether it was UK, French, German, whatever it was — to IFRS and try to gauge how earnings changed. I don’t think the effect was always in one direction.
Differences in rules between US GAAP and IFRS will have disparate effects on companies. Reversal of impairment charges is an example of something that is permitted under IFRS. Therefore, if a company must report an impairment charge and the asset later appreciates in value, the company can generally reverse the earlier impairment loss and report a gain. This is not the case under US GAAP.
Effect on Transactions
MR. MARTIN: What should someone working on acquiring a US company do differently, if anything, in the deal documents given the expectation the US will be switching to IFRS?
MR. SAKR: At least one thing comes to mind immediately. There is often a reference in the legal document to US GAAP-based financial statements. Such references will need to change. To the extent there is an earnout or other form of purchase price to be paid over time tied to earnings, that may also be affected. One of the major differences from a deal perspective between US GAAP and IFRS used to be in the accounting for business combinations. However, the standards have become fairly well aligned. The Financial Accounting Standards Board in the US issued FAS 141-R on business combinations. The IASB issued IFRS 3-R. The differences there are minor.
MR. MARTIN: What, if anything, should be done differently in corporate or project finance loan transactions? These are long-term borrowings or initial public offerings of stock.
MR. SAKR: Depending on which company you are talking about, the change to IFRS could potentially be as early as next year or as distant as eight years from today. You must first determine the time frame of the agreement to assess the potential relevance of IFRS.
The conversion to IFRS may have to be considered in setting debt coverage ratios. The numbers may look different after the conversion. A drop in debt coverage could trigger cash traps, cash sweeps or defaults. That possibility should be considered in drafting the loan agreement.
MR. MARTIN: What should be done differently, if anything, in risk factor disclosures in SEC filings?
MR. SAKR: Risk disclosures are another interesting area. The SEC requires disclosures in securities filing, but these are a matter of SEC rules. There is no US accounting rule requiring detailed risk disclosures in the notes to financial statements. However, IFRS requires detailed risk disclosures in financial statements. The required disclosures are described in IFRS 7. It focuses mainly on disclosures or risks related to financial instruments and provides a framework for quantitative disclosures relating to market risk, liquidity risk and credit risk and what steps the company has taken to manage the risks.
There will be a big shift. US companies will be required to make the same types of risk disclosures they make in the management discussions and analysis section of SEC filings and even provide more details in footnotes to the financial statements once IFRS is adopted.
Another point to emphasize here is that because IFRS generally focuses on the risks and rewards or substance of a transaction over its legal form, in many cases, you will see expanded disclosures supporting the company’s accounting conclusions about complicated transactions that are not black and white. There are definitely more extended disclosures under IFRS than what you see under US GAAP.
MR. MARTIN: Is there a risk disclosure that is required just to put investors on notice that the change in accounting methods may have an effect on earnings?
MR. SAKR: Absolutely. Companies must disclose anticipated significant changes in accounting policies. Also, when a company first switches to reporting under IFRS, it must reconcile its equity and net income with the amounts that would have been reported under US GAAP. The company must also explain the adjustments it made to get to the new figures under IFRS.
MR. MARTIN: I have just a couple more questions briefly and then I will turn it over to others who may have questions. This change in accounting method only applies to public companies. Is that correct?
MR. SAKR: It only applies to public companies at this point, yes.
MR. MARTIN: And what do private companies do typically? Do they prepare US GAAP statements today? Would you expect them to switch?
MR. SAKR: I think it depends. There will definitely be an evaluation of the cost and benefit. Any move to IFRS will be a major exercise that will have relatively significant costs. If the company is planning to do an initial public offering some day, it will have to switch to IFRS as a practical matter. If the company is being acquired or is targeting another company, its new parent or the target may be on IFRS.
MR. HORD: Will the change to IFRS affect the SEC’s XBRL process? I gather that the taglines for US GAAP are likely to be different from the taglines for IFRS.
MR. SAKR: The SEC is emphasizing the need to be able to expand the use of XBRL. One of the milestones that must be met before the SEC will implement full adoption of IFRS by US public companies is the need to make sure the new XBRL system can work with IFRS reporting.
MR. MARTIN: Charlie Hord, please explain what XBRL is for anyone who is unfamiliar with it.
MR. HORD: It is a new SEC initiative that essentially tags line items in financial statements and ultimately footnotes to financial statements, so that they can be accessed and analyzed in a variety of software programs. For example, if you wanted to compare the compensation of the chief financial officers of Microsoft, Google, GM, and any other public company, you could literally just type that into the SEC website, push a button, and it would produce a table or anything else you wanted by pulling the tagged financial information and making it readily comparable.
It means that there has to be greater comparability, among other things, in the line items and the entries in the financial statements, and that’s part of what IFRS does.
MR. MARKSON: How do you expect the change in the national accounting standard would affect taxes?
MR. SAKR: Any changes in the composition and the values of the assets and liabilities of a company — and let’s stay with US GAAP for a second without even moving to a different standard — could have potential tax implications from a deferred tax perspective, or even from an income tax perspective, based on the net income of the company.
Another potential effect is structured finance transactions that were tax driven may no longer achieve the same outcome after the accounting treatment changes or new forms of transactions may become possible. For example, a special-purpose entity used in a transaction might not have been consolidated under US GAAP but would have to be consolidated under IFRS. One of the goals of the transaction was to keep the transaction off balance sheet for certain accounting and tax reasons. The transaction may no longer work under IFRS.
MR. ZEITLIN: Unless the US tax laws change, it is hard to see how the switch from GAAP to IFRS will have any affect on the taxes US companies must pay, with the exception that if LIFO is eliminated as a method for determining book earnings, then companies will not be able to use it for taxes either, since use for book purposes is a prerequisite for using it for taxes.
MR. SAKR: I agree with you. The potential impact is on how transactions with tax consequences are structured. In some cases, a company may not be able to recognize the benefits from the transaction on its books.
Another potential impact is on companies with tax exposure in multiple countries. Take, for example, a company, headquartered in the US that has subsidiaries in other countries. In many cases, the tax reporting in overseas jurisdictions is based on the financial reports that the company files. As an example, if you change the statutory reporting from French GAAP to IFRS, now you have a different tax impact because you used to pay taxes based on your statutory French GAAP report and today you are filing your taxes based on the IFRS statutory report, and the numbers could be vastly different.
MS. SKIDAN: In view of the fact that the SEC is moving to an IFRS standard, do you expect that this will have any impact on private placements or so-called 144A offerings in terms of the types of financial information that must be included in offering memoranda?
MR. SAKR: That’s a very interesting question, and I don’t think there is a definitive answer to it yet. The SEC is expected to issue the IFRS roadmap laying out its current thinking about IFRS and how it will affect different areas, not just the financial reporting environment. Hopefully you will see some discussion around that in the roadmap.
MR. GIROLAMI: Can you comment about the implementation of IFRS in Latin America, particularly in Mexico, Brazil, Argentina, Chile?
MR. SAKR: There is a global shift to IFRS. Probably the two major capital markets that currently prohibit the use of IFRS for their domestic filers are the US and Japan.
So go to Latin America. Chile is converting to IFRS by 2009. Brazil is converting by 2010. Mexico has formalized a plan and is working to change national accounting standards to comply with IFRS.
MR. AYALI: What special issues does the conversion to IFRS raise for public companies that must comply with Sarbanes-Oxley?
MR. SAKR: That’s definitely an interesting question, and companies need to think about the conversion more broadly than as a mere accounting exercise. Companies will have to make sure that any new controls and accounting procedures put in place during the conversion still comply with Sarbanes-Oxley. Also, documentation will need to be updated and processes must be put in place to mitigate new risks.
When the European Union moved from local GAAP to IFRS between 2003 and 2005, some companies may have underestimated the level of effort that conversion would require. Some started too late to work through the issues and ended up having to do certain adjustments manually because the accounting and data systems were not reprogrammed to collect or report data in the needed form. Some were thinking they could continue to track everything under local GAAP and basically do a top-level adjustment to reconcile to the new IFRS standards. That led to more use of Excel spreadsheets which is not a good controlled environment from a Sarbanes-Oxley standpoint.Depending on the size of the company, it can take from one or two years up to five years to convert to IFRS. It is a massive exercise that will require careful planning and a well-managed process. It will probably require more effort than what was required to comply with Sarbanes-Oxley.