By Robert K. Larson and Donna L. Street
Status of Accounting Convergence
In recent years, the International Accounting Standards Board (IASB) and its IFRS have made great strides toward achieving global accounting convergence. As of January 2005, all EU companies listed on EU exchanges have been required to prepare consolidated accounts based on IFRS. In addition, dozens of non-EU countries, including Australia, Hong Kong, Israel, and New Zealand, are converging their national standards either partially or completely with IFRS. In January 2006, Canada’s Accounting Standards Board ratified a five-year plan to converge Canadian GAAP with IFRS. (Details are available at www.cica.ca/index.cfm/ci_id/29532/la_id/1/print/true.htm.)
In the United States, support for convergence has grown steadily. The 2002 “Norwalk Agreement” between FASB and the IASB (www.fasb.org/intl/convergence_iasb.shtml) formalized the boards’ commitment to convergence. In this agreement, FASB and IASB pledged their best efforts to: “(a) make their existing financial reporting standards fully compatible as soon as is practicable and (b) to coordinate their future work programs to ensure that once achieved, compatibility is maintained.” The boards agreed to prioritize removing a variety of differences between U.S. GAAP and IFRS in both the short term and the long term; to coordinate future work programs; to continue joint projects; and to encourage their interpretative bodies—FASB’s Emerging Issues Task Force (EITF) and the IASB’s International Financial Reporting Interpretations Committee (IFRIC)—to coordinate their activities.
Significant steps have been achieved since the Norwalk Agreement. FASB and the IASB meet on a regular basis, and FASB has issued several standards that eliminate differences with IFRS (i.e., SFASs 151, 153, and 154) and amended one (SFAS 123) to be more in line with IFRS. Exposure drafts proposing the amendment of SFAS 128 and the addition of a fair-value option to U.S. GAAP for certain financial assets and liabilities are also aimed at convergence. FASB and the IASB are also working jointly to develop common standards in several key areas, including business combinations (applying the acquisition method), revenue recognition, liability extinguishment, leasing, and financial performance reporting by business entities. Additionally, a long-term project is underway to develop a common conceptual framework that will incorporate significant improvements. The first draft chapters of the common framework (which define the objective of financial reporting and the qualitative characteristics of decision-useful information) were jointly issued by the two boards during July 2006. Short-term convergence projects are examining earnings per share, income taxes, and research and development. Since April 2005, FASB has included IFRS in its proposed Hierarchy of Generally Accepted Accounting Principles.
The IASB has also modified several of its standards in line with U.S. GAAP, a recent example being an exposure draft issued in January 2006 that proposes aligning IASB segment reporting requirements with SFAS 131 by requiring adoption of the management approach. Given the many changes associated with U.S. GAAP convergence, and in order to allow companies time to translate and implement new IFRS, the IASB decided in July 2006 that no new major IFRS will be effective until January 1, 2009. However, the IASB will continue to work jointly with FASB during this time on the development of new standards in the areas cited above.
The Roadmap in the United States
The April 2005 announcement that top EU and SEC officials agreed on a roadmap toward “equivalence” between IFRS and U.S. GAAP was widely seen as a positive step. In speeches, both EU and SEC officials continue to highlight its importance. Despite the progress, much work remains.
The roadmap is essentially an iterative set of reviews on the convergence process until the SEC staff decides whether and when it can recommend to the SEC that the IFRS–to–U.S. GAAP–reconciliation requirement be eliminated. The target date is officially 2009, or possibly sooner. The roadmap itself is a 25-page document setting forth a series of steps and standards to be met before IFRS will be accepted by the SEC as equivalent to U.S. GAAP for non-U.S. private issuers. Exhibit 1 summarizes Appendix 1 of the roadmap. In February 2006, SEC Chairman Christopher Cox reaffirmed the SEC’s commitment to the roadmap, and in a memorandum of understanding FASB and the IASB reaffirmed their commitment to convergence.
The key points of the roadmap are that FASB and the IASB must continue their convergence efforts and that high-quality standards must remain a cornerstone. During subsequent discussions with FASB and the IASB, the SEC identified key changes it deems necessary before the reconciliation requirement can be eliminated. The SEC has also stressed that the two boards should not focus on converging standards that need significant improvement. Rather, FASB and the IASB should work jointly to develop new reporting requirements in areas where both U.S. GAAP and IFRS require improvement. In a December 5, 2005, speech, SEC Deputy Chief Accountant Julie Erhardt recommended that FASB and the IASB “tackle the toughest, most intractable and problematic standard setting issues.” She specifically highlighted the need for the boards to prioritize financial instruments, performance reporting, revenue recognition, pensions, leases, and consolidation policy.
As part of the roadmap, the SEC will review the faithfulness and consistency of foreign private-issuer IFRS financial statements and their reconciliation to U.S. GAAP from 2005 forward. IFRS statements prepared by EU companies are already being scrutinized. In August 2006, the SEC developed a work plan with the EU’s Committee of European Securities Regulators (CESR) to promote “the high quality and consistent application of IFRS around the world.”
Europe’s Role in Convergence
The roadmap notes the importance of the EU and of European companies in the convergence process. This includes the adoption of IFRS in the EU and how EU companies implement IFRS. European Commission (EC) Regulation 1606/2002 requires all EU-listed companies to prepare consolidated accounts in accordance with “EU-endorsed IFRS” as of January 1, 2005. A major assumption of convergence proponents is that countries will adopt IFRS “as issued by the IASB” (i.e., with no modifications) for all companies. If all EU countries eventually adopt IFRS as their national GAAP, then U.S. corporations with EU-based subsidiaries would not need to prepare financial statements under multiple accounting regimes.
The EU decision to require IFRS for listed companies’ consolidated accounts was a significant event in the drive toward convergence. However, the EU has limited convergence in two important ways—thereby introducing “speed bumps” along the road to convergence.
EU convergence with IFRS beyond listed companies’ consolidated financial statements. The EC did not mandate complete convergence within its member countries. Regulation 1606/2002 allows each of the 25 member countries to determine whether “EU-endorsed IFRS” is required or allowed in preparation of listed companies’ individual financial statements and nonlisted companies’ consolidated or individual financial statements. (In some countries, the individual financial statements, or accounts, may be known as annual, single-entity, or parent-only.) Allowing choices yielded inconsistent IFRS adoption. As of May 2006, eight EU countries require, and 10 more allow, IFRS for listed companies’ individual accounts. Only three EU countries require IFRS for the consolidated statements of nonlisted companies. (An overview of country convergence decisions can be found at europa.eu.int/comm/internal_market/accounting/docs/ias/ias-use-of-options_en.pdf.)
Beyond listed companies’ consolidated accounts, the adoption of IFRS appears less commonly in the first 15 EU member countries than in the 10 new members. Of the first 15 EU states, only Greece, Italy, and Denmark (effective in 2009) require IFRS for the individual accounts of listed companies. None of the 15 requires IFRS for nonlisted companies’ consolidated or individual financial statements. Notably, Italy and Portugal require IFRS for many financial institutions’ consolidated statements, and Germany allows companies to provide individual accounts using IFRS but still requires them to prepare primary statements following national (i.e., German) standards.
The 10 newest EU members are more quickly adopting IFRS. Five new members require IFRS for listed companies’ individual accounts, and two require IFRS for nonlisted companies’ individual accounts. For nonlisted companies’ consolidated accounts, three countries require IFRS, and five more require IFRS for certain financial institutions. Hungary decided to allow companies to use IFRS for individual accounts, but companies must still prepare annual statements according to the Hungarian Accounting Act.
Clearly, a “two-standard” system is emerging in much of the EU, whereby IFRSs are used for listed companies’ consolidated accounts while national standards are required for individual accounts. This likely stems from a desire to maintain the tax orientation (i.e., the alignment between financial reporting standards and tax rules) in several continental European countries. For example, one study (Pat Sucher and Irena Jindrichovska, “Implementing IFRS: A Case Study of the Czech Republic,” Accounting in Europe, Volume 1, 2004) found that many Czech corporate officials were very concerned about taxation and “how the move to IFRS reporting would affect the calculation of company tax.” Indeed, many studies suggest the relationship of tax to financial reporting in EU member states is definitely affecting convergence now and may remain a speed bump for years to come.
A related problem is that some EU members failed to adopt into national law the Accounting Modernization Directive (2003/51/EC). This directive amends the Fourth Company Law Directive (78/660/EEC) on annual accounts and the Seventh Company Law Directive (83/349/EC) on consolidated accounts and was supposed to be implemented by January 1, 2005. The Accounting Modernization Directive brings EU accounting requirements into line with modern accounting theory and practice. In member states that do not require IFRS for all companies, the goal is to move companies toward similar, high-quality reporting. Seven EU members had not incorporated the directive into law by July 2005. In January 2006, Greece and Italy had still not complied, thereby prompting the EC to turn the issue over to the European Court of Justice. The EC stated that this failure “undermines the comparability” of Italian and Greek companies’ accounts with competitors from other countries of the European Economic Area (EEA).
EEA members have responded more positively to convergence. The EEA agreement of 1994 allows Iceland, Liechtenstein, and Norway to participate in the EU single market without full EU membership. Nevertheless, EEA countries must comply with EU accounting regulations and directives. All three EEA members require listed companies to prepare consolidated statements using IFRS. For listed companies’ individual accounts, Iceland will require IFRS beginning in 2007, whereas Norway and Liechtenstein allow, but do not require, the use of IFRS. All EEA countries allow IFRS to be used for the consolidated and individual accounts of nonlisted companies, except in the case of small companies in Iceland. As a result, convergence with IFRS is becoming more of a reality in the EEA countries.
EU-Endorsed IFRS
The EU announcement requiring listed companies to prepare consolidated accounts using IFRS was widely applauded. What many failed to realize, however, was that the EU requires companies to use only those IFRSs the EU has specifically determined to be suitable for use in the EU (i.e., endorsed). Indeed, the EU has established an elaborate endorsement process to determine whether each IASB standard and interpretation will be approved for use in the EU, thereby introducing a second speed bump to convergence.
Most of the attention has focused on the strong disagreement within the EU regarding the recognition and measurement of financial instruments, as detailed in IAS 39. This led the EU to carve out three paragraphs of IAS 39 prior to its endorsement, thereby creating a hybrid EU-endorsed IFRS. This decision not to fully adopt IAS 39 may severely restrict the reality of EU and U.S. convergence via IFRS. In 2004, the SEC warned the EC that watering down the controversial rules in IAS 39 could endanger efforts to achieve convergence between IFRS and U.S. GAAP.
The EU IFRS-Endorsement Process
The EU has established an extensive process for endorsing IFRS for use within the EU. First, the European Financial Reporting Advisory Group (EFRAG) technically assesses each new standard and interpretation approved by the IASB and submits the assessment to the EC. EFRAG is an independent private body whose task is to provide the EC “advice on the technical soundness of new standards.” EFRAG’s members are academics, analysts, auditors, industry representatives, and users. To approve or disapprove an accounting standard, two-thirds of the members of EFRAG’s Technical Expert Group must agree.
In July 2006, the EC created the Standards Advice Review Group (SARG) to review EFRAG’s opinions to ensure their objectivity and proper balance. The EC will appoint up to seven members to SARG. Members will be independent accounting experts and high-level representatives from EU national accounting standards setters. SARG will be expected to deliver its advice within three weeks of EFRAG responses.
The EC then submits a proposed standard to the European Parliament and the Accounting Regulatory Committee (ARC). The ARC is chaired by the EC and composed of representatives of the EU member states. This represents the political aspect of the endorsement process. If a majority of the member states favors a proposed standard, it is approved by the ARC.
After approval by the ARC and the European Parliament, the EC formally decides on the use of new IASB standards and interpretations within the EU. Therefore, the final—and some would say most important—part of the endorsement process requires the EC to adopt new IFRSs and publish them in the Official Journal of the EU. This latter step requires that standards be published in all 20 official EU languages. In the past, the translation of new IFRSs has delayed publication in the Journal.
The World of EU-Endorsed IFRSs
“EU-endorsed IFRS” has enormous implications. On a positive note, the time-consuming process notwithstanding, the EU has eventually endorsed almost all IFRSs put before it. The problems, however, have to do with the two exceptions.
The carve-out of IAS 39 paragraphs 9b, 35, and 81a to yield an EU-endorsed IAS 39 generated considerable controversy. In an April 2005 speech on EU priorities, McCreevy explained, “We had to listen to the major concerns of the users of international accounting standards. Concerns raised by many banks, the European Central Bank, and the world’s leading banking supervisors could not be ignored.” (For further background regarding the IAS 39 controversy, see Kennard S. Brackney and Philip R. Witmer, “The European Union’s Role in International Standards Setting,” The CPA Journal, November 2005.)
While its effects continue to be debated, some believe this particular EU decision damaged the goal of convergence. In an October 2004 Accounting Today interview, IASB Chairman Sir David Tweedie warned that, “[I]f political pressures in a national or regional context are able to overrule standards that have been developed in a deliberate and open manner, then it may lead to a system of ‘beggar thy neighbor,’ which will not provide the consistency and quality of accounting standards that the world’s markets demand.” After much discussion, in 2005 the IASB approved an amendment to eliminate some of the controversial provisions in IAS 39. This move was applauded by many Europeans and was officially approved by the EU in December 2005. Nevertheless, the IASB has no immediate plans to reconsider the hedge accounting provisions that the EU did not adopt.
Another concern is that the carve-out was not an isolated incident. In May 2005, EFRAG officially recommended that the EU not endorse IFRIC 3, Emission Rights. In part, IFRIC 3 required that emission rights for pollutants granted by governments be recognized as intangible assets. Following EFRAG’s response, the EC officially requested that the IASB defer the March 1, 2005, effective date. In late June 2005, the IASB withdrew IFRIC 3. In addition, a number of Europeans raised objections to the IASB’s proposed insurance standard. The EU requirement to examine every IASB rule before endorsing it, even though the standards were previously approved through the IASB’s own elaborate process, raises concern for the goal of convergence between the EU and U.S.
IFRS Versus EU-Endorsed IFRS
EU-endorsed IFRS has created confusion and given rise to many questions. In response, the EC issued guidance in question-and-answer format to explain the current situation with regard to IAS 39 (see europa.eu.int/rapid/pressReleasesAction.do?reference=MEMO/04/265), herein excerpted:
What should a company state in its accounting policies, when it applies the carved-out version of IAS 39? Does the company have to refer to IFRS or to IFRS as adopted by the European Commission? Companies that apply the carved-out version of IAS 39 should refer in their accounting policies to IFRS “as adopted by the EU.” Companies should accordingly explain their accounting policies in their financial statements … .
In November 2005, the EU’s ARC confirmed the following wording for use in financial statements and audit reports: “in accordance with International Financial Reporting Standards as adopted by the EU.” The plural “IFRSs” emphasizes that IASB standards will continue to be endorsed one by one rather than as a package.
The EU approach may violate IAS 1, which specifies that IFRS should be used in its entirety and not implemented only partially. A major criticism in the late 1990s was that many companies were adopting only those international standards that benefited them. What, then, about EU companies that want to adhere to the spirit of IAS 1 and desire to implement all IFRSs?
Will companies have to prepare two sets of accounts, one applying the full set of IAS for stock exchange purposes, one with “European IAS”?
They are not required to do so. However, it is up to each company to choose whether it wishes to issue another set of accounts as well as accounts based upon endorsed IAS, for instance using full IAS or US GAAP. However, since the carve-outs are a temporary solution, the Commission would not recommend this course of action.
In effect, the answer allows companies to choose whether to provide the public with both “IASB-approved IFRS” and “EU-endorsed IFRS.” However, what a company may or must do becomes even more confusing upon reading another question and answer:
Can Member States either permit or require companies to apply the full version of IAS 39 in respect of the hedge accounting carve-out?
Yes … Since the EU Accounting Directives do not contain provisions on hedge accounting, Member States may therefore require companies to comply fully with the hedge accounting provisions of IAS 39, including those that have been carved out … Member States may only act in this way as long as the Commission has not adopted a revised standard covering these issues or has not explicitly rejected its adoption on the basis of the criteria in Article 3(2) of the IAS Regulation such as going against “the true and fair view principle”… .
This answer further confuses the situation because it essentially allows each EU country to dictate how listed companies account for hedges in consolidated statements. EU member states may thus require compliance with the IAS 39 paragraphs that the EU declined to endorse. This could represent a step backward for EU convergence with IFRS. The answer also raises an issue regarding the roadmap. In the eventuality that companies using IFRS do not need to reconcile to U.S. GAAP, the SEC may determine that “EU-endorsed IFRS” is not the same as IFRS. In such a scenario, EU companies electing to use the carved-out, EU-endorsed version of IAS 39 would presumably not be exempt from the reconciliation requirement.
Another question is whether companies can use IFRSs not yet endorsed by the EU. At a November 2005 meeting, the ARC stated that IFRSs endorsed by the EU after the balance-sheet date but before the date the financial statements are signed can be used (but are not required). While aimed at speeding up convergence, this decision means that, at any point in time, EU companies might be applying different definitions of “in accordance with IFRSs as adopted by the EU.”
To address such concerns, the Fédération des Experts Comptables Européens (FEE) released a discussion paper in April 2005 (see www.fee.be). Given the controversy, McCreevy has responded in an effort to provide some reassurance by stating that “the carve-out has not affected the Commission’s determination to have globally accepted standards.”
Bumpy Road Ahead?
All EU countries now effectively require listed companies to prepare consolidated statements in accordance with IFRS. Most EU members, however, do not require IFRS for either the individual accounts of listed companies or the accounts of nonlisted companies. Hence, a two-standard system is developing in the EU. If the problem reflects a continuation of the strong linkage between tax and financial reporting as suggested by GAAP Convergence 2002 and others, this represents a major speed bump to convergence, and one that will be difficult to overcome.
The carve-out of IAS 39 led to a set of EU-endorsed IFRS that differs in some respects from IASB-approved IFRSs. While many anticipated a time lag between the IASB issuing standards and the EU endorsing them, few believed the endorsement process would evolve into a major barrier to true convergence. EFRAG also rejected IFRIC 3 because of how the interpretation would affect EU businesses. As noted, the IASB withdrew IFRIC 3 soon thereafter.
A further cause for concern arises from comments made in recent speeches by McCreevy. He has cautioned that the “convergence exercise” is a two-way street and must not be allowed to destabilize the IFRS platform in Europe. At a seminar hosted by FEE on December 1, 2005, McCreevy stressed that convergence is not an invitation to standards setters to try and advance the “theoretical frontiers” of accounting. He stated, “I will not take on board any revolutionary new standards. … We will not be adding new carriages to the IFRS train, just as it has left the station” (emphasis in transcript). McCreevy’s statements may be viewed as a challenge to FASB and the IASB as they consider addressing “the toughest, most intractable and problematic standard setting issues”—that is, financial instruments, performance reporting, revenue recognition, pensions, leases, and consolidation policy—targeted by the SEC as primary candidates for change.
On a brighter note, the SEC roadmap represents a positive step and encourages convergence and the ultimate elimination of the 20-F reconciliation requirement for foreign issuers using IFRS. Many EU countries now allow U.S. companies to file their subsidiaries’ financial reports using IFRS. Indeed, global convergence has many U.S. supporters. In June 20, 2005, U.S. President George W. Bush issued a statement “promoting convergence of accounting standards as soon as possible.” While the road ahead includes speed bumps, the drive for convergence continues.
Click here to view Exhibit 2.
Robert K. Larson, PhD, CMA, CPA, is an associate professor, and Donna L. Street, PhD, MAcc, is a professor and the Mahrt Chair in Accounting; both are in the school of business administration at the University of Dayton, Dayton, Ohio.
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