Major sources of investment capital have long favored greater harmony and transparency in global accounting standards (Ohlgart & Ernst, 2011). While world accounting standards in the modern sense originated in the US, a divergence has occurred between GAAP criteria and the prevailing international accounting standards, currently represented by IFRS criteria. The latter are now in official use in 120 nations (Tyson, 2011, p. 27). In October 2002, FASB and IASB formalized the Norwalk Agreement, to converge in their accounting rules over time (Charron & Moores, 2011; Tyson, 2011). Since then, both the major accounting associations and government regulators have moved toward convergence in accounting practices. In light of this development, this paper will look at whether to recommend that the SEC maintain GAAP criteria for firms that report in the US or move to IFRS criteria, especially concerning the issue of intangible assets.
After the Enron and WorldCom accounting fiascos, which “culminated in huge financial losses and decimated capital markets worldwide,” there has been vociferous pressure, especially from European firms and auditing agencies, for the US to join the growing world community of accounting practice by moving away from GAAP and toward IFRS criteria (Tyson, 2011, p. 25). This assumes that globally standardized criteria would have improved transparency in financial reporting at Enron and WorldCom, raising awareness of irregularities earlier. Thus, some have argued that IFRS standards, which rely on principles more than rules, foment more professional judgment, which creates transparency (Tyson, 2011, p. 30). Admittedly, GAAP criteria are better at industry-specific detail, but there have also been arguments that they may encourage “financial engineering” (Tyson, 2011, p. 27). Nevertheless, credible academic sources find no evidence that IFRS standards are superior to GAAP criteria (Tyson, 2011, p. 30).
Henry, Lin, and Yang (2007) reported that intangible assets, including both goodwill and development costs (e.g., in research and development) play a central role in determining critical measures of value for “reconciling items for both net income and shareholders’ equity” (p. 710). Because the difference between GAAP and IFRS concern intangible assets more than any other area, especially in cases of mergers and acquisitions, this concern lies at the crux of the question of whether the US should move toward the IFRS model.
Goodwill refers to the intangible benefit that comes from a company’s acquiring another firm at a cost that is less than its current fair-market price (Charron & Moores, 2011). The key difference between GAAP and IFRS in measuring goodwill concerns how acquirers allocate this intangible value by unit in their own accounting structures. Under GAAP criteria, “the acquirer assigns goodwill to the various reporting units of the combined entity,” but under IFRS criteria, “goodwill is assigned to the various cash-generating units” (Charron & Moores, 2011, p. 50). In fact, Henry, Lin, and Yang (2007) found that the largest differences between IFRS and GAAP in calculating shareholder equity related to goodwill. Moreover, between 2004 and 2006, pensions and goodwill have dominated disparities between GAAP and IFRS accounting, despite evidence of convergence over time (Henry, Lin, & Yang, 2009).Shareholders’ equity under IFRS is lower than that reported under GAAP criteria, in most cases.
Because the definition of control differs between GAAP and IFRS, some events qualify as mergers and acquisitions in one system but fall short of that definition in the other (Charron & Moores, 2011). GAAP looks for a mathematical majority of shares to define having a controlling financial interest. In contrast, the IFRS looks at effective control, defining control as the “power to govern the financial and operating policies of an entity to obtain benefits from its activities” (Charron & Moores, 2011, p. 48). This requires judgment. To discern this, analysts must judge whether interested shareholders can appoint executives, dissolve a business unit, appoints board members, exercise special voting rights, or alter bylaws (Charron & Moores, 2011).
The principle of convergence, as one of multiple paths to US adoption of IFRS criteria, involves first cooperatively adjusting GAAP and IFRS criteria, and then permitting US firms to adopt IFRS practices at a point at which the latter “would be adopting IFRS almost automatically or be very close” (Ohlgart & Ernst, 2011, p. 41). The advantages of convergence include making US-based sources of capital funding more competitive in capital global markets, lower expected costs of capital overall, greater financial-reporting efficiency for US-based multinational sources of capital and auditing firms, and more transparency for investors (Tyson, 2011). Henry, Lin, and Yang (2007) noted that “the greater confidence in financial reporting” from harmonizing global accounting reporting standards “translates into a lower cost of capital” (p. 710). The pursuit of convergence between GAAP and IFRS criteria is also likely to encourage more repatriation of foreign earnings by US corporations (Epstein & Macy, 2011).
Ohlgart and Ernst (2011) predicted that the SEC would permit a minimum of five years for US corporations to make the transition to IFRS criteria, assuming that it ultimately adopts the convergence plan. For some companies, however, the main disadvantages of convergence have to do with the time necessary to make the transition, rather than any permanent loss of financial advantage. Nevertheless, many firms will also have to adapt to new reporting systems after years of developing internal ERPs that will be vexing to rework. As Ohlgart and Ernst (2011) noted, many firms’ accounting ERPs “are a conglomeration of disparate systems pieced together over the years that will either not support a massive change,” even if such a change promises to afford substantial efficiencies at some point in the future (p. 43).
Nevertheless, two-thirds of Fortune 1000 firms already favor eventually full convergence (Tyson, 2011, p. 30). While international organizations and major audit firms support proceeding with the transition to IFRS in the United States, industrial interests are far more reticent (Tyson, 2011). Most cautious are the aerospace, financial-services, and public-utilities sectors (Tyson, 2011), which have come out strongly in favor of convergence as the optimal path to adoption, with sufficient time for GAAP criteria to align with IFRS standards. Major multinational firms headquartered in the US have voiced similar concerns to those of the foregoing industry sectors. Lastly, US-based trade associations and large investment firms have come out in agreement with US-based industrial interests.
In consideration of the effect on the cost of capital and more generally the benefits of having a more transparent international-accounting system, the only reasonable recommendation is to follow the advice of the foregoing US-based industrial interests. However, given that the IFRS criteria are actually the eventual offspring of accounting standards first formed in the US, a better solution is a policy of condorsement (Ohlgart & Ernst, 2011, p. 42). This is a combination of convergence and the additional qualification that the FASB exercise oversight over residual changes that need to occur in both GAAP and IFRS criteria. In this way, the product may be an optimal combination of rules-based criteria and principles-based criteria, which may thus permit greater objectivity and lesser subjectivity in the accounting rules that currently prevail in IFRS criteria alone. This way, there may be an opportunity to resolve the ambiguities associated with some IFRS criteria, while otherwise pursuing a semblance of convergence in the end.