THE ECONOMIC IMPACT OF IFRS---A FINANCIAL
ANALYSIS PERSPECTIVE
Sharon S. Seay, University of West Georgia
For almost 40 years, a movement has existed to establish one set of global accounting standards to facilitate international trade and investment. Foreign companies of ten list their stock on the NYSE. One common set of accounting standards would promote greater understandability of international financial reports as well as increase transparence and comparability on a global scale, facilitating capital flow. On November 14, 2008 the SEC released a proposed road map toward IFRS (International Financial Reporting Standards) Convergence. The mandated implementation date for large publicly traded companies is 2015. The purpose of this paper is to examine key reporting differences between IFRS and U.S.GAAP as reflected in a reporting entity’s financial rations---key performance metrics used by analysts and other users. Differences in key metrics measuring liquidity, profitability, efficiency, and solvency are examined. Implications of IFRS’ elimination of LIFO inventory model are also explored. Finally, the paper discusses IFRS vs. GAAP valuation models, financial statement presentation, and disclosure requirements
INTRODUCTION
In 2000, the SEC issued a concept release on international accounting standards, soliciting comments. FASB and the International Accounting Standards Board (IASB) initiated a convergence process in 2002. Since that time, the United States has been on a journey toward the adoption of International Financial Reporting Standards (IFRS). The shared objective of FASB and IASB has been the development of common, high-quality accounting standards with the ultimate goal of a single set of global accounting standards. In November 2008, the SEC issued a proposed road map to IFRS convergence. Subsequent opposition to the perceived too-rapid adoption of IRFS has been significant. Another recent milestone in the journey toward convergence was reached in 2010 with the issuance of the “SEC Statement in support of Convergence and Global Accounting,” providing an update and ongoing support for the convergence of U.S.GAAP and IFRS. The Sec permits foreign companies who list on U.S. exchanges to use IFRS in lieu of conversion to U.S.GAAP.
To date, approximately 120 countries have adopted IFRS as their home country standard. The SEC’s convergence approach is “improve and adopt.” IFRS incorporates a principles-based approach to standard setting vs the rules-driven regime under U.S.GAAP. The Sarbanes-Oxley Act (SOX) of 2002 called for an SEC study addressing the need to adopt a principles-based approach to standard setting to replace U.S.GAAP’s rule-based system defined by bright-line rules to establish acceptable. The SEC study noted that weaknesses/imperfections exist when standards are promulgated on either a rules or principles only basis. The SEC expressed concern that principles-based standards provide little guidance or structure on implementation.
Rules-based standards applying bright-line tests often enable company financial engineers to structure a transaction to achieve technical compliance with a standard while evading the standard’s intent and thus, contributing to a lack of comparability among firms’ financial statements. The SEC study [SEC 2008] recommends standard development on an objectives-oriented basis
LITERATURE REVIEW
In 2005, IFRS replaced U.S.GAAP as the single most widely use accounting standard in the world. Proponents of IFRS argue that it has become the “gold standard” for financial reporting in global financial markets, and that its widespread adoption places U.S.GAAP users at a competitive disadvantage in attracting foreign capital [Bloomberg and Schumer, 2007; SEC 2008]. Prior research has examined the effects of IFRS adoption on firms in adopting countries [Defund et al. 2011; Landsman et al. 2012], and the resulting evidence supports greater comparability benefits among IFRS user due to lower information cost. Defund et al. 2012 finds that the widespread adoption of IFRS reduces U.S. firms’, particularly small firms’, attractiveness to foreign investors.
The case for IFRS adoption in the United States and in other countries is generally made on the basis of improvements in reporting quality and comparability across firms and countries. Financial reporting and disclosure quality are generally linked to economic outcomes, such as market liquidity, cost of capital, and corporate decision making. Empirical studies support this argument and provide evidence that higher quality disclosures reduce information asymmetry and increase market liquidity [Welker 1995; Healy et al. 1999; Leuz and Verrecchai 2000; Bushee and Leuz 2005]. Likewise, empirical studies support the existence of a statistically significant link between reporting and disclosure quality and firm’s costs of capital [Botosan 1997; Botosan and Plumlee 2002; Hail 2002; Fracis et al. 2004, 2005; Hail and Leuz 2006; Leuz and Schrand 2009]. Better reporting reduces information asymmetries the otherwise inhibit capital acquisition. Quality reporting facilitates external monitoring, such as from institutional investors and analysts, which in turn enables more efficient managerial decision making [Bushman and Smith 2001; Lombardo and Pagano 2002; Lambert et al. 2007]. Quality reporting and disclosure in one firm may also help reduce agency problems in other firms [Hail et al. 2010]. Another important dimension of corporate reporting is its comparability across firms. Making it easier and less costly for investors and other stakeholders to compare across firms from different countries facilitates cross-border investment and capital market integration [Aggarwal et al. 2005; Leuz et al. 2009].
Despite the aforementioned benefits of better and more comparable reporting and disclosure, ther also exist direct and indirect costs to improving or changing corporate reporting. While higher quality and more comparable reporting and disclosure may have economy-wide benefits and positive externalities, economic assessment of the current reporting environment within a market or country must determine if changes to the reporting environment can move reporting quality and comparability to socially optimal levels (net of cost). Prior research evidence supports that capital market reward high quality reporting and transparency. However, recent studies challenge the premise that changing accounting standards in and of themselves leads to more informative, more comparable corporate reporting. These studies point to the importance of firms’ reporting incentives as a key driver of reporting quality [Ball et al. 2000, 2003; Leuz et al. 2003; Ball and Shivakumar 2005; Burgstahler et al 2006]. Managers’ reporting incentives are influenced by a country’s legal institutions (rule of law), enforcement regime strength (auditing and regulation), capital market forces (financing need), a firm’s specific operating characteristics, product market competition, capital structure, and corporate governance.
RESEARH METHODOLOGY
The purpose of this paper is to examine key reporting differences between IFRS and U.S.GAAP as reflected in a reporting entity’s financial ratios---key performance metrics used by analysts and other users to evaluate a firm’s effectiveness and efficiency. Financial statement analysis is the use of the financial statements to analyze a company’s current financial position, results of operations, and cash flows as well as to assess future financial performance. Financial analysis is an integral part of investment and credit analysis and is useful for internal and external decision making. Company managers use industry norm a benchmarks in evaluating performance and as desirable performance targets for future performance. The research question addressed in this paper is:
What is IFRS’s impact on key financial ratios? In order to answer this question, this study will address material differences between IFRS and current U.S.GAAP. Ratios evaluating firm liquidity, profitability, solvency, efficiency, and leverage will be examined to determine the size and direction of the change induced by IFRS adoption. Implications of IFRS’ elimination of the LIFO inventory model are explored. The paper also discusses IFRS vs. GAAP valuation models, consolidation standards, financial statement presentation, and disclosure requirements. The ratios examined and the performance characteristics measured are listed below:
Liquidity
1. Current Ratio
2. Quick Ratio
Activity/Efficiency
1. Inventory Turnover
2. Fixed Asset Turnover
3. Accounts Receivable Turnover
Profitability
1. Net Profit Margin
2. Return on Assets
3. Return on Equity
Coverage/Solvency
1. Times Interest Earned
2. Debt/Equity Ratio
3. Debt/Total Assets Ratio
Stockholder Ratios
1. Earnings Per Share
Since mandated or early adoption of IFRS by U.S. public companies does not currently exist, this study examines each area of difference between IFRS and current U.S.GAAP and from this analysis posits the most likely generic effect on the majority of U.S. firms. A year-end balance sheet and income statement for a hypothetical U.S. public company transitioning to IFRS are prepared, showing U.S.GAAP balances, IFRS transition effects, and IFRS balances with accompanying explanatory notes. Utilizing the derived financial statement information, key financial ratios are prepared under U.S.GAAP and under IFRS. Following this analysis, convergence opportunities and challenges are explored.
COMPARISON OF IFRS AND U.S.GAAP---SIGNIFICANT DIFFERENCES
INVENTORY VALUATION
U.S.GAAP provides guidance regarding inventory valuation in ARB 43; the IASB offers detailed guidance under IFRS in IAS 2. Inventories are defined as assets that a company intends to sell in the normal course of business or is in pro
THE ECONOMIC IMPACT OF IFRS---A FINANCIAL
ANALYSIS PERSPECTIVE
Sharon S. Seay, University of West Georgia
For almost 40 years, a movement has existed to establish one set of global accounting standards to facilitate international trade and investment. Foreign companies of ten list their stock on the NYSE. One common set of accounting standards would promote greater understandability of international financial reports as well as increase transparence and comparability on a global scale, facilitating capital flow. On November 14, 2008 the SEC released a proposed road map toward IFRS (International Financial Reporting Standards) Convergence. The mandated implementation date for large publicly traded companies is 2015. The purpose of this paper is to examine key reporting differences between IFRS and U.S.GAAP as reflected in a reporting entity’s financial rations---key performance metrics used by analysts and other users. Differences in key metrics measuring liquidity, profitability, efficiency, and solvency are examined. Implications of IFRS’ elimination of LIFO inventory model are also explored. Finally, the paper discusses IFRS vs. GAAP valuation models, financial statement presentation, and disclosure requirements
INTRODUCTION
In 2000, the SEC issued a concept release on international accounting standards, soliciting comments. FASB and the International Accounting Standards Board (IASB) initiated a convergence process in 2002. Since that time, the United States has been on a journey toward the adoption of International Financial Reporting Standards (IFRS). The shared objective of FASB and IASB has been the development of common, high-quality accounting standards with the ultimate goal of a single set of global accounting standards. In November 2008, the SEC issued a proposed road map to IFRS convergence. Subsequent opposition to the perceived too-rapid adoption of IRFS has been significant. Another recent milestone in the journey toward convergence was reached in 2010 with the issuance of the “SEC Statement in support of Convergence and Global Accounting,” providing an update and ongoing support for the convergence of U.S.GAAP and IFRS. The Sec permits foreign companies who list on U.S. exchanges to use IFRS in lieu of conversion to U.S.GAAP.
To date, approximately 120 countries have adopted IFRS as their home country standard. The SEC’s convergence approach is “improve and adopt.” IFRS incorporates a principles-based approach to standard setting vs the rules-driven regime under U.S.GAAP. The Sarbanes-Oxley Act (SOX) of 2002 called for an SEC study addressing the need to adopt a principles-based approach to standard setting to replace U.S.GAAP’s rule-based system defined by bright-line rules to establish acceptable. The SEC study noted that weaknesses/imperfections exist when standards are promulgated on either a rules or principles only basis. The SEC expressed concern that principles-based standards provide little guidance or structure on implementation.
Rules-based standards applying bright-line tests often enable company financial engineers to structure a transaction to achieve technical compliance with a standard while evading the standard’s intent and thus, contributing to a lack of comparability among firms’ financial statements. The SEC study [SEC 2008] recommends standard development on an objectives-oriented basis
LITERATURE REVIEW
In 2005, IFRS replaced U.S.GAAP as the single most widely use accounting standard in the world. Proponents of IFRS argue that it has become the “gold standard” for financial reporting in global financial markets, and that its widespread adoption places U.S.GAAP users at a competitive disadvantage in attracting foreign capital [Bloomberg and Schumer, 2007; SEC 2008]. Prior research has examined the effects of IFRS adoption on firms in adopting countries [Defund et al. 2011; Landsman et al. 2012], and the resulting evidence supports greater comparability benefits among IFRS user due to lower information cost. Defund et al. 2012 finds that the widespread adoption of IFRS reduces U.S. firms’, particularly small firms’, attractiveness to foreign investors.
The case for IFRS adoption in the United States and in other countries is generally made on the basis of improvements in reporting quality and comparability across firms and countries. Financial reporting and disclosure quality are generally linked to economic outcomes, such as market liquidity, cost of capital, and corporate decision making. Empirical studies support this argument and provide evidence that higher quality disclosures reduce information asymmetry and increase market liquidity [Welker 1995; Healy et al. 1999; Leuz and Verrecchai 2000; Bushee and Leuz 2005]. Likewise, empirical studies support the existence of a statistically significant link between reporting and disclosure quality and firm’s costs of capital [Botosan 1997; Botosan and Plumlee 2002; Hail 2002; Fracis et al. 2004, 2005; Hail and Leuz 2006; Leuz and Schrand 2009]. Better reporting reduces information asymmetries the otherwise inhibit capital acquisition. Quality reporting facilitates external monitoring, such as from institutional investors and analysts, which in turn enables more efficient managerial decision making [Bushman and Smith 2001; Lombardo and Pagano 2002; Lambert et al. 2007]. Quality reporting and disclosure in one firm may also help reduce agency problems in other firms [Hail et al. 2010]. Another important dimension of corporate reporting is its comparability across firms. Making it easier and less costly for investors and other stakeholders to compare across firms from different countries facilitates cross-border investment and capital market integration [Aggarwal et al. 2005; Leuz et al. 2009].
Despite the aforementioned benefits of better and more comparable reporting and disclosure, ther also exist direct and indirect costs to improving or changing corporate reporting. While higher quality and more comparable reporting and disclosure may have economy-wide benefits and positive externalities, economic assessment of the current reporting environment within a market or country must determine if changes to the reporting environment can move reporting quality and comparability to socially optimal levels (net of cost). Prior research evidence supports that capital market reward high quality reporting and transparency. However, recent studies challenge the premise that changing accounting standards in and of themselves leads to more informative, more comparable corporate reporting. These studies point to the importance of firms’ reporting incentives as a key driver of reporting quality [Ball et al. 2000, 2003; Leuz et al. 2003; Ball and Shivakumar 2005; Burgstahler et al 2006]. Managers’ reporting incentives are influenced by a country’s legal institutions (rule of law), enforcement regime strength (auditing and regulation), capital market forces (financing need), a firm’s specific operating characteristics, product market competition, capital structure, and corporate governance.
RESEARH METHODOLOGY
The purpose of this paper is to examine key reporting differences between IFRS and U.S.GAAP as reflected in a reporting entity’s financial ratios---key performance metrics used by analysts and other users to evaluate a firm’s effectiveness and efficiency. Financial statement analysis is the use of the financial statements to analyze a company’s current financial position, results of operations, and cash flows as well as to assess future financial performance. Financial analysis is an integral part of investment and credit analysis and is useful for internal and external decision making. Company managers use industry norm a benchmarks in evaluating performance and as desirable performance targets for future performance. The research question addressed in this paper is:
What is IFRS’s impact on key financial ratios? In order to answer this question, this study will address material differences between IFRS and current U.S.GAAP. Ratios evaluating firm liquidity, profitability, solvency, efficiency, and leverage will be examined to determine the size and direction of the change induced by IFRS adoption. Implications of IFRS’ elimination of the LIFO inventory model are explored. The paper also discusses IFRS vs. GAAP valuation models, consolidation standards, financial statement presentation, and disclosure requirements. The ratios examined and the performance characteristics measured are listed below:
Liquidity
1. Current Ratio
2. Quick Ratio
Activity/Efficiency
1. Inventory Turnover
2. Fixed Asset Turnover
3. Accounts Receivable Turnover
Profitability
1. Net Profit Margin
2. Return on Assets
3. Return on Equity
Coverage/Solvency
1. Times Interest Earned
2. Debt/Equity Ratio
3. Debt/Total Assets Ratio
Stockholder Ratios
1. Earnings Per Share
Since mandated or early adoption of IFRS by U.S. public companies does not currently exist, this study examines each area of difference between IFRS and current U.S.GAAP and from this analysis posits the most likely generic effect on the majority of U.S. firms. A year-end balance sheet and income statement for a hypothetical U.S. public company transitioning to IFRS are prepared, showing U.S.GAAP balances, IFRS transition effects, and IFRS balances with accompanying explanatory notes. Utilizing the derived financial statement information, key financial ratios are prepared under U.S.GAAP and under IFRS. Following this analysis, convergence opportunities and challenges are explored.
COMPARISON OF IFRS AND U.S.GAAP---SIGNIFICANT DIFFERENCES
INVENTORY VALUATION
U.S.GAAP provides guidance regarding inventory valuation in ARB 43; the IASB offers detailed guidance under IFRS in IAS 2. Inventories are defined as assets that a company intends to sell in the normal course of business or is in pro
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