It’s been over a year since we first told you about how the Generally Accepted Accounting Principles (GAAP) will be replaced by the International Financial Reporting Standards (IFRS). The project is still on track.
The Securities and Exchange Commission signaled the demise of U.S. accounting standards, kicking off a process Wednesday that could ultimately require all publicly listed American companies to follow an international model instead.
Sounds good, especially since GAAP has some pretty onerous requirements. But it won’t be easy.
Introduced in two steps, the shift could eventually cut costs for companies and smooth cross-border investing. At the same time, investors worry it will create confusion, especially during the transition. Other critics worry that the international system offers too much wiggle room for companies, compared with the more precise rules enshrined in U.S. standards.
The feared "wiggle room" results from the difference in philosophy between the two standards.
The U.S. accounting system, which is ingrained in textbooks, business schools and company treasuries, is based on detailed rules, while the international system expects companies to follow broad principles. In practice, the systems differ on smaller matters, such as the timing of when a company should note any change in the value of an investment.
Rules versus principles. Where else do we see that type of situation? FDA cGMP vs. ISO perhaps? Principles create a thoughtful and hopefully logical framework, while rules create barriers that are continually attacked for workarounds. In this case the rules have been hurting U.S. companies.
The SEC says the change will help the U.S. to compete globally because many other nations use the international standards or plan to do so. Larger companies, especially those with overseas subsidiaries, have urged the SEC to move in this direction. They hope a single accounting standard will enable U.S. investors to more easily compare a retailer in the U.S. with one in France, for example.
SEC Chairman Christopher Cox noted that 100 countries around the globe use IFRS and two-thirds of U.S. investors currently own securities of foreign companies. "The increasing world-wide acceptance and U.S. investors’ increasing ownership of foreign companies make it plain that if we do nothing and simply let these trends develop, comparability and transparency will decrease for U.S. investors and issuers," he said.
An example of how principles will govern instead of rules includes the following.
Under U.S. GAAP, for example, research and development costs are generally treated as expenses when they occur. Under the international standards, once a project gets to the development stage the costs are spread out over time. GAAP also provides specific instructions for industries such as oil and insurance. IFRS doesn’t.
And another has a direct relationship to something near and dear to the lean manufacturing world: inventory. GAAP considers inventory an asset, lean considers it a cost and a potential waste; IFRS considers it… well, I don’t exactly know.
Arnold Hanish, chief accounting officer of Eli Lilly & Co., said he wouldn’t recommend that the drug maker adopt the international standards earlier, assuming it was eligible to do so. "We wouldn’t be ready," he said, since the company estimates it will take two and a half years to make the shift, which he called "a massive effort." A major issue that remains to be resolved, he said, relates to how inventories will be treated for tax purposes.
It will be interesting to see how a profession steeped in rules changes to deal with principles, and how that resolves itself with Sarbanes-Oxley and other recent legislation.