Bridging the GAAP
The International Accounting Standards (IAS) was supposed to be a unifying conceptual framework which would bring accounting practices of various firms and industries under a single umbrella of standards. No matter if it is a Greek shipping magnate or an Italian fish processing plant, the EU envisioned that they would work within a single standard to better facilitate trade amongst various nations. Indeed, the EU attempted to achieve this through the means of directives, which were soon abandoned. Directives, aimed at forcing compliance with EU accounting standards and practices were discarded because of complaints such as those voiced by the 2003 Report on the Observance of Standards and Codes with regards to the Czech Republic that “The wording of primary and secondary legislation suggests that the Czech Republic’s real priority is compliance with EU directives, rather than adoption of IAS.” Indeed, these two seemed to be not only different goals, but mutually exclusive ones- companies could either sate the directives issued or the requirements of the IAS, but rarely both, especially in Eastern Block nations where both concepts were fairly new.
Now, however, a new complication is on the horizon in the form of bilateral trade with the U.S. and U.S.-E.U. joint ventures. Obviously the directives, which have been scrapped in any case, would have no force of law in U.S. courts. But nevertheless, there has been considerable movement on this issue as of late. In 2006, the IASB issued a paper called “A Roadmap for Convergence between IFRSs and US GAAP- 2006-2008 Memorandum of Understanding between the FASB and the IASB”. The memorandum, based upon work done during a 2002 meeting between the FASB (U.S.) and the IASB, as well as subsequent meetings in 2005, stated that “the FASB and the IASB reaffirmed their commitment to the convergence of US generally accepted accounting principles (US GAAP) and International Financial Reporting Standards (IFRSs).” Nevertheless, this is bound to be a complicated venture because it can not be resolved by boards or government agencies. As the memorandum itself recognized, “the ability to meet the objective set out by the roadmap depends upon the efforts and actions of many parties—including companies, auditors, investors, standard-setters and regulators.” In other words, bridging the gaap is not merely a matter of ironing out a combined framework of accounting practices. It is a matter of a company in Los Angeles following the same accounting standards and practices that a company in London would. It is also a question of training assessors and auditors in this new standard so that they can ensure compliance with it. For these reasons, the U.S. Securities and Exchange Commission recently put forth a proposal which would allow U.S. listed companies to choose between IFRS and the U.S. GAAP. While some in Europe and the U.S. fear that allowing companies to make this choice would hinder the process of converging the two systems (Johnson, 2007) it is nevertheless a practical solution which should be given serious thought and consideration. The European Union, an offspring of NATO, was fifty years in the making. The idea that uniform standards can be achieved on both sides of the pond between thousands of individual companies is fanciful. As a pragmatic matter as well, people are often leery of change- especially change that is being forced upon them, which was another reason the Directives approach previously discussed failed. While the ultimate goal of uniformly adopting the IFRS may well be desirable, it is certainly not something that can or will happen overnight. Allowing a choice between GAAP and IFRS for U.S. companies should not be viewed as an effort to “halt or slow the convergence process” (Johnson, 2007) but rather as an acknowledgement of the real world difficulties inherent to any large-scale transitions.
To understand the scope of the proposed transition, it would be helpful to recall why and how the EU adopted the IAS. As mentioned before, the IAS replaced Brussels-originated Directives which were spottily enforced and which were perceived to unduly burden companies and nations less equipped to handle said requirements. Thus, it can fairly be said that the success of the IAS was born of the failure of the Directives-based approach. However, as with all births, it was hounded by complications and proved to be not an easy task. A 2004 ROSC/World Bank report mentioned that not only were there problems with having individual companies follow the requirements of International Auditing Standards, but even government enterprises and governments themselves were struggling. In reporting this, the Board noted another issue- the fact that IAS standards are not appropriate under all circumstances and that regulators ought to specify when IAS should be implemented and when it is not appropriate or expected.
If even individual governments do not know or can not discern which events merit IAS use and which do not and how to properly use IAS in order to meet the goal of financial transparency, it may well be too much to ask of individual businesses, especially smaller ones or those in less-fully developed countries. None of this is meant to say that the IAS is a bad idea- after all, it is based on sound accounting practices and principles and has proven easier to follow than Directives, due to its more cohesive and simplified nature. Nevertheless, it is an idea which has taken time to implement. It is the recognition of this transitional time that drove the SEC proposal to allow GAAP filings alongside IFRS ones- and on those grounds, the proposal should be accepted.
The IAS sprung from the 1957 Treaty of Rome and the 1970 EU Common Industrial Policy initiative, both of which had harmonization of accounting practices as the goal. The implementation of IFRS continues this trend with the goal of having all companies within the EU report under the IFRS standards by 2007.To be sure, the foregoing is a quest for the harmonization of details. The essential accounting methods are the same, whether they concern a potato farm in Boise or a windmill operator in Rotterdam. For instance, the most basic and fundamental accounting rule- that Assets-Liabilities=Capital, is unchanged by new rules. The same can be said for the calculation of net assets or the definitions of income and capital and the distinctions between the two including the fundamental relationship that capital is an asset which generates income. In a sense, these competing views of filing standards are really about the rules which govern that most fundamental of all business necessities- an accurate and honest appraisal of a company’s worth- in other words, their asset valuation. This is not a simple task- not merely a question of adding up the profit and loss sides of the ledger- rather, it involves considerations of what to designate as capital maintenance, which amounts can be heralded as operating profits- and why all this is so. In that sense, asset valuation is really a series of judgment calls. If I own a shoe store and I purchase shoe leather, could that be an operational expense? Can it be justified? Is it a personal expense instead? What will I use it for? How will I account for its use? All of these are questions which need to be answered for an asset valuation to be prepared. At times, the answer is obvious- if I own a bookshop and decide to splurge on a Bentley, I can hardly claim that the Bentley is a business-related expense. After all, what use would my bookshop have for it? But many times, indeed most times, it is a more complicated line of enquiry, such as the one regarding the shoe leather. It could be for my personal use but could also be used on the inventory. Perhaps I have overstock that is merely collecting dust and need to be cleaned.
As mentioned, the FASB and the IASB are working on a conceptual framework for uniting these two accounting standards. In closing of this paper, it would be prudent to discuss some of the sticking points at this juncture, having just reviewed and emphasized that the nature of asset valuation- indeed of accounting itself- is the use of independent, though guided judgment calls. One example of the conflict is one of expectations- should the entity in question report what the entity expects to occur or what the contract requires? As a pragmatic example, let’s return to our shoe store. Imagine that the shoe store enters a contract with a supplier and as part of the contract, the shoe store must prepare a table showing how many shoes it purchased each month and how many it expects to sell. The goal would be to show that the store is a viable enterprise. And yet, what if the store has purchased 100 pairs of shoes and is required to report the sales for the quarter in the middle of the third month? The store knows how many shoes it has sold in month one and month two- but does not have the complete figure for month three even though a deadline looms. Should the store estimate the number of sales through the use of current figures? Or should the store be prudent and delay reporting, even though the contract is violated through the stores’ untimeliness? Consider the below sales figures:
Week One: 23 pairs Week Two: 23 pairs Week Three: 23 pairs Week Four: 27 pairs
Week Five: 23 pairs Week Six: 23 pairs Week Seven: 21 pairs Week Eight: 23 pairs
Week Nine: 19 pairs Week Ten: 18 pairs
The store can reasonably expect to sell twenty-three pairs of shoes in week eleven and twenty-three in week twelve, since six of the ten weeks show twenty-three shoes sold. On the other hand, weeks nine and ten have seen a slump and that slump may well continue. Thus, estimating the sales figures for weeks eleven and twelve are tricky at best. Perhaps weeks nine and ten are the start of the summer season and sales will be sluggish throughout. But perhaps weeks nine and ten are anomalies. This is one of the real world difficulties presented by the attempt to reconcile standards and expectations.
Another of the many issues on which FASB and IASB differ is whether conservatism conflicts with neutrality in financial reports. The goal of all financial reporting is to be neutral. An asset valuation is not an advertisement- it is an honest statement of your inventory. It may make your company look good or look bad, but it can not be altered in content for the sake of appearances. At the same time, auditors and governments encourage companies to practice conservatism in their estimations. The reasoning for this is that it is always better to err on the side of safety. How do these two goals- conservatism and neutrality- mesh in the real world?
Lets return to our shoe store, whose sales figures are above. Weeks nine and ten show declines with fewer shoes sold in week nine than in week eight and fewer shoes sold in week ten than in week nine. These figures hardly lend an air of optimism to the auditing process. If we combine that with conservative accounting principles, we would be well advised to project that sales in week eleven will decline. After all, they have been declining for two straight weeks, something that is unique to this quarter. Additionally, there has been a decline that is steeper than anything encountered this quarter. As such, if we were conservative, we would surely predict further, possibly steep declines. However, notice that there was a strong decline from week four to week five as well, yet figures stabilized. Based on that limited history, is conservatism really pessimism? Thus, does conservatism in this instance deviate from neutrality?
The goal of achieving uniformity in accounting practices is a worthy one. In an integrated world where economies and businesses have come to depend on one another, it makes sense that expectations be harmonized. Moreover, it is not as difficult a task as it may seem, given that the basics of sound business and accounting practices are fairly uniform throughout the world. The principles governing accounting also have a high degree of uniformity. However, this is still a matter of aligning different businesses, cultures and even continents along a single fiscal path. The goal is a worthy one and may well be achieved. But, like Rome, it wont be done in a day. Or even a year.
Hegarty, J. and Gielen F. and Barros A.C.H. (2004) “Implementation of International Accounting and Auditing Standards: Lessons Learned from the World Bank’s Accounting and Auditing ROSC Program,” September 2004, accessed via http://www.worldbank.org/ifa/LessonsLearned_ROSC_AA.pdf on 16 November 2007.
IASB (2006) “A Roadmap for Convergence Between IFRSs and U.S. GAAP— 2006-2008 Memorandum of Understanding Between the FASB and the IASB” 27 February 2006, accessed via http://www.iasb.org/NR/rdonlyres/874B63FB-56DB-4B78-B7AF-49BBA18C98D9/0/MoU.pdf on 16 November 2007.
IFA (2003) “Report on the Observance of Standards and Codes (ROSC): Czech Republic,” accessed via http://www.worldbank.org/ifa/czerosc_aa.pdf on 16 November 2007.
Johnson S. (2007) “What if IFRS Replaced GAAP?” CFO.com, accessed via http://www.cfo.com/article.cfm/9634508?f=rsspage on 16 November 2007.
Bridging the GAAP