Progress report: International convergence of accounting standards

In 2002, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) agreed to work together to develop high quality, compatible accounting standards that could be used for both domestic and cross-border financial reporting. Since then, the bodies’ efforts to achieve the so-called “convergence” of US Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) have had their ups and downs. This quest now appears to be reaching the end of the road, with FASB proposing an informal, collaborative model that will reduce differences in financial reporting, in lieu of the IASB’s one-size-fits-all approach. Here’s how it got to this point.

Aspirations run into reality

In 2002’s Norwalk Agreement, FASB and the IASB agreed to undertake a short-term project to remove a variety of individual differences between US GAAP and IFRS and to remove remaining differences through future joint projects. The goal of the Norwalk Agreement was to improve the consistency and comparability of financial statements worldwide.

Convergence turned out to be more difficult than anticipated. The respective standard setters had difficulties agreeing on what’s best for stakeholders, and the approval process took much longer than expected. Eventually, the boards focused primarily on four specific joint projects: revenue recognition, insurance, financial instruments, and leases.

The rubber meets the road

The revenue recognition project has been the greatest success to date. A major global standard — issued under US GAAP in Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers — takes effect for reporting periods beginning after Dec. 15, 2016, for public companies. While private companies may also opt to implement the new rules at that time, they have an extra year before they’re required to comply.

The new guidance is intended to standardize and simplify the revenue recognition process for customer contracts across different industries and geographic locations. (Previously, GAAP had general revenue recognition rules along with more than 200 industry- and transaction-specific rules, while IFRS provided only limited guidance.) But many companies are uncertain how to apply the new standard. The American Institute of Certified Public Accountants (AICPA) has already established 16 industry-specific task forces to help companies implement the new rules.

The projects on insurance and financial assets have failed to produce joint guidance, and the boards have resigned themselves to producing different standards. FASB plans to release two major amendments on these topics by early 2015. A FASB spokesperson explained the breakdown in the insurance and financial assets joint projects by saying that, “when standards for convergence do not represent an improvement to US GAAP, we must do what we believe is in the best interests of investors who use it.”

For example, if FASB had adopted the IASB’s approach to financial asset impairment, US banks would probably have seen reduced loan loss reserves. FASB felt that such a change would be unwise in the aftermath of the 2008 financial crisis and resulting recession. Existing US GAAP requires companies to maintain higher reserves for a longer period of time than the IASB’s approach.

The final event

At this point, the lease project is the only outstanding convergence project. Accounting for leases is not only complex, but inconsistent across the globe. When companies rent such items as real estate or equipment, existing accounting standards often permit them to leave lease expenses off their balance sheets, effectively hiding significant liabilities from financial statement users.

In 2013, FASB and the IASB released largely converged proposals addressing how to report long-term lease contracts. The boards generally agreed companies should record liabilities for lease contracts that extend for more than 12 months. But the proposals have been met with vocal opposition, especially from businesses reluctant to report higher debt to stakeholders.

The boards also diverge on other major lease issues, most notably the recognition of expenses on the income statement. FASB has voted to keep the current model for expense recognition, but the IASB has reverted to the previously discarded approach of front-loading expenses by the lessee for all lease contracts, in effect treating all leases primarily as financing transactions. Unless the boards can reach consensus on the areas of disagreement, a fully converged standard — or even acceptance of the joint proposal on long-term lease contracts — is unlikely.

As the lease convergence project drags on, the boards have shifted their attention to minor issues, such as lease modifications, variable lease payments, discount rates, and whether to exempt small-ticket leased items from the new rules.

If FASB and the IASB can reach a compromise, final lease rules could be released in 2015. Otherwise, FASB may opt to update its standards independent of the IASB, similar to how it’s decided to handle the insurance and financial asset topics.

A new collaboration

Conceding that a one-size-fits-all global financial reporting model is a nice idea that doesn’t work in practice, FASB in September announced plans to establish an informal, collaborative network of accounting bodies in major capital markets to improve financial reporting and minimize differences in global accounting standards.

The group is intended to foster a common understanding of financial accounting and reporting issues of critical interest to standard setters around the world. It will identify cultural, legal, political, and other issues in each country that can constrain the development of more comparable accounting standards. The collaborative network doesn’t have a name yet, but FASB Chairman Russell Golden would like the group to hold its first meeting before year end. The IASB has been invited to participate.

SEC considers an IFRS reporting option

SEC Chair Mary Jo White, a staunch proponent of IFRS, has suggested that domestic companies that trade on US markets could have the option to file IFRS financial statements in the future. This dual accounting approach has the potential to confuse investors who are familiar with US GAAP, and it could allow the skewing of financial results.

It could, however, make sense in industries with global players that adhere to IFRS. For instance, European pharmaceutical companies apply IFRS, and US investors may have an easier time comparing their performance to US competitors that opt for IFRS reporting. About 450 foreign companies in a variety of industries currently use IFRS for their SEC filings.

Going forward

With the convergence efforts seeming to have reached an impasse, it appears the Norwalk Agreement may have been overambitious. But that doesn’t mean the efforts to improve comparability and consistency in financial reporting globally have come to an end. Both FASB’s informal network and market demand may produce additional guidance to move us closer to a quasi-convergence.

For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.