SEC to change accounting rules: Bridging the gap between GAAP and IFRS

Posted December 9, 2008

SEC to change accounting rules: Bridging the gap between GAAP and IFRS

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By Lee C. Hodge, Ward and Smith, P.A.

Editor's Note: Lee Hodge is a member of the Business Practice Group at Ward and Smith, P.A.

What is Changing?

The U.S. Securities and Exchange Commission ("SEC") has announced a proposed timetable for U.S. public companies to transition from use of the United States Generally Accepted Accounting Principles ("GAAP") when preparing financial statements filed with the SEC to use of the International Financial Reporting Standards ("IFRS"). While the use of IFRS is not yet mandatory for U.S. public companies, it is very likely that it soon will be. There are substantial differences between GAAP and IFRS, and it is important for business owners, managers, officers, and directors to understand how the transition to IFRS will impact their companies.

Why Would the SEC Mandate the Use of IFRS?

Unlike GAAP, which is used only by companies in the United States, IFRS is used in most other developed countries for company financial reporting. In fact, over 100 countries worldwide have adopted IFRS, and the use of IFRS is required for publicly held companies chartered by European Union nations.

Also, securities trading markets have become much more globalized over the past decade as other countries attempt to compete with U.S. securities markets. The SEC is seeking to increase foreign investment in U.S. public companies and make the U.S. securities markets more competitive. As the economies and businesses of the world become more global, GAAP becomes less relevant. Moving to the use of IFRS should increase international investment in U.S. companies because international investors will understand those companies' financial statements better.

The Proposed Timetable for IFRS

The SEC has proposed the following timetable for the use and rollout of IFRS:

• The largest 20 companies in each industry may elect to transition to IFRS for fiscal years ending after December 15, 2009.

• The SEC will make a final decision in 2011 about the U.S. transition to IFRS.

• If the SEC requires U.S. public companies to use IFRS, compliance will be phased in as follows:

Companies with outstanding stock valued:

(i) in excess of $700 million will be required to begin using IFRS in 2014;

(ii) between $75 million and $700 million will be required to begin using IFRS in 2015; and,

(iii) less than $75 million will be required to begin using IFRS in 2016.

GAAP v. IFRS Generally

GAAP and IFRS envision accounting rules differently. GAAP generally is viewed as more onerous than IFRS. GAAP provides very specific rules in order to minimize management interpretation, which makes GAAP very detailed and tailored to specific situations. IFRS, however, uses broad conceptual standards. IFRS provides more leeway to a company's management in how to account for and report specific transactions. However, it is critical to understand the specific differences between GAAP and IFRS because they can have a big impact on the earnings of a company.

Specific Differences Between GAAP and IFRS

While the differences between IFRS and GAAP are many, certain specific differences include:

• Statement Presentation: IFRS requires that certain minimum information be contained on the balance sheet and income statement. Unlike GAAP, however, no precise format for the information is required.

• Debt and Equity Investments: IFRS will cause certain legal instruments, such as instruments that can be converted from debt to equity, to be bifurcated between their equity and debt elements. Under GAAP, however, such an instrument is reported as a liability.

• Extraordinary Items: IFRS prohibits reporting extraordinary items on the income statement. GAAP allows the reporting of certain infrequent and unusual extraordinary items on the income statement.

• Revenue Recognition: IFRS gives companies more flexibility to determine when revenue is recognized.

• Inventory Accounting: IFRS does not allow the use of Last In First Out ("LIFO") inventory accounting, which is acceptable under GAAP. Furthermore, IFRS requires that the same cost formula be applied to all inventories. GAAP allows companies to pick and choose different treatments for different types of inventory which, in turn, helps companies to manage earnings.

Will This Change Affect My Business?

At first glance, it appears that the SEC's proposed transition to IFRS will impact only publicly-traded companies. However, the real impact of the transition is much broader in scope. It is highly likely that high-growth private companies, many of which are technology-based companies, will quickly adopt IFRS. Such companies usually plan to go public or merge with a publicly-traded company in the future, and voluntary adoption of IFRS will make either process easier. Other private companies also may transition to IFRS if lenders and other financing sources begin to require the use of IFRS for lending. Stay tuned in the coming months, as the chapter on IFRS in the United States has only begun to be written.

Ward and Smith, P.A. provides a multi-specialty approach to the representation of technology companies and their officers, directors, employees, and investors. Lee C. Hodge practices in the Business Practice Group, where he concentrates his practice on business formations, acquisitions, and other transactional matters. Comments or questions may be sent to lch@wardandsmith.com.
This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.

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