Are International Financial Reporting Standards (IFRS) an Unstoppable Juggernaut for US and Global Financial Reporting?

L. Murphy Smith Department of Accounting Mays Business School Texas A & M University 4353 TAMU College Station, Texas 77843-4353 Tel: 979-845-3108, Fax: 979-845-0028 Email: Lmsmith@tamu.edu

Forthcoming in The Business Review, Cambridge

Electronic copy available at: http://ssrn.com/abstract=1125069

Are International Financial Reporting Standards (IFRS) an Unstoppable Juggernaut for US and Global Financial Reporting?
Dr. L. Murphy Smith, Texas A&M University, College Station, Texas

ABSTRACT Importance of International Financial Reporting Standards (IFRS) has greatly increased in recent years. Pivotal events include acceptance of IFRS for financial reporting in the European Union in 2005 and the US Securities and Exchange Commissions announcement in late 2007 to accept IFRS for financial reporting by non-US firms trading in US markets. How far away is worldwide acceptance of IFRS for financial reporting? To answer this question, this study offers a review of recent events, including a longitudinal analysis of adoption of IFRS by the countries of the world. In addition, perspectives regarding acceptance of IFRS, from top corporate accounting officers, are acquired and evaluated. Findings indicate that IFRS are increasingly accepted around the world and that top accounting officers are very favorable to adoption of IFRS worldwide. Based on these findings, acceptance of IFRS in virtually all countries, including the US, appears imminent, perhaps occurring within the next few years. INTRODUCTION Revolutionary changes are occurring in accounting and financial reporting in the US and other countries. Until 2008, the Securities and Exchange Commission (SEC) in the US required for financial reporting by companies traded in the US stock market, that their financial statements either follow US generally accepted accounting principles (GAAP) or be reconciled to US GAAP. The SEC did not accept the International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB). Until the early 2000s, securities commissions in most countries took the same basic position toward IFRS as did the United States SEC. Starting in the mid-2000s, a series of events, notably in the US and European Union, greatly advanced worldwide acceptance of IFRS. This study seeks to determine whether IFRS are an unstoppable juggernaut for US and global financial reporting. To make this determination, a review of recent events, including a longitudinal analysis of adoption of IFRS by the countries of the world. Also, perspectives about IFRS held by top corporate accounting officers among Fortune 500 business firms will be obtained and evaluated. THEORETICAL SUPPORT AND MOTIVATION FOR STUDY Signaling theory (Spence 1973) has been used to show why companies adopt IFRS in international capital markets (Tarca 2004). Agency problems and information asymmetry are likely reduced following adoption of IFRS, as insiders face greater risk of legal action by minority shareholders (Hope et al. 2006). Ding et al. (2006) show that IFRS require greater disclosure than that required by most countries domestic accounting standards. Rees and Weisbach (2002) show that greater investor protection lessens the capacity of managers to expropriate wealth from the company; this consequently improves the companys stock price. In countries that have weak financial disclosure requirements, investors generally demand additional financial information when companies issue equities (stock). As a result, governments in these countries are often compelled to revise or develop securities laws that require improved financial reporting disclosure. Developing accounting and financial reporting requirements, that is, generally accepted accounting principles, is a complex and time-consuming process. An easier and more effective solution is to adopt IFRS, which have a higher level of financial reporting disclosure than most countries GAAP (Ding et al. 2006). For those countries that have strong financial disclosure requirements, such as the US, there is less incentive to adopt IFRS, due to a smaller incremental benefit of investor protection. However, countries with strong financial disclosure requirements in their existing GAAP can still benefit from adopting IFRS; specifically, these

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Electronic copy available at: http://ssrn.com/abstract=1125069

countries benefit by participating in uniform reporting standards across countries. Investors therefore benefit from cross-country comparability (Pownall and Schipper 1999). Uniform reporting standards lower the costs of financial statement reconciliation associated with multinational equity (stock) listings (Biddle and Saudagaran 1989) and potentially promote economic development (Hope et al. 2006). RESEARCH QUESTION The role of International Financial Reporting Standards in the capital markets is important to the US and other nations. Many nations have adopted IFRS, but so far, the US has not done so for domestic-based companies. As a result of recent events, this may be about to change. The research question addressed by this study is as follows: Are International Financial Reporting Standards an unstoppable juggernaut for US and global financial reporting? To answer this question, a review will be made of recent events, including a longitudinal analysis of adoption of IFRS by the countries of the world. In addition, perspectives regarding IFRS held by top corporate accounting officers will be obtained and evaluated. BACKGROUND AND PRIOR RESEARCH Nations of the world have engaged in global commerce since the beginning of recorded history. If international trade occurs, accounting and financial reporting are useful for recording and reporting the results. Global operations are becoming more important to all types of business firms. Many firms are increasing their international operations and the number of countries in which they do business. A greater number of business firms are now providing products and services to customers around the world. Table 1 provides a model of information flows mediated by the various border crossings inherent in global operations. Further complexity connected to multinational operations results from subsidiary operations in business settings that may differ substantially from the parent, thereby resulting in a complex operating, reporting, and information environment. Information asymmetry between management and external stakeholders is increased for firms functioning in a complex environment. Multinational firms carry on business in a more complex environment than strictly domestic firms (Runyan and Smith 2007). Globalization of business and capital markets has led to an economic environment in which uniform procedures for financial statement preparation would benefit investors, lenders, financial analysts, accountants, and auditors (Gaspar et al. 2006). Uniformity in accounting standards helps provide comparability of financial statements among companies in diverse country locations. The International Accounting Standards Board (IASB) is endeavoring to develop harmonized financial accounting standards to satisfy worldwide demands. Companies engaged in international business encounter a variety of challenges as a result of their global operations. Challenges result from different cultures, language differences, different legal systems, political differences, different operating environments, and different accounting and financial reporting standards. Much past research examines the effect of culture on accounting and business. Some representative recent and older studies include Karahanna et al. (2005), Patel (2004), Blanco and Osma (2004), Davison and Martinsons (2003), Hofstede et al. (1990), Hofstede and Bond (1988), and Hofstede (1984). Karahanna et al. (2005) consider cultural levels and their impact on individual behavior. Patel (2004) examines theoretical strengths and weaknesses of prior research regarding accountants values and judgments. Blanco and Osma (2004) review differences between US GAAP and International Financial Reporting Standards, by looking at Form 20-F reconciliations in the period 1995-2001. They find that significant differences exist, but that international standards and US GAAP appear to be converging. Hofstede (1984) provides foundational work concerning the effect of culture on business activities. Herrmann and Hague (2006) indicate that international accounting standards and US GAAP increasingly influence each other. They note that the US Financial Accounting Standards Board and the IASB entered into a memorandum of understanding formalizing their commitment to converge on a single set of accounting standards in 2002. This convergence effort makes it important for US accountants to understand how the conformance of a US accounting standard to an international standard can significantly affect US companies.

Table 1 Information Flows of Subsidiary and Parent Information to Investors and Analysts
Subsidiary 1 S u bsidiary 1 (c,l,p,x,r,g,i)

(c,l,p ,x,r,g,i) S ub sid iary 2 (c,l,p,x,r,g,i) (c,l,p,x ,r,g ,i)

Subsidiary 2

Investor (s,n) r Inv esto S ,C Parent P arent (c,l,p,x,r,g,i)

(c,l,p ,x,r,g,i)

FAnalysts inan cial A n aly st S ,C (b,n)

Financial

Subsidiary Su bsid iary 3 3 (c,l,p,x,r,g,i) (c,l,p ,x ,r,g ,i)

Jo Joint in t VVenture en tu re (c,l,p,x,r,g,i) (c,l,p,x ,r,g ,i)

Note: Environmental differences contributing to complexity are cultural (c), legal system (l), political risk (p), exporting/importing activities (x), subsidiaries operating in a different industry or with a different business model (related-unrelated diversification - r), geographic distance from parent and subsidiaries (g), and information infrastructure/availability of news media (i). Investors differ by sophistication (s) and nation (n). Analysts differ by representation (buy/sell -b) and nation (n) (Runyan and Smith 2007).

Fontes et al. (2005) analyzed three methods for measuring success attained in achieving convergence between two sets of accounting standards. They reviewed a measurement method based on the concept of Euclidian distances. They proposed two better measures of assessing progress of national accounting standards setting bodies in converging their standards with IFRSs. For illustrative purposes they measured convergence of national standards in Portugal with international standards over the period 1977-2003. Mir and Rahaman (2005) evaluated the decision of the Bangladeshi government and accounting profession to adopt international standards. These researchers used archival data and interviews of key actors, including preparers and users of financial reports, members of the SEC, and members of professional accounting bodies. Results indicate that institutional legitimization is a key factor that drives the decision to adopt international standards. The International Organization of Securities Commissions (IOSCO) and the individual securities commissions, which make up the IOSCO, play a key role in determining worldwide acceptance of international standards. Over 60 securities regulatory agencies worldwide comprise the IOSCO. The US Securities and Exchange Commission is a member of the IOSCO. A major objective of the IOSCO is to facilitate cross-border securities offerings and multiple listings without compromising the financial statement information provided (Gaspar et al. 2006). IASB member Patricia L. OMalley (2004), in a speech to the International Accounting section of the American Accounting Association, cited lower financial statement preparation costs as a benefit of reducing differences in accounting standards among nations. Resolving differences in multiple GAAPs can be a substantial cost to multinational business firms. Multinational firms with tens and even hundreds of subsidiaries must translate

host country financial statements into home country statements. The process of consolidating parent and subsidiary statements is a massive and complex process. In a pivotal event in 2005, the European Union (EU) required use of IFRS in consolidated financial statements of all EU listed companies, about 9,000 companies. Approximately 400 EU firms are traded on US markets. Besides the EU countries, many other countries have adopted IFRS almost word for word as their national GAAP. Countries adopting IFRS include: Australia, New Zealand, South Africa, Singapore, Hong Kong, and the Philippines. Some countries that have stopped developing a national GAAP and just use IFRS include: Bahrain, Croatia, Costa Rica, Cyprus, Dominican Republic, Ecuador, Guatemala, Haiti, Honduras, Jamaica, Kenya, Malta, Mauritius, Nepal, Oman, Panama, Tanzania, Tajikistan, Trinidad, and United Arab Emirates (Practer 2003). In December 2007, the Securities and Exchange Commission revised its rules so that non-U.S. companies will be permitted to include in their SEC filings financial statements without reconciliation to US GAAP if the financial statements are prepared in accordance with IFRS as issued by the International Accounting Standards Board (IASB). This is a landmark event in US financial reporting, as acceptance of IFRSs removes a major obstacle for foreign private issuers to enter and to remain in the US markets (Deloitte Touche Tohmatsu 2008, Gibson, Dunn and Crutcher 2008, Bergman et al. 2008). The SEC seems on the verge of accepting IFRS, not just for non-US companies trading in the US stock market but for US-based companies, as well. Among those calling for acceptance of IFRS are John Thain from the New York Stock Exchange and former Federal Reserve Chairman Paul Volcker (White 2007). FASB Chairman Robert Herz has expressed his expectation that US companies would eventually be required to follow a single accounting standard, which would be IFRS (Leone 2007). The ongoing globalization and resulting complexity of business makes accounting financial reporting a technically demanding and oftentimes daunting process. Across countries, accounting standards standards diverge as a result of unique cultural, political, legal, and economic factors. Effective and efficient functioning of the global marketplace necessitates uniformity in accounting standards. At the current time, businesspersons, financiers, and investors must take into consideration the differences that exist. Such differences substantially curtail the development of international business activity. Harmonization of standards has the potential of benefiting economic activity around the globe (Gaspar et al. 2006). As far back as the beginning of recorded history, peoples of the world have participated in global commerce. As long as international trade has occurred, accounting is useful for recording and reporting the results. Multinational operations are increasingly important to all types of business firms. Numerous multinational firms are either expanding international operations, or becoming part of other multinational firms via mergers or acquisitions. Consequently, more firms than ever before are providing products and services to customers around the globe. The internationalization of business and capital markets has resulted in an economic environment in which uniform procedures for financial statement preparation would benefit investors, lenders, financial analysts, accountants, and auditors (Gaspar et al. 2006). Uniformity facilitates comparability of financial statements among firms of diverse country locations. The International Accounting Standards Board (IASB) is endeavoring to develop harmonized financial accounting standards to satisfy worldwide demands. Numerous multinational firms are required or voluntarily choose to follow international standards in preparing their financial reports. ACTIVTIES OF THE INTERNATIONAL ACCOUNTING STANDARDS BOARD The International Accounting Standards Board was established in 2001 by its forerunner, the International Accounting Standards Committee (IASC), which itself was formed in 1973. The IASC Foundation remains the parent body of the IASB. The structure and organization of the International Accounting Standards Board resulted from a strategy review undertaken by its predecessor body, the Board of the International Accounting Standards Committee. The IASB issues standards in a series of pronouncements called International Financial Reporting Standards (IFRSs). The IASB adopted the body of standards issued by the Board of the International Accounting Standards Committee. These standards were issued between 1973 and 2000, and continue to be designated International Accounting Standards.

The IASB is a London-based, independent, privately funded accounting standard-setting body. Board members come from nine countries and have a variety of functional backgrounds. The IASB is committed to developing, in the public interest, a single set of high-quality, understandable, and enforceable global accounting standards that require transparent and comparable information in general purpose financial statements. The IASB works with national accounting standard-setters to achieve convergence in accounting standards around the globe. The IASB represents over 100 accounting and financial organizations, from over 80 counties. IASB projects typically require a minimum of three years from formation to standard issuance. Issuance of a Standard, Exposure Draft or final SIC Interpretation requires approval by 8 of the boards 14 members. DATA GATHERING, ANALYSIS, AND RESULTS A longitudinal analysis was made of the use of IFRS in 178 countries in 2003 and 2006. Data was acquired from publications of Deloitte Touche Tohmatsu (2004, 2007). A pivotal event occurred between these two years, which was adoption of IFRS by the EU. A total of 178 countries were included in this longitudinal analysis. Use of IFRS more than doubled, from 24 countries in 2003 to 59 countries in 2006. The majority of this increase, 26 of the additional 35 countries adopting IFRS between 2003 and 2006, occurred in Europe, as a result of the EUs adoption of IFRS. Table 2 provides a breakdown of the analysis by world region.
Table 2 Use of IFRSs by Region in 2003 and 2006 Required for all domestic listed companies in 2006 33 0 8 5 11 2 59 Required for all domestic listed companies in 2003 7 0 7 3 6 1 24

Region Europe North America Central and South America Africa Asia Australia Oceania Total

Total countries 47 3 19 54 49 6 178

Change 26 0 1 2 5 1 35

Source: Deloitte Touche Tohmatsu (2003, 2007).

Perspectives about IFRS held by top corporate accounting officers were sought to help evaluate the likelihood of future acceptance of IFRS worldwide, including in the US. To gather this data, a questionnaire survey was mailed to the chief accounting officers of the Fortune 500 companies. The survey was conducted prior to the SECs announcement in 2007 that it would accept IFRS for non-US firms traded in US markets. Had this major change in SEC policy occurred prior to the survey, some of the responses would likely have been different. A total of 81 usable responses were received, thus providing a 16.2 percent response rate. A statistical comparison was made of early and late respondents, used as proxies for respondents and non-respondents. Results indicate no significant difference, thus suggesting that the sample is representative of the population. Responses are summarized in Table 3. As to whether the IOSCO would endorse IFRS, 88.9 percent of the accounting officers thought the IOSCO would do so, which the IOSCO now has. A number of stock exchanges accept financial statements of foreign-based firms prepared using IFRS without reconciliation, including London, Frankfurt, Zurich, Hong Kong, Amsterdam, and Rome (Hope et al. 2006). Regarding US SEC acceptance of IFRS for financial reporting by non-US companies, 74.1 percent of accounting officers thought the SEC would do so. Subsequent to the survey, the SEC did exactly

that. Regarding acceptance of IFRS worldwide, including the US, 90.1 percent of accounting officers were in favor of such acceptance.
Table 3 Perspectives of Corporate Chief Accounting Officers on IFRS Yes 88.9% 74.1% 90.1% No 11.1% 25.9% 9.9%

Believe IOSCO will endorse IFRS Believe SEC will accept IFRS for financial reporting by non-US companies Favor acceptance of IFRS for financial reporting by all companies in all countries, including the US

Regarding the longitudinal analysis of use of IFRS in countries around the world, results suggest a significant momentum for eventual adoption of IFRS worldwide, including in the US. The US now accepts IFRS for non-US firms traded in the US markets; eventual acceptance of IFRS for US-based publicly traded firms seems likely. Regarding the survey of perspectives about IFRS held by top corporate accounting officers, results indicate that accounting officers are highly favorable to acceptance of IFRS for financial reporting by all companies in all countries, including the US. IMPLICATIONS FOR ACCOUNTING EDUCATION In countries that adopt IFRS, accounting students must be prepared to work with the new GAAP, that is IFRS. Educators will need to incorporate more international materials into their accounting curriculums (Nix and Smith 2006). This can be done either by offering supplemental classes or by integrating international content into current classes. Students can obtain further exposure to international accounting through international internships or international work-study projects. Shown in Table 4 are methodologies suggested by Kwok et al. (1994) for schools to internationalize their accounting curriculums.
Table 4 Methodologies for Internationalizing the Accounting Curriculum 1. Infusion of international material into current coursework 2. Offering general International Business courses 3. Offering specialized International Business courses in functional fields 4. Offering non-business International topics courses

Teaching students how to handle international accounting and financial reporting issues will remain a challenge even if all the countries in the world adopt IFRS. Uniformity in accounting standards is a gigantic step toward understanding financial statements prepared in different nations; however, uniformity alone is not a total solution. Environmental factors such as culture, language, legal system, and economic conditions affect how any GAAP, including IFRS, is applied. For example, the litigation environment affects conservatism in financial reporting. For a company located in a nation where there is a high risk of investor lawsuits, such as the US, there

will be a different perspective on conservatism than in a nation that is less litigious. Thus, IFRS will be applied differently depending on the national culture. Properly evaluating investment opportunities in any country requires that the investor understand the culture of that country. Even between countries using the same language, there may be differences in the meaning of common accounting terms. Table 5 shows some terminology differences between the UK and the US, both English-speaking countries (Sorensen and Kyle 2007).
Table 5 Differences in Accounting Terminology Between the US and UK UK Terminology Turnover Stocks Debtors Accounts Sales Inventories Accounts Receivable Financial Statements US Equivalent

Given the importance of international issues, an accounting curriculum benefits greatly from a course on international accounting. Even if IFRS were fully integrated into other accounting courses, the international accounting course would still be needed to introduce students to other international issues such as accounting for transactions denominated in foreign currency, preparing foreign currency translated financial statements, management accounting functions in a multinational firm, and environmental factors such as culture, language, and economic conditions.

SUMMARY, CONCLUSIONS, AND SUGGESTED FUTURE RESEARCH

This study reviews International Financial Reporting Standards and how their use worldwide has dramatically increased in recent years. A review of prior research shows that IFRS have the potential to improve the function of capital markets and facilitate economic progress. Based on the longitudinal analysis of adoption of IFRS by the countries of the world, there appears to be significant momentum for eventual adoption of IFRS worldwide, including in the US. The US already accepts IFRS for non-US firms traded in the US markets. Eventual acceptance of IFRS for US-based firms seems quite probable. A survey of perspectives about IFRS revealed that top corporate accounting officers are highly favorable to acceptance of IFRS for financial reporting by all companies in all countries, including the US. Combining the favorable perspectives of top accounting officers with the increasingly widespread adoption of IFRS in countries around the world, IFRS seem to be an unstoppable juggernaut for US and global financial reporting. Based on this analysis, acceptance of IFRS in virtually all countries, including the US, appears imminent, perhaps occurring within the next few years. Future research could investigate the benefits and problems associated IFRS. Future research could develop a longitudinal analysis of how international standards change over time. In addition, future research could evaluate the economic benefits of using international standards at the micro (corporation) level and macro (national or global) level. Future research could consider whether adoption of international standards leads to easier access by a firm to foreign capital markets, lower cost of capital, and financial transparency.

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