The Coming Transition from U.S. GAAP to IFRS:
Implications for Attorneys

Barry Jay Epstein, Ph.D., CPA
Susan Cheng, CPA, CA, CFA, CFE
Russell Novak & Company, LLP

Background

Following a unanimous vote in August, 2008, the Securities and Exchange Commission (SEC) recently published for public comment a proposed Roadmap on the potential future mandatory use, by all U.S. issuers, of International Financial Reporting Standards (IFRS) as issued by the International Accounting Standards Board (IASB). This Roadmap sets forth seven milestones which, if achieved, could lead to having U.S. issuers filing with the SEC financial statements prepared in accordance with IFRS, beginning as soon as 2014. Currently, we are in the 90-day comment period, with all public comments due back to the SEC no later than February 19, 2009. This latest development followed an earlier final rule release, a little more than a year ago, in December, 2007, whereby the SEC allowed foreign private issuers (FPIs) in the U.S. to file financial statements without reconciliation to U.S. Generally Accepted Accounting Principles (GAAP) if those financial statements are prepared using IFRS as issued by the IASB.

While it is still not yet a total certainty that U.S. domestic issuers will be required to use IFRS, the mere fact that this is under active consideration is a positive step towards the ongoing movement towards alignment of U.S. and international accounting standards. The fact that SEC Chairman Christopher Cox publicly hailed that “an international language of disclosure and transparency is a goal worth pursuing on behalf of investors who seek comparable financial information to make well-informed investment decisions” clearly signals the SEC’s desire to bring about an end to the era of multiple sets of financial reporting regimes, making enactment of this change highly probable.

The anointing of IFRS as the global standard for accounting and financial reporting, for publicly held and private companies alike, seems to be only a matter of time – and a brief time, at that. This all-but-inevitable outcome was ordained when FPIs were given the unfettered right to report under IFRS, making it politically problematic (if not actually impossible) to deny this same right to U.S.-based registrants.

Separately, since 2002 the primary U.S. accounting standard-setter, FASB, has been engaged in a “convergence” effort with IASB. As a result, a number of older standards were revised, and several new standards were promulgated, mostly to conform to IFRS (although a few older IFRS have been modified to embrace U.S. GAAP). In other words, whether IFRS are formally acknowledged or not, U.S. GAAP is in the process of becoming indistinguishable from IFRS.

It is often claimed (including by the IASB) that adoption of IFRS-based reporting would reduce preparers’ cost of capital. Widely cited theoretical arguments based on well-accepted economic and finance postulates credit the anticipated effects of reduced estimation risk of future returns on investments, decreased transaction costs, and mitigated information asymmetries between management and external investors, while logical arguments focus on greater transparency in financial reporting. Despite academicians’ actual research yielding mixed findings regarding these claimed benefits, neither theoretical arguments nor research results have cited any downside risk to adopting IFRS, other than the short-term cost of implementing the new requirements.

In any event, the trend is irreversible, with over 100 countries, including the 27 members of the European Union, now requiring or permitting the use of IFRS (some for all companies, others only for publicly traded ones), and with major nations such as Canada, Japan, China, and Russia all committed to implementing IFRS within a few years. On a more local level, bilateral trade between New York State and Canada amounts to some $35 billion annually, and almost 470 thousand NY jobs depend on that trade – underscoring the need for NY-based businesses to continue to communicate freely and effectively with their Canadian partners.

Major reasons cited for the U.S. to adopt IFRS is to open up U.S. capital markets, remove barriers to raising capital anywhere in the world, lower transaction costs, and facilitate business on a global scale. The fear of losing listings to London or other exchanges (which would exacerbate the already-experienced loss of some listings, allegedly due to the cost of Sarbanes-Oxley compliance) has encouraged the financial services sector to line up solidly behind IFRS adoption. As with any major change, unexpected impediments are sure to be encountered, beyond the already well-anticipated costs of modifying accounting systems, training staff, and increasing audit time and cost.

While the expected permission to transition to IFRS-based financial reporting is great news for U.S. listed companies seeking reporting parity with foreign peers and competitors, this shift may create potential ramifications, including increased litigation and greater challenges in structuring terms of business transactions. For those U.S.-based attorneys that are conversant with IFRS -- currently only a relative handful -- those challenges could indeed present them with opportunities.

In the following paragraphs, certain of these matters are addressed.

Attorney IFRS Readiness

Given what has unfolded to date, and what seems likely to follow, attorneys clearly have a need to be trained in this new accounting “language,” in order to effectively assist their clients in the transition. As accounting standards impact all aspects of a client’s business, attorneys need to be aware of the changes IFRS bring, and how those changes may affect their clients. For instance, while U.S. GAAP has traditionally been the accounting standard to invoke in many contractual arrangements, with the wide respect that IFRS has gained over the past ten years, it is no longer a foregone conclusion that U.S. GAAP will be the only – or even the primary – standard to follow. With IFRS now mandated or permitted by over 100 nations, and even the U.S. GAAP-look-alike Canadian GAAP is being scheduled for replacement by IFRS in 2011 for publicly accountable profit-oriented enterprises (PAEs), it is clear that, in the immediate future, international business arrangements will need to be largely or exclusively measured and reported under IFRS. It is therefore highly likely that future contractual and other legal instruments will stipulate IFRS as the accounting standard to which the parties will adhere.

Implications for Transactional Attorneys

Transactional lawyers, who play a key advisory role in structuring contractual relationships with foreign-based entities on behalf of their clients, will benefit from increased knowledge about international legal and financial reporting issues. Oftentimes, the risks and rewards of the contracts – such as those governing joint ventures or earn-outs associated with business acquisitions – are closely linked to the counterparties’ reported financial performance. Lack of familiarity with accounting principles may affect one party’s judgments regarding the other’s financial position and/or recent results of operations, and consequentially hinder initial and continuing decisions to engage in such routine relationships as those between vendor and customer, and between lessee and lessor. The impact will be even more pronounced if U.S. entities are investees or joint venturers with foreign-based enterprises, and reporting “upstream” on an IFRS basis is suddenly mandated. Converting to a new financial reporting basis could impose a range of burdens, and could have deleterious effects on these relationships, with possibly major economic consequences for attorneys’ commercial clients.

U.S. lawyers should, accordingly, seek to quickly develop a more in-depth understanding of the differences between current U.S. GAAP and IFRS, in order to better service corporate clients. If their U.S. business clients are, or become, subsidiaries or investees of foreign companies, there will be an immediate demand for them to produce IFRS-basis financial statements to upstream to their parent or investor entities – a marked change from the recent past, when many of these foreign parent entities were quite willing to accept U.S. GAAP-based financial reporting packages, performing conversion duties, if at all, at the parent company level. For large, international law and accounting firms, accommodating these new demands will not prove a major problem, because resources for such undertakings doubtless already exist. For other advisors, there may be a need to establish relationships with technical experts from the law firms’ regular accounting firms, other consultancies, or university faculties, which are rapidly becoming attuned to the demand for IFRS expertise.

Based on gaining an understanding of the still-substantial differences between U.S. GAAP and IFRS, various business and legal strategies may present themselves, in an effort to mitigate or isolate the risks of having changing GAAP affect contractual compliance. One example of such a strategy is to include what is sometimes referred to as a “frozen GAAP” contractual provision, where the accounting principles employed at the inception of the relationship are preserved, for measurement purposes, throughout the term of the arrangement. In the authors’ experience, this has been most successfully invoked within a GAAP regime (e.g., within U.S. GAAP, for instance by keeping goodwill amortization in place even in the face of new standards that eliminated amortization in favor of impairment testing).

Superimposing a “frozen GAAP” provision on the rapidly changing landscape of international financial reporting may be more challenging to achieve, however. Given the wholesale changes that would have to be made if IFRS supersedes U.S. GAAP, the need to maintain two sets of books and records may prove impractical, and even if possible, could pose potential litigation risks. Attorneys who possess an enhanced understanding of IFRS are therefore better equipped to proactively educate – and to add value for – their existing clients, as well as to more effectively market their capabilities to prospective clients. Counsel, together with accounting advisors, might offer prospective clients various aids (such as “accounting convergence checklists”) to further assist them in making this transition process. In the authors’ opinion, this would be more effective, and better provide for long-term client satisfaction, than would fighting a “rear-guard” action to preserve the remnants of U.S. GAAP compliance in the face of growing internationalization of financial reporting standards.

Opportunities for U.S. Securities Lawyers

Having the SEC’s former reconciliation requirement waived (to the extent foreign private issuers file financial statements that fully comply with IFRS) provides potential opportunities for domestic law firms, as well. From the perspective of foreign registrants, this move will reduce compliance costs, improve efficiencies, and most importantly, facilitate cross-border capital formation. Improving access to the U.S. capital markets by eliminating reconciliation may result in some lost business for accounting firms, but (if basic economic theory holds true) this should also result in expanded business opportunities for both law and accounting firms. U.S.-based securities lawyers may be called upon to advise an expanded number of foreign would-be registrants in completing their securities offerings in U.S. capital markets. Additionally, some FPIs that now have the option of filing under IFRS may wish to consult with U.S. securities counsel to determine if it is in their best interest to do so under current U.S. securities laws.

Potential Litigation Risks

Clearly, any changes to reporting standards (even routine changes to U.S. GAAP) can engender disputes that may evolve into contractual or securities litigation. Notwithstanding the significant convergence that has already occurred, substantial differences between U.S. GAAP and IFRS do still remain. A change from U.S. GAAP to IFRS reporting standards would create – in the near term, at least – greater risk of misunderstandings, and of improper application of unfamiliar rules by preparers and even by auditors. Thus, the change could exacerbate already serious litigation risks, where investors or other users of financial statements claim to have suffered harm flowing from reliance on improperly prepared or inadequately explained financial reports. In the authors’ opinion, based on extensive experience with securities litigation, the expanded use of IFRS-based reporting will, for some period of time, create expanded litigation risk, which has long been disproportionately a U.S. phenomenon. Therefore, having an awareness that these risks exist should stimulate the exercise of greater care and caution, which hopefully would, to a degree, ameliorate the dangers.

Are There Governance Implications for the Board and/or Audit Committee?

Corporate directors – and in particular, audit committee members – need to be mindful in the selection and application of financial reporting standards. Specifically, the risks of “opportunistic behavior” by management, or “accounting principles shopping” in choosing between U.S. GAAP or IFRS adoption, in order to affect key financial ratios and other performance measures, potentially affecting bonus awards and option grants, may demand greater board scrutiny. Directors, together with any legal or accounting counsel, must gain comfort with management’s choices, both as to the propriety and appropriateness of the actual accounting standards selected, and also as to the internal control implications of making those choices. Furthermore, they should anticipate, and in fact insist upon, greater scrutiny of these management decisions by the reporting entity’s outside auditors. This is another area where audit committee consultation with special counsel or independent accountants – the engagement of which is explicitly authorized under the Sarbanes-Oxley Act (Section 301) – may be particularly warranted, for both substantive and defensive reasons.

Concluding Thoughts

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About the Authors. Barry Jay Epstein, Ph.D., CPA, (BEpstein@RNCO.com) is Partner in the Chicago, Illinois firm, Russell Novak & Company, LLP, where his practice is concentrated on technical consultations on GAAP and IFRS, and as a consulting and testifying expert on civil and white collar criminal litigation matters. Dr. Epstein is the co-author of Wiley GAAP 09, Wiley IFRS 09, Wiley IFRS Policies and Procedures, and other books. Susan Cheng is a senior manager with Russell Novak & Company, LLP, specializing in international accounting matters, litigation consulting, and forensic accounting.