International accounting standards: why they might not be for us

(First of two parts)

Given up for dead just eight months ago, adoption of international accounting standards still has a pulse. And while that may seem like something for someone else to worry about, adopting the standards would add expense and complexity to U.S. companies’ financial reporting.

Here’s why your business should be following and possibly contributing to this debate. But first, a little background:

Adopting an international accounting standard grew out of recognition of a world economy and spurred by a series of financial crises, including the Enron scandal. By the time the Bernie Madoff Ponzi scheme hit, the so-called “roadmap” to a global accounting standard had been established under the Bush administration. In the wake of the current economic crisis and President Obama’s election, many in the industry thought the roadmap would be abandoned, but newly appointed SEC Chief Accountant, James Kroeker, said an international standard is very much one of his priorities and it looks like we are turning back to the roadmap. So, game on.

What are international accounting standards?

At first blush, you might think the call for a “suitable set of high quality accounting standards” that everyone in the world lived by would bring the world economy closer together, make trade and lending easier and facilitate international transactions and mergers and acquisitions. You might think these international standards are based in a tough interpretation of the facts. In reality, international standards are more judgmental than US Generally Accepted Accounting Principles (GAAP).

Here’s an example of the principle-based approach used by the International Financial Reporting Standards. Lease financing has become the most widely used method of personal property financing in the U.S. today.

Under U.S. GAAP rules, there are two ways to record leases. You can expense the monthly costs (off balance sheet) or you can record it as a capital lease, adding up the value of all your future lease payments as debt. Most companies don’t like to record the leases as debt because it makes their balance sheets look bad, but US GA has a “bright line standard.”

Under the bright line standard for leases, you must meet one of four tests to write off the lease directly, otherwise you have to record it as debt on the balance sheet. The main test is to compare the present value of future lease payments to the value of the leased asset. If you’re at 90 percent or greater, it goes on the balance sheet. That’s the “bright” line. Because of this clear standard, it’s easy for companies to structure their leases to either expense or capitalize them.

Now let’s look at a lease from the international standards approach.

Under the principle-based approach used in the international standards, an auditor asks, “Does this look more like a financing transaction, where they used a lease to obtain the funds to acquire an asset or does it look like a real lease, where the company is paying a monthly fee to use the property?” Under international rules, the accounting is based on the substance of the transaction, and not on the form of the lease agreement. You won’t have bright line standards to guide the company or the auditor. That invites judgment and judgments can obviously vary widely.

Another way to look at the difference between U.S. GAAP and international standards is the sheer volume of literature. The U.S. GAAP standards for lease accounting are made up of over 50 original pronouncements, which when codified result in over 120 pages. The international lease accounting standards consist of one primary standard with three interpretations, included in fewer than 30 pages.

An invite for litigation?

One thing we know for sure is that U.S. companies are involved in more litigation than the rest of the world. If companies and their auditors are making more judgments and don’t have standards to fall back on, it invites more suing of companies and their reporting and in turn their auditors, who may have been pressured to make judgments that favor certain types of financial reporting. U.S. companies have to ask themselves if this is truly advancement of financial reporting or just the invitation for more headaches in the future.

International Standards Part II: My next article will explore how adopting international accounting standards will add to a company’s costs and make their reporting more complicated, not less. In addition, I’ll talk about why companies should join the discussion on whether to adopt these standards.

Useful links for this article:
International Accounting Standards Board


IFRS open to comment

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Categories: Finance