Evaluating the Influence of Accounting
Standard Convergence on Financial
Reporting, Debt Covenants and Audit Risk
By Phil Rickard
Associate Professor of
Accounting, Mount Vernon
Nazarene University
What is U.S. Accounting Convergence?
Accounting Harmonization
Accounting Convergence
• Relates to the process of
substantially standardizing the
rules and regulations for
international securities and
the related accounting
principles across countries.
• Relates to the more
precise objective of
improving the quality of
U.S. GAAP to the extent
a common solution can
be found in collaboration
with the international
board.
What is the potential concern with IFRS?
• There is limited specific guidance in the IFRS
discovered in research.
• There will be a shift in focus from the matching
principle and its influence on the income statement.
• There will be a shift toward a fair value
measurement view, which concentrates on
inclusions in the balance sheet.
» The primary thrust for principles-based
accounting relates to the focus on meeting
the letter of a rule in U.S. GAAP, more than
the spirit of the concepts behind the rules.
What influence do professionals have in
the convergence process?
• Aggressive lobbying will continue as economic and
political factors serve as the catalyst for the
development of accounting standards.
• Current and future accounting/finance professionals
will engage in the political, legal, and economic
process, which will shape these standards.
Do Christian business faculty and
students have a legitimate
opportunity to participate?
What are the advantages/disadvantages of
a single set of global accounting standards?
Advantages
Disadvantages
• Global capital expansion
• Transaction cost reduction
• Appropriate division of labor
• Increased market competition
• Accelerated innovation
Sources: Hope, Jin & Kang, 2006
• Foreign financial reporting quality
may not be dramatically improved
• Investment home bias strategies
will not be circumvented by IFRS
adoption
• Auditor professional judgment will
need to overcome the inferior
quality of regulation and
compliance
Sources: Beneish & Yohn, 2008
Carmona & Trombetta, 2008).
Are the principles-based standards
superior to rules-based guidelines?
• The international business and political participants prefer the
IFRS on the basis of the principles-based emphasis.
• These parties primarily criticize the lengthy guidance issued
by the FASB in the U.S. and blame rules-based accounting
as the mechanism propelling fraud and other financial
engineering in the financial statements.
• Some researchers (Haswell, 2006; Beneish & Yohn, 2008)
refer to poorly-developed standards within the IFRS.
» Will the move to principles-based accounting
actually establish the need for more rules to
clarify some of the principles resulting from
complex financial transactions?
What are the cost of shifting to new
accounting standards?
Advantages
Disadvantages
• Global capital expansion
• Transaction cost reduction
• Appropriate division of labor
• Increased market competition
• Accelerated innovation
Sources: Hope, Jin & Kang, 2006
• Foreign financial reporting quality
may not be dramatically improved.
• Investment home bias strategies
will not be circumvented by IFRS
adoption.
• Auditor professional judgment will
need to overcome the inferior
quality of regulation and
compliance.
Sources: Beneish & Yohn, 2008
Carmona & Trombetta, 2008).
What are the costs of convergence in the
U.S. for corporations and other parties?
• SEC estimates the cost of adopting IFRS at nearly
$32 million for each company.
• For the nearly 110 issuers who are expected to
reach early adoption, the total cost for the first 3
years would be about $3.5 billion (Yallapragada,
Toma & Roe, 2011, p. 62).
• Accounting firms must adjust financial reporting,
auditing, taxation and consulting
approaches for the new standards.
Where are we headed?
• The U.S. Securities and Exchange Commission created a roadmap,
which may lead public companies reporting to the agency, to the eventual
mandated adoption of the IFRS (Hail, Leuz & Wysocki, 2010).
• The governance structure of the International Accounting Standards
Board is worthy of the academic community’s attention, because
international and national political factors will shape the movements of
this standards-setting body.
• The convergence strategy of the SEC is an “improve and adopt”
approach; the IFRS are being assessed and an objectives-oriented
outcome is desired.
• The SEC is concerned about the increased professional judgment
required with principles-based accounting.
Where are we headed?
• An illustration of the benefits from the cooperative environment of the
standard setters can be illustrated through the exploration of lease
accounting theory
• The SEC has requested adjustments in the rules for lease accounting
since 2005, because of off-balance sheet accounting concerns (Bryan,
Lilien & Martin, 2010)
• In essence, it appears the FASB and the IASB have rejected both U.S.
GAAP and the IFRS lease accounting approaches, since neither is
effective in assessing the legitimate substance in lease arrangements
• Not all accounting convergence movements will be addressed in this
manner (i.e. inventory valuation)
Accounting for Leases
For accounting purposes, leases have been identified as
either Capital or Operating according to FASB
Statement No. 13. If one of the four criteria below was
satisfied, the lease was subject to capitalization.
 The lease transfers
ownership at the end
of the lease term.
 The lease contains a
bargain purchase
options.
 The lease term = or >
75% of the asset’s
estimated useful life.
 The minimum lease
payments > 90% of
the PV of the asset.
Financial Management using Leases
• A major objective in financial management is successful
engineering of lease contracts.
• Exclusion from the balance sheet is one objective, and is
usually accomplished by structuring an operating lease.
• Financial analysts can normally extract relevant investment
data from a variety of disclosure formats.
• Shifting to balance sheet inclusion will enhance financial ratio
analysis and likely positively impact the capital markets.
» Will the move away from lease classification
engineering remove an important strategic
component or lead to more efficient business
management and investment soundness?
Accounting for Leases
Accounting for leases is shifting to a right-of-use
model, which will lead to significant increases in the
amount of capital leases, because the standard bodies
are trying to include the substance of lease transactions
on the balance sheet.
All leases would be
accounted for in a
consistent manner.
Off-balance sheet
financing would likely
be curtailed
Locating debt financing
may be more
challenging.
More debt covenants
violations will likely
occur.
Financial Analysis Repercussions
• Long-term financial commitments and performance indicators
could be evaluated with more precision by bankers who
thrive on security in the judgment of liquidity, solvency and
risk ratings (Durocher & Fortin, 2009).
• Capital lease information is vital to the granting of credit, and
most loan agreements will specify the maintenance of a
specific current ratio for credit security protection.
• Previously, technical default has been manipulated through
accounting choices and discretionary accruals.
» “Decreases in cash flow are a strong predictor of
covenant violations, and a firm that violates a
covenant loses access to 15 to 30% of its line of
credit capacity” (Sufi, 2009, p. 1086).
Inventory valuation
• Not all accounting conversions to IFRS will involve the creation of an
overhauled standard and inventory accounting serves as a viable
example.
• The most significant distinction in the valuation relates to the fair-market
measurement approach in IAS 2.
• Also, IAS 2 possesses a feature, disallowance of LIFO cost flow
accounting, which creates a monumental tax policy issue.
• In order for companies to benefit from the tax advantages of LIFO, the
method must also be adopted for financial reporting purposes in U.S.
GAAP currently.
• LIFO was a controversial adoption in the U.S., and has never gained
acceptance worldwide.
Is there a Biblical basis for reassessing
accounting standards?
• Biblical stewardship demands monitoring.
• Old wineskins are not suitable for new wine;
however, stewardship requires assessment of this
new wine.
• Accounting standards assist in keeping shrewdness
and innocence in balance, thus ethics are
embedded in these standards.
» God has always modeled excellence in creativity,
administration and accountability. Our moral
responsibility is to glorify God through our
approach to creativity, administration and
accountability.
Potential discussion points with students: Is there a
Biblical basis supporting accounting convergence?
• Earnings management activities are more likely when LIFO is
utilized, because it accommodates the need to smooth
income for corporations when input costs are rising. Is
earnings management sound Biblically?
• Auditors will likely encounter a more combative environment.
Does this fit with Biblical principles?
• Will a shifting of business judgments from management to
auditors serve as a prudent stewardship model?
• Should the needs of the international community trump the
heritage embedded with the established principles and
practice of a nation?
What do accounting students need to
know for proper equipping?
• Students should be exposed to the limited specific
guidance in the IFRS, and faculty must prepare
them for the greater professional judgments needed
in this volatile environment.
• Students should be trained to rely upon Biblical
wisdom (the Proverbs and the teachings of Jesus)
and Business Law to protect them during the
vulnerabilities, which will likely be created
by accounting convergence.
What do finance students need to know
for proper equipping?
• Future financial reports will reflect fair market
valuation for more assets, and this means a less
conservative financial focus.
• There will be an increase in reported liabilities on the
balance sheet.
• Negotiation of debt covenant terms stands to benefit
more from accounting standard transformation.
»Business valuation experts will likely be
important partners for auditors.