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Evaluating the Influence of Accounting Standard Convergence on Financial Reporting, Debt Covenants and Audit Risk

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.

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Evaluating the Influence of Accounting Standard Convergence on Financial Reporting, Debt Covenants and Audit Risk

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  1. 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

  2. What is U.S. Accounting Convergence? Accounting Harmonization Accounting Convergence 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. • Relates to the process of substantially standardizing the rules and regulations for international securities and the related accounting principles across countries.

  3. 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.

  4. 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?

  5. What are the advantages/disadvantages of a single set of global accounting standards? Advantages Disadvantages Foreignfinancial 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). • Global capital expansion • Transaction cost reduction • Appropriate division of labor • Increased market competition • Accelerated innovation Sources: Hope, Jin & Kang, 2006

  6. 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?

  7. What are the cost of shifting to new accounting standards? Advantages Disadvantages Foreignfinancial 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). • Global capital expansion • Transaction cost reduction • Appropriate division of labor • Increased market competition • Accelerated innovation Sources: Hope, Jin & Kang, 2006

  8. 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.

  9. 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.

  10. 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)

  11. 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. 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.

  12. 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?

  13. 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. 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.

  14. 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).

  15. 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.

  16. 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.

  17. 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?

  18. 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.

  19. 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.

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