Transparency in Financial Reporting. Ruth Ann McEwen

      

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      First published in Great Britain in 2009

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      ISBN13: 978-0-85719-022-2

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      About the author

      Ruth Ann McEwen is Associate Dean of Accreditation and Administration and Professor of Accounting for the Sawyer Business School at Suffolk University. She earned her Ph.D. in Industrial Management with a concentration in Accounting from the Georgia Institute of Technology and taught Financial Accounting at the Master’s and Doctoral levels for more than 20 years. She is the author or co-author of more than 40 refereed articles and proceedings focusing on the usefulness of accounting information. She has published in such premier journals as The Accounting Review, Decision Sciences, Accounting Horizons, CPA Journal, International Journal of Accounting and the Journal of Business Ethics and is the author of “Earnings Per Share” and co-author of “Asset Retirement Obligations” published by Tax Management, Inc. In 1998, she presented a series of research papers to a joint seminar of the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB) focusing on current financial reporting.

      From 2005 until 2008, Ruth Ann McEwen served as a consultant to the FASB, authorized as a content expert to codify United States Generally Accepted Accounting Principles (US GAAP), which comprises authoritative guidance for US corporate financial reporting. She has received numerous scholarly, teaching and research awards.

      Introduction

      By January 1, 2012, all major economies will provide financial reports using International Financial Reporting Standards (IFRS) except for Argentina, Greenland, parts of Africa and the United States. While the US Securities and Exchange Commission (SEC) recently published a roadmap for transition from US GAAP to IFRS, the roadmap does not include an irrevocable transition date; instead, mandatory adoption will depend on accomplishing objectives represented by milestones. It is likely that these objectives will be met and transition will occur by 2016. This work will set out the key differences between IFRS and US GAAP from a practitioner’s perspective, although financial analysts also will benefit from the material presented. The work identifies issues related to potential adoption of IFRS in the US and is aimed at intermediate to advanced practitioners and analysts.

      IFRS differs in many respects from US GAAP, but no difference is as substantive as the IFRS view that all assets and liabilities can be revalued to fair value each reporting period, implicitly suggesting that only one value is “fair” and that managers are able to measure it. Unlike IFRS, US GAAP recognizes assets and liabilities at cost and, in most cases, revaluation reflects only decreases in value.

      Balance sheet items are shown net of adjustments that keep assets from being overstated and liabilities from being understated. Alternately, assets and liabilities under IFRS are revalued each period to reflect both increases and decreases in value. Under both US GAAP and IFRS, decreases in value lead to unrealized losses that are recognized into current earnings or equity. Under IFRS and in fewer circumstances under US GAAP, increases in value lead to unrealized gains that may be recognized into current earnings. Recognition of these unrealized (no transition has occurred) holding gains may seriously inflate measures of earnings and income.

      IFRS, and in certain circumstances US GAAP, is viewed by some as providing useful information for investors and creditors because of the fair value requirement. Under either system, revaluation methods may be straightforward or extremely obscure. An example of a straightforward method would be revaluing a building at a price for similar buildings in a similar area in a functioning real estate market. But most revaluations are not straightforward.

      More obscure methods employ pricing models based on unobservable inputs in markets that are not fully functioning. For example, consider the case of fair valuation of a contingent consideration acquired as part of a business combination. Recognition and periodic revaluation requires estimates of the cash flows associated with the contingency (usually based on a subjective probability distribution) and the choice of an appropriate discount rate reflecting the risk of the acquired entity. Depending on the nature of the consideration, active markets may not exist. Both IFRS and US GAAP require the consideration to be recognized at fair value and that its estimates and managerial judgments be disclosed. But even with extensive disclosure about cash flow estimates and risk analysis, additional disclosure does not guarantee greater transparency or enhanced usefulness of the financial information being presented.

      The financial crisis which began in 2008 has been attributed to, among other things, a perceived lack of transparency in the financial markets. In general, transparency implies an ability to see the reported results of an entity’s financial activities clearly and to use these results in making investment decisions. At question is the belief that transparency in financial reporting will lead to transparency in financial markets. Unfortunately, this link may be more subjective than most of us wish.

      This book presents an analysis of reporting issues affecting transparency under IFRS, compared with US GAAP, and suggests areas of concern for preparers and users of financial reports. I also provide a technical analysis of major accounting issues raised by convergence, and indicate areas of interest during initial adoption of IFRS by US entities.

      Part One: Transparency of Financial Reporting

      In recent years, the transparency debate has largely focused on US GAAP and whether its proper application could offset Wall Street greed. Many believe that even with proper application, US accounting principles are too complex and proscriptive, and result in a system in which entities tend to follow form over substance while violating the underlying spirit of transparency. IFRS guidelines focus on broader principles and give entities more leeway to reflect those principles. Managers are provided with guidance that encourages reporting which reflects the true underlying substance of financial transactions. There is an expectation that convergence of US GAAP and IFRS will take the best practices of rules-based and principles-based accounting standards, resulting in the highest quality financial reporting possible. Under such a setting, transparency would be greatly enhanced.

      1. Transparency and Financial Reporting Quality

      Transparency may be viewed as a financial reporting quality indicator. While a single definition of financial reporting quality does not exist, markets have described a similar construct: earnings quality. Some view