For many companies significant changes in their accounting practices are appearing on the horizon, given impetus by proposals from the U.S. Securities and Exchange Commission (SEC). That agency is calling for a migration from U.S. Generally Accepted Accounting Principles (GAAP) to International Financial Reporting Standards (IFRS). Such a convergence seems inevitable, and smart companies will want to prepare sooner, rather than later. In the following series of questions and answers, I share my insights on what topics executives should address for a smooth transition.

Preparing for ‘Crunch Time’ in the Transition to IFRS – Part 1

What are the timelines for conversion to IFRS in the U.S.?
While the SEC may allow some of the largest U.S. public companies to make the switch as early as 2009, mandatory use of IFRS in this country would likely begin in fiscal 2014 for large accelerated filers; fiscal 2015 for accelerated filers; and fiscal 2016 for non-accelerated filers. The SEC will evaluate progress on certain significant milestones in 2011 to see how things stand. By 2016, all public companies, regardless of size, will be expected to report financial results using international accounting standards if IFRS requirements are adopted by the SEC in 2011.

Is adoption of IFRS mandatory for all companies?
Conversion to IFRS presently deals only with public companies. The Financial Accounting Standards Board (FASB) provides accounting standards for all U.S. companies. Through the convergence process, as differences between IFRS and GAAP are eliminated, eventually all companies will be using IFRS.

The 2014 adoption date is still speculative; no one is allowed to begin the “phase-in” period yet. The only thing happening is that certain U.S. standards are changing to look just like international standards, such as FAS 141R relating to business combinations. That makes U.S. purchase accounting look much like IFRS as of January 1, 2009. It may be traumatic for the companies that have to adopt, but it is something of a “test drive” and we will see how it goes.

What are the principal differences between current U.S. GAAP and IFRS?
U.S. GAAP and IFRS vary depending on the industry, capital structure and revenue streams. The transition affects everything from revenue and cash flows to the balance sheet and footnotes. Companies will have to take a fresh look at how they report on business segments, discontinued operations, revenue recognition, income taxes, impairments, inventory, measurement of liabilities, development costs, fixed assets, equity versus debt obligations, insurance contracts and cash flows.

Which differences are being addressed by the convergence?

1. Business combinations– Many of the costs in business combinations that were previously capitalized are now expensed and vice-versa. Certain mark-to-market valuation timing is affected, so a company’s ability to model the effect of an acquisition has to change, potentially dramatically so. Even for a company that is not in an acquisition mode, its deal model will be impacted.
2. Non-controlling interest– This relates to how a company presents its consolidated financial statements. It could change for companies with a lot of equity interests but no sole shareholder position, e.g., in partnerships or joint ventures.
3. Fair value– In this instance, the International Accounting Standards Board (IASB) has taken a step toward GAAP in the guidance provided to users. Companies will have to be prepared to justify management judgments related to fair value and document their rationale.

What lessons should companies take from their Sarbanes-Oxley (SOX) Section 404 compliance process to enhance the IFRS transition?
In one word: Plan. SOX implementation did not have this kind of lead time: up to three to five years advance notice. Companies should use such an opportunity to perform a diagnostic to identify what may have to change and integrate conversion activities into other scheduled projects, such as systems modifications. For example, if upgrades to information technology (IT) systems are planned in the near term, incorporating IFRS related upgrades at the same time will reduce costs and prevent the need for a second upgrade. Companies should use every minute of the advance time to prepare – and not to delay. To a degree, convergence already has begun to occur. If the SEC for some reason pulls the plug on IFRS, then convergence will come one FASB statement at a time. So it is either conversion or convergence.

How does the IFRS convergence impact the internal audit function? What role will the audit team play in this process?
Internal auditors face a steep learning curve as their roles become more active. They will have to revise how they plan and scope an audit, which will not be as focused on auditing rules, as much as how to audit the exercise of judgment. Auditors will need to be up to speed on alternatives and prepared to do more qualitative auditing. They will also need to consider auditing the company’s change management processes for IT and other controls, and take a new and fresh view of segregation of duties within any new decision-making constructs.

Why should companies not wait until the 11th hour to prepare for the transition?
Companies that delay addressing the conversion put themselves at risk of not being able to find available resources because of the supply of qualified resources and anticipated demand, as well as increased costs for conversion given the shortened timeline to complete the project.

Why is it important to develop a point of view around the perceived benefits and costs of implementing IFRS, if given a choice to adopt it?
Experts compare the effort required to switch to IFRS as monumental as the previous adoption of Section 404. If they are right, it is worth the initial view of evaluating the benefits and costs associated with this step in order to bring into focus the opportunity to streamline global reporting and to reduce costs through those efficiencies. Centralizing finance operations also offers opportunities in terms of capital market access, benchmarking and other comparability analyses.

On the risk side, a company needs to consider how its transition to IFRS might impact its resources and strategic initiatives planned for the next few years. From a cost standpoint, even if the transition to IFRS is at a level equal to or half as much as spent on Section 404, cost is going to be a significant number for most companies. It will be important to be able to measure what those costs will be in relation to the benefits. The real heavy lifting of IFRS goes well beyond the numbers as companies consider the impact on processes, systems and controls used to manage the business.

How can executives begin educating board members, audit committee members and employees to understand the principal differences between U.S. GAAP and IFRS?
First – start placing IFRS considerations on agendas. If the topic never hits the agenda, then there is less likelihood of it being discussed along with a reduced opportunity to educate and to start developing expectations. Also important is an initial assessment on what the impact might be on the organization. It can be helpful to provide board members with some of the experiences or lessons learned from IFRS conversions in Europe and elsewhere. For companies with Section 404 experience under their belts, comparing and contrasting the conversion with IFRS to Section 404 is a way to put the project into perspective for the board and get their attention. This puts the scope of IFRS conversion in context with something they already understand.

IFRS Poll 

Preparing for ‘Crunch Time’ in the Transition to IFRS – Part 2

Why is it important that companies complete a pre-convergence assessment when preparing to move to IFRS?
Most large transformation initiatives or significant strategies that a company undertakes frequently are underestimated by the board and management in terms of the impact on the culture, the capabilities of its workforce, and wear and tear on an organization. They often lowball the necessary effort, cost and level of resources and skill sets. We know that the key to execution is proper planning.

Relevant topics important to cover in this assessment include:

1. Impact on key reporting areas. Revenue is one of the key financial statement accounts used by analysts and investors to measure a company’s financial performance. Revenue recognition, as currently promulgated, has significant differences under GAAP and IFRS. Given its complexity, trying to gain an understanding now, as opposed to later, of the impact the transition to IFRS would have on the revenue recognition policy will contribute towards effective planning and managing expectations.
2. Changes in reporting methodologies, systems and data. The reporting of financial results is only as good as the data input into whatever system is used to gather, accumulate, analyze and post the financial information. Since IFRS is, for the most part, more principle based than rules based, the accuracy of the information used for the judgments made and the methodologies, policies and procedures need to be more robust in an IFRS reporting environment. If, in fact, there are fewer rules to rely upon when applying IFRS, more judgment is going to be used in the process. Manual or semi-automated processes, including the use of spreadsheets, only increase the risk of potential misstatement. Opportunities to automate where the information is coming from, how it is summarized, analyzed and reported are key in regards to how companies manage the risk of reporting under IFRS and during any transition period.
3. Impact on internal management reporting, including key performance measures and metrics and the related effects on the incentive compensation structure. The budgeting and forecasting performed by the financial planning group will require that any changes made under the historical reporting of IFRS will cause changes in the assumptions used to estimate the future. As it relates to performance measures and metrics, if the basic financial statements change, the company may have to reconsider the usefulness and accountability around some of the key metrics or ratios it uses for benchmarking. Companies should ask themselves: “Are those really the appropriate measures?” And any time incentive compensation is tied to financial statement captions, changes to those financial statements or alterations in the way those amounts are determined can have a direct impact on the morale and productivity of employees.
4. Impact on contractual agreements, loan covenants and other legal documents with provisions tied to financial performance. Many company agreements and other documents currently have provisions that reference U.S. GAAP. A change to reporting under IFRS will likely require a lot of potential amendments to those agreements that have financial statement-based covenants. Companies also will have to examine what reporting under IFRS does to those covenants and the company’s ability to maintain them. From the financial statement user perspective, it will be important to consider whether those covenants should be modified. The decision to either let contracts run their course or re-negotiate comes with significant operational and strategic considerations that much be addressed.
5. Changes in the finance function. Finance organizations will need to have more robust policies and procedures to ensure that judgments are made at the right level by the right people, and that they are consistent throughout the organization. For companies with international operations, consistency in the use of judgment in the application of accounting policies and procedures is critical to reporting accurate results. In addition, IFRS will move increasingly toward more frequent use of fair value accounting which will call for increased training for many U.S. finance organizations whose teams are primarily oriented toward historical cost accounting.
6. Organization of a Project Management Organization (PMO) structure to drive the change process. The PMO role provides an opportunity for people in the organization to be part of the process but not to the extent that it is a distraction to the key activities they perform in their day jobs. Also, the PMO role clearly builds discipline and accountability into the process, helps develop and manage expectations, and hopefully reduces surprises on the back end as the transition occurs and the international standards are fully implemented.
7. Development of an effective communications plan. Communication is the key to any successful change management initiative, and being able to manage and deliver on expectation is a key success factor in any major initiative. Stakeholders in IFRS are both external and internal. Effective communication is going to be as crucial to this initiative as it is to any other major company initiative.

How far in advance of IFRS adoption should an assessment occur?
Our position at Protiviti is that companies need to do an initial assessment/diagnostic now. The extent of the assessment may vary depending on how soon they are looking at a transition to IFRS. The assessment will either confirm that a company has some time before it needs to prepare; or it may identify some issues that have not been previously considered but should, particularly in terms of strategic initiatives to start building into its planning process.

Why is it important to understand, in advance, the implications of a change to IFRS on the organization’s internal and external financial reports?
Accurate external reporting establishes credibility with investors and analysts, and the consequences of misreporting are dramatic. A transition to IFRS requires an understanding of what the key differences are, analyzing the implications and putting together a sustainable process to get the right number – and doing that right now rather than trying to figure it out at the last moment. Accurate internal reporting provides that same level of credibility with internal users of financial information.

Why is it important for leaders to remember that this transition process is not limited to just the finance and accounting departments, but also impacts people, processes and technology throughout the organization?
The accounting and finance functions account for all transactions and activities that occur throughout the enterprise. To say that the transition to IFRS is just a finance and accounting exercise is naive. For example, those U.S. companies which invest heavily in research and development on products and solutions will need to change the way they track development activities. Under IFRS, certain provisions require at least some of the development costs to be capitalized. This would require that the research and development function will need to track activities and monitor their time in a much different manner than they did historically. That is just one of many examples of how this transition process touches other parts of the organization.

Why is it important in this process to evaluate such items as change readiness, a PMO leadership structure and the implications around accounting policies and procedures and potential systems changes?
The success of any transition to IFRS will require the appropriate “tone at the top” of the organization. There will be a change in the financial reporting mindset with more focus around the use of judgment and principles as opposed to rules. Anytime you increase the use of judgment, there is a direct increase in risk. There is also the issue of people who are adverse to or have a low tolerance to change.

With a PMO structure, a company is looking at building processes and systems and to train its employees so they not only can produce that first report under IFRS but have a process that is sustainable and will serve the company quarter after quarter for years to come under IFRS. You do not want to view IFRS transition as a one-time project.

There are opportunities, particularly for global companies, to be able to streamline the finance organization and implement consistent methodologies and policies around the world. IFRS also will provide an opportunity to flatten out the finance organization and make it more efficient.

One would be hard-pressed to find an IT department that is not already overloaded with requests and initiatives from finance and accounting and other parts of the organization. IT departments will need to understand that a transition to IFRS is not just another routine accounting request. This is a potential transformation of the finance organization and the financial reporting function – both externally and internally, that is going to require a lot of thoughtful planning. However, there will not necessarily be an off-the-shelf solution. It will require careful consideration of resource requirements, customization, programming and coordination with finance and other parts of the organization. Someone must think about how changes to processes and systems will impact the internal control structure of the business. How do we make sure those controls are in place? How does that impact the testing of controls under Section 404?

The other key consideration for companies who fail to use their systems to automate processes and controls related to IFRS reporting is that the numbers may be subject to manual intervention, and by default, be subject to errors that are inherent in manual processes.

For more information on topics discussed in this article, please contact:

Christopher Wright
Global IFRS Leader
(212) 603-5434
Christopher.Wright@protiviti.com

Steve Hobbs
U.S. IFRS Leader
(408) 808-3253
Steve.Hobbs@protiviti.com