Northeast Business & Economics Association Established in 1973

IFRS for U.S.-Based SMEs: Whos on First, and What U.S.-Based SMEs Need to Look Out For
Dori Lombard Marist College dlombard@marist.edu ABSTRACT At first glance an accountant for a small and medium-sized entity (SME) might assume that whatever the SEC, the AICPA, or FASB says about whether or not IFRS apply to his or her U.S.-based SME client would be controlling. However, SMEs with certain types of relationships with publicly traded companies, or with companies in other countries, may also need to deal with IFRS and IASB. This paper attempts to tease out the jurisdictional threads concerning IFRS as they pertain, or may well in the near future pertain to, U.S.-based SMEs, and then to suggest where there are issues that need to be considered and resolved. Keywords IFRS for SMES, IFRS, IASB, FASB, SEC 1 INTRODUCTION International Financial Reporting Standards (IFRS) for Small-and-Medium-Sized Entities (SMEs) are being proposed by the International Financial Reporting Standards Foundation, which represents a non-U.S. constituency. Just as IFRS for publicly traded corporations will have enormous impact across the globe on how public companies prepare their financial statements, so, too, IFRS for SMEs are going to be of concern to U.S.-based SMEs. First, an overview of the institutional setting in which the development, promulgation, and enforcement of financial accounting standards takes place is in order. 2 THE FASB In the United States, the Securities and Exchange Commission (SEC) delegated to the private sector the power to develop and promulgate financial accounting standards for companies wishing to register their shares for sale on the exchanges, but it did not delegate its enforcement power. 1 It reaffirmed this delegation and the legitimacy and authoritativeness of the Financial Accounting Standards Board as the body currently empowered to create the standards in its April 25, 2003 Policy Statement Reaffirming the Status of the FASB as a Designated PrivateAccounting,Law&Taxation Caroline V. Rider Marist College caroline.rider@marist.edu Sector Standard Setter. 2 The Financial Accounting Standards Board (FASB) is a board appointed by the Trustees of the Financial Accounting Foundation. 3 The Financial Accounting Foundation (FAF), established in 1972, is a not-for-profit, non-stock corporation organized under the laws of the State of Delaware. 4 The Certificate of Incorporation of FAF states in Article FIFTH that .[t]here shall be a Financial Accounting Standards Board (the FASB) to which there is hereby delegated all authority, functions, and powers of the Corporation and the Board of Trustees in respect of standards of financial accounting and reporting.. The Trustees of the parent, FAF, have charge of the finances of the FASB, and of the Financial Accounting Standards Advisory Council (FASAC), also appointed by the FAF Trustees. In addition, the FAF Trustees must, according to Article 1-A, Section 1 of the By-Laws, periodically review both the short-range and long-range project plans of the FASB and FASAC. As the SEC Policy Statement referenced above points out, the FAF By-Laws are very specific about the qualifications for being on the board of FAF or FASB or FASAC. Lack of conflicts of interest plus knowledge and experience which will be directly relevant are the main considerations. In theory, although the SEC states that it expects the FAF to give it notice of proposed appointments, and to give some weight to the SECs opinions regarding proposed appointments, the FAF, FASB, and FASAC are independent, private-sector entities. Whether this arrangement can continue given the U.S. Supreme Courts recent decision in Free Enterprise Fund v. Public Company Accounting Oversight Board, 5 remains to be seen. Since the FASB arrangement does not involve a statute, and since the SEC clearly retains the power to dump FASB by declaring its standards to be NOT authoritative, one suspects that the overall structure is unlikely to be disturbed. 3 THE IASB The International Accounting Standards Board is a Page69

Northeast Business & Economics Association Established in 1973 Committee of the International Financial Reporting Standards Foundation (IFRS Foundation, formerly the International Accounting Standards Committee Foundation). Although the organization is European in initial inception, the IFRS Foundation is a non-stock corporation organized and existing under the General Corporation Law of the State of Delaware, but it is registered in England and Wales as an office of a foreign corporation6. Section 13 of the IFRS Foundation Constitution7 provides that the Trustees shall themselves determine what kind of a legal entity the Foundation is to be, and where it shall legally and operationally be headquartered. The IFRS Foundation has also established a Monitoring Board, pursuant to its Constitution. 8 The Monitoring Board participates in the IFRS Trustee-nomination process, approves Trustee nominees, and works with the IFRS Trustees in their oversight of the IASBs finances and the standard-setting process. The Memorandum of Understanding between the IASCF, now the IFRS Foundation, and the Monitoring Board, dated April 1, 2009, provides that [t] primary purpose of the IASCF Monitoring Board is to serve as a mechanism for formal interaction between capital markets authorities and the IASCF, thereby facilitating the ability of capital market authorities that allow or require the use of IFRS in their jurisdictions to effectively discharge their mandates relating to investor protection, market integrity and capital formation.9 Thus, interestingly, the FASB and the IASB have similar structures and contexts: they are committees of U.S.-incorporated foundations, overseen both by the Trustees of the foundations, and by an external body which is concerned with financial markets. The difference is, however, that FASBs standards are officially recognized as authoritative by the Securities and Exchange Commission, an arm of the U.S. government with enforcement authority in the area of financial reporting of registered companies, whereas although IFRS are the required and exclusive mode for presenting financial information of companies in a great many countries10, it is not at all clear whether those countries have any direct oversight power, or whether they rely on the Monitoring Board. 4 CONVERGENCE The FASB and the IASB are working together to see if convergence of the two sets of rules for publicly traded companies is possible. They expect to have the bulk of their report completed in 2011, 11 so that the Commissioners of the SEC can make a decision as to whether, when, and how to require or allow companies registered on the exchanges must or may use IFRS for their required financial reporting/disclosure. Currently they are required to use GAAP. Accounting,Law&Taxation 5 SMES Against that background, then, we see that if publicly traded companies, many of which are global or at least international, end up using IFRS instead of U.S. GAAP, there may be situations in which U.S.-based SMEs will need to consider whether THEY need to use IFRS. First, of course, we need to know who SMEs are in this context. Page ten of the IFR Standard for Small and Medium-sized Entities12 defines SMEs: 1.2 Small and medium-sized entities are entities that: (a) do not have public accountability, and (b) publish general purpose financial statements for external users. Examples of external users include owners who are not involved in managing the business, existing and potential creditors, and credit rating agencies. 1.3 An entity has public accountability if: (a) its debt or equity instruments are traded in a public market or it is in the process of issuing such instruments for trading in a public market (a domestic or foreign stock exchange or an over-thecounter market, including local and regional markets), or (b) it holds assets in a fiduciary capacity for a broad group of outsiders as one of its primary businesses. This is typically the case for banks, credit unions, insurance companies, securities brokers/dealers, mutual funds and investment banks. NOTE that this definition is not the definition used in the scholarly management literature. Here under IFRS for SMEs, a SME can actually be ANY size, despite the name. The determining criterion is whether the entity is or is not publicly accountable, which will usually but perhaps not always be determined by whether or not it sells its shares on public exchanges. The scholarly management literature, on the other hand, AND many governments, define SMEs in terms of factors relevant to their SIZE, and their privately held or publicly accountable status of the entity is irrelevant. Since many governments around the world have developed their own definitions of the term SME for a broad range of purposes, including financial reporting, it will be important to keep in mind the possible differences. 6 IFRS FOR SMES What is IFRS for SMEs? IFRS for SMEs is a modification and simplification of full IFRS aimed at meeting the needs of private company financial reporting users and easing the financial reporting burden on private companies through a cost-benefit approach. IFRS for SMES is a global Page70

Northeast Business & Economics Association Established in 1973 accounting and financial reporting standard applicable to the general-purpose financial statement of, and other financial reporting by, entities that are defined in the IFRS for SMEs as small- and medium-sized entities. 13 Why did the IASB Issue the Standard? There are two main factors: Users of financial statements of SMEs do not generally have the same needs as the users of full IFRS. (Full IFRS were designed to meet the needs of equity investors in companies in public capital markets.) Users of SME financial statements are more focused on assessing shorter-term cash flows, liquidity and solvency, since they tend to be lenders and grant-givers. Therefore they can do without much of the information that equity investors in publicly traded companies would want. Second, many SMEs ARE actually fairly small, and may find full IFRS too complex and costly to adopt and maintain. If a simplified, pared down Standard can be arrived at which is acceptable both to users of SME financial statements and to the SMEs themselves, it will facilitate comparability in many situations -- for example, when full-IFRS companies acquire or invest in SMEs; when U.S.-based SMEs want to partner with foreign SMEs or other foreign entities; and when U.S.-based SMEs ask non-U.S.-based lenders for credit. 14 Can a U.S. Small and Medium-sized Entity that is Publicly Traded Adopt IFRS for SMEs? This may cause confusion for many small and medium-sized entities that are public traded. Page ten of the IFR Standard for Small and Medium-sized Entities15 excludes SMEs that are publicly accountable (defined above): 1.5 If a publicly accountable entity uses this IFRS, its financial statements shall not be described as conforming to the IFRS for SMEs even if law or regulation in its jurisdiction permits or requires this IFRS to be used in publicly accountable entities. 1.6 A subsidiary (whose parent uses full IFRSs, or that is part of a consolidated group that uses full IFRSs) is not prohibited from using this IFRS in its own financial statements if that subsidiary by itself does not have public accountability. If its financial statements are described as conforming to the IFRS for SMEs, it must comply with all of the provisions of this IFRS. Can a U.S. Private Entity Adopt IFRS for SMEs? U.S. private companies are not required, like public companies, to use a particular basis of accounting when preparing their financial statements. Currently, private companies in the United States can prepare their financial statements in accordance with U.S. GAAP as promulgated by the Financial Accounting Standards Board (FASB); another comprehensive basis of accounting (OCBOA), such as cashor tax- basis; governmental grant requirements, or full IFRS, Accounting,Law&Taxation among others. Now, with the issuance of IFRS for SMEs, U.S. private companies may have another alternative. 16 What are Some Reasons a Private Company in the U.S. Might Consider Using IFRS for SMEs? Many factors drive a private companys choice of which financial accounting and reporting framework to following in preparing its financial statements. A variety of factors will drive that decision, such as each companys objectives, the needs of financial statement users and possible regulatory reporting requirements, such as might be required when a company seeks government grants or loans. A U.S. company owned by a foreign private company; has a foreign investor, foreign parent, or foreign venture partner; is a supplier to foreign companies; or seeks loans from a foreign bank might be a candidate for using IFRS for SMEs. An ever increasing number of private companies are looking to conduct business outside the U.S. and obtain foreign financing. In these kinds of situations, SMEs and the entities with which they deal or are intertwined will benefit from being able to present lenders, investors, and possible partners with financial statements that have optimal comparability. Many foreign countries already have a simplified version of their national accounting standard; with the issuance and official approval of IFRS for SMEs, U.S. companies will have a similar option to use accounting standards tailored for smaller, private companies. 17 SMEs may find the new standard an attractive alternative to the more complex and voluminous U.S. GAAP. For example, IFRS for SMEs may reduce the accounting and disclosure requirements for pensions; IFRS for SMEs are principles based instead of the rules based requirements of U.S. GAAP, and may be easier to apply once the accountants and companies understand the approach to applying the IFRS for SMEs principles. And just on a very basic level, IFRS for SMEs is contained within 230 pages, while full IFRS is 2,700 pages, and U.S. GAAP is approximately 17,000 pages after codification.18 Are There Any Barriers to U.S. Private Companies Using IFRS for SMEs? In May 2008, the AICPA governing Council voted to recognize the IASB as an accounting setting body for purposes of establishing international financial accounting and reporting principles. The amendment to Appendix A of AICPA Rules 202 and 20319 gives AICPA members the option to use IFRS as an alternative to U.S. GAAP. As a result, IFRS or IFRS for SMEs is an acceptable alternative for privately-held entities in the U.S., because many if not most states defer to AICPA for accounting and auditing standards. 20 CPAs may need to check with their state boards of accountancy to determine the status of reporting on financial statements prepared in accordance with IFRS for SMEs within their individual state. In addition, a private company will need to evaluate Page71

Northeast Business & Economics Association Established in 1973 the benefits received versus the companys expenditure of money, time and effort to convert to IFRS for SMEs. 21 There is currently no requirement for IFRS for SMEs to be adopted, and no requirement is expected in the future. There are significant hurdles for widespread use of IFRS or IFRS for SMEs in the U.S. For example, most users, preparers and their auditors in the U.S. have not been trained on IFRS or IFRS for SMEs, nor do most have practical experience applying IFRS. The cost of training users on U.S. GAAP, full IFRS and IFRS for SMEs is likely to be high. There has not yet been wide acceptance of IFRS for SMEs by lenders. If and when IFRS is mandated for public companies by the U.S. Securities & Exchange Commission (SEC), a ripple-effect in the U.S. banking system is expected to impact privately-held entities. 22 Can CPA Practitioners Report on Financial Statements Prepared in Accordance with IFRS for SMEs? The AICPAs Auditing Standards Board and the Accounting and Review Services Committee have developed clarifying language on how audit, review and compilation reports can be modified when reporting on financial statements prepared in accordance with IFRS23 The CPA may need to check with their state boards of accountancy to determine the status of auditing on financial statements prepared in accordance with IFRS for SMEs within their individual state. Are IFRS and IFRS for SMEs Considered Generally Accepted Accounting Principles? The AICPAs governing Council recognizes the IASB as an accounting body for purposes of establishing international financial accounting and reporting principles. 24 Full IFRS and IFRS for SMEs are not another comprehensive basis of accounting (ACBOA). Rather, they are generally accepted accounting principles. Therefore, an audit report of a company that prepares financial statements in accordance with IFRS for SMEs can state that the financial statements are audited in accordance with auditing standards generally accepted in the United States of America and in accordance with International Standards on Auditing and that financial statements are prepared in conformity with International Financial Reporting Standards as issued by the International Accounting Standards Board. 25 What are Some Key Differences Between U.S. GAAP and IFRS for SMEs? In creating IFRS for SMEs, the IASB eliminated many accounting topics that are not generally relevant to private companies. Some of the key differences under IFRS for SMEs are26: 1. Generally IFRS is more principles and judgment based and less specific guidelines and rules than U.S. GAAP. Because IFRS for SMEs takes a principles-based approach rather than a rules-based approach, adherence to the Accounting,Law&Taxation standards may ultimately be less costly to apply than adhering to U.S. GAAP. Although companies may have more freedom to present relevant information under IFRS for SMEs, the principles-based focus of IFRS for SMEs requires interpretive judgments that could ultimately impair the comparability of two companies financial statements, even if both companies are using IFRS for SMEs. 2. Disclosures under IFRS for SMEs are simplified in a number of areas including pensions, leases and financial instruments. 3. Inventory costing methods may be significantly different. According to IFRS for SMEs 13.16, an entity may use techniques such as the standard cost method, the retail method or most recent purchase price for measuring the cost of inventory if the result approximates cost. Standard costs take into account normal levels of materials and supplies, labor, efficiency and capacity utilization. They are regularly reviewed and, if necessary, revised in the light of current conditions. The retail method measures cost by reducing the sales value of the inventory by the appropriate percentage gross margin. IFRS for SMEs 13.17 states that items that are not ordinarily interchangeable and goods or services produced and segregated, an entity is to use specific identification method of their individual costs. IFRS for SMEs 13.18 states that for inventories other than those dealt with in paragraph 13.17, entities may measure the cost of inventories using the first-in, first-out (FIFO) or weighted average cost formula. The last-in, first-out method (LIFO) is not permitted by IFRS for SMES. For U.S. GAAP, some inventory estimation methods used are the retail method, the LIFO retail method, and the gross profit method. LIFO is used and doesnt need to approximate cost. LIFO increases cost of goods sold, which reduces net income and results in lower income taxes. Some companies may incur significant increases in income tax if they change from LIFO to another inventory method. 4. Goodwill and indefinite life intangible assets under IFRS for SMES are amortized over a period not exceeding ten years. U.S. GAAP does not currently amortize goodwill. Goodwill impairment is evaluated annually. 5. Depreciation under IFRS is based on a components approach. U.S. GAAP uses straight line, sum of the years, declining balance (such as double), and units of activity, among other acceptable methods. 6. IFRS applies a simplified temporary difference approach to income tax accounting. 7. Reversal of impairment charges (except goodwill), if certain criteria are met, is allowed under IFRS for SMEs. U.S. GAAP requires impairment charges if conditions are met, but does not allow for the impairment charges to be reversed.

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Northeast Business & Economics Association Established in 1973 8. Research and development costs (R&D costs) under IFRS for SMEs are expensed. U.S. GAAP requires companies to capitalize acquired R&D costs and expense internally developed R&D costs. 9. Borrowing costs under IFRS for SMEs are expensed. U.S. GAAP generally requires borrowing costs to be capitalized and amortized. 10. Accounting for financial assets and liabilities under IFRS for SMES makes greater use of cost than does U.S. GAAP. U.S. GAAP uses fair value, equity method, consolidation, amortized cost, and other methods depending on the type of security and extent of significant influence. What Does One Do When an Entity has a Transaction Not Addressed in IFRS for SMEs? If IFRS for SMEs does not specifically address a transaction, other event or condition, an entitys management needs to use its judgment in developing and applying an accounting policy that results in information that is relevant to the economic decisionmaking needs of users and is reliable.27 7 CONCLUSION IFRS for SMEs are not likely to be mandatory for private companies in the United States, but given the recognition by AICPA, and given the informal but widespread recognition of AICPAs standards by State regulatory bodies, it appears that they are available on an optional basis for use right now. They may be worthwhile for private companies that need to interact with non-U.S. entities, since so many other countries (though not yet China or Russia) are requiring full IFRS for publicly held companies. Further investigation needs to be done into the level of awareness that actual small-tomedium-sized entities and their accountants have of IFRS for SMEs, as well as into what the business case for or against the use of IFRS for SMEs might be for these smallish, private companies. REFERENCES 1 See SEC Accounting Series Rel. No. 4, Statement of Policy on the Establishment and Improvement of Accounting Principles and Standards (April 25, 1938) 2 Release Nos. 33-8221; 34-47743; IC-26028; FR-70; found at http://www.sec.gov/rules/policy/33-8221.htm 3 http://www.fasb.org/home 4 http://www.fasb.org/jsp/FASB/Page/SectionPage&cid=117 6154526571>Corporate Governance>Restated Certificate of Incorporation AND >By-Laws 5 2010 U.S. LEXIS 5524, June 28, 2010 6 email from Tamara Feldman, Assistant Corporation Secretary and Internal Legal Counsel, June 9, 2010 7 Available at: http://www.iasb.org/NR/rdonlyres/A3010B6C-3F80-401FAccounting,Law&Taxation BE81-359E1E015E22/0/Constitutionfinal.pdf on July 12, 2010. 8 Available at: http://www.iasb.org/NR/rdonlyres/A3010B6C-3F80-401FBE81-359E1E015E22/0/Constitutionfinal.pdf on July 12, 2010. 9 Available at: http://www.iasb.org/NR/rdonlyres/FD1356A8-5F81-4B8B8BF9-BD70B9BBCA46/0/MoU.pdf on July 12, 2010, page 3. 10 see http://www.iasplus.com/country/useias.htm for a nonexhaustive list 11 http://www.iasb.org/News/Announcements+and+Speeches /IASB+and+FASB+issue+statement+on+their+convergence +work.htm, accessed July 12, 2010 2 Available at http://www.ifrs.org/Home.htm> IFRS for SMEs; registration required 3 www.iasb.co.uk; http://wiki.ifrs.com; http://www.ifrs.com/overview/IFRS_SMES/IFRS_SMES_F AQ.html 4 www.iasb.co.uk; http://wiki.ifrs.com; http://www.ifrs.com/overview/IFRS_SMES/IFRS_SMES_F AQ.html 5 Available at http://www.ifrs.org/Home.htm IFRS for SMEs; registration required 6 Available at: http://www.ifrs.com/overview/IFRS_SMES/IFRS_SMES_F AQ.html 7 Available at: http://www.ifrs.com/overview/IFRS_SMES/IFRS_SMES_F AQ.html 8 IFRS for SMEs/Private Companies; Webinar 9-2-2009, Moss-Adams LLP, Slide 24 9 http://www.iasplus.com/usa/aicpa/0805rule203.pdf 20 For example, New York says, in the context of defining attest as an activity of accountancy, says that any audit to be performed in accordance with generally accepted auditing standards or other similar standards, developed by a federal governmental agency, commission or board or a recognized international or national professional accountancy organization, that are acceptable to the department in accordance with the commissioners regulations. NYS Education Law Section 7401-a(1)(a) 21 Available at: http://www.ifrs.com/overview/IFRS_SMES/IFRS_SMES_F AQ.html 22 Available at: http://www.ifrs.com/overview/IFRS_SMES/IFRS_SMES_F AQ.html 23 Interpretations No. 14 and No. 19 of AU section 508 and Interpretation No. 30 of AR Section 100; Available at: http://www.ifrs.com/overview/IFRS_SMES/IFRS_SMES_F Page73

Northeast Business & Economics Association Established in 1973 AQ.html http://www.aicpa.org/Research/Standards/AuditAttest/Down loadableDocuments/AU-00508_9.pdf; http://www.aicpa.org/Research/Standards/CompilationRevie w/DownloadableDocuments/AR-00100_9.pdf 24 http://www.iasplus.com/usa/aicpa/0805rule203.pdf 25 http://www.mossadams.com/publications/international/ifrssme.aspx; http://www.aicpa.org/Research/Standards/AuditAttest/Down loadableDocuments/AU-00508_9.pdf 26 http://www.ifrs.com/overview/IFRS_SMES/IFRS_SMES_ FAQ.html http://www.mossadams.com/publications/international/ifrssme.aspx; http://wiki,ifrs.com/Inventories; Available at http://www.ifrs.org/Home.htm> IFRS for SMEs; registration required. 27 http://www.ifrs.com/overview/IFRS_SMES/IFRS_SMES_ FAQ.html

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