INTRODUCTION
The U.S. has abided by General Accepted Accounting Principles (GAAP) since 1967. These principles, which provide guidance, are actually required in the U.S. to assist investors and creditors in properly evaluating a company's financial standing; thus, it helps creditors and investors make intelligent decisions. Yet, recent criticism is encouraging the U.S. to change these standards. Critics suggest that the U.S. use International Financial Reporting Standards (IFRS), a set of accounting standards first used in 2001 and now partially used by over 100 countries. The rapid growth of countries has increased the pressure on U.S. companies to become IFRS compliant. With the increased pressure, the Financial Accounting Standards Board (FASB) has begun proposing new standards that would ultimately help the U.S. and GAAP converge with IFRS.
DIFFERENCES BETWEEN IFRS AND GAAP
There are numerous differences between IFRS and GAAP, with one of the main differences being the offsetting of assets and liabilities on the balance sheet. Offsetting, or “netting”, is the presentation of assets and liabilities as a single amount in the balance sheet. The following conditions must be met when an entity offsets a liability and asset under the given set of standards:
Under IFRS:
• Currently have a legally enforceable right to set off the recognized amounts
• Intend either to settle on a net basis or to realize the asset and settle the liability simultaneously.
Under GAAP:
• Each of two parties owes the other determinable amounts
• The reporting party has the right to offset the amount owed with the amount owed by the other party
• The reporting party intends to offset
• The right of offset is enforceable by law.
However, according to PricewaterhouseCoopers, GAAP allows an exception to its intent condition for derivatives executed with the same counterparty under a master netting arrangement. An entity may offset:
1) Fair value amounts recognized for derivative instruments; and 2) Fair value amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral arising from derivative instruments recognized at fair value.
Entities must adopt an accounting policy to offset fair value amounts under this guidance and apply that policy consistently (KPMG)
These different offsetting conditions and requirements can cause a substantial difference between amounts recorded under IFRS and GAAP. Seeing that the main difference is the policy regarding derivatives, it can be expected that companies with large derivative activities will especially have vast differences in amounts recorded between the two set of standards.
“For example, reporting under IFRS, Deutsche Bank’s total assets amounted to US$2,146 billion, of which 40 per cent (or US$863 billion) were derivatives. In contrast, reporting under U.S. GAAP, J.P. Morgan’s total assets amounted to US$2,032 billion, of which only 4 percent (or US$80 billion) were derivatives. Furthermore, should J.P. Morgan have to report under IFRS, they would have reported US$1,485 billion of additional assets (ISDA).”
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The importance of understanding an entity's financial standing, or assets and liabilities in this case, must be noted. It will enable users of financial statements to properly compare entities and their risk, which is why the FASB and IASB are continuously working together to bridge the gap. Needless to say, the treatment of offsetting derivations is a major concern in converging IFRS and GAAP.
WHAT ARE DERIVATIVES AND WHY ARE THEY TREATED DIFFERENTLY
A derivative can refer to a variety of
financial instruments whose values are derived from one or more underlying assets, market securities or indices. In practice, it is a
contract between two parties that specifies conditions under which payments are to be made between the parties. Conditions are dates, resulting values and definitions of the underlying variables, the parties' contractual obligations, and the
notional amount. The most common underlying assets include: commodities, stocks, bonds, interest rates and currencies (Hall).
Derivatives, which are not bought or sold like other financial instruments, are carried at fair value and managed on a portfolio basis. Although the management of derivatives and bonds is different, the risk can be the same. The International Swaps and Derivatives Association (ISDA) gave the following example:
“If an entity buys an IBM bond, it is exposed to the risk of default of IBM. If the entity sells the bond, both the (i) risk of default and the (ii) bond disappear from its balance sheet. In contrast, if an entity executes a derivative contract that exposes the entity to the risk of default of IBM, the entity may not sell the derivative; it may enter into an offsetting derivative contract. The two contracts must remain in the balance sheet until maturity. However, the entity will not have a risk of default of IBM anymore. As derivatives contracts are usually traded in large numbers throughout the day, the result may be an accumulation of transactions11 in the balance sheet even when the risks are cancelled out.
To be expected, banks and financial institutions are affected the most by the difference between the two standards.
CONVERGING IFRS AND GAAP
Changes must be made in regards to “netting” or “offsetting” to better compare global financial statements. Even the Chairman of the IASB, David Tweetie, stated “the fact that companies can [...] report IFRS balance sheet figures that are double the size of their US GAAP numbers is not acceptable in global capital market (FASB).” In hopes of resolving the differences in offsetting assets and liabilities, in early 2011 the IASB and FASB drafted a proposal. The proposal provided more “narrow conditions” than what was and is used by GAAP. Despite the major attempt to find a solution, there was much backlash from stakeholders. Using feedback from stakeholders, the FASB and IASB ultimately decided to retain their offsetting models; however, they issued disclosure requirements to assist financial statement users in evaluating, comparing, and investing and to improve transparency in regards to how companies mitigate credit risk. The new disclosure requirements, which help bridge the gap between IFRS and GAAP, are listed below:
Amendments to IFRS 7
For financial instruments that are set off with IAS 32.42, these new disclosures are required in tabular form:
a) the gross amounts of those recognized financial assets and recognized financial liabilities;
b) the amounts that are set off when determining the net amounts presented in the statement of financial position;
c) the net amounts presented in the statement of financial position;
d) the amounts subject to an enforceable master netting arrangement or similar agreement that are not otherwise included in paragraph b), including:
i) amounts related to recognized financial instruments that do not meet some or all of the offsetting criteria;
ii)amounts related to financial collateral (including cash collateral); and e)the net amount after deducting the amounts in d) from the amounts in c) above.
Amendments are to be applied retrospectively for periods beginning on or after 1 January 2013 and interim periods within those annual periods. Earlier application is permitted. Also, IFRS clarified is offsetting standards with the following Amendment to IAS 32, which are effective for annual periods beginning on or after 1 January 2014, and are applied retrospectively: an entity currently has a legally enforceable right to set-off if that right is: not contingent on a future event; and enforceable both in the normal course of business and in the event of default, insolvency or bankruptcy of the entity and all counterparties; and gross settlement is equivalent to net settlement if and only if the gross settlement mechanism has features that: eliminate or result in insignificant credit and liquidity risk; and process receivables and payables in a single settlement process or cycle. (KPMG)
WHY THE U.S. SHOULD NOT ADOPT IFRS
With IFRS' popularity rampantly growing, people often question why the U.S. does not adopt IFRS altogether. With further look, one will see several deficiencies in IFRS. In the case of offsetting derivatives, GAAP once again provides better information for financial statement users. Even the IASD said it “believes that the current U.S. GAAP principles are superior because they provide robust offsetting principles to facilitate investors’ evaluation of relative balance sheet size, leverage, returns on investment and overall financial condition. We believe that U.S. GAAP provides the best reflection of an entity’s solvency and its exposure to credit and liquidity risks for both derivatives and repurchase agreements.”
It is important that the balance sheet is presented accurately and fairly, and not overstated or understated. Presenting “net” (GAAP) instead of “gross” (IFRS) on the balance sheet is favorable for a true reflection of a company's financial standing. Needless to say, in a time when the accounting profession is being more relied on than ever to prevent financial crises, the U.S. must stick to its stronger and stricter principles which have an informational advantage.
CONCLUSION
The benefits of having a global set of global accounting standards would be astronomical. Having one set of standards would give users of financial statements a better ability to evaluate an entity's financial standing; also, it would help investors and creditors make intelligent decisions. With the U.S. under pressure to comply with IFRS, the IASB and FASB have made major strides in converging standards. But by not immediately giving into pressure to adopt IFRS, the U.S. has also given the IASB incentive to provide stronger and improved standards. In the case of offsetting derivatives, a solution was not met in the form of a new standard, but both the FASB and IASB agreed on new disclosure requirements which will help give a better picture of an entity's financial standing.
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