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SEC Proposes to Adopt International Accounting Standards

On Aug. 27, the Securities and Exchange Commission (SEC) voted unanimously to propose a road map for shifting U.S. companies from U.S. Generally Accepted Accounting Principles (U.S. GAAP) to International Financial Reporting Standards (IFRS). The move to a global accounting language is intended to improve the comparability and transparency of financial reporting worldwide. It will also have important implications for U.S. employers in how they account for employee benefit and stock plans.

The proposal would allow approximately 110 large U.S. companies to use international accounting standards in financial statements issued in fiscal year 2010, as a test of the new rules. If the SEC is satisfied with the results for this test group, it would phase in a mandated shift to international standards for all U.S. public companies over three years, beginning with certain large companies for fiscal year 2014, and ending with smaller companies for fiscal year 2016.

There are many differences between the U.S. and international standards. Moreover, the International Accounting Standards Board (IASB) is contemplating additional changes to IFRS in the near future, which could make it more difficult for U.S. companies to measure the impact of the conversion.

Preparing for the transition
Many questions about the transition remain unanswered. It will, however, require significant changes to financial systems and processes, so companies might not have the luxury of waiting for all the answers before forging ahead. U.S. companies and accounting firms will have to make significant investments in education and training to comply with the new standards. At least one of the big four accounting firms has already advised clients to start preparing for the change now.

How difficult will the conversion be? Fortunately, U.S. companies can learn from the experience of European companies in 2005. Their transition to IFRS was considered a huge success, despite the number and complexity of the issues involved, which varied from country to country. The success of the European transition was a consideration in the SEC’s decision to move forward with this change.

In principle, full retrospective application is required, but there are various overrides and options available. In practice, many European companies transitioned to IAS 19 – the IFRS standard for accounting for employee benefit plans – by starting with all assets and liabilities recognized as of the date of adoption. Only a few companies chose to perform retrospective calculations and start their IAS 19 reporting with some off-balance sheet liabilities.

IFRS generally requires disclosing one prior year of comparative figures upon adoption. However, the SEC has generally required disclosure of three years of results when accounting changes are adopted. Therefore, U.S. companies that must adopt the new standards for the 2014 fiscal year could have to develop IFRS accounts as early as 2012. We expect the SEC to issue transition rules and/or guidance to help companies determine when they need to begin developing IFRS accounts.

Change represents shift from rules-based to principles-based approach
U.S. GAAP has often been described as a “rules-based” accounting system, whereas IFRS is often described as a “principles-based” accounting system. U.S. GAAP is sometimes criticized for providing too much guidance, while IFRS is sometimes criticized for providing too little. Concerns have been expressed that a principle-based system requires more professional judgment in applying the rules and, therefore, generates a wider range of results and less consistency among corporate financial statements.

Different accounting rules ahead for employee benefit and stock-based compensation plans
There are some notable differences between IAS 19 and the various accounting standards applicable to employee benefit plans under U.S. GAAP, such as Financial Accounting Standards (FAS) 87, FAS 106, FAS 158, FAS 43 and FAS 112. In addition, the transition rules for first-time adopters offer a few options for companies to consider. For more information, please click here to view a table highlighting key differences between U.S. GAAP and IAS 19.

IFRS makes few substantive changes to FAS 123(R), the U.S. GAAP rules applied to stock-based compensation. Thus, companies will not need to make many adjustments to existing programs because of the accounting changes to financial statements. However, IFRS does not permit companies to provide a 5 percent discount under their employee stock purchase plans without incurring an accounting charge, so some companies might rethink whether the additional expense is worth it. For more information, please click here to view a table highlighting key differences between FAS 123(R) and IFRS.

Proposal would reclassify some defined benefit plans as “contribution-based promises”
The IASB released its preliminary views on proposed changes to IAS 19 earlier this year. The target date for implementing the changes is fiscal years beginning after December 2012. The preliminary views would eliminate some deferred recognition and smoothing features in the balance sheet and income statement, and would change the financial statement presentation for defined benefit plans.

The most controversial proposal, however, calls for separate accounting treatment for “defined benefit promises” and “contribution-based promises.” As defined in the proposal, many U.S. plans contain elements of both plan types. In general, any pension plan not based on final average pay will be classified as a contribution-based promise. So cash balance plans, traditional career average plans, flat-dollar plans and possibly even frozen plans would be treated as contribution-based promises. Traditional final average pay plans and traditional postretirement medical and life plans would be classified as defined benefit promises.

The IASB proposes that contribution-based promises should be measured at “fair value,” which has yet to be clearly defined. The IASB’s fair value project is in progress and could develop a standard before the new IAS 19 is finalized — but not in time to be considered in this preliminary views paper. Hence, it is hard to gauge the impact of applying fair value concepts to contribution-based promises. In contrast, the measurement of obligations for final average pay plans would continue to typically reflect an AA corporate bond assumption for the discount rate, so the accounting treatment of the two types of promises could differ significantly.

Action steps
Companies can act now to prepare for the changes ahead. Finance personnel can develop a transition schedule with their accountants. The new requirements will affect information technology systems, data collection and accounting processes. Companies should review the effects on employee benefits and compensation plans, debt covenants, bonus and incentive agreements, and any other items based on U.S. GAAP reporting measures.

Additionally, both the SEC’s proposal and the IASB’s proposed amendments to IAS 19 are open for public comment. The SEC will accept public comments for 60 days and the IASB comment period is open until Sept.26, 2008. By providing early feedback, employers can influence the development of final standards.

Comparison of Current U.S. and International Standards for Pension Accounting

Item	Current U.S. GAAP (FAS)	Current IFRS (IAS19)
General Rules
Scope	Legal, contractual or substantive commitment Funded or unfunded Covers pension benefits (FAS87, FAS88, FAS132R, FAS158), other post-retirement benefits (FAS106, FAS132R, FAS 158) and post-employment benefits (FAS112)	Conceptually, same as U.S. GAAP, except: Covers all employee benefits except equity compensation benefits (see IFRS2) including short-term employee benefits, termination benefits and long-term benefits (such as Jubilee awards)
General Approach	Balance sheet driven Market-based measurement Some smoothing allowed Gradual recognition of some items	Conceptually, same as U.S. GAAP, except: More emphasis than FAS87 on immediate recognition and less smoothing (for example, immediate recognition applies to vested benefits) Option available that allows deferred items to be kept off balance sheet
Measurement Frequency	Annually	Conceptually, same as U.S. GAAP
Measurement Date	Balance Sheet Date, once FAS 158 transition is complete	Conceptually, same as U.S. GAAP
Ownership of Assumptions	Employer	Conceptually, same as U.S. GAAP
Liabilities
Actuarial Method	Projected Unit Credit Method Full attribution of non-service related benefits	Conceptually, same as U.S. GAAP, except: Silent on non-service related benefits
Discount Rate	Settlement yield/market yield on high-quality corporate bonds (for funded and unfunded liabilities) Provides option to reflect rates implicit in annuity contracts (this does not exist under IAS 19)	Market yield on high-quality corporate bonds (for funded and unfunded liabilities). If no deep corporate market, use government bonds (most auditing firms now do not permit a margin over government bonds). It is not clear when a corporate bond market is sufficiently “deep”’ but markets in the United States, United Kingdom, Euro Zone and Canada are among those generally considered to be “deep.”
Assets
Valuation	Market Value for Balance Sheet Reporting Market-related value (smoothing over up to 5 years permitted) for income statement expense determination	Conceptually, same as U.S. GAAP, except: Market value (no smoothing) Strict definition of plan assets and detailed requirements in relation to insurance policies. Rights to reimbursements from other parties may also be allowed and are treated as additional assets and presented separately on the balance sheet as reimbursements.
Expected Return on Assets	Long-term estimate of expected return from plan’s assets	Conceptually, same as U.S. GAAP
Cost Recognition
Benefit Improvements	Spread capital cost over future working lifetime (or faster) Immediate Balance Sheet Recognition	If vested, immediate recognition in P&L of capital cost in excess of any surplus which the Company is obliged to use for the benefit of scheme members; otherwise, spread over the vesting period
Actuarial Gains/Losses	Spread over average future working lifetime outside optional 10% corridor (straight line method), or faster Spread using average pensioner lifetime if no active members Immediate Balance Sheet Recognition	At company’s choice upon adoption of IAS 19, either: Spread over average future working lifetime outside optional 10 percent corridor (straight line method or faster). Spreading not possible if no active members. Or Immediate recognition in balance sheet via statement of recognized income and expense (SORIE); no direct effect on P&L Long-term plans, such as Jubilee plans, must use immediate recognition through the P&L
Discretionary Benefit Increases	Only allowed in advance if part of substantive commitment; otherwise, spread capital costs when granted	Allow in advance if part of constructive obligation; otherwise, immediate recognition of capital cost when granted (subject to vesting)
Curtailments and Settlements	Gains or losses recognized in Balance Sheet on occurrence of event (FAS88) For curtailments, a proportion of deferred prior service cost must be recognized in P&L and gain/loss recognition in P&L is possible For settlements, a proportion of deferred gain/loss must be recognized in P&L for settlements More prescriptive than IAS19	Gains or losses due to event recognized directly in P&L on occurrence of event. A proportion of unrecognized gain/loss (if any exists) must also be recognized in P&L. The settlement calculation is subtly different, and the curtailment calculation is significantly different to FAS
Balance Sheet
Liability/Asset Recognized	The unfunded PBO (or APBO) is placed directly on the balance sheet The unamortized pieces of net actuarial gain/loss, prior service cost/credits and transition obligation/asset are aggregated and included in Accumulated Other Comprehensive Income	The balance sheet asset or liability is taken as the unfunded DBO with adjustments for: Unvested Past Service Costs Unrecognized gains and losses (only where the deferred gain/loss recognition method is used) Unlike FAS, the gains/losses and other adjustments which have been recognized through the SORIE do not accumulate in a separate account on the balance sheet. The unrecognized gains/losses are nil and there is no “recycling” of gain/loss through the P&L once it has passed through the SORIE, either as amortization in future periods, or via settlements/curtailments in the current period.
Balance Sheet Limitation	None	Balance sheet asset limited to value of refunds of surplus/future contribution reductions plus unrecognized losses, past service costs and transition costs Further adjustments may be required in future years if the asset ceiling applies If there is a requirement to fund at a level higher than the DBO and the company cannot recover the excess, an additional liability must be included

Comparison of Current U.S. and International Standards for Stock-Based Compensation

Item	Current U.S. GAAP (FAS 123R)	Current IFRS
Grant Date Defined	Generally the date when fair value expense is measured Grant dates occur when the company and employee have a mutual understanding of the key terms and conditions (T&Cs) Often, a grant may be approved by the Board but not communicated to all employees until some time later FASB Staff Position FAS 123(R)-2 allows Board approval to be used as grant date if (a) it is a unilateral grant and (b) the key T&Cs are communicated within a short period of time	Conceptually, same as FAS 123R, except: Requires an offer and acceptance of grant, either explicitly (e.g., by signing a contract) or implicitly (e.g., by commencing to render services) Grant date cannot be before such offer and acceptance occur Not clear if grant dates can be before the start of the requisite service period
Measuring Fair Value	Share-based payments to employees are measured with reference to fair value If market prices are not available, then fair value is estimated using a valuation technique No requirement to use a specific valuation technique, so different approaches can be used (e.g., Black Scholes, lattice models) A small discount (normally 5 percent or less) is permitted for ESPPs and no compensation cost is recognized	Conceptually, same as FAS 123R, except: ESPP plans that provide discounts are not addressed and would cause recognition of a compensation expense
Vesting Conditions	Fair value of equity instruments is measured at grant date, with some “true-up” for instruments that are forfeited Entities must distinguish between the following types of conditions: - Service conditions: a specified period of service - Market conditions: achieving a target share price, specified amount of intrinsic value or specified growth in relative share price - Performance conditions: achievement of a specified performance target by reference to the employer’s operations	Conceptually, same as FAS 123R
Period for Expense Recognition	Expense is recognized over the requisite service period, which is generally the vesting period Market conditions that accelerate vesting must be considered and requisite service period is the most likely vesting period If award vests in tranches, expense can be recognized individually by tranche (which frontloads the expense) or in total on a straight-line basis over the full vesting period Tranche-specific expensing required for market and performance conditions	Conceptually, same as FAS 123R, except: Where grants vest at different dates based on service, expense must be recognized separately for each tranche (graded vesting)
Equity v. Liability Awards	Equity awards are those that are settled in shares Equity awards are generally measured at fair value at grant (fixed) Liability awards are generally those that are settled in cash or remove the risk of stock ownership from participants Liability awards are re-measured at fair value at each reporting date until they are settled (variable)	Conceptually, same as FAS 123R except: No exceptions from liability accounting; for example, a cash settlement for minimum tax withholding will require variable accounting for that feature of the grant
Additional Equity v. Liability Issues	FAS 123R calls for liability classification if the company can be required to settle in cash under any circumstances, except in limited circumstances out of the control of the employer and employee (e.g., a CIC) FASB Staff Position FAS 123(R)-4 relaxed this provision and allows for a probability test to be applied in determining award classification	Conceptually, same as FAS 123R except: No guidance provided on whether conditionally cash-settled shares are treated as liabilities
Market Conditions Defined	They are vesting measures based on stock price metrics Includes stock price and total shareholder return measures May be comparative against other companies or indices Market performance conditions are reflected in the initial estimate of fair value - there is no true-up if performance is above or below fair value calculation	Conceptually, same as FAS 123R
Non-market Performance Conditions	They are vesting measures based on performance metrics that are not stock price related Examples could be cash flow or earnings per share measures May be comparative against other companies or indices Not included in the fair value determination Expense is trued-up to actual performance	Conceptually, same as FAS 123R
Modifications and Cancellations	Modification could include changes to price, vesting, term, etc. The value of the award should be measured before and after modification The incremental value of the modification is recognized as an additional expense The original expense continues to be recognized as well Accelerated vesting results in any unrecognized expense being recognized immediately	Conceptually, same as FAS 123R

Disclaimer: The information contained in this article does not constitute legal, accounting, tax, consulting or other professional advice. Before making any decision or taking any action relating to the issues addressed in this article, please engage a qualified professional adviser.

October 2008