Financial Reporting Standards:
Global Or International?
By Frederick Lindahl and Hannu
Schadewitz
Peer Reviewed
2
Frederick Lindahl is an Associate
Professor of Accountancy, The George
Washington University.
Hannu Schadewitz is a Professor of
Accounting, Turku School of
Economics, University of Turku,
Finland.
Acknowledgements
The authors would like to thank Huihong Tan, Yinka Dare, Jianing Liu,
Rami Katajisto, and Atte A. Salminen for their able research assistance.
This research has benefited from funding by the OP Bank Group
Research Foundation and the Turku School of Economics.
Abstract
Purpose – This paper studies quantitative, monetary information about
differences between IFRS and US GAAP in the three principal financial
statements.
3
Design/methods/approach – Comparative data from the same company
are compared. The explanations of differences are found in lengthy end
notes. The sample is from civil law countries with reputations for high
integrity, which reduces the possible confounding effects of legal systems
or earnings management. Sample countries are highly economically
developed, thereby reducing distortions that would result from different fair
value conditions.
Findings – A few key standards account for most of the monetary
differences between the accounting standards. In some cases large
differences in one direction offset large differences in the other direction,
reducing the insights obtainable from only comparing income.
Research limitations/implications – The window of data availability for
single company reporting under both standards was narrow. However,
because of convergence activities, these differences are likely slowly to
decline.
Originality/value – This is the only paper to examine the footnote
disclosure in sufficient detail to accurately measure differences. It is also
the only paper to analyze the cash flow statement. It is valuable for
financial analysts and academic researchers who study accounting quality
and make international comparisons.
I. INTRODUCTION
The world of corporate governance was radically changed when the
European Union, Australia, and New Zealand adopted IFRS applicable to
financial reports from 2005. EU adoption created a massive economic
bloc that used a common “language” to report financial results. For the
first time, those countries spoke the same “language”, and reports from
their companies were comparable with each other and with many other
IFRS countries throughout the world. It is largely agreed that IFRS is a set
of high quality accounting standards replacing local standards of varying
quality. Thus, these countries joined the US in using uniformly high quality
accounting. An important question is, “Are these two sets of high quality
standards comparable with each other?” While IFRS had some of its
origins in US standards, it is not clear how similar are final IFRS to US
standards.
4
This paper addresses that question. If US and IFRS standards
are similar, it can be said that standards are “global”; and that financial
reporting is comparable around the world. The comparability of reporting
would be increased if the US were to adopt IFRS. The US Securities and
Exchange Commission is studying whether to adopt IFRS as the US
standard (SEC 2012). The likelihood of this depends on the similarity of
the two sets of standards.
Motivated by these two crucial questions—the global character of
accounting standards and the likelihood of future uniformity--this study
offers evidence on the quantitative differences at the time of IFRS
adoption based on information available around the time of the change.
Convergence—increasing similarity—of accounting standards is an
expressed goal (“Norwalk Agreement” in 2002). However, progress has
been slow since the choice of accounting standards involves legal,
economic, political, and cultural factors. This paper addresses the core
issue: do IFRS and US GAAP provide similar accounting figures for the
same firm? We analyze this issue from the perspectives of (1) investors,
(2) financial analysts, and (3) academic researchers who investigate the
quality of financial reporting. We show the degree of similarity in these
data, which are the raw material for these three groups of users. Since
the needs for these three constituencies are not the same, we treat them
separately.
We know from many sources (e.g., KPMG, 2014; Baudot, 2014)
that the standards say different things. We know much less about whether
in practice these differences occur often and when they do occur, if they
lead to material differences in monetary amounts. Our contribution is to
measure, rather than verbally describe, differences between IFRS and US
GAAP.
There is vigorous debate among academics (Albrecht, 2008; Dye
and Sunder, 2001; Sunder, 2009), practitioners (Selling 2008), standard
setters, and regulators (Niemeier, 2008) about the relative strengths of US
GAAP and IFRS. For example, some argue that IFRS is the stronger set
because it is “principles-based” (Tweedie, 2007). Others argue that US
GAAP is equally “principles-based” (Kershaw, 2005) or that GAAP is
better because it has more “bright line” rules that limit earnings
management (Bratton and Cunningham 2009). Furthermore, accounting
5
research shows that IFRS is better than GAAP (e.g., Ashbaugh and
Olsson, 2002), and that GAAP is better than IFRS (e.g., Bradshaw and
Miller 2008). Much of the disagreement comes from the imprecision of
“better.” Some base their view on smaller analyst forecast errors, some
on “value relevance”, and some on “accounting quality” metrics (Dechow
et al., 2010).
Perhaps this debate has not reached consensus because the
participants in the debates have too little data, as mainly they have verbal
descriptions of differences. In this context, this research asks whether the
representations based upon IFRS and US GAAP deliver the same
mapping of economic events onto financial reports.
Contributions
The first contribution shows the degree of difference using actual
reported data. Investors often use numbers standing alone: “Has net
income increased?” We look at reported data from all three primary
financial statements, the income statement, the balance sheet, and the
statement of cash flows. We use the best information available: financial
statements for the period 2004 to 2006 that reconcile the two sets of
numbers. (The last year that the SEC required reconciliation was 2006.)
Secondly we contribute to financial analysis. Users often use
numbers in combination, e.g., as ratios, to assess profitability, liquidity and
risk. One can reach one conclusion based on analysis of the primary
numbers but a different conclusion from ratios. There are an infinite
number of ratios that could be computed. We choose from standard
textbooks a few important, widely used ratios to analyze differences
between the standards.
We also make a third contribution. Studies of “accounting quality”
draw judgments about the adequacy of standards. Much research
analyzes international quality differences. This research is built on the
premise that the properties of accounting numbers in different countries
can reveal underlying country differences in quality. It is important to know
if the premise is warranted, because this literature is often cited to support
quality differences between IFRS and GAAP (Hail et al., 2010; Kothari et
al., 2009). We contribute to the research on international accounting
differences by providing empirical evidence on the comparability of data
that researchers commonly use.
6
We do not judge which standards are better, or conclude on the
merits of harmonization. We offer new quantitative information that will
help others reach those conclusions.
Modes of analyses
In this section we explain the three modes of analysis that
constitute our research approach.
Reported data
This section addresses the reported data. It is important in
debating whether IFRS is better than GAAP to understand detailed, written
descriptions of differences (e.g., KPMG 2014). It is equally important to
see quantitative evidence about the importance of the different data in
practice.
Hail et al. (2010), in considering the choice of IFRS vs. GAAP, state
“proponents argue that … the remaining differences are small” (p.368).
However, this is based on qualitative differences and convergence
activities, as they do not cite numbers. Our study analyzes the remaining
differences from a quantitative viewpoint. We analyze the reported data
resulting from the two sets of accounting standards for the same
companies, one set prepared under IFRS and one under US GAAP.
We analyze the data reported in the three main financial
statements, including the cash flow statement. Cash flow reporting under
the two systems must be understood. It is one of the primary financial
statements. We first analyze the primary results such as net income.
Second, we analyze the data line by line. As we show, reading only the
line item labels in the reconciliation leads to misinterpretation of the
underlying accounting differences. Third, we choose a sample of
countries where there is a tradition of high quality accounting (as
described below) and where economic conditions are similar. In this way
we hope to avoid differences in accounting that may result from different
traditions of accounting quality (Bozzollan et al., 2009; Cascino and
Gassen, 2015) and different economic conditions that can affect, for
example, fair value accounting.
Financial analysis
7
The reason to compare financial ratios based upon alternative sets
of accounting standards is that, while the reported data are important in
themselves, they are often interpreted in relation to other data in the
financial statements. For instance, it is important to know net income, but
it is also important to know what resources were used to generate that
income; that is, “return on equity” tells users more than just earnings: the
former, how management used the assets entrusted to it, and the latter,
how effectively financial management engaged leverage.
Investment decisions are based on financial analyses applied
across firms. To interpret the results correctly, one must know whether
differences in the computed results reflect different economic performance
or differences due to accounting rules. Lev and Thiagarajan (1993) show
that fundamental information analysis, which rests heavily on financial
statement numbers, can have a substantial role in explaining excess
returns. We measure some differences that arise through the standards,
which can be isolated from financial performance because our comparison
is intra-company. This gives insight into the importance of the rule
differences.
Many financial ratios assess profitability using net income (Wahlen
et al., 2011), so valid comparisons require that the net income numbers be
comparable. In this paper we compare income, computed according to
IFRS and US GAAP. Since other ratios use line items (e.g., sales and
inventory to detect sales decreases or obsolete inventory), we analyze the
line items that lead to differences in net income. Further, we compare
shareholders’ equity (another measure common in financial analysis) and
cash flow (often an element of ratio analysis). It is indisputable that
different standards generate different numbers. Our question is “How
big?”
Accounting research studies
The third reason to compare the accounting numbers generated by
alternative sets of accounting standards is that accounting research often
uses reported data that are created according to different sets to assess
which countries’ financial reporting environments are better. The studies
use reported data to compare countries using different approaches such
as “value relevance” and “earnings quality.”
8
What are the potential pitfalls in these studies that stem from the
reported data? Researchers have increasingly conducted studies in the
area of international accounting using financial reports from many
countries (e.g., Barth et al., 2008; Ball et al., 2000; Brüggmann et al.,
2012; DeFond and Hung, 2007; Hail, 2007; Leuz et al., 2003; Pope et al.,
2011; Wysocki, 2005). In conducting studies of accounting quality, there
should be a clear understanding of the role of the reported data. When
one studies quality in different countries, one should not compare the level
of accruals as a measure of “earnings management” without
understanding that different accounting standards almost surely use
different accrual methods. Without making an adjustment for the different
methods, the researcher would attribute differences to “earnings
management” when in fact what he or she might have observed were
different accounting methods.
We find that studies often implicitly assume that differences
between systems are small enough that they do not require adjustments.
Our study shows that many of the differences are not small. Researchers
may consider whether empirical validity can be achieved if the differences
are ignored.
Our analysis may be useful in (a) assessing the strength of
conclusions drawn from past studies, and (b) designing future tests that
may better measure quality.
1
Some researchers have noted that there was a reconciliation
requirement, and then there wasn’t (e.g., Tang et al., 2012; Kim et al.,
2012). They investigate changes from the “before” to the “after” period.
They could make much better interpretation of the results if they knew
more than just that the reconciliation disappeared, and knew in addition
exactly what information—items and amounts—ceased with the
reconciliation.
Because researchers often pool cross-sectional with time series
data, there is a potential pitfall to using numbers from transition years and
treating them as if they were from a “steady state” application of different
accounting standards. Our study, done year by year, shows the extent of
this distortion.
9
II. LITERATURE REVIEW
In this section we consider papers that analyze IFRS-GAAP
differences. Only a few studies have examined whether there are
significant IFRS vs. US GAAP differences that might result in non-
comparable measurements and interpretations of data from the separate
accounting regimes.
2
Ucieda Blanco and García Osma (2004) examined SEC filings and
found a number of material differences between IAS and US GAAP.
3
They used data from 1995-2001, so their findings are stale in light of the
IOSCO project (Flower 2004, chap. 7), recent changes in IAS, and the
process of convergence since Norwalk Agreement.
Street et al. (2000) analyze violations of IFRS. This was informative
about how indiscriminately “IFRS” was used among issuers. Many
companies that stated that their reports were in accordance with IFRS did
not follow those standards. Adherence to standards was problematic
during an earlier period and today´s standards are much changed. To
answer questions about size and magnitude, one cannot rely too much on
studies that used earlier data.
Henry et al (2009) describe differences between US GAAP and
IFRS net income and shareholders´ equity. They access the first three
years (2004-2006) of EU adoption data from the European companies that
file Forms 20-F. The basis for their sample (n=75) is that their firms are at
a “comparable stage of economic development to the United States” (p.
122). This is a desirable attribute for the study design, though it seems a
stretch to say that Hungary (a country in their sample) is at a stage
comparable with the US or that the level of accounting integrity is the
same.
4
Their sample is heterogeneous, drawn from northern and southern
European countries, and even from eastern Europe.
They classify line items by the label they find in the 20-F “rather
than the more in-depth, typically multi-page footnoted explanations” (p.
133). They present the line items on a before-tax basis and classify “tax”
10
on the reconciling item list as a separate adjustment, when in fact it is the
tax effect of all the other reconciling items.
5
They find higher net income under IFRS and lower shareholders´
equity. They analyse net income and stockholders´ equity, but not cash
flow. They find marginally significant evidence that net income differences
between 2004 and 2006 decrease, which they take as evidence of
convergence. Two data points are not strong evidence of convergence,
especially since they do not find a significant decrease between 2004 and
2005 or between 2005 and 2006. They also find that shareholders´ equity
is getting closer between 2004 and 2006, citing this as further evidence of
convergence. It is in fact the same evidence. Equity becomes closer when
retained earnings become closer; that is, converging net income
automatically converges the equity accounts in the long run, assuming
clean surplus equation. IFRS allows “first time adoption” provisions. It is
not really possible to judge whether a measured difference between net
income between 2004 and 2006 is convergence in the underlying
standards or the one-time effect of first-time adoption amounts.
Plumlee and Plumlee (2008) describe 100 IFRS-GAAP
reconciliations, measuring frequency and size of the individual line item
categories and the overall effects on profits and book value of equity. The
sample is a “random” (method not described) selection. They group the
line items into 22 classes of their own construction. They do industry
analysis and find differences in the reconciling items, as one would expect;
for example, firms in finance businesses have reconciling items related to
hedging more often than firms doing manufacture.
Gray et al. (2009) compare net income and shareholders’ equity for
2004-2006 and find IFRS income higher than GAAP and equity lower.
Gordon et al. (2013) use 156 Forms 20-F that reconcile IFRS and
GAAP for three years, 2004-2006. They evaluate accounting quality and
value relevance. They conclude that GAAP still differs from IFRS,
showing “incremental informativeness” over and above the IFRS numbers.
They also state that GAAP has higher “cash persistence” and value
relevance. They use cash flow measures, but do not adjust for differences
in reporting between GAAP and IFRS. They establish that differences
11
exist, and in that sense complements the first of our three research
contributions.
In sum, while all these studies contribute to proving that differences
exist between IFRS and US GAAP, our work explores how and why the
differences exist.
III. SAMPLE
We measure the dollar differences between GAAP and IFRS
uncontaminated by differences in national implementations of IFRS. To
achieve that, we use a sample of countries where there is a tradition of
sophisticated accounting, good enforcement, and similar conditions of
development (Belgium, Denmark, Finland, Germany Luxembourg, the
Netherlands, Sweden and Switzerland). Dissimilar conditions would result
in non-comparable numbers even with complete compliance. Fair value
accounting requires the use (when available) of similar assets traded in
active markets. But markets for traded assets vary around the world, so
“level 1” may be chosen in one country while “level 2” might be appropriate
elsewhere. Even if level 1 is feasible in both countries, different market
conditions might give different values.
To find countries with high quality accounting, one possibility would
be to rely on studies of “accounting quality.” However, many of these
studies are plagued by problem that they assume, without checking, that
data from different accounting standards are directly comparable. The
point of our paper is that it is necessary to validate that assumption before
drawing conclusions. It would be possible to rely on direct ratings of
accounting, but these are very old and are based on different regimes
(e.g., CIFAR (1995) is based on 1993 data).
By limiting the number of sample countries, we have the resources
to analyze every word of the reconciliation notes, which sometimes
exceed 20 pages. Nevertheless, we have a sample large enough for
reliable statistical inference. Our design emphasizes depth rather than
breadth.
We study all the U.S.-listed companies from our sample countries
covering years 2004 though 2006. Table 1 below supports the quality
criterion. Table 2 below shows countries and sample size.
12
Table 1. Ranking of business integrity: proxies for accounting
excellence
Rank
4
Corruptions
Perception
Index
1
Global
Competitiveness
Report
2
(“ethical
behavior of
firms”)
World
Competitiveness
Yearbook
3
(“management
practices: ethical
practices”)
Belgium
20
21
17
Denmark
4
1
5
Finland
1
3
3
Germany
16
15
17
Luxembourg
11
11
12
The Netherlands
9
16
11
Sweden
6
18
9
Switzerland
7
10
13
Total countries in rating
163
117
117
Notes:
1. Corruptions Perceptions Index (Transparency International, 2006; McAdam and
Rummel, 2004)
2. Global Competitiveness Report (Ochel and Röhn, 2006; Lopez-Claros et al.,
2005)
3. World Competitiveness Yearbook (Garelli, 2004, p. 593)
4. Lower numbers are higher ratings.
Table 2. Sample description
Country
Number of
firms
Belgium
1
Denmark
3
Finland
4
Germany
8
Luxembourg
4
The Netherlands
8
Sweden
8
Switzerland
6
Total firms in sample
42
Notes:
1. The sample consists of all companies from the sample countries that report on
SEC Form 20-F.
2. Because of de-listings and mergers, year 2006 has 31 firms.
IV. RESEARCH METHODS
Our research method compares net income, shareholder equity,
and cash flow prepared under IFRS that also show reconciliation to US
GAAP. We compare absolute money amounts and relative figures
between IFRS and US GAAP. We also test the statistical significance of
the differences.
We collected data from SEC Form 20-F on every firm in our sample
countries that reconciles IFRS to US GAAP, 2004 to 2006. The SEC
requires this of all foreign private issuers, which either trade their shares in
the US or have certain types of American Depositary Receipts. Form 20-
F includes, as a note to the financial statements, the differences between
net income and shareholders’ equity under IFRS and under US GAAP.
The presentation starts with IFRS income (or equity), then shows the
reconciling amounts, and arrives at net income (or equity) under GAAP.
The reconciling amounts are also explained in written text, which is key to
understanding the differences.
One problem with relying on the label to the reconciling item, as
done in other studies, is that some line items include more than one
difference. Deutsche Telekom lists “Mobil Communications Licenses.”
Without reading the associated note, one cannot know that this includes
two IFRS-GAAP differences, one for recording impairment and one for
14
recording capitalized interest cost. In the same report is a line item called
“Fixed Assets.” This item includes both a capitalized interest difference
and an exception allowed by IFRS 1 for “deemed cost” of the assets.
Another factor that requires reading is that some items are labeled
as “other.” In sum, labels are not enough; to find the standards that differ
and by how much requires thorough analysis of the disclosure.
We report the net income difference and disaggregate it into its line
item components, both the relative and absolute importance of each. We
use the five largest items for each company. In cases where there are
fewer than five major items, we use them all. Nevertheless, in any case
we exclude an item less than ½% of IFRS net income. This captures all
reconciling items that are at least 1% of net income.
No prior research has compared cash flow statements. Cash flow
from operations (CFO) is a fundamental disclosure in financial reporting
(e.g., Fama and French, 1995). It is used in ratio analysis (e.g., Wahlen et
al., 2011, chapter 5), and in studies of IFRS value relevance (e.g., Gordon
et al., 2013; Banker et al., 2009). CFO is subject to classification
differences between US GAAP and IFRS (Stolowy et al., 2013). We
measure these differences to see whether CFO under GAAP is close
enough to CFO under IFRS that differences can be ignored.
V. RESULTS
We report first on whether there are material monetary differences
between IFRS and US GAAP. We take several approaches to measuring
the differences.
Reported data
Net income
Because many managers and analysts use earnings as a measure
of financial performance, we examine the income statement for differences
between IFRS and US GAAP.
Panel A of Table 3 below reports the aggregate dollar effects of
adjusting from IFRS to GAAP. In 2005 the mean is $2,180 million and the
15
median is $521 million.
6
The incomes for 2004 are smaller and for 2006
are larger under IFRS. Net income is positively skewed for the sample
under both accounting regimes.
Table 3. Income effects of reconciling items, IFRS to US GAAP
Panel A: Statistics compiled for whole sample
2006
2005
2004
(in $ millions)
Mean
%
med.
%
mean
3
%
med.
%
mean
3
%
med.
%
Net income, IFRS
2,971
100%
969
100%
2,180
100%
521
100%
1,628
100%
477
100%
Net income, US GAAP
2,664
89.7%
797
82%
1,983
91.0%
513
98.6%
1,635
100.4%
454
88.3%
Total of all reconciling
items
2
(difference in
rows above)
-307
-
10.3%
-196
-9.0%
6.5
-0.0%
Total of 5 largest
reconciling items
1
-123
-4.1%
-127
-5.8%
-55.7
-3.4%
Total of absolute mean
value of 5 largest
reconciling items
5
310
10.4
237
10.9%
308
19%
Panel B: US GAAP divided by IFRS net income, compiled firm-by-firm
2006
2005
2004
Average among firms, US GAAP / IFRS
98.6%
106%
4
105%
Standard error
34%
24%
4
38%
Median
98%
94%
97%
First quartile
88%
84%
92%
Third quartile
98%
99%
115%
Sample size
4
: 31, 42 and 42 for years 2006, 2005, and 2004.
Notes: This table shows the differences between net incomes compiled under IFRS and
US GAAP. Panel A shows the statistics for all firms in the sample combined. Panel B
computes the statistics for each firm, then shows the average across firms. Panel B
removes the possibility that one or two very large firms might be “driving” the results. It
shows that the reconciling items are pervasive throughout the sample.
1. The “5 largest reconciling items” refers to the five largest items for the
individual firm, not the five most frequent ones overall. For every sample firm
these five (or less) items include all reconciling items that are at least 1% of net
income.
2. The reconciling items are “after tax” numbers, directly comparable with net
income. The amount reported on Form 20-F is multiplied by (1-statutory tax
rate). The differences in net incomes under the two standards arise from the
net effect of the individual reconciling items.
3. The Mann-Whitney-Wilcoxin t-test rejects equality of IFRS and GAAP
distributions at a p-value less than 0.01 for the 2005 and 2006 samples, but does
not reject equality at the 0.10 level for 2004.
4. One firm is removed because a “small denominator” distorts the overall pattern.
This firm had net income close to zero. If that firm were included, the mean
would be 265% and standard error 102%.
5. The absolute value is computed by taking the algebraic mean of all firms for a
particular line item, then transforming that to an absolute value. It is not taking
the absolute value at the firm level, then averaging. The average value for a
firm of the five largest reconciling items as a percentage of IFRS income are 29%
for 2004, 45% for 2005, and 16% for 2006.
For the sample as a whole, we find that GAAP net income is lower
by 9.0% in 2005.
7
IFRS and GAAP mean earnings are statistically
different in 2005 and 2006 (p<.01), but the null of equality is not rejected
for 2004.
On the basis that the null of equality is not rejected, one might be
tempted to think that for 2004, IFRS and GAAP are so close that,
regardless of what the underlying standards say, the differences in
application have no economic significance. This is true only on average,
and only when looking at the “bottom line.” Table 3 shows the absolute
value of the five largest differences. The averages (e.g., 0.4% in net
income for 2004) hide big positive adjustments that are offset by big
negative adjustments. The absolute values of the adjustments are about
19% of net income in 2004 and 10-11% in 2005 and 2006.
18
Averages hide differences in line items, and they also hide
differences among firms. Figure 1 below shows large variation among
individual firms.
This analysis shows that the different accounting rules under GAAP
and IFRS create substantial differences in financial reports. Those who
argue about which system is better are addressing a relevant question
since the amounts differ substantially.
Frequency of income statement adjustments
“The reliability of an aggregated number, such as net income, is
likely to be a complicated function of the separate reliability of each of its
components” (Schipper, 2007, p.316). There are many possible causes
for line item differences, as found in the written comparisons of IFRS and
GAAP (e.g., KPMG, 2014). Table 4 below shows where the most
common differences occur in practice. A handful of differences accounts
for almost the entire amount of earnings differences.
Table 4. Frequency of occurrence of reconciling items among the
sample firms
2006
2005
2004
Pensions
17
Pensions
22
Goodwill
24
Goodwill
17
Financial instruments
22
Financial instruments
20
19
Financial instruments
13
Goodwill
18
Pensions
19
Impairments
11
Revenue recognition
16
Share-based
compensation
16
Revenue recognition
8
Share-based
compensation
12
Revenue recognition
13
Share-based
compensation
8
Restructuring
10
Restructuring
12
Restructuring
5
Impairments
10
Intangible assets
1
11
Debt
5
Intangible assets
(note 3)
9
Impairments
8
Fixed assets
5
Fixed assets
6
Deferred taxes
5
Interest capitalization
5
Debt
6
Acquisitions
5
Intangible assets
(note 3)
4
Acquisitions
5
Debt
5
Acquisitions
4
Interest capitalization
4
Development costs
4
Totals
102
140
142
Sample size 31, 42 and 42 respectively in 2006, 2005, and 2004. Because of de-listings
and mergers, year 2006 has 31 firms.
Notes:
1. All reconciling items that occur for at least 10% of the sample are reported here.
2. The table is compiled from the largest five reconciling items for each sample
firm. Every reconciling item for every firm is included if it is at least 1% of net
income.
3. “Intangible assets” does not include accounting for development costs, a
separate category for which we observed four reconciling items in 2005 and, as
shown, five in 2004.
Pension, financial instruments, and goodwill accounting are the
most common reconciling items, recorded by around half the firms. Many
of the items appear in all years.
Table 4 also reveals: (a) The top three or four items are all common
(no dominant adjustment); and (b) the same items appear in roughly the
same order of frequency in all three years, which is not surprising since
they are the same companies. The rank correlations for the items that
appear in both years are 0.93 for 2004-2005, and 0.90 for 2005-2006.
Dollar amounts of income statement adjustments
20
It is important to know not just frequency of differences, but their
magnitudes. Even if the differences are common, they do not matter if
they are small.
Tables 4 above and 5 below show that the frequency of items is not
highly correlated with the dollar amount. For example, for an individual
firm the pension adjustment is either the biggest or second biggest in 14 of
the 24 firms that made the reconciliation in 2005. By contrast, although
share-based compensation is ranked #5 in frequency in 2005, for only one
firm is it the largest.
Pensions, the most frequent item in 2005, have large dollar effects:
almost 1% of net income in 2005. But other items do not follow the same
pattern. Goodwill, for example, is the most frequent item in 2004, but the
magnitude is only 40% of what it is in 2005, when the frequency rank
drops to 3
rd
. These are sign reversals; the process that generates
accounting numbers for similar accounts in consecutive years is not a
stationary process.
Table 5. Largest reconciling items, as a percentage of IFRS
net income
2006
2005
2004
Derivatives and
hedging
-2.7%
Goodwill
-2.2%
Impairments
-2.3%
Intangible assets
1
1.5%
Derivatives and
hedging
2.0%
Pensions
-1.7%
Impairments
-1.3%
Financial instruments
-1.0%
Goodwill
0.9%
Pensions
-1.2%
Pensions
-0.9%
Intangible
assets
1
-0.9%
Deferred taxes
0.5%
Intangible assets
1
-0.8%
Restructuring
0.6%
Share-based
compensation
0.6%
Deferred taxes
0.6%
Interest capitalization
0.5%
Debt
-0.5%
Foreign
currency
-0.5%
Sample size 31, 42 and 42 respectively in 2006, 2005 and 2004
Notes:
1. The table is compiled from the largest five reconciling items for each sample
firm. Every reconciling item for every firm is included if it is at least 1% of net
income.
2. The minus number indicates that the item is reduced under U.S. GAAP relative
to IFRS.
3. All adjustments equal to at least 0.1% of IFRS net income are shown.
4. The reconciling items are “after tax” numbers, directly comparable with net
income. The amount reported on Form 20-F is multiplied by (1-statutory tax
rate).
Some items may occur rarely, and they are not big on the average,
but may be very significant for individual firms. Comparability, an objective
of the framework, is a firm-to-firm characteristic, not an average result.
Firm differences
As shown above in Table 3, there was a 9.0% mean reduction and
1.4% median reduction going from IFRS to GAAP in 2005. This does not
22
show how large the adjustments were for individual firms. In both 2005
and 2004, two different firms had reductions going from IFRS to GAAP
income of 50% or more.
Interest costs incurred in construction are an example. While for
the 42 firms, the effect is small, only 0.3% of earnings, for those firms that
experience borrowing in connection with large scale construction, the
average effect is +4.6%.
Equity values
The book value of equity accumulates all current and previous
income differences. It is the net of the assets and liabilities and may also
include adjustments that do not pass through the income statement.
If net income differs, then retained earnings differ. These are early
years of IFRS use, so there has not been time for IFRS-GAAP differences
to have become a large effect. Another difference can be IFRS No. 1.
This standard permits, under some conditions, “deemed costs” of assets,
which are not the same as costs that would normally be applied under
IFRS. Goodwill accounting under IFRS and US GAAP has been different.
Any adjustment of the asset accounts affects the equity accounts.
Impairment of goodwill affects asset balances for years or decades.
Those differences cumulate over years, so balances can become quite far
apart.
As Table 6 below shows, there are major differences in equity
values under the two sets of standards.
Table 6. Book Values of Shareholders’ Equity
1
2006
2005
2004
US GAAP
IFRS
US GAAP
IFRS
US GAAP
IFRS
Average
($ million)
2
16,739
15,936
12,970
11,825
11,913
10,263
Median ($ million)
5,001
5,175
4,364
4,269
3,624
3,838
Average ratio
(GAAP to IFRS)
1.11
1.10
1.15
Median
1.00
1.02
1.05
1
st
quartile
0.97
1.09
0.97
1.13
1.00
1.19
3
rd
quartile
Sample size
31
42
42
Notes:
1. Source of information is the reconciliation reported on Forms 20-F.
2. The Mann-Whitney-Wilcoxin t-test for equality of the IFRS and GAAP
distributions is rejected at the p=0.01 level for all samples.
We show that in equity, as well as earnings, there are considerable
differences, both at the firm and at the aggregate level. This is one more
reason why the choice between IFRS and GAAP matters, and invites
attention to the underlying reasons
Cash flow
The last element of the study is the classification of cash flows.
SEC policy did not require that IFRS cash flow reporting be reconciled to
GAAP. We took cash flow data from annual reports.
IFRS and GAAP differ in the allowable classifications, specifically
for interest paid and received, dividends paid and received and taxes paid
(Stolowy et al., 2013). IFRS, but not GAAP, allows alternatives.
Although the average effect is small, the averages mask substantial
effects for individual firms. More than 15% of firms in our sample use an
IFRS classification that does not match GAAP. The effect is understated
since not every firm reports these adjustable items separately, so they are
not always identifiable.
In this section we have reported on differences in all three primary
income statements, and we have done a “by firm” analysis. The
differences in the aggregate and at the firm level show that the choice
between IFRS and GAAP is meaningful.
Financial analysis
This section discusses our second analysis: whether the choice of
GAAP or IFRS makes a difference for financial analysis. If the choice
does create differences, then a considering which set of standards is more
reliable is important.
Net income
Net income is an element of most financial analysis. Measures
such as return on assets, return on equity, and return on sales are primary
measures of performance. We have shown that these amounts vary
considerably, the use of IFRS or GAAP may influence performance
evaluation.
Frequency and dollar amounts of income statement
adjustments
Large line item differences between IFRS and GAAP may offset
each other. For example, ROA for a particular firm may be very nearly the
same under either set of standards. This does not imply that the question
of “which is better” is moot. The “DuPont” formula points to different
elements having different significance.
8
Return on sales multiplied by
asset utilization equals ROA. If revenue recognition rules give higher
revenue from IFRS at the same time that fair value rules give a higher
asset base, then ROA might be close under the two standards. But the
two components could differ and lead to different conclusions about
“product profitability” (return on sales). Thus, a careful consideration of
which system gives the better analytical result can rest on individual line
items. Table 4 above shows that the differences caused by revenue
recognition principles are common and are large for some firms.
Financial analysis is done at the firm, not the aggregate level.
Variation of the individual items, not the average, matters in analyzing
firms.
Shareholders’ equity adjustments
As is the case of income, this measure is used in performance
evaluation. In some cases, the differences in net income and equity might
even accentuate the need for close evaluation of which set of standards is
better. For instance, net income (x) may be higher under one standard but
equity (y) is lower. The percentage differences in ROE measures (x/y)
exceeds the percentage differences of both x and y.
To see whether this is just conjecture or whether it is observed, we
compute the difference. Figure 2 below shows a substantial difference in
this performance ratio. Note that only about 20% of the firms are within
5% of each other, and a quarter differ by more than 15%.
Another common use of equity in financial analysis is in leverage
characteristics (Lantto and Sahlström, 2009). Having shown how widely
equity varies under IFRS in comparison with GAAP, it is probable that
IFRS and GAAP do not deliver comparable leverage measures.
Cash flow
Cash flow is used in financial analysis (e.g., Lev and Thiagarajan,
1993). For example, a measure like how many times cash flow covers
interest obligations approximates the risk of default on debt. It seems a
reasonable question to ask, for example, whether it is better to classify
dividends paid as operational or financing. We add to that the evidence
that the classifications are empirically different (Table 7 below), and that
they are significant for some firms.
Academic research
Net income
Measures of “earnings management” are used in a large area of
accounting (Dechow et al., 2010). A favorite measure is accruals, on the
belief that higher the correlation between a firm’s cash flows and its
income, the less use is being made of accruals as a means to manage
earnings.
Since accruals are the difference between income under IFRS and
GAAP, in measuring earnings quality with accruals, one must recognize
that the level of accruals is a matter of both discretionary adjustments to
manage earnings, and different accounting standards. Unless this is
understood, the researcher may mistake different accrual standards for
deliberate actions to mislead investors.
Frequency and dollar amounts of income statement
adjustments
Many accounting studies make use of line items to test their “value
relevance.” One research question might be whether the IFRS values are
more value relevant than the GAAP numbers. This study has been done
for income (Gordon et al., 2013), but not for line items. The value
relevance of items can differ only if the accounting numbers differ. Table 5
above indicates which items it might be candidates for value relevance
tests.
Shareholders’ equity adjustments
Accounting researchers believe that the ratio of book value of
equity to market value of equity measures future growth opportunities
(Collins et al., 1989; Kothari, 2001; Roychowdhury and Watts, 2007). If a
study combines firms that use IFRS with firms that use GAAP, the ratio will
be affected by (a) different growth opportunities and (b) different
accounting standards. So, once again, the question is whether the equity
figures differ enough so that (b), which is not controlled for, will distort
conclusions about (a)? This is addressed in Figure 3 below.
We present book to market ratio under the two sets of standards.
As shown in Fgure 3, they are not likely even to be close.
9
The researcher
is confronted with a dilemma. “Market” is the same in both cases, so if the
book-to-market ratio really does measure growth opportunities, then either
“book value” under IFRS or else “book value” under GAAP captures this
growth element better. For a large segment of firms the book-to-market is
larger under IFRS, and for another large segment it is smaller. It supports
the debate about which is better.
Cash flow
McGinnis and Collins (2011) study the role of analysts’ cash flow
forecasts in curbing earnings management. This study utilizes entirely US
data, but it would be natural to test the same thing using international data.
IFRS (but not GAAP) allows discretionary choices for classification of
some cash flow items (See Table 7 below.) In an international comparison,
the question may be: “What are analysts forecasting? Do they use the
companies’ conventions or do they use uniform classification?” For this
purpose, it is arguable that “GAAP is better” since it excludes discretion
and gives comparability in large data set studies where hand-collecting is
not done. Our evidence shows considerable differences among firms.
That fact should be addressed in designing research.
Table 7. Cash Flow from Operations, IFRS compared with US
GAAP
2006
2005
2004
Mean Ratio: US GAAP / IFRS
.973
.967
.995
Range: Low
.694
.750
.804
High
1.08
1.00
1.20
Number of observations
39
42
42
With differences
7
7
7
Note: Three of the original firms in the sample merged in 2006.
Some research studies make use of cash flow from
operations (CFO) as an input to measuring “accounting quality.” As
Gordon et al. (2013) show (using Dechow and Dichev, 2002),
discretionary accruals, a principal input to the earnings quality measure,
are calculated by subtracting CFO from net income. Clearly, if cash flow
from operations differs between IFRS and GAAP, then different
conclusions are possible. They are more likely the farther apart are the
CFO measures. Gordon et al. perform an international “accounting
quality” study, comparing earnings management results based on the
IFRS vs. GAAP viewpoint. They take the necessary step of basing the
accrual computation on two methods, one using net income from IFRS
and one using net income from GAAP. But they do not account for
different rules for measuring CFO.
Banker et al. (2009) measure the association of cash flows with
pay-for-performance and value relevance.
10
An interesting extension
would be to investigate whether the same associations are detected
outside the US. Since compensation policies in the US tend to differ from
those in Europe (e.g., more US use of stock options), the relation might be
expected to differ. But in an international comparison the conclusions
could be robust only if CFO were measured on a consistent basis.
CFO has an important role in financial analysis, so it is
important to know that the measures can differ, as table 7 above shows.
VI. SUMMARY AND CONCLUSIONS
Here we summarize the three concerns that motivated this study.
First, we contribute to the policy debate over whether the US should
change to international standards. The farther apart the standards are,
the more important is this choice. If harmonization and convergence have
reached their goal, then the benefits from the US changing are small since
GAAP largely replicates IFRS. But the standards are still far apart, so the
decision is more complex. The comparability from a single set of
standards is an advantage, but if the quality is lower, then the higher costs
to investors is a disadvantage. This study does not attempt to assess
which standards are better, only to show that they are not very
comparable yet.
The detail shows that a handful of accounting principles drive a
significant difference in income and net assets. That handful causes large
differences on average. The differences are even more significant when
considered firm-by-firm. This is important since it is not an “aggregate”,
but firm level comparability that is the goal of accounting convergence.
We consider the GAAP-IFRS differences from the viewpoint of the
financial analyst who does analysis on a firm-by-firm basis. Even where
there are small average differences (e.g., in net income), those small
averages often hide a wide variability among firms. The goal of financial
reporting is to provide information for investors. Investors examine results
at the firm level. GAAP-IFRS differences have significant effects at the
firm level on indicators of financial performance and position such as
shareholder equity, net income, return on equity, and book to market ratio.
Academic research is often cited in policy deliberations (e.g.,
Niemeier, 2008). Research studies often involve items where there can
be large differences—income, line items, equity, and cash flows. In
summary, the line item differences can be large and occur frequently, but
there are not very many of these line items. For any one firm, five or fewer
of the differences explain almost the whole GAAP-IFRS reconciliation.
Since only a few standards cause most of the differences, then only
a few standards must be harmonized for the average numbers to become
comparable (though there may be other standards with big effects only on
a few firms).
Researchers can look at a few, known differences, and adjust them.
Even if making the appropriate adjustment is not feasible, at least the
direction of the bias in the results can be addressed. This study allows the
researcher to understand the most important differences in financial
reporting and representation. For example, a test of the hypothesis that
European companies invest less in product development would be biased
against rejecting the null. The future investigator must be aware that
changes in standards will reduce the longitudinal consistency of the
numbers. Users of data from these years should be mindful that a non-
stationary process generated these data, and the time series is unstable
(Box and Jenkins, 1976).
1
We use the term “accounting quality” as a blanket to cover studies of
“earnings management,” “earnings quality,” “information content,”
“conservatism,” and “timely recognition.”
2
Because of the small number of foreign private issuers that used IFRS
before 2005, there are many more studies that compare US GAAP with
local GAAP.
3
Foreign private issuers reconcile on SEC Form 20-F the accounting
results in accordance with the basis of preparation (e.g., IFRS) with what
the corresponding accounting results would have been under US GAAP.
The SEC required this for net income and shareholders’ equity until
November 2007.
4
In 2005, GDF per capita in the US was $44,308. In Hungary it was
$11,092 (World Bank, 2013).
5
“[T]axes, which require adjustment for nearly all sample countries” (134).
6
We convert everything to dollars at the rates prevailing in October 2006.
7
Net income is after tax, and we have tax-adjusted each line item. For
companies with net losses, we do not apply any tax adjustment.
8
Soliman (2008) shows that this is an important tool in financial analysis.
9
A test of means rejects the null of equality of book values at the p=0.003
level.
10
They use earnings as well as cash flows, so the points raised here also
apply to the “net income” section, above.
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Source of title photo: By Hansjorn, CC BY-SA 3.0,
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