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Legal considerations in the proposed transition to International Financial Reporting Standards.

A transition from financial reporting under United States generally accepted accounting principles to International Financial Reporting Standards raises significant legal issues that need to be considered by U.S. issuers. These include changes in financial-disclosure requirements and related litigation risks.

In the following IFRS section, Gerard G. Pecht and Seth D. Wexler, from the law firm of Fulbright & Jaworski LLP, highlight some basic legal issues for financial executives to focus on.

--IFRS Section Co-developers Cheryl Graziano, CPA, and Ellen M. Heffes

A transition to financial reporting under IFRS would require companies to change their public financial reporting from the more prescriptive, rules-based approach under U.S. GAAP to the principles-based approach under IFRS. Though U.S. issuers have thousands of pages of guidance and literature to wade through under U.S. GAAP, there is often relevant, rules-based guidance for a particular issue.

As contemplated by the draft SEC roadmap issued last November (for which comments were due April 20), transition to IFRS by 2014 for large, accelerated filers and 2016 for smaller public companies will require more judgment, as U.S. issuers will have to fill in the gaps where specific guidance does not exist under IFRS.

In the long-term, the new approach may give U.S. issuers flexibility and more discretion in their financial reporting.

From a legal perspective, however, U.S. issuers will have to modify their mindset (much like has been required with respect to disclosure of executive compensation) to focus on disclosure of the true substance of a transaction, while still addressing the litigation risks associated with any public disclosures.

Legal Impacts of IFRS on Transactional Issues

There are numerous ways in which differences between U.S. GAAP and IFRS may impact completed and future transactions. Many U.S. issuers have contractual agreements containing financial covenants that require certain performance criteria to be met or ratios to be maintained. The differences between IFRS and U.S. GAAP could affect compliance with those covenants.

In particular, a transition to IFRS could increase volatility in a U.S. issuer's earnings because, among other reasons, IFRS generally requires more fair-value accounting for assets and derivatives than U.S. GAAP. If this volatility causes the U.S. issuer's financial statements to reflect different results than under U.S. GAAP, that issuer could fail to meet its financial tests and breach those contracts.

An increased volatility could also affect how "material adverse change" provisions or materiality thresholds are interpreted in contracts. Additionally, many contracts in the U.S. employ U.S. GAAP or GAAP as a defined term, but such definitions may not be broad enough to encompass a transition to IFRS. U.S. issuers may need to reexamine and renegotiate these existing contracts to provide for the possibility of IFRS reporting.

Any transition to IFRS may also impact how a U.S. issuer chooses to finance its operations. Because the standards for classifying a financial instrument as debt or equity are different under IFRS, a U.S. issuer seeking to report a particular mix of debt and equity on its balance sheet would want to take these differences into account when making financial decisions.

The adoption of IFRS could impact employee benefits programs, including compensation. Differences in financial results reported under IFRS could affect, for example, whether a threshold or target is met for determining incentive compensation.

Legal Impacts of IFRS on Disclosure

IFRS and U.S. GAAP have different disclosure requirements, which could have profound legal implications for a transitioning U.S. issuer. Many of these differences derive from IFRS requiring a company to provide a detailed explanation of how it arrived at its accounting conclusions in its public disclosures.

These disclosure requirements will apply to, among other filings, a U.S. issuer's financial statements contained in its annual report on Form 10-K, its quarterly reports on Form 10-Q, its proxy or information statements and its financial statements that are included in its registration statements under both the Securities Act of 1933 (1933 Act) and the Securities Exchange Act of 1934 (1934 Act).

Conversion from U.S. GAAP to IFRS will require earlier disclosure of certain provisions (legal and constructive obligations) and other contingent liabilities in a U.S. issuer's financial statements.

Although both U.S. GAAP and IFRS require recognition of provisions and contingent liabilities based upon the probability of occurrence, the definition of probability differs under the two accounting standards.

U.S. GAAP currently requires recognition when the event is "likely" to occur, while IFRS requires recognition when the event will "more likely than not" occur. "More likely than not" is generally interpreted to be a lower threshold than "likely" and could require earlier recognition of provisions and contingent liabilities.

Similarly, after a provision or contingent liability is recognized, the measurement of this obligation may be different under IFRS than under U.S. GAAP.

A transition from U.S. GAAP to IFRS will require more detailed disclosure regarding the nature and extent of risks arising from financial instruments held or issued by a U.S. issuer. Although reporting under U.S. GAAP requires disclosure of some risks, IFRS requires more specific qualitative and quantitative disclosures, including providing more information regarding the nature and extent of credit, liquidity and market risks arising from a company's financial instruments.

Under IFRS, a company generally must disclose all of the risks that weigh on the minds of management and how these risks have been managed.

Any transition will also require a reevaluation and modification of internal controls, including to ensure continued compliance with Section 404 of The Sarbanes-Oxley Act of 2002.

Because an IFRS-reporting company will have to use more judgment when preparing its financial statements than a U.S. GAAP-reporting company, management will need to focus on its company's internal controls to align this increased judgment with the risk appetite of the U.S. issuer.

Litigation Issues Related to Transition

A U.S. issuer making the transition from U.S. GAAP to IFRS must prepare for the possibility of litigation related to the transition and adoption of IFRS. First, because the transition to IFRS and the accompanying accounting and disclosure changes may cause the reported financial results of a U.S. issuer to differ materially from results previously reported under U.S. GAAP, shareholders and other potential plaintiffs will naturally be curious about those differences.

If the results under IFRS are materially worse, shareholders may allege that the previously reported results were overstated, and, if the results are materially better, the new results could be called into question.

Second, IFRS-reporting companies have more potential exposure for forward-looking statements that they make in their annual and quarterly reports than U.S. GAAP-reporting companies.

An IFRS-reporting company is required to provide forward-looking statements within the footnotes to the financial statements, and statutory safe harbor protections under the 1933 Act and the 1934 Act are not currently available for these forward-looking statements.

Those statements, if deemed inaccurate or misleading, could form the basis for claims under the securities laws.

Third, if IFRS results in more volatility in a U.S. issuer's financial statements (and, consequently, in its share price), such increased volatility could lead to more litigation, both from shareholders and transaction or financing counterparties.

Finally, implementation of IFRS may also impact the ability of auditors to obtain audit inquiry letters related to litigation from a U.S. issuer's counsel. As noted, IFRS may require income statement recognition of contingent liabilities, including those related to litigation, earlier than under U.S. GAAP.

Auditors currently rely on audit inquiry letters from outside counsel to corroborate the information supplied by management about those contingent liabilities related to claims and litigation.

Outside counsel, in turn, must be cautious in disclosing information related to litigation to protect the confidentiality of communications between lawyer and client. The American Bar Association "Statement of Policy Regarding Lawyer's Responses to Auditor's Requests for Information" sets the boundaries for a lawyer's response to audit requests by setting thresholds for disclosures and limitations on responses.

Because the ABA's statement was drafted under the U.S. GAAP regime, however, it may be inconsistent with some IFRS provisions.

And, without changes in the statement, auditors may find it difficult to obtain all of the information they request from outside counsel about claims and litigation.

By press time, with the comment period for the draft roadmap expired, the U.S. Securities and Exchange Commission had not stated publicly when it would make a decision on whether to finalize the roadmap.

In addition, the appointment of Mary Schapiro as the SEC's new chairwoman has added uncertainty regarding the IFRS timeline adoption, and Schapiro has made it clear that her staff should reconsider every aspect of the draft roadmap.

Finally, several comments filed with the SEC have stated that the current global financial crisis is not the time to be considering a transition to IFRS. Nevertheless, over the past 30 years, the SEC has consistently expressed an interest in a single set of high-quality international accounting standards. So, financial executives and others in management need to be prepared for the legal ramifications of a transition in the near future to IFRS or some other convergence of international accounting standards.

Any company that has not done so already should begin a dialogue among its management, board of directors--including its audit committee--and internal and outside legal advisors, to discuss the legal issues surrounding a transition to, and implementation of, IFRS.

--Gerard G. Pecht ( is a Securities Litigation partner and Seth D. Wexler ( is a Corporate and Securities partner, each in the Houston office of Fulbright & Jaworski LLP.
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Title Annotation:financial reporting
Author:Heffes, Ellen M.
Publication:Financial Executive
Date:May 1, 2009
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