The implications of IFRS on the functioning of the securities antifraud regime in the United States.

Author:Phillips, Lance J.
Position::International Financial Reporting Standards

The United States is home to one of the most investor-friendly securities antifraud regimes in the world. Corporate misstatements that form the basis for a cause of action under one of the many antifraud provisions arise in a variety of contexts, an important one being as violations of U.S. generally accepted accounting principles ("GAAP"). For several years, the Securities and Exchange Commission has been considering changing the standardized accounting practice in the United States from GAAP to International Financial Reporting Standards ("IFRS") to promote comparability between global investment opportunities. IFRS is a principles-based system of accounting, while GAAP is rules based. Because of the flexibility of financial reporting inherent in the principles-based approach of IFRS, investors and the Securities and Exchange Commission will face greater difficulty in relying on accounting violations to establish the elements of the securities antifraud causes of action if IFRS is adopted.

TABLE OF CONTENTS INTRODUCTION I. THE ROLE OF GAAP VIOLATIONS IN SECURITIES-FRAUD CASES A. The U.S. Securities Antifraud Regime B. GAAP Violations as Probative of the Elements of Securities Antifraud Causes of Action 1. Existence of a Misstatement 2. Scienter. II. THE DIFFERENCES BETWEEN GAAP AND IFRS A. "Rules Based" vs. "Principles Based". B. Specific Differences Between the Two Systems 1. Revenue Recognition 2. Uncertain Tax Positions 3. Consolidation of Special-Purpose Entities III. THE IMPACT OF THE DIFFERENCES ON THE SECURITIES ANTIFRAUD REGIME A. The Impact of IFRS on the Securities Antifraud Regime B. Carpenters Health & Welfare Fund v. The Coca-Cola Co CONCLUSION INTRODUCTION

Public companies in the United States have not always been required to prepare financial statements in accordance with standardized accounting practices. In fact, public companies in the United States have not always been required to issue financial statements at all. (1) Of the billions of dollars in new securities purchased during the years leading up to the Great Depression, most of the investment decisions were made without adequate financial information. (2) To protect investors, Congress enacted the Securities Act of 1933 (3) and the Securities Exchange Act of 1934, (4) which force companies to make certain disclosures and seek to discourage fraud. (5)

Concomitant to the promulgation of the securities laws, the desire for comparability between the financial positions of various firms and within the same firm across time inspired the movement for a uniform system of financial reporting. (6) In 1933, the American Institute of Accountants (7) ("AIA") adopted six broad principles that formed the basis for what later came to be known as generally accepted accounting principles, or GAAP--a term first used by the AIA in 1936. (8) Authoritative rulings from various official accounting standard-setting bodies (9) combined with other statements approved by a significant segment of the accounting profession comprise the current body of U.S. GAAP. (10)

The advantages of having comparable financial data among various firms have garnered recurring relevance amidst the globalization of securities markets. Technological innovation has greatly facilitated cross-border capital flows. (11) The benefits of financial globalization have been widespread. Two thousand and five marked the first year in which over half of all global saving was invested abroad. (12)

Though technological advancements have eliminated some barriers to cross-border securities transactions, other barriers remain. For example, variations in standardized accounting practices create one of the biggest impediments to worldwide capital-market integration by hindering the ability of investors to compare financial data and by forcing companies to compile financial statements that comply with the reporting requirements of every country in which they wish to enlist. (13)

Every country with an established securities market now requires companies to comply with a standardized accounting practice, (14) but not all standardized accounting practices are alike. Some countries, including the United States, employ a "homegrown" system developed by a wholly internal body and often unique in substance, known as a local GAAP system. (15) Many other countries have adopted the International Financial Reporting Standards ("IFRS") as the official domestic accounting practice. IFRS is a system of financial reporting developed by the International Accounting Standards Board ("IASB"), (16) a private and independent international standard-setting body comprised of representatives from several different countries. (17)

Since its origination in 1973, IFRS has spread with considerable popularity. In 2005 the European Union adopted it with a few minor variations, (18) marking a major milestone in the move toward global uniform accounting standards. Other major securities markets including Hong Kong, Australia, New Zealand, Singapore, and the Philippines have since followed suit, (19) and there are currently over 100 IFRS-based countries. (20)

The future of IFRS in the United States is still uncertain. The SEC currently permits foreign countries to compile financial reports in accordance with IFRS without reconciling them to U.S. GAAP. (21) The question is whether the SEC will either permit or require U.S. companies to use IFRS in lieu of U.S. GAAP. (22)

In 2008, the SEC published its Roadmap for the Potential Use of Financial Statements Prepared in Accordance with International Financial Reporting Standards by U.S. Issuers, (23) a proposed time line for U.S. conversion from GAAP to IFRS. The report contemplates conversion by 2014, with a select category of companies eligible for IFRS by 2010. (24) Though the proposed roadmap for conversion is not binding, many commentators inside and outside of the accounting profession nevertheless believe that conversion is a matter of when and not if. (25)

Numerous countervailing considerations inform the debate surrounding the prudence of conversion. IFRS advocates continue to rely on the age-old comparability justification for support. (26) IFRS opponents, on the other hand, identify several potential problems. They argue:

[M]andatory [implementation of IFRS by U.S. issuers] will result in a high risk that users of financial information will be confused and thus lack confidence in the information; companies will not have the expertise to implement an entirely new set of roles; auditors will struggle to accept conflicting policies that companies within the same industry may adopt; and finally, and most importantly, companies will incur significant costs in implementing the rules with little or no tangible benefit at a time when the economy is very weak. (27) IFRS opponents also cite the difficulty of reorganizing accounting-education curriculum (28) and the susceptibility of the IASB to political pressure. (29)

What the pundits of conversion have not considered is the impact that the substantive differences between GAAP and IFRS will have on the functioning of the securities antifraud regime in the United States. Given that former SEC Commissioner Christopher Cox has emphasized that the interests of investors will drive the decision to adopt IFRS in the United States, (30) and that the securities antifraud regime is perhaps the most potent investor-protection vehicle in the United States, it is surprising that the implications of IFRS on the domestic securities antifraud regime have largely been overlooked. (31) The various aspects of U.S. securities regulation are inextricably interrelated. A change in the rules governing financial disclosure cannot be considered in isolation of the effects it might have on the functioning of the antifraud provisions. This Note argues that the principles-based approach of IFRS, which provides companies with increased flexibility in financial reporting, will threaten the current level of success enjoyed by plaintiffs bringing claims under the various federal securities antifraud laws. Part I explains the role that GAAP violations have traditionally played in securities-fraud cases under U.S. law. Part II articulates some of the important differences between IFRS and GAAP and places special emphasis on the flexibility in financial reporting allowed under the former as compared to the latter. Part III argues that the flexibility of IFRS will diminish the ability of shareholders and the SEC to rely on accounting violations to establish the elements of securities-fraud claims, particularly the existence of a misstatement and scienter.


    This Part explains the role that GAAP violations have traditionally played in securities-fraud cases. Section I.A provides a brief introduction to the antifraud framework in the United States. Section I.B shows that GAAP violations have frequently been used to prove the existence of a misstatement, one element required in securities-fraud cases, and scienter, another oft-required element.

    1. The U.S. Securities Antifraud Regime

      The U.S. securities-law framework is among the most comprehensive and investor friendly in the world. (32) Investor protection has always been the primary motivation behind government regulation of securities transactions, (33) and Congress has passed many acts that seek to accomplish this goal in various ways. (34) But when it comes to protecting investors from corporate fraud and deception, the Securities Act of 1933 (35) ("Securities Act") and the Securities Exchange Act of 1934 (36) ("Exchange Act") do most of the heavy lifting. Four provisions in particular provide shareholders and the SEC with the weaponry needed to combat corporate fraud: Sections 11, (37) 12, (38) and 17 (39) of the Securities Act and Section 10 of the Exchange Act (40) (and rule 10b-5 promulgated thereunder). (41)

      Section 11 of the Securities Act...

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