The SEC’s First Progress Report on its Consideration of Incorporating IFRS into the U.S. Financial Reporting System

It has been nearly nine months since the U.S. Securities and Exchange Commission (“SEC” or the “Commission”) directed the staff of the Office of the Chief Accountant of the SEC (the “Staff) to develop and execute a work plan related to incorporating IFRS into the U.S. financial reporting system.

The Staff published the Work Plan back in February 2010. In the words of the SEC, “The purpose of the Work Plan is to consider specific areas and factors relevant to a Commission determination in 2011 as to whether, when, and how our current financial reporting system for U.S. issuers should be transitioned to a system incorporating International Financial Reporting Standards (“IFRS”).”

Since the publishing of the Work Plan, the Staff has stated that they have spent a significant amount of time in executing the Work Plan. Therefore, as a public update to their efforts and findings thus far, the Staff issued their first progress report (“Progress Report”) on October 29, 2010.

The Progress Report summarizes the objectives of the Work Plan, the efforts of the Staff, and more importantly describes the Staff’s preliminary observations to date.

Highlights of the Staff’s October 29, 2010 Progress Report are as follows:

Sufficient Development and Application of IFRS for the U.S. Domestic Reporting System

In order to study this area of the Work Plan, the Staff indicated in its Progress Report that it is currently researching international jurisdictions that scan over 90 percent of the world’s gross domestic product (“GDP”) and cover six continents. Although, the Staff is still in process of evaluating and studying this area, preliminary findings of the Staff to date indicate that the greater part of the sample jurisdictions intend on incorporating IFRs either in full or to some extent into their reporting requirements for listed companies. However, the manner of incorporation by these jurisdictions can vary from incorporating IFRS in full or in some hybrid fashion. Lastly, while the Staff noted that listed companies of the sample jurisdictions are required to use IFRS either in full or in some hybrid fashion, their respective statutory financial reporting requirements do continue to vary.

Independent Standard Setting for the Benefit of Investors

Most of the Staff’s efforts are currently in process or will not be conducted until 2011 for this area of the Work Plan. The Staff notes that the IFRS Foundation has the responsibility to obtain funding for the International Accounting Standards Board (” IASB”). The IASB is not, however, a governmental organization and therefore it has no authority to enforce funding requirements. Further, the IFRS Foundation Trustees assigned to each country are tasked with fundraising for that country. Unfortunately, their fundraising efforts have not achieved mandatory and long-term funding commitments, as was hoped or intended. The IFRS Foundation has indicated that based on current funding commitments it could experience an operating deficit for fiscal 2010 and, more specifically, a $4 million funding “gap” from the United States. The Staff is currently researching other funding mechanisms and models as alternatives to contribute to the IFRS Foundation by reviewing public information and models used by other countries, including the United States’ model and methods to fund its standard setting bodies.

Investor Understanding and Education Regarding IFRS

The Work Plan also indicated the importance of evaluating the impact on investors, related to the potential incorporation of IFRS into the financial reporting system of U.S. issuers. For this area of the Work Plan, the Commission issued a request for comment from the public to aid the Staff in their understanding of U.S. investors’ current familiarity with IFRS and how investors educate themselves about changes in accounting standards. The Staff is currently in process of reviewing the comment letters received and evaluating if additional public input is warranted for their analysis of this area.

Regulatory Environment

The Work Plan noted that in addition to filing financial statements with the Commission, U.S. issuers frequently provide their financial statements to other regulatory bodies. Based on this, the Staff is assessing whether the Commission should determine in the future to incorporate IFRS into the reporting system for U.S. issuers. The Staff would need to evaluate transitional concerns of other regulatory regimes. The Staff’s study of transitional considerations for other regulatory regimes will be accomplished through the Staff reaching out to the various affected parties. These discussions have begun between the Staff and the various affected parties and will continue into 2011. Based on preliminary findings, the Staff has noted a consistent area of concern by regulators related to the prominence of the reference to “U.S. GAAP” currently in U.S. laws, contractual documents, regulatory requirements and guidelines, and other similar documents. Based on this, regulators have indicated to the Staff that if U.S. GAAP is used as the mechanism for incorporation of IFRS into the financial reporting system for U.S. issuers, this would resolve a number of issues identified by such regulators. Nonetheless, regardless of the manner by which the U.S. may ultimately incorporate IFRS into its reporting system, some regulators have indicated that such change will entail significant efforts on their part.

Impact on Issuers

The impact of a potential IFRS incorporation into the financial reporting system of U.S. issuers also requires consideration of costs, effort, and time of U.S. issuers and whether such a change would justify such costs and effort. Adequate transition time for U.S. issuers is an equally an important aspect for consideration. The Staff will request public comment to understand the estimated effort and costs involved as well as reach out to jurisdictions that have already incorporated IFRS into their financial reporting systems to better understand and assess the magnitude of such changes to accounting systems, controls and procedures. Similarly, the Staff is also in the process of evaluating, via a comment letter process or by other means the related effects on contractual arrangements, corporate governance, accounting for litigation contingencies, and considerations for smaller issuers versus larger issuers.

Human Capital Readiness

Education and training, and auditor capacity are important aspects to evaluate in assessing human capital readiness. The readiness of all parties involved in the financial reporting process such as issuers, attorneys, auditors, regulators, and educators should be considered. Staff has initially determined that the assessment of human capital readiness will be most efficiently conducted after further progress on the Work Plan. In order to achieve this, the Staff will obtain the perspectives of key stakeholders such as market participants, academics, accounting firms (including large, medium and small size firms). Lastly, as part of this analysis the Staff will obtain and consider feedback from foreign regulators.

Some have characterized the potential incorporation of IFRS into the financial reporting system for U.S. issuers as one of the most sweeping and monumental changes to the U.S. financial markets and those affected entities since the epicand historical formation of the SEC in the early 1930’s.

This monumental change is more than just accounting and financial statements. Affected U.S. entities would need to consider, plan, and cost out the potential implications to their domestic and foreign business operations; general ledgers; financial statements; IT systems; internal controls; contract negotiations, execution, and management; corporate governance; etc. Also, and as equally as important, affected U.S. entities would need to assess if personnel in their finance departments possess the specific, necessary abilities and skill sets needed to successfully and effectively implement such a sweeping change.

The Progress Report, as summarized above, issued on October 29, 2010, is the first Progress Report of the Staff. Therefore, they expect to continue to report periodically to the public on their efforts and observations under the Work Plan and status of the Work Plan. Ultimately, the Staff does not expect a completion date of the Work Plan until 2011.

So be sure to stay tuned, as more news will be coming from the SEC as the Staff provides more clarity in 2011 on their progress of the Work Plan, followed by the long awaited and ultimate decision in 2011 by the SEC as whether or not U.S. issuers will be required to incorporate IFRS into their financial reporting systems.