In November 2005, the Professional Committee of the Israel Accounting Standards Board decided that financial statements of corporations which are subject to the provisions of the Securities Law should comply with International Financial Reporting Standards (IFRS) starting from 2008. Since this transition, Israel has joined the exclusive club of countries complying with IFRS.
IFRS are set by the International Accounting Standards Board, a London-based independent international body. IFRS constitute a global and modern business language for reporting by corporations, aimed at reflecting the dynamic business and economic reality. At the backdrop of the rise of IFRS as a global business language is the globalization of businesses and capital markets. IFRS were formed as early as 1973. A milestone in the rise of IFRS to its current status was the transition of EU countries to IFRS reporting by public companies starting from 2005.
Over the years, many other countries adopted IFRS as a mandatory financial reporting system. Among others, reporting corporations in Canada began implementing the standards in 2011, while in 2017-2018, Saudi Arabia joined the club. A comprehensive survey carried out by the International Accounting Standards Board showed that in 144 out of the 166 countries and jurisdictions that were reviewed in the survey (approx. 87%), most or all domestic public companies were required to apply IFRS. Interestingly, of the 144 that adopted IFRS as the mandatory financial reporting system, Israel is one of six countries in which IFRS was not adopted for financial corporations (in Israel – this applies to banks only); other such countries include Argentina, El Salvador, Mexico, Peru and Uruguay.
Despite the fact that the adoption of IFRS constitutes a significant step towards applying a worldwide unified set of financial reporting framework, several major countries are conspicuously absent from the list of countries in which IFRS reporting is mandatory for public companies. This group includes, inter alia, India and China. Furthermore, in Japan IFRS reporting is only one of several financial reporting alternatives that domestic and foreign issuers are permitted to implement.
The countries that do not apply IFRS are headed by the USA. This, in effect, splits the accounting sphere into two: On the one hand, IFRS which are implemented by EU countries and by many other G20 countries; on the other hand, US Generally Accepted Accounting Principles (US GAAP), which are applied in the USA and may be applied in several other countries, such as Japan.
Nevertheless, the USA took a very significant step towards recognizing IFRS when the U.S. Securities and Exchange Commission (SEC) made a historical decision whereby foreign issuers may file financial statements prepared in accordance with IFRS starting from 2008, without being required to add an adjustment note. Previously, the SEC did not recognize any foreign accounting standards. The decision means that a company which was incorporated outside the USA and applies IFRS in the preparation of its financial statements can use those financial statements as the basis for listing its shares in almost any capital market worldwide without making any adjustments to those financial statements. Accordingly, many dual-listed Israeli companies, whose shares are listed both on the Tel Aviv Stock Exchange and on US stock exchanges currently prepare their financial statements in accordance with IFRS.
IFRS reflect a principle-based approach, rather than a rule-based approach. Metaphorically speaking, under a rule-based approach, financial statements are prepared based on a “cookbook” that includes clear and precise recipes. A principle-based approach, on the other hand, is based more broadly on exercising judgment and analyzing transactions and events in accordance with all relevant facts and circumstances. US GAAP, from which Israeli accounting standards have drawn inspiration prior to transitioning to IFRS reporting, largely takes a rule-based approach.
It should be noted that while IFRS are mostly adopted by public companies, Israeli local GAAP joined the trend, and in the past two decades many IFRSs were adopted in Israel by the local standard-setting body for private companies. These include inventory, property, plant and equipment, investment property etc. Since all companies in Israel are required by law to prepare and file audited financial statements with the tax authority, the result is that the users of those financial statements enjoy the benefits of the principle-based approach.
The significant advantage of accounting standards based on a principle-based approach is that they require exercising judgment and undertaking responsibility, while striving for a fair and relevant presentation. However, to a large extent this is also their biggest flaw. Exercising judgment can also undermine the comparability between companies when applying different accounting treatments to identical cases; judgment can also be subject to “over-creativity”. This can be illustrated by referring to the definition of “control”, that has changed dramatically under IFRS in 2013. The definition of “control” is very significant since investees over which the reporting entity has control must be consolidated in the financial statements. Through 2013, control over an investee was based (from the point of view of many of the reporting entities) mainly on whether the voting rights held exceeded 50%. Following the publication of IFRS 10 – Consolidated Financial Statements – control is now determined based on the concept of effective control. According to this principle, control depends on all relevant facts and circumstances. Thus, for example, it may very well be that holding voting rights that are significantly lower than 50% may still confer control over a subsidiary. This might be the case, for example, if the remaining voting rights in that subsidiary are widely dispersed. The requirement to assess control using a principle-based approach prevents abusive situations where effective control over a public company is retained, while formal control is lost due to the sale of a small number of shares, such as in the case of a sale that reduces the holding from 50.01% to 49.99%.
In this equation, it appears that managements’ judgment and responsibility greatly outweigh the procedural comparability that might lead to exploitation of formal rules in order to report desirable but distorted results without any accountability. It should be noted that the Americans have already experienced several instances of the colossal failure of accounting standards based on rules rather than on principles. One of those instances was the Enron scandal, in which formal rules were used to avoid the consolidation of financial statements of subsidiaries by creating off-balance sheet entities.
Another significant feature of IFRS is the increasing use of fair value as a basis for measurement in the financial statements. This is also why many perceive IFRS as “fair value accounting”. The most commonly used definition of the term “fair value” is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is being used, among other things, as a mandatory or optional basis for measurement of property, plant and equipment, investment property, financial instruments and many other items. However, historical cost is still widely used as a measurement base in financial statements in the IFRS era.
It is important to note that IFRS are not flawless; however, they are constantly being improved and adapted to the ever-changing reality. Some very significant accounting standards came into effect at the beginning of 2018 and 2019: IFRS 15 – Revenues from Contracts with Customers, IFRS 9 – Financial Instruments, and – IFRS 16 – Leases, all of which are related to business and managerial concepts, a clear trend which is also reflected in IFRS 17 – Insurance Contracts. This transformation may improve the relevance of financial statements, but can also be very hard to implement and requires extensive exercise of judgment.
The transition under IFRS to measurement of many passive assets at fair value (including investments in securities and investment property), while the principal measurement base of core active assets (such as inventory and property, plant and equipment) is still their historical cost, corresponds to the concept generally accepted in appraisals based on the DCF model. According to this concept, the value of surplus assets, net of the value of the financial debt, is added to the value of the operation that is derived from the current value of the future cash flows generated therefrom. This transition is designed to facilitate analysis by investors and analysts. Nevertheless, although the measurement of items in the statement of financial position has improved, the relevance of operating results reported in the statement of profit or loss has continuously deteriorated, including in the context of identifying non-cash items, or non-recurring items.
In response to this deterioration, in December 2019, on the eve on a new decade, the IASB published a proposal for a significant reform in the reporting of operating results, which mainly includes classifying income and expenses in the statement of profit or loss into three categories: operating, investing and financing, as well as identifying unusual items of income and expense in the notes to the financial statements. These measures are expected to complete the picture, provide investors with improved tools for projection and analysis and improve comparability. In that context, the proposal also includes a revolutionary disclosure whereby management reports its operating results in the manner which, according to management, best reflects its results. The inclusion of non-GAAP information in audited financial statements is not trivial, to say the least; if the inclusion of such data will eventually be permitted, entities will face challenges when implementing this, including from the perspective of the audit. But in any case, this reform shows the great importance that the IASB now attaches to these information items, that are of great interest to investors, who are much more interested in such items than in other marginal accounting issues. Furthermore, this major reform in reporting operating results may largely resolve, although indirectly, the lack of a clear-cut conceptual basis for distinguishing between profit and loss and other comprehensive income (OCI), which led to great confusion among investors.
From an Israeli perspective, although such a transition naturally involves some difficulties, there is no doubt that IFRS contribute to the relevance of financial statements of public companies – especially with regard to income-generating real estate properties – as reflected in the pricing of shares and in analysts’ use of financial statements of public companies. One may also say that the transition to IFRS greatly changed the way different users perceive financial statements, that have become more dominant than before.
However, it appears that some of the major problems that plagued Israel’s transition into IFRS still remain unresolved more than a decade after the transition. It appears that the tax system has still not adapted to the new accounting standards system, at least not in a methodical manner. Furthermore, the Companies Law was not revised in respect of the tests relating to dividend distribution (in particular, revising the profit test in order to neutralize notional gains), even though accounting standards have changed dramatically since the Companies Law has been enacted.
We are hopeful that the completion of the aforementioned regulatory framework, together with the major changes in the manner of reporting operating results as described above, will bring about considerable improvement in the relevance and use of financial statements of Israeli public companies in the new decade (2020-2030).