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ASU research addresses upcoming SEC decision on earnings reconciliation from IAP to U.S. GAAP

September 17, 2007

Lucy Huajing Chen, an assistant professor in accounting at Arizona State University’s School of Global Management and Leadership, has co-authored a study with Heibatollah Sami of Lehigh University on short-term trading volume reactions to the earnings reconciliation from international accounting standards (IAS) to United States generally accepted accounting principles, or GAAP, that will appear in an upcoming issue of the Contemporary Accounting Research.

And the timing couldn’t better, as the U.S. Securities and Exchange Commission (SEC) recently proposed – after prodding from overseas, as well as its own sense of self-preservation – allowing foreign countries listed in the U.S. to report financial statements using international financial reporting standards (IFRS) without reconciling the numbers to U.S. GAAP, and noting the differences, as is currently required. The proposal addresses cost issues associated with dual reporting, as well concerns that this country’s financial markets are losing listings to the London and Tokyo stock exchanges, among others.

“If the SEC rushes to eliminate the earnings reconciliation requirement, it may reduce investor protection,” said Chen, who received her Ph.D. in accounting from Temple University after receiving her master’s and bachelor’s degrees at Xiamen University in China. “Investors need the same type of earnings information to decide to invest in either foreign or domestic companies. Our research shows that U.S. investors still used the earnings reconciliation information from IFRS to U.S. GAAP in their trading decisions. This suggests that IFRS may not be comparable to U.S. GAAP.”

Titled “Trading Volume Reaction to the Earnings Reconciliation from IAS to U.S. GAAP,” the study is the first empirical, or statistical, evidence on the trading volume reaction to earnings reconciliation from IAS to U.S. GAAP and contributes to prior research in that trading volume can capture the aggregate reaction for all investors, while price reflects the average reaction of investors. Additionally, as it examines the period from 1995-2004, it is more recent and more relevant to the SEC’s current proposal. The sample included 48 firms listed on U.S. stock exchanges that reconciled their earnings information from IAS to U.S. GAAP.

“Eliminating the earnings reconciliation requirement may reduce the costs of preparing financial statements under dual accounting standards,” said Chen. “This, in turn, may encourage foreign issuers to list more on the U.S. stock exchanges. However, the benefits of a one-report system should be accomplished only if IFRS and U.S. GAAP are comparable.

“If investors do not have the option to compare oranges with oranges, at least we should allow them to compare tangelos with tangerines; we don’t want them to compare oranges with apples.”

The SEC is the only regulatory authority in the world that requires all firms listed on U.S. stock exchanges to file their financial information prepared in accordance with U.S. GAAP or reconciled to U.S. GAAP. The multiple disclosure requirements increase the costs for foreign issuers to list in U.S. financial markets, and as a result of such costs, foreign companies might choose to list in countries with fewer requirements than the United States. The most recent study on the subject adds to the debate of whether it is necessary to require dual accounting standards for foreign countries, while also contributing to the current body of literature.

“If the two standards of reporting are consistent with each other, it can reduce the preparing costs of foreign issuers,” says Chen, who grew up in Fuzhou City in the Fujian Province on the southeast coast of China, across the Taiwan Strait from Taiwan. “Otherwise, it will confuse investors more when they compare foreign companies with U.S. domestic companies.

“Right now, it is just too risky to adopt one system. Actually, if investors – especially unsophisticated investors – are not familiar with the differences between IFRS and U.S. GAAP, they may be reluctant to invest in foreign stocks without any reconciliation information. This, in turn, may increase the costs of capital for those foreign companies.”

What advice would Chen suggest to the SEC, based on the findings of her research?

“I would suggest that the SEC does not act too fast before they can quantify and analyze possible costs and benefits. Our study provides one of the costs of eliminating reconciliation: Investors could not fully understand the differences between IFRS and U.S. GAAP. As a result, investors still need the earnings reconciliation in their trading decisions.”

In other words, investors should at least compare tangelos with tangerines.