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Purpose: This research paper aims to provide education on International Financial Reporting Standards. The focus of the study is to comprehend the principles of IFRS and how they affect accounting principles. I will be researching the history of IFRS and its future of IFRS. I will be examining the differences between rules and principles within IFRS. I will be researching the requirements of IFRS, IFRS policies and procedures, and the advantages and disadvantages of IFRS. Also to gain better knowledge this research paper will analyze the difference in GAAP and IFRS financial statements. By examining financial statements it will be simple to comprehend how IFRS affects accounting and companies.
Overview of International Financial Reporting Standards (IFRS):
Accounting is the means of providing the financial information of any given organization. It summarizes all the company's transactions, and provides a clear image of the business. Accounting keeps the record of all financial reports which is very important for all the managers and stake holders like share holders, creditors or owners. Every country has its own set rules and follows their own accounting standards. (Duquesne University, 2006). International Financial Reporting Standards are sets of standards that were developed by the International Accounting Standard Board. The standards are used to prepare financial statements for public companies (Accountants, 2012). International Financial Reporting Standards are being used by almost 100 countries including European Union, Australia, and South Africa, but some companies do have their own accounting standards. Many countries including United States of America use Generally Accepted Accounting Principles (GAAP) which differs from IFRS in some features. Globalization is the main reason numerous companies are going into the foreign market so those companies raise funds and attract investors to invest in the companies. When accompany goes into the foreign market this brings forth the need for a standardized accounting standard. IFRS is important to companies that are involved in business operations worldwide. IFRS allows the companies that operate globally to create financial statements that are understandable for all of the countries they operate in. IFRS is a principle based system which allows rules to be broader. The main purpose of IFRS is to have a uniform system of accounting standards that is implemented worldwide. By having a uniform system of accounting it would simplify financial reporting for companies involved in operations in different countries. IFRS contains 2,500 pages with many detailed accounting decisions that are decided by the judgment of the accountant. IFRS is designed for countries with highly developed capital markets (Jean Jinghan, 2010).
Under International Financial Reporting Standards the objective of financial statements provide valuable information that will help make economic decisions. one of The financial statements purpose under IFRS are to provide statements that can be compared with statement from previous years from the same company, and statements that can be compared with other companies statements. The accounting method that is used for the financial statements under IFRS is the accrual basis of accounting. For a company to have a full set of financial statements that company must have a balance sheet which shows the company's financial position, a statement of changes in equity, a statement of comprehensive income, and explanatory notes which includes accounting policies. Also to have a full set of financial statements the company must have a statement of cash flows. The cash flow statement is considered to be the primary statement of financial statements. There is no exact format that must be followed when preparing the financial statements but there are guidelines that must be followed. One guideline on the format is there being a minimum amount of disclosure that must be provided in the financial statements as well as in the notes. Management of a company is supposed to use their judgment when deciding what format should be used.
Numerous companies have operations worldwide or do business with customers and suppliers overseas, which make those companies, handle different currencies. Under IFRS if a company has operations in a foreign country and if the foreign operation maintains their own accounting records then that foreign operation will be reported in the local currency and not the currency of what the company's uses. Since two different currency transactions can't be combined under IFRS the foreign operation's results and financial position are translated into a single currency. If a company is taking part in transactions with customers and suppliers that are overseas then that company will report that transaction in their own currency. IFRS are used by SEC foreign registrants without reconciliation to US GAAP. IFRS are used by foreign subsidiaries of U.S. IFRS are used by U.S. subsidiaries of non-U.S. multi-nationals for the purpose of consolidation.
The Financial Accounting Standards Board (FASB) is known as the private sector body that is responsible for the establishment of U.S. accounting standards. The FASB is similar to International Accounting Standards Board (IASB). IASB develops proposals, and distributes these among interested organizations, receive feedback, and then issue a final pronouncement. The IASB plays an important role in developing and enhancing the creditability of international financial reporting. The difference between FASB and IASB is IASB is to develop accounting standards worldwide and the FASB establishes accounting standards for U.S. entities. The IASB board members come from many countries and most members are CPA's with auditing experience.
IASB's purpose is to make accounting standards fully compatible. Some of the standards they are trying to make standardized are the accounting for business combinations, issues as revenue recognition, and a joint conceptual framework. Some of the issues that they have standardized are accounting for the exchange of nonmonetary assets, inventory costs, the computation of earnings per share, the reporting of accounting changes. In the international aspect, transparent and reliable financial reports are a necessity because it is a provider of capital because the company requiring the investment capital may be in a different business environment and different culture than those providing the capital. So ultimately another one of IASB's goals is to lower the cost of capital by lowering information risk.
Securities and Exchange Commission (SEC) was created to guard the interest of the investors by implementing full and fair disclosure. The SEC was given legal authority to establish accounting standards for companies that want to publicly issue shares in the U.S. IFRS is used to set standards that can be used by all companies regardless of where the country is. According to the SEC its "primary missionâ€¦ is to protect investors and maintain the integrity of the securities market" (book). In 2008 the Securities and Exchange Commission (SEC) began allowing non-U.S. companies with shares trading on U.S. stock exchange to issue their financial reports using IASB standards.
The History of IFRS:
The history of International Accounting standards really began in 1966. In 1966 there was a proposal to form an International Study Group which came from the Institute of Chartered Accountants of England & Wales. In 1967 the Accountant International Study Group was founded, and this group's purpose was to write papers on important accounting topics. Those papers then led to standards of accounting that could be used internationally. In 1972 the International Accounting Standards Committee (IASC) was formed. This committee's purpose was to form standards that were easy to implement and could be accepted worldwide. From 1973 to 2000 IASC was responsible for all of the International Accounting Standards that were developed. In 1989 the IASB proposed eliminating the base stock method which is an extreme form of LIFO.
In 1991 it was decided to eliminate the base stock method and LIFO. In 1992 the IASB decided to primarily use FIFO and the average cost method, but allow LIFO to be used as a second choice. In 1997 "The Standing Interpretations Committee (SIC) was established in 1997 to consider contentious accounting issues that needed authoritative guidance to stop widespread variation in practice" (ICAEW, 2012).
In 2001 the IASC was restructured and replaced by International Accounting Standards Board (IASB). In 2002 the IASB entered the Norwalk Agreement to develop accounting standards that could be implemented for domestic and cross-border financial reporting. In 2003 the IASB finally did away with LIFO for good. "The first IFRS was issued in 2003, by which time at least 19 countries required compliance with the international standards. Since then, nearly 70 countries (including EU countries) have mandated IFRS for all listed companies. Further, about 23 countries have either mandated IFRS for some listed companies or allow listed companies to voluntarily adopt IFRS. However, as of 2007, at least 40 countries continue to require domestically developed accounting standards over IFRS" (Sletten, 2009).
Beginning in 2005, the European Union made it necessary that its listed companies were to prepare consolidated financial statements under IFRS. During 2006, the FASB and the IASB work together on a number of joint major projects. Two actions by the Securities and Exchange Commission (SEC) during 2007 accelerated the timeframe of potential conversion from GAAP to IFRS. In November 2008 the SEC proposed a guide for potential use of IFRS by U.S. issuers. 'This guide if executed would result in improvements in accounting standards, provide education and training relating to IFRS, and improve the ability to use interactive data for IFRS reporting. The fair value option under IFRS has been applied only to financial assets' The Fair value option is "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participant at the measurement date" (Intermediate financial accounting, 2008). In May 2010 the IASB issued a draft proposing the extension of the fair value option to financial liabilities. In 2011 the SEC was supposed to decide if the guide they proposed in 2008 would be implemented, but they have now decide that the decision will be made in the near future.
Advantages and Disadvantages of International Financial Reporting Standards:
There are advantages of IFRS because it is a principle based system. A principles-based philosophy means that the goal of each standard is to arrive at a reasonable valuation and that there are many ways to get there. This gives companies the freedom to adapt IFRS to their particular situation, which leads to more easily read and useful statements. One of the main advantages of IFRS is its compatibility if all companies worldwide are using the same accounting standard it is easier to prepare financial statements and compare them accurately. Which ultimately helps investors see what would be a good investment or not by having the tools to compare their investment opportunities in the global capital markets in a cost-effective manner. A potential benefit of IFRS adoption is this type of financial reporting makes it easier for companies to raise capital. Also IFRS lowers financial reporting costs for companies with subsidiaries that prepare IFRS-based financial statements. Another potential benefit of adopting IFRS is providing career opportunities for professionals that are knowledgeable about IFRS. In the long run, International Financial Reporting Standards will potentially lower the cost of capital. An advantage of IFRS for companies that are operating globally or any company that may be looking into operating globally IFRS will provide access to global financial markets. IFRS disclosures are reported more extensively which increases comparability.
With advantages there are always disadvantages, and one disadvantage of International Financial Reporting Standards is there is a high initial cost of converting to IFRS. A reason why the initial cost of converting to IFRS is so high is because when converting one will also need to convert their accounting information systems. When a company converts to IFRS that company will have to prepare financial accounting information fewer than two sets of accounting standard during the first few years because the company will need them for comparative purposes which again is costly. Another disadvantage of IFRS in the U.S. is since Generally Accepted Accounting Principles is the primary way of financial reporting many investors, certified public accountants, auditors, and companies in general lacks the knowledge of IFRS. So when companies to convert again it will be pricey because the company will need to provide training.
There are expected effects of IFRS on financial statements of U.S. companies. Some of the effects are: increasing assets, equity, and income. This occurs when companies no longer use Last in First out (LIFO). The LIFO inventory method is not permitted under IFRS. Another effect is increasing assets and stockholders' equity by writing up plant, property, and equipment up to market value. IFRS allows the profit and loss account to be presented either as one statement a statement of comprehensive income or as two statements as profit and loss account and a statement of other comprehensive income. IFRS requires a company to present expenses recognized in the profit and loss account using a classification based on either their nature or their function within the company. IFRS gives an option to classify the interest and dividend paid and interest and dividend received, as item of operating cash flows.
Rules vs. Principles:
Rules based accounting is when specific accounting rules are enforced when preparing financial statements these rules must comply with GAAP. "Excessively detailed reporting guidance can invite transaction structuring and incentive-consistent standard interpretation to achieve preferred accounting treatments" (FASB 2002; Bockus et al. 2003; Nelson 2003). Principles based accounting has few exact rules and provides little implementation guidance. Less guidance increases the need to enforce professional judgment which is uniform with the purpose of the standards. Companies that are principle based must ensure that their financial statements are accurate and fair, and do follow the principles that were set forth. Since principles based accounting does not have exact rules this type of accounting can be less accurate if not enforced correctly. Principle based accounting is recognized as a less aggressive approach of financial reporting than rules based accounting. A less aggressive approach of financial reporting leads to higher quality financial reporting and gives companies fewer opportunities to "exploit the gaps in GAAP" (Agoglia 2011).
To gain a better understanding of how Generally Accepted Accounting Principles which is rules based is different from International Financial Reporting Standards which is principle based highlighting some of the differences in reporting is necessary. Under IFRS LIFO (Last in First Out) inventory method is prohibited. When a company switches from LIFO to FIFO (First in First Out) or weighted average would increase income for the company increase income, inventory, and retained earnings for the current year on the balance sheet. IFRS allows more discretion for mangers when analyzing R&D expenditure than GAAP. This discretion can be used for earnings management purposes. When revaluating other comprehensive income under IFRS revaluations are recognized in a revaluation account under other comprehensive income. This increases accumulated other comprehensive income and equity. Under IFRS subsequent impairments reduces equity, and excess impairments are documented as losses in profit on the income statement. On the other hand subsequent recoveries are documented as gains if they are related to the subsequent impairment amount. Under GAAP extraordinary items is a valid category but under IFRS it is not. Under IFRS extraordinary items would be classified as other revenue, expense, or gain or loss. IFRS allows development costs to be capitalized but GAAP does not. IFRS allows impairments to be reversed in subsequent years which GAAP does not allow. There is only impairment that may not be reversed in subsequent years under IFRS and that is goodwill impairment because this is irreversible. IFRS requires companies to record an accrual the moment an obligation happens, but under US GAAP, additional formal criteria must be met before recording an accrual. Lastly under IFRS convertible bonds issue price is allocated between debt and equity.
Lease Accounting Under Rules Based Accounting and Principle Based Accounting:
After seeing how rules based accounting and principle based accounting operate differently a demonstration on a specific topic of accounting will show how these two types of accounting work differently. Leases in the accounting aspect are a written contract between the owner of an asset and the lessee who is the person who is paying to use the asset for certain period of time. There are two main types of leases and they are capital leases and operating leases. Capital leases are leases that are used to purchase a capital asset by paying in installment for a fixed period. Capital leases are usually non-cancelable. Operating leases can be cancelable and are for a short period of time. Operating lease is an agreement written by the owner of the asset and the owner of the asset expects to get the asset back after the lease period. During the lease period the lessee is given the right to use the asset until the lease period is over under certain conditions.
The rules based accounting approach for lease is either capital or operating. Financial Accounting Standard 13is GAAP's rule on leases and it identifies four tests to determine if a lease is capital or operating. The four tests are if the ownership transfers, if the lease term is for the majority of the asset's useful life, if the present values of commitment accounts are for a substantial part of the asset's fair value, and if there is a bargaining purchase option. When FAS 13 refers to a lease term being the majority of the asset's useful life the economic life must be greater than or equal to 75% of the asset's life. When FAS 13 defines substantially all of the asset's fair value it must be 90% of the fair value of the property. If the four tests are satisfied then under GAAP the lease is a capital lease, and if they are not satisfied then the lease is an operating lease. FAS 13 uses the lessee's incremental borrowing rate if the implicit borrowing rate is not know, and if it is know and the and the implicit borrowing rate is lower than the incremental borrowing rate than the incremental borrowing rate is used. An incremental borrowing rate is the interest rate the lessee would pay if they were not leasing the item but instead financing the purchase of the same asset. An implicit borrowing rate refers to a loan that has not identified an interest rate. For example a person would pay $75 a month for six months instead of paying $425 in cash up front for the asset. Under GAAP operating leases are to keep the debt off the balance sheet and capital lease are on the balance sheet even though both types of leases give the right to use the leased item and both have an obligation to pay for it.
The principle based accounting approach for leases is a lease contract is either capital, financial or operating. The principle based approach is a lease is a financial lease if it transfers almost of the risk and rewards to the lessee. If it is a capital lease then the property must be recorded as an asset and a liability on the lessee's books. Title transfers under capital leases in a principle based accounting approach occurs and the end of the lease period. Capital leases under IFRS contain a bargain purchase option which gives the lessee the right to purchase the asset at the end of the lease period. The lease is for a major part of the assets economic life. The present value of the minimum of a lease payment is the minimum lease payment is greater than or equal to almost all of the fair market value of the property. IFRS determines a lease to be an operating lease depending on the substance of the transaction rather than the form of the transaction. Some of the things that determine if a lease is a financial lease are if the lease transfers ownership of the asset to the lessee at the end of the lease period, if there is an option to purchase the asset at a price which is expected to be lower than fair value at the exercise date, and the lease assets are of a specialized nature such that only the lessee can use them without major modifications being made (Deloitte 2012). International Accounting Standard 17 is the principle under IFRS that account for leases. According to IAS website IAS 17 objective is "The objective of IAS 17 (1997) is to prescribe, for lessees and lessors, the appropriate accounting policies and disclosures to apply in relation to finance and operating leases" (Deloitte 2012). Under IAS 17 the implicit borrowing rate is used if the incremental borrowing rate is unknown.
Comparing IFRS and GAAP Financial Statements:
To compare IFRS and GAAP's financial statements Kroger's financial statement which is under GAAP will be compared to Delhaize financial statements which is under IFRS. Both of these companies are in the same supermarket industry. When analyzing the income statement Delhaize income statement is set up with eight main sections which are Revenues, Gross Profit, Operating Profit, Profit Before Taxes and Discontinued Operations, Net Profit from Continuing Operations, Net Profit, Earning Per Share, and Weighted Number of Share Outstanding. Kroger's income statement is set up with five main sections which are total Revenues, Operating Income, Net Income from Continuing Operations, Net Income from Total Operations, and Total Net Income.
Delhaize Balance sheet account for goodwill, intangible assets, deferred tax assets in its non-current asset section which Kroger does not account for. They account for accumulated depreciation and depletion which Delhaize did not. In Kroger's non-current asset section In Delhaize section for current assets in the balance sheet investment in securities and derivative instruments are accounted for which are not accounted for in Kroger's current asset section. The differences in the liabilities section in the balance sheet is Delhaize accounts for provisions, obligations under finance leases, and derivative instruments which is not accounted for in Kroger's liability section. In the equity section Delhaize accounts for share capital, share premium, treasury shares, and retained earnings, other shares, cumulative translation adjustments, and non-controlling interests. Kroger's equity section is set up much differently first with common stock equity, common par, additional paid in capital, retained earnings, treasury stock, other equity adjustments, and total capitalization. Both companies have a section to total up their liabilities and equity, but after Kroger's total liabilities and equity they
account for cash flow, working capital, free cash flow, and invested capital which Delhaize did not. In the cash flow statement under the operating activities section Delhaize accounts for
impairment which Kroger does not. Kroger does account for other working capital which
Delhaize does not. Under the investing activities is set up much differently, this is shown below.
Business acquisitions, net of cash and cash equivalents acquired
Business disposals, net of cash and cash equivalents disposed
Purchase of tangible assets (capital expenditures)
Purchase of intangible assets (capital expenditures)
Sale of tangible and intangible assets
Sale of maturity of (investment in) debt securities, net
Purchase of other financial assets
Sale and maturity of other financial assets
Settlement of derivatives instruments
Net cash used in investing activities
Net Cash from Investing Activities
Issuance of Debt
Issuance of Capital Stock
Repayment of Debt
Repurchase of Capital Stock
Payment of Cash Dividends
Other Financing Charges, Net
The differences in the financing activities section of the cash flow statement is cash proceeds from issuing shares or other equity instruments, and cash payments to owners to acquire or redeem the entity's shares are accounted for in Delhaize statement but not in Kroger's. Also cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other short or long-term borrowings, and cash repayments of amounts borrowed cash payments by a lessee for the reduction of the outstanding liability relating to a finance lease is accounted for by Delhaize but not Kroger.
Future of International Financial Reporting Standards:
When the United States adopts IFRS the FASB will be able to turn its focus to improving IFRS instead of U.S. GAAP. By doing this financial reporting can be improved worldwide. Some of the impacts IFRS will have on companies are financial reporting systems, taxes, internal controls. According to IFRS Resources adoption would mean that the SEC sets a specific timetable when publicly listed companies would be required to use IFRS as issued by the IASB. Convergence means that the U.S. Financial Accounting Standards Board (FASB) and the IASB would continue working together to develop high quality, compatible accounting standards over time. More convergence will make adoption easier and less costly and may even make adoption of IFRS unnecessary. Supporters of adoption, however, believe that convergence alone will never eliminate all of the differences between the two sets of standards. In 2010 the Securities Exchange Commission outlined a new plan that lays the groundwork for a major vote to decide when to transition to IFRS. The securities exchange commission believes that IFRS will not be required for use by U.S. companies until 2015.The groundwork that must be put into force for IFRS to implement is ample development and application of IFRS for the US domestic reporting system. Also investors must become educated and understand International Financial Reporting standards, and the U.S. regulatory environment must be examined to see how the changes in accounting standards will affect the environment. With large companies transferring to IFRS this will bring forth opportunities, such as facilitate more capital allocations. Which means since companies will be using a single set of high quality global accounting standards. This would give companies the opportunity to raise capital in different jurisdictions worldwide. Companies will still be able to let investors to compare global investment opportunities but just in a more efficient way. When transferring to International Financial Reporting Standards the United States will become aligned with the rest of the world. The standard has been translated into 12 languages, with plans for a further 11 translations. Since more than 100 nations have adopted IFRS when the U.S. adopted IFRS they will become a part of accepting a sing set of global accounting standards. When the United States transfers to IFRS they will be protecting a long-term competitiveness of U.S. capital markets. They will be doing this by making "Cross-border investment and the integration of capital markets may be easier among those nations that adopt IFRS" (CAQ 2009). There will be increased transparency for the U.S. when IFRS is adopted because IFRS is principle-based it may allow companies and auditors to focus less on stern observance. In the future IFRS is will be converging the rules of the IASB with the rules of America's FASB. Of course it should be expected when implementing all these changes there will be a large expense to upgrade information technology systems. "Over the next decade the international community will see and embrace the convergence of IFRS and US GAAP with other international capital markets" (Charter 2011).
As a conclusion, IFRSs has its own pros and cons. There has been an increase in international trade, multinational companies, foreign investments, and that is the reason there is a need for the financial world to become globalized. For globalized economy there is a need for one accounting language and therefore it can be said that IFRS is very important in today's financial world. There are lots of challenges for lot of countries to face before they adapt to this new standard. Although IFRS's can harmonizes global accounting standards and stimulate greater cross border transactions and increased market efficiencies, it also can create confusion since every country has different accounting practices and it is hard to form mutual agreement between all countries. The International Accounting Standard Board has to put more effort into implementing the IFRSs standard. Even though it takes a long time to standardize the world accounting, but all those efforts are worth being done since IFRSs will contribute a lot in creating a greater efficient integrated capital market. "IFRS may become the new standard for accounting practitioners, but until all of the facts are in, it's business as usual â€¦ with an eye on the future. Whichever path accounting standards take, the most important tool professionals can have is education and the most important skill is preparation" (AuditWatch 2009).