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Last year the Securities and Exchange Commission (SEC) chairman Christopher Cox released a timeline for the mandatory adoption of International Financial Reporting Standards (IFRS) by all publicly traded companies beginning in 2014. This was a significant move by the SEC because it signaled the inevitable end to Generally Accepted Accounting Principles (GAAP). This move, while appearing hasty on the surface, had been in the works since 2001 and was well expected by the accounting profession.
IFRS and GAAP have many rules in common and several more that are not. I will perform the following steps in order to gain a better understanding of international accounting rules:
I will review international accounting literature and spend considerable time describing all differences between GAAP and the international standards.
I will describe the financial statement differences and present statements prepared on the IFRS model.
As a result of this project, I hope to obtain a higher understanding of the new standards and be able to apply them to current market conditions. As a practicing CPA, it is necessary that I master the new rules so that I may effectively advise my managers and clients.
Introduction to International Accounting
The International Accounting Standards Committee (IASC) was formed in 1973 by professional accounting organizations of Australia, Canada, France, Japan, Mexico, The Netherlands, the UK, and Germany. The goal was to create an independent organization of accounting professionals for the development of international financial reporting standards. The IASC was empowered as a standards setting body and authorized to issue International Accounting Standards (IAS) and Interpretations issued by the Standing Interpretations Committee (SIC) for member organizations to follow.
In 2001, the IASC gave way to the International Accounting Standards Board (IASB). The IASB's first order of business was the adoption of all existing IASC IASs and Interpretations. The IASB model is based on the US model created by the Financial Accounting Standards Board (FASB) except it was determined to issue far fewer pronouncements. The IASB regulates international standards in the form of International Financial Reporting Standards (IFRS) which is comprised of IAS, IASC Interpretations, and new standards issued by the IASB. The US model has 168 pronouncements and multitude Interpretations, Technical Bulletins and EITF Abstracts. Currently, there are 29 IAS and only 8 IFRS. Interpretations include 11 SIC (issued by the IASC) and 17 Interpretations issued by the International Financial Reporting Interpretations Committee (IFRIC).
In 2002, the IASB and the FASB executed the Norwalk Agreement which identified significant areas of inconsistency between the two sets of standards and set a goal of creating a single set of global accounting standards. At that time, it was expected that the collaboration between the two organizations would result in the rest of the world adopting US GAAP. Instead, what resulted was a framework of convergence as outlined in a formal Memorandum of Understanding issued in 2006. Convergence, as described in the memo, is the process of reconciling or aligning the two sets of standards to a very short list of differences.
The mission of the IASB is to develop a single set of high quality, understandable and enforceable global accounting standards. All standards are designed to facilitate the issuance of high quality, transparent, and comparable information in financial statements and other financial reporting mechanisms. The overall goal is to protect the public interest and help participants in the various capital markets of the world and other users of the information to make strong sound economic decisions. Since 2006, more than 100 countries require or permit IFRS for public companies. Significant events in the process of global acceptance of IFRS include:
Adoption by the listed countries in the European Union in 2005 for consolidated accounts.
Australia incorporated IFRS in its GAAP in 2005.
Canada committed to switching over by 2011.
India adopting in 2011.
The USA, Japan, Korea, and China committed to the convergence agenda. The USA's initial goal included convergence by 2016(?).
In 2006, convergence was pursued using two distinct tracts, short-term and through other projects (long-term). The short-term goals include the elimination of major differences relating to borrowing costs, joint ventures, segment reporting, impairment recognition, and income taxes. All short-term goals were set to be completed by 2008. Long-term projects include business combinations, consolidations, fair value measurement, uniform presentation of financial statements, revenue recognition, post-retirement benefits, and leases. The approach to other projects is to make progress by 2008 and eventual joint standards later. Overall, the IASB and FASB agree that current standards are too complicated and in need of simplifying. The question remained whether standards should be left to the interpretations of auditors and preparers.
International Financial Reporting
The purpose of financial statements under FASB and IASB is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions. They must meet the common needs of the average user and effectively portray the financial effects of past events. International financial statements will also need to show the results of management's decision-making activities and highlight the accountability of management for the resources entrusted by the company to him/her.
International financial statements will be reported using the accrual basis of accounting. Under the accrual basis, the effects of transaction and other events are recognized in the accounting records when they occur. Further, the transactions are reported in the financial statements of the periods to which they relate. The final significant underlying assumption involves going concern recognition. Under international rules, a going concern is the assumption that an entity will continue in operation for the foreseeable future provided the organization has no intention or need to liquidate. GAAP limits the evaluation of ongoing operations to an operating cycle or a year.
The qualitative characteristics of international financial statements are very similar to GAAP. Financial statements must have the following characteristics:
Substance over form
Note that the characteristics of international financial statements are the same as those in the U.S. The difference between the two is that timeliness is not expressly mentioned as a separate characteristic as with GAAP. In international accounting, timeliness is a component of relevance because conceptually, information must be obtained in a timely fashion in order to be relevant.
Elements of Financial Statement
A complete set of international financial statements include the Statement of Financial Position, Statement of Comprehensive Income, Statement of Changes in Equity, the Statement of Cash Flows for the period and notes to the financial statements comprised of a summary of significant accounting policies and other explanatory information.
Statement of Financial Position
The international Statement of Financial Position is similar to the balance sheet under GAAP in that it includes assets, liabilities and equity. An asset is recognized when it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably. A liability is recognized when it is probable that an outflow of economic benefits will result from the settlement of a present obligation and the amount can be measured reliably. Several measurement bases are used to report assets and liabilities. They can be measured at its historical cost, current cost, realizable or settlement value and or its present value.
International financial statements require a current and a non-current classification. Unlike GAAP, IFRS statements are not presented in the order of liquidity unless more reliable and relevant information is provided by doing so. The current asset/liability category is explicitly defined as such while are other assets/liabilities default into the non-current category. Current assets are classified as such if any one of the following criteria is met:
The asset is expected to be realized or intended for sale/consumption within the normal operating cycle or within a year after the reporting period.
If the assets are trading.
If the asset can be classified as unrestricted cash or cash equivalent.
Current liabilities are defined as obligations whose liquidation is reasonably expected to require the use of current assets or the creation of current liabilities. Current assets are classified as such if any one of the following is present:
Items are entered into the operating cycle to pay for materials and supplies used in production or for services to be offered for sale
Items are collections in advance for goods or services
Items are accruals for wages, commissions, rentals, etc.
If none of the above are met, the assets and liabilities are classified as non-current. The following are the minimum assets line items that must be presented (in order):
Property, plant and equipment
Investments (equity method)
Trade and other receivables
Cash and cash equivalents
Non-current assets for sale and assets of disposal groups
Note: My research could not determine if there is a minimum liability presentation requirement.
IFRS: Classify long-term financial liabilities due within 12 months as current unless refinancing agreement is completed on or before the end of the reporting period. Also, under IFRS, if a long-term financial liability becomes immediately payable upon violation of a debt covenant, the liability should be classified current unless a waiver is granted before the end of the reporting period.
GAAP: Classifies long-term financial liabilities due within 12 months as current provided a refinancing agreement is completed before the issuance of the financial statements. GAAP also deviates from IFRS in that it classifies long-term financial liabilities, which becomes immediately payable upon the violation of debt covenants as non-current only if a 12 month waiver is granted before the date of issuance of the financial statements.
Converged: Other changes included the line item Minority Interest which was changed to Controlling Interests and included in equity. Also, Preferred Stock with mandatory redemptions or redemption outside the issuer's control is now classified as a liability per FAS 150.
Note: As a result of the convergence of US GAAP to IFRS, FASB has proposed that the U.S. change its standards in this area to mirror those of the IFRS. This has been met with considerable controversy in the U.S.
Statement of Comprehensive Income
The international Statement of Comprehensive Income measures organizations' performance. The statement includes income, expenses, and capital maintenance adjustments. Income is recognized when an increase in future economic benefit related to an increase in an asset or decrease of a liability has arisen that can be measured reliably. Expenses are recognized when a decrease in future economic benefit related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably. Revenues and Expenses are measured on the same basis at that used for assets and liabilities.
Statement of Comprehensive Income present all items of income and expense recognized in a period in a single statement or two statements which begins with the total profit or loss and displays components to arrive at other comprehensive income. Minimum line items include:
Shares of profit or loss of associates and joint ventures (related parties) accounted for using the equity method
A single amount comprising post-tax profit/loss of discontinued operations, and; post-tax gain/loss on measurement to fair value less costs to sell or dispose of assets (net of tax)
Total profit or loss
Each component of OCI (see below)
Share of OCI of related parties accounted for using the equity method
Total comprehensive income
Note: For material items of income and expense the company must disclose the nature and amount separately in the footnotes. Examples include write-downs/impairments, disposals of PPE, discontinues operations, etc. Also, IFRS does not present any income or expense items as extraordinary items in the income statement, statement of comprehensive income or the notes to the financial statements.
Other comprehensive income items are reported net of related tax effects and before related tax effects with one amount shown for the aggregate amount of income tax relating to the components. The following are the components of OCI:
Changes in revaluation surplus
Actuarial gains/losses on defined benefit plans
Gains/losses on revaluation of available-for-sale financial assets
The effective portion of gains/losses on hedging instruments in a cash flow hedge
IFRS requires a thorough analysis of expenses in the notes to the financial statements. The purpose is to ensure that the expenses are properly classified by nature or function of the expense. If classified by function, the organization is also required to disclose information on the nature of the expenses including depreciation/amortization and employee benefit expenses. Other than the function or nature requirement, IFRS does not prescribe a standard format for its income statement. However, the statements must be presented as described above (minimum accounts). See the exhibits for expense presentations examples.
Statement of Changes in Equity
The single statement approach or the two statement approach can be used to present the Statement of Comprehensive Income (see exhibit for the single statement approach). The statement is required to present total comprehensive income for the period separated by amounts attributable to owners of the parents and non-controlling interests. For each component of equity the organization must present the effects of retrospective application or restatement and a reconciliation between the carrying amount at beginning and the end of the period. As part of the reconciliation, the company must separately disclose the profit or loss, each item of comprehensive income and transactions with owners in their capacity as owners (related parties).
Statement of Cash Flows
This Statement of Cash Flows under IFRS is very different than under GAAP. Under IFRS interest paid and interest received can be classified as either operating or financing while under GAAP both can only be classified as operating. Similarly, the company can choose between operating and financing when reporting dividends paid or received under IFRS. Under GAAP, dividends paid are classified as financing while dividends received are classified as operating.
Convergence of Financial Statements
As part of the eventual convergence, the FASB and the IASB are approaching the standardization of financial reporting is eight phases starting with objectives and qualitative characteristics and ending with its application to not-for-profit entities and the delivery of the final product. The overriding objective of standardized financial reporting is for the country to move towards a complete and consistent framework for developing reporting standards that are principles-based, internally consistent, and internationally converged. The final chapter of the Discussion Paper relating to financial reporting was expected to be completed by the end of 2009. At the top of the list for convergence is a more consistent principle for displaying and aggregating information in each financial statement. There is a distinct difference between the two sets of statements as to what totals and subtotals should be recognized in each financial statement. Also, there is considerable discussion about whether components of OCI should be reclassified to profit or loss, and if so, the characteristics and types of transactions that should be reclassified. There has also been discussion about whether the direct or indirect method of presenting cash flows from operations provides more useful information for the statement users.
IFRS: Under current IFRS rules, companies must express an explicit and unreserved statement of compliance with International Financial Reporting Standards. Organizations are encouraged to refrain from disclosing compliance unless it has complied with all relevant requirements of standards and interpretations.
GAAP: U.S. companies with registered securities must comply with U.S. GAAP and the rules of the SEC without exception. Registered non-U.S. companies were allowed to issue financial statements under U.S. GAAP or other comprehensive basis such as IFRS provided that a reconciliation of net income and equity to U.S. GAAP is provided. However, this provision was discontinued for IFRS filings on or after March 4, 2008.
IFRS: A minimum of one year of comparative financial information must be provided. IAS 1 (revised) required an additional comparative statement of financial position at the beginning of comparative period if company had a policy change, error correction or reclassification is applied retrospectively.
GAAP: Comparative statements are desirable but not mandated. SEC regulations generally require two years of comparative financial information. This includes a one comparative balance sheet.
Significant Differences in Individual Accounts
Under IFRS, LIFO is not permitted. The inventory will be carried at the lower of cost or net realizable value and previously recognized impairment losses can be reversed up to the amount of the impairment. Under GAAP, LIFO is permitted, inventory is carried at the lower of cost or market and impairment losses can not be reversed once recognized.
Both IFRS and GAAP report/recognize financial instruments in similar fashion with one distinct difference. Under IFRS an entity may designate a financial asset or liability on initial recognition as one to be measured at fair value, with changes to be recognized in profit or loss under certain conditions. The conditions exist when the designation eliminates or significantly reduces an accounting mismatch; when a group of financial instruments are managed and performance is evaluated on a fair market basis (matches management's investment strategy); and, when the contract contains an embedded derivative that meets certain conditions.
Available for sale instruments
Must be classified at purchase under IFRS and can not be classified into any other category. Under GAAP investments that do not meet any of the other categories must be classified as AFS.
Investments in Unlisted Equities
These assets are measured at fair market value if it can be reliably measured. Otherwise, the equities must be reported at its cost. Under GAAP, unlisted equities must be measured at its cost.
HTM instruments are classified similarly under both IFRS and GAAP. The difference comes into play when the company decides that the asset/liability will no longer be held to maturity. Under IFRS, the instrument is reclassified as AFS with the adjustment to FMV recorded in equity. Under GAAP, the instrument can be reclassified as AFS or trading. If AFS, the FMV adjustment is recognized in equity. If HTM, the FMV adjustment is taken into earnings. IFRS takes the decision to reclassify instruments from HTM a step further. Under IFRS, a change from HTM to AFS results in all the remaining HTM assets being reclassified as well. The reclassification must remain in effect for two full financial years before the entity may again classify financial assets as HTM. This rule does not exist under GAAP but the SEC does follow the IASB and imposes a two year rule on this transaction.
Property, Plant and Equipment
PPE under IFRS is revalued to fair value on a regular basis. Major overhaul costs are capitalized if they meet the definition of an asset. Component depreciation is required. GAAP does not permit revaluation except in cases where the asset is impaired.
Investment property under IFRS is separately defined and accounted for either at historical cost or fair value. The classification must be consistent with the way the company handled similar transactions in the past. Under GAAP the property is not separately defined and accounted for as held for sale.
Differences can also be found in the accounting for capital leases as well. IFRS permits companies the ability to separate the land and building when recording capital leases. Under GAAP, the land and building are generally reported together.
Research and Development Costs
IFRS requires separate classification of the costs associated with the research phase and the development phase. Research costs are always expensed as incurred. U.S. GAAP requires that all research and development costs be expensed as incurred unless the R&D is related to the development of software.
U.S. GAAP and IFRS treat liabilities in similar fashion. However, IFRS allows derivatives and liabilities to be classified as held-for-trading and measured at fair value. GAAP does not allow liabilities to be included as held-for-trading.
There are many differences between IFRS and GAAP. There is no single principle under GAAP but there are a number of specific requirements when determining whether to classify an item as equity or a liability. Some instruments that are liabilities under IFRS are classified differently under GAAP depending on the contractual arrangement's substance, not by the legal form. Another notable difference is that under IFRS, convertible debt is split and classified into its liability and equity components. Generally under GAAP the entire instrument is classified as a liability except under special circumstances.
Note: The FASB is considering the IASB approach.
IFRS requires the classification of all deferred taxes as non-current items while in the U.S.; the classification is based on the nature of the related asset or liability. Deferred tax assets are only recognized if it is probable that they will be realized under IFRS while GAAP requires its recognition in full.
My initial project was focused on the economic downturn and the effect fair market valuation played on the mortgage crisis. However, as the result of my research and readings, I have actually come to notice that asset valuation played little if any role in the worldwide crisis. In fact, in most cases, the international accounting standards under IFRS appear to be less complicated but more restrictive. As in the case of mortgage backed securities, IFRS would require that the entire class of held-to-maturity be reclassified to AFS if even one of the instruments is reclassified. Also, like GAAP, AFS securities are marked to market at each reporting date with gains and losses recognized in OCI.
I reviewed a tremendous amount of literature and am now confident that I have a firm grasp on the new concepts presented by the U.S. impending convergence to IFRS.
SIDNEY'S INTERNATIONAL BEER AND COOKIE HOUSE
STATEMENT OF COMPREHENSIVE INCOME
FOR THE YEAR ENDED DECEMBER 31, 2009
Cost of Sales
Marketing and sales expenses
General and administrative expenses
Loss of disposal of financial assets
Results from investments in associates and joint ventures
Profit before income taxes
Income tax expense
Profit for the year from continuing operations
Loss for the year from discontinued operations, net of tax
Profit for the year
(Statement of Comprehensive Income - continued)
Other comprehensive income, net of taxes:
Exchange differences on translating foreign operations
Cash flow hedges
Other comprehensive income, net of taxes
Total Comprehensive Income for the year
Profit attributable to:
Owners of the parent
Total comprehensive income attributable to:
Owners of the parent
Earning per share
From continuing and discontinued operations
Basic earnings per share
Diluted earnings per share
From continuing operations
Basic earnings per share
Diluted earnings per share
(single statement approach using the function of expense method)
Nature of Expense Method
Changes in inventories
Raw materials used
Employee benefits expense
Depreciation and amortization expense
Profit before tax