Chapter 4

International Financial Reporting Standards (IFRSs)

International Financial Reporting Standards (IFRSs) Basics of recognition and measurement. IFRSs: Recognition and measurement of assets. IFRS / U.S. GAAP differences: Recognition and measurement. IFRS / U.S. GAAP differences: Presentation and disclosure.

Recognition and Measurement: Some background

Review of important terminology Assets resources controlled by the enterprise from which future economic benefits are expected to flow to the enterprise. Recognition inclusion of items (e.g., assets, liabilities) into the financial statements with the amount included in statement totals.

Recognition and Measurement: Some background

Measurement choice of the attribute by which to quantify a recognized item. The most commonly used attributes: Historical cost Net realizable value Current (replacement) cost Current market value Present value of future cash flows

Recognition and Measurement: Some background

Historical cost amount paid to acquire an asset or, for liabilities, the amount received when the obligation is incurred. Net realizable value amount of cash (sometimes the present value) minus collection and other costs incurred.

Recognition and Measurement: Some background

Current (replacement) cost amount needed to acquire an equivalent asset. Current market value amount of cash received from an immediate sale of the asset. Present value of future cash flows amount of cash to be received, discounted at the appropriate interest rate.

Recognition and Measurement: IFRSs

IFRSs Substantially similar to U.S. GAAP. However, significant differences do exist. An effective way to understand IFRSs is to compare to U.S. GAAP. Describe IFRSs in terms of significant differences from U.S. GAAP.

Questions to consider

In what way(s) would US GAAP and IFRSs be expected to differ? Why?

Recognition and Measurement: IFRSs and U.S. GAAP compared

Types of Differences Definitions Recognition Measurement Alternatives Lack of requirements or guidance Presentation Disclosure

Recognition and Measurement: IFRSs and U.S. GAAP compared

Form 20-F Some firms filing Form 20-F initially use IFRSs to prepare financial statements. The Form 20-F of some of these firms can be used to gain an understanding of IFRS / U.S. GAAP differences.

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Recognition and Measurement: IFRSs and U.S. GAAP compared

Areas with significant differences Inventory (IAS 2) Property, Plant, and Equipment (PP&E) (IAS 16) Intangible Assets (IAS 38) Impairment of Assets (IAS 36) Borrowing Costs (IAS 23) Leases (IAS 17)

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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 2, Inventories compared to U.S. GAAP Requires lower of cost or net realizable value (U.S. GAAP uses lower of cost or market). IAS 2 does not allow use of last-in, firstout (LIFO). IFRSs would tend to lead to Higher inventory balances. Lower cost of goods sold. Higher net income compared to U.S. GAAP if LIFO is used.
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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 2, Inventories compared to U.S. GAAP Allows for capitalization of interest on borrowings for some inventories. Capitalization of interest on inventories will lead to Higher inventory balances. Lower cost of goods sold. Higher net income compared to U.S. GAAP.
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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 2, Inventories numerical comparison to U.S. GAAP Application of lower of cost of net realizable value. Assume the following: Historical cost $500 Replacement cost 400 Estimated sales price 450 Estimated disposal costs 25 Normal profit margin 20% of sales price

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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 2, Inventories numerical comparison to U.S. GAAP Lower of cost or net realizable value using IAS 2 Historical cost = $500 Net realizable value (NRV) = estimated sales price estimated selling costs = $450 - $25 = $425 (lower of cost or NRV)
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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 2, Inventories numerical comparison to U.S. GAAP Lower of cost or market under U.S. GAAP Historical cost = $500

Designated market is middle value of NRV ($425), Replacement cost ($400), and NRV normal profit margin ($425 $90 = $335). Designated market is $400 and lower of cost or market = $400
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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 2, Inventories numerical comparison to U.S. GAAP The recognized inventory amount under IAS 2 is $425 and under U.S. GAAP is $400. Note: under U.S. GAAP the $400 now represents historical cost. Under IAS 2, historical cost remains at $500 which might be used as lower of cost or NRV in future years.
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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 16, PP&E compared to U.S. GAAP Subsequent to initial measurement, IAS 16 allows the two different measurement approaches. Historical cost -- (the benchmark treatment) recognizes the asset at cost less accumulated depreciation, required by U.S. GAAP.

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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 16, PP&E compared to U.S. GAAP Revaluation -- (the alternative treatment) requires that all assets within a class be revalued periodically A major difference between IFRSs and U.S. GAAP as fixed assets are often substantial. Revaluation is generally not allowed under U.S. GAAP.

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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 16, PP&E compared to U.S. GAAP Accounting for revaluations Revaluation increases require a journal entry to increase the asset to fair value:
Property, plant, and equipment Revaluation surplus xxxx xxxx

Note: The revaluation surplus is an equity account.

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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 16, PP&E compared to U.S. GAAP Accounting for revaluations

Revaluation decreases require a journal entry to decrease the asset to fair value:
xxxx

Expense xxxx Property, plant, and equipment

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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 16, PP&E numerical comparison to U.S. GAAP

Accounting for accumulated depreciation at time of revaluation. Assume the following as of 12/31/X2: Historical cost $10,000 Accumulated depreciation 2,000 Current market value 18,000 Ratio of carrying value to cost 80%

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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 16, PP&E numerical comparison to U.S. GAAP Revaluation adjustment Treatment 1

Asset and accumulated depreciation are restated. Restated carrying amount equals current market value. The ratio of carrying value to gross carrying amount is maintained.

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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 16, PP&E numerical comparison to U.S. GAAP: Treatment 1

Revaluation Cost Gross amt $10,000 + 12,500 = Acc dep 2,000 + 2,500 = Carrying value$ 8,000 + 10,000 = Total Original $22,500 $4,500 $18,000

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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 16, PP&E numerical comparison to U.S. GAAP Revaluation adjustment Treatment 2

Asset is first decreased by the amount of accumulated depreciation. Asset account is then increased by the amount of the revaluation (current market value carrying value).

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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 16, PP&E numerical comparison to U.S. GAAP: Treatment 2

Accumulated Depreciation Asset Asset Revaluation surplus 2,000 10,000 2,000

10,000

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When revaluation is applied:

It must be used consistently for an entire class of assets. Selectivity within a class is not OK but selectivity of a class is. Revaluated assets must be kept at fair value- this need determines the frequency of future revaluations.

Treatment of the revaluation surplus

Subsequent decreases in asset value are charged first to revaluation surplus, if any, and then expensed. When the surplus is realized (e.g., when the asset is sold), it may be transferred to retained earnings, a portion depreciated as the asset is used up, or left untouched.

Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 38, Intangible Assets Purchased intangibles. Intangibles acquired in a business combination. Internally generated intangibles. Does not address Goodwill (see IAS 3).

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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 38, Intangible Assets compared to U.S. GAAP

Purchased intangibles consistent with U.S. GAAP except that fair value is used in some cases. Intangibles acquired in a business combination consistent with U.S. GAAP except that in-process development costs are capitalized.
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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 38, Intangible Assets compared to U.S. GAAP Internally generated intangibles: Major difference with U.S. GAAP. U.S. GAAP (SFAS 2) requires expensing of almost all Research and Development (R&D) costs. IAS 38 allows capitalization, also called deferral, of many development costs.

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Criteria for capitalization of development costs:

Technical feasibility Intent to complete and use/sell. Ability to use/sell. How the asset will generate future economic benefits, e.g., the existence of a market and/or usefulness. Availability of resources to complete developmnent. Ability to reliably measure the expenditure needed.

Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 38, Intangible Assets numerical comparison to U.S. GAAP Internally generated intangibles Development Costs. Assume the following:

Development costs of $100,000 during 2005 70% of costs qualify for capitalization Product sales begin on January 2, 2006 Five years of sales expected Capitalized costs amortized on a straight-line basis

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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 38, Intangible Assets numerical comparison to U.S. GAAP Internally generated intangibles Development Costs

Accounting treatment under IAS 38 in 2005:

Development expense Deferred development costs Cash, payables, etc. 30,000 70,000 100,000

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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 38, Intangible Assets numerical comparison to U.S. GAAP Internally generated intangibles Development Costs

Accounting treatment under IAS 38 in 2006: Amortization expense 14,000 Deferred dev costs 14,000

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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 38, Intangible Assets numerical comparison to U.S. GAAP Internally generated intangibles Development Costs

Accounting treatment under U.S. GAAP - in 2005: Dev expense 100,000 Cash, payables, etc. 100,000 In 2006 No entry

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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 36, Impairment of Assets compared to U.S. GAAP Has lower threshold for impairments, sometimes results in impairments when U.S. GAAP does not. For assets considered impaired under U.S. GAAP, impairment is carrying amount minus fair value. Impairment is carrying amount minus the recoverable amount (greater of net selling price or value in use). This is likely to differ from fair value.
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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 36, Impairment of Assets compared to U.S. GAAP Allows for reversal of impairment loss in subsequent periods when recoverable amount exceeds carrying value. U.S. GAAP prohibits such reversals. Impairment test for goodwill requires both a bottom-up and top-down test. U.S. GAAP requires only a bottom-up test.

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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 36, Impairment of Assets numerical comparison to U.S. GAAP

Assume the following: Carrying value Selling price Cost of disposal Expected future cash flows Present value of expected future cash flows $440 400 25 450 380

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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 36, Impairment of Assets numerical comparison to U.S. GAAP Impairment under IAS 36:
Value in use $380 Net selling price 375 Recoverable amount $380 (greater of these two) Impairment loss = carrying amount recoverable amount = $440 380 = $60

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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 36, Impairment of Assets numerical comparison to U.S. GAAP Impairment under U.S. GAAP

Carrying amount of $440 is less than expected future (undiscounted) cash flows of $450. No impairment.

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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 23, Borrowing Costs U.S. GAAP (SFAS 34) requires capitalization of interest on borrowings attributable to construction, acquisition, or production of qualifying assets. Capitalization of interest is the benchmark treatment under IAS 23. However, an alternative treatment allows for expensing of all interest.

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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 23, Borrowing Costs Explicitly allows for capitalization of interest on borrowing for the production of some inventories. U.S. GAAP explicitly prohibits the capitalization of interest on borrowings for production of most inventories.

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Recognition and Measurement: IFRSs and U.S. GAAP compared

IAS 17, Leases Distinguishes between operating and finance (capital) leases in much the same way as U.S. GAAP (SFAS 13). The criteria for classifying a lease as either operating or finance is less detailed than U.S. GAAP Leases is often used as an example in arguing that U.S. GAAP is rules-based and IFRSs are principles-based.
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Recognition and Measurement: IFRSs and U.S. GAAP compared

Finance lease criteria, IAS 17 Lease transfers ownership. Bargain purchase option. Lease term is for the major part of the leased assets economic life. Present value of minimum lease payments equals substantially all of the fair value of the asset. The leased asset is specialized so that only the lessee can use it.

Capital lease criteria, SFAS 13 Lease transfers ownership. Bargain purchase option. Lease term is for 75 percent of the leased assets economic life. Present value of minimum lease payments equals 90 percent of the fair value of the asset.

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Recognition and Measurement: IFRSs and U.S. GAAP compared

IFRSs and U.S. GAAP differ somewhat in each of the following areas Cash Flow Statements (IAS 7) Classification of dividends and interest paid is more flexible under IFRS. Segment Reporting (IAS 14) U.S. GAAP requires management approach, IFRS is more flexible as of March 2005. This item is part of short-term convergence project. Interim Financial Reporting (IAS 34) U.S. GAAP treats interim periods as integral part of the full year.
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Liabilities

Contingent Liabilities vs provisions If losses are probable, then they must be recognized. Same as US GAAP, except that, with IAS37, probable is defined as more likely than not. Under US GAAP, the definition of probable is left vague.

Contingent assets

IAS allows recognition if the inflow of economic benefits is virtually certain. US GAAP generally allows no recognition until it has been realized.

Defined Benefit Pension Plans

Past service costs are expensed more quickly than under US GAAP. A minimum liability (the unfunded accumulated pension obligation) is recognized under US GAAP, but not under IAS 19. Both methods allow gains and losses to be brought in slowly and smoothly. IAS caps the amount of a pension asset that can be booked. US GAAP has no such cap.

A few other areas:

Some differences in accounting for income taxes Revenue recognition also differs, but differences are hard to pinpoint.