IAS 1 Presentation of Financial Statements, the Preliminary

IAS 1 Presentation of Financial Statements was issued by the International Accounting Standards Committee in September 1997. It replaced IAS 1 Disclosure of Accounting Policies (originally approved in 1974), IAS 5 Information to be Disclosed in Financial Statements (originally approved in 1977) and IAS 13 Presentation of Current Assets and Current Liabilities (originally approved in 1979).

In December 2003, the International Accounting Standard Board (IASB) issued a revised IAS 1, and in August 2005 issued an Amendment to IAS 1 Capital Disclosures.

Latest, in September 2007 the IASB issued a revised IAS 1.

Main features of IAS 1

IAS 1 affects the presentation of owner changes in equity and of comprehensive income. It does not change the recognition, measurement or disclosure of specific transactions and other events required by other IFRSs.

IAS 1 requires an entity to present, in a statement of changes in equity, all owner changes in equity. All non-owner changes in equity (i.e. comprehensive income) are required to be presented in one statement of comprehensive income or in two statements (a separate income statement and a statement of comprehensive income). Components of comprehensive income are not permitted to be presented in the statement of changes in equity.

IAS 1 requires an entity to present a statement of financial position as at the beginning of the earliest comparative period in a complete set of financial statements when the entity applies an accounting policy retrospectively or makes a retrospective restatement, as defined in IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, or when the entity reclassifies items in the financial statements.

Changes from previous requirements

The main changes from the previous version of IAS 1 are described below

A complete set of financial statements

The previous version of IAS 1 used the titles ‘balance sheet’ and ‘cash flow statement’ to describe two of the statements within a complete set of financial statements. IAS 1 uses ‘statement of financial position’ and ‘statement of cash flows’ for those statements.

IAS 1 requires an entity to disclose comparative information in respective of the previous period, i.e. to disclose as a minimum two of each of the statements and related notes. It introduces a requirement to include in a complete set of financial statements a statement of financial position as at the beginning of the earliest comparative period whenever the entity retrospectively applies an accounting policy or makes a retrospective restatement of items in its financial statements, or when it reclassifies items in its financial statements. The purpose is to provide information that is useful in analyzing an entity’s financial statements.

Reporting owner changes in equity and comprehensive income

The previous version of IAS 1 required the presentation of an income statement that included items of income and expense recognized in profit or loss. It required items of income and expense not recognized in profit or loss to be presented in the statement of changes in equity, together with owner changes in equity. It also labeled the statement of changes in equity comprising profit or loss, other items of income and expense and the effects of changes in accounting policies and correction of errors as ‘statement of recognized income and expense’.

IAS 1 now requires:

1. All changes in equity arising from transactions with owners in their capacity as owners (i.e. owner changes in equity) to be presented separately from non-owner changes in equity. An entity is not permitted to present components of comprehensive income (i.e. non-owner changes in equity) in the statement of changes in equity. The purpose is to provide better information by aggregating items with shared characteristics and separating items with different characteristics.

2. Income and expense to be presented in one statement (a statement of comprehensive income) or in two statements (a separate income statement and a statement of comprehensive income), separately from owner changes in equity.

3. Component of other comprehensive income to be displayed in the statement of comprehensive income.

4. Total comprehensive income to be presented in the financial statements.

Other comprehensive income – reclassification adjustments and related tax effects

IAS 1 requires an entity to disclose income tax relating to each component of other comprehensive income. The previous version of IAS 1 did not include such a requirement. The purpose is to provide users with tax information relating to these components because the components often have tax rates different from those applied to profit or loss.

IAS 1 also requires an entity to disclose reclassification adjustments relating to components of other comprehensive income. Reclassification adjustments are amounts reclassified to profit or loss in the current period that were recognized in other comprehensive income in previous periods.

Presentation of Dividends

The previous version of IAS 1 permitted disclosure of the amount of dividends recognized as distributions to equity holders (now referred to as ‘owners’) and the related amount per share in the income statement, in the statement of changes in equity or in the notes. IAS 1 requires dividends recognized as distributions to owners and related amounts per share to be presented in the statement of changes in equity or in the notes. The presentation of such disclosures in the statement of comprehensive income is not permitted.

The purpose is to ensure that owner changes in equity (in this case, distribution to owners in the form of dividends) are presented separately from non-owner changes in equity (presented in the statement of comprehensive income).

When it is impracticable to apply a new accounting policy, how to deal with it ?

IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors replaces IAS 8 Net Profit or Loss for the Period, Fundamental Errors and Changes in Accounting Policies and should be applied for annual periods beginning on or after 1 January 2005.

The standard retains the ‘impracticability’ criterion for exemption from changing comparative information when changes in accounting policies are applied retrospectively and prior period errors are corrected. The standard now includes a definition of ‘impracticable’ and guidance on its interpretation.

Based on this standard, applying a requirement is impracticable when the entity cannot apply it after making every reasonable effort to do so.

Paragraph 27 IAS 8 stated that when it is impracticable for an entity to apply a new accounting policy retrospectively, because it cannot determine the cumulative effect of applying the policy to all prior periods, the entity, in accordance with paragraph 25, applies the new policy prospectively from the start of the earliest period practicable.

It therefore disregards the portion of the cumulative adjustment to assets, liabilities and equity arising before the date.

Changing an accounting policy is permitted even if it is impracticable to apply the policy prospectively for any prior period.

Paragraphs 50-53 provide guidance on when it is impracticable to apply a new accounting policy to one or more prior periods.

Paragraphs 50 stated that in some circumstances, it is impracticable to adjust comparative information for one or more prior periods to achieve comparability with the current period. For example, data may not have been collected in the prior period(s) in a way that allows either retrospective application of a new accounting policy (including, for the purpose of paragraphs 51-53, its prospective application to prior periods) or retrospective restatement to correct a prior period error, and it may be impracticable to recreate the information.

It is frequently necessary to make estimates in applying an accounting policy to elements of financial statements recognized or disclosed in respect of transactions, other events or conditions. Estimation is inherently subjective, and estimates may be developed after the reporting period.

Developing estimates is potentially more difficult when retrospectively applying an accounting policy or making a retrospective restatement to correct a prior period error, because of the longer period of time that might have passed since the affected transaction, other event or condition occurred. However, the objective of estimates related to prior periods remains the same as for estimates made in the current period, namely, for the estimate to reflect the circumstances that existed when the transaction, other event or condition occurred.

Therefore, retrospectively applying a new accounting policy or correcting a prior period error requires distinguishing information that (a) provides evidence of circumstances that existed on the date(s) as at which the transaction, other event or condition occurred, and (b) would have been available when the financial statements for that prior period were authorized for issue from other information.

For some types of estimates (example, an estimate of fair value not based on an observable price or observable inputs), it is impracticable to distinguish these types of information. When retrospective application or retrospective restatement would require making a significant estimate for which it is impossible to distinguish these two types of information, it is impracticable to apply the new accounting policy or correct the prior period error retrospectively.

Hindsight should not be used when applying a new accounting policy to, or correcting amounts for, a prior period, either in making assumptions about what management’s intentions would have been in a prior period or estimating the amounts recognized, measured or disclosed in a prior period.

For example, when an entity corrects a prior period error in measuring financial assets previously classified as held-to-maturity investments in accordance with IAS 39 Financial Instruments : Recognition and Measurement, it does not change their basis of measurement for that period if management decided later not to hold them to maturity.

In addition, when an entity corrects a prior period error in calculating its liability for employees’ accumulated sick leave in accordance with IAS 19 Employee Benefits, it disregard information about an unusually severe influenza season during the next period that became available after the financial statements for the prior period were authorized for issue.

The fact that significant estimates are frequently required when amending comparative information presented for prior periods does not prevent reliable adjustment or correction of the comparative information (Hrd) ***

How IFRS deals with Changes in Accounting Policies ?

In the preparation of financial statements there is an underlying presumption that an accounting principle, once adopted, should not be changed, but rather is to be uniformly applied in accounting for events and transactions of a similar type. This consistent application of accounting principles enhances the utility of the financial statements. The presumption that an entity should not change an accounting principle may be overcome only if the reporting entity justifies the use of an alternative acceptable accounting principle on the basis that it is preferable under the circumstances.

When IFRS are revised or new standards are developed, they often are promulgated a year or more prior to the date set for mandatory application. Disclosure of future changes in accounting policies must be made when the reporting entity has yet to implement a new standard that has been issued but that has not yet come into effect.

In addition, disclosure is now required of the planned date of adoption, along with an estimate of the effect of the change on the entity’s financial position, except if making such an estimate requires undue cost or effort.

Changes in Accounting Policy

A change in an accounting policy means that a reporting entity has exchanged one accounting principles for another.

According to IAS 8, the term accounting policy includes the accounting principles, bases, conventions, rules and practices used. For example, a change in inventory costing from weighted-average to first-in, first-out would be a change in accounting policy, as would a change in accounting for borrowing costs from capitalization to immediate expensing.

Changes in accounting policy are permitted if :

1. The change is required by a standard or an interpretation, or

2. The change in accounting principle will result in a more relevant and reliable presentation of events or transactions in the financial statements of the enterprise.

IAS 8 does not regard the following as changes in accounting policies :

1. The adoption of an accounting policy for events or transactions that differ in substance from previously occurring events or transactions; and

2. The adoption of a new accounting policy to account for events or transactions that did not occur previously or that were immaterial in prior periods.

The provisions of IAS 8 are not applicable to the initial adoption of a policy to carry assets at revalued amounts, although such adoption is indeed a change in accounting policy. Rather, this is to be dealt with as a revaluation in accordance with IAS 16 or IAS 38, as appropriate under the circumstances.

Changes in accounting policy pursuant to the adoption of a standard

When a change in an accounting policy is made consequent to the enactment of a new standard, it is to be accounted for in accordance with the transitional provisions set forth in that standard.

Generally, the transitional provisions will require the restatement of comparative period information. Nonetheless, comparative information presented for a particular prior period need not be restated if doing so is impracticable.

When the comparative information for a particular prior period is not restated, the new accounting policy is to be applied to the balances of assets and liabilities as at the beginning of the period following that one, with a corresponding adjustment made to the opening balance of retained earnings for the first period restated.

The cumulative effect as of the beginning of the earliest comparative period presented (for which restatement is applied), if any, is to be reported as an adjustment to beginning retained earnings of that period.

For example, assume that a change is adopted in 2008 and comparative 2007 financial statements are to be presented with the 2008 financial statements. The change in accounting policy also affects previously reported 2005-2006 financial position and results of operations, but these are not to be presented in the current financial report.

Therefore, the cumulative effect (i.e., the cumulative amount of expense or income which would have been recognized in years prior to 2007) as of the beginning of 2007 must be reported as an adjustment to beginning retained earnings in 2007.

In certain circumstances, a new standard may be promulgated with a delayed effective date. This is done, for example, when the new requirements are complex and IASB wishes to give adequate time for preparers and auditors to master the new materials.

If, as of a financial reporting date, the reporting entity has not elected early adoption of the standard, it must disclose (1) the nature of the future change or changes in accounting policy; (2) the date by which adoption of the standard is required; (3) the date as at which it plans to adopt the standard; and (4) either (a) an estimate of the effect that change(s) will have on its financial position, or (b) if such an estimate cannot be made without undue cost or effort, a statement to that effect.

A change in an accounting policy other than one made pursuant to the promulgation of a new standard or interpretation must, under revised IAS 8, be accounted for retrospectively.

With retrospective application, the results of operations for all prior periods presented must be restated, as if the newly adopted policy has always been used. If periods before the earliest period being presented were also affected, then the opening balance of retained earnings for the earliest period being presented must be restated to reflect the net impact on all earlier periods.

(Source of this article : Wiley IFRS 2008 : Interpretation and Application of International Accounting and Financial Reporting Standards 2008)

A controversial revised of Accounting for Contingencies

CFO.com on this August 2008 published several articles regarding on controversial proposal proposed by FASB that require more company disclosure about potential lawsuit liabilities.

In its article titled "Bar Fight : Accounting for Lawsuits", CFO.com wrote that :

The proposed new standard would overhaul FAS 5, Accounting for Contingencies. Under the proposed rule, companies would have to disclose "specific quantitative and qualitative information" about loss contingencies. The new rule will also affect the contingent losses companies must disclose under FAS 141, which applies in the wake of mergers and acquisitions.

Under current accounting rules, companies are only required to take a financial charge for a contingent loss if it appears probable that the loss has occurred and its amount can be reasonably estimated. If those conditions are not met, companies must still disclose the loss contingency, but only if there is a reasonable possibility that a loss has occurred.

Under the new rule, companies would have to disclose all loss contingencies unless their likelihood is remote. And companies also would be required to disclose any contingency - no matter how remote - that is expected to be resolved within a year, and could have a severe impact on the company's financial position, financial results, or cash flow.  That's a change that would put substantially greater detail about potential lawsuit liabilities into the footnotes of corporate financial statements.

That is the part of the proposal that has many companies upset.

Here is the link to articles published by CFO.com regarding on above matter.

(1) Bar Fight : Accounting for Lawsuits (CFO.com); (2) Who Should Write the Rules ? (CFO.com); (3) Contingent Liabilities Draft Ignities Ire (CFO.com); (4) Contingent Liabilities Draft Stirs It Up

Changes in Estimated Useful Life of Property, Plant and Equipment, how to handle it ?

In accordance with one of the more important of the basic accounting conventions, the matching principle, the cost of property, plant and equipment are allocated through depreciation to the periods that will have benefited from the use of the assets.

Whatever method of depreciation is chosen, it must result in the systematic and rational allocation of the depreciable amount of the asset (initial cost less residual value) over the asset’s expected useful life.

The determination of the useful life must take a number of factors into consideration. These factors include technological change, normal deterioration, actual physical use, and legal or other limitations on the ability to use the property.

(Wiley – IFRS 2008 Bound Volume, Interpretation and Application)

International Accounting Standard (IAS) 16 Property, Plant and Equipment defined useful life as the period over which an asset is expected to be available for use by an entity, or the number of production or similar units expected to be obtained from the asset by an entity.

Par. 50 of IAS 16 stated that the depreciable amount of an asset shall be allocated on a systematic basis over its useful life.

Par. 51 stated that the residual value and the useful life of an asset shall be reviewed at least at each financial year-end and, if expectations differ from previous estimates, the change(s) shall be accounted for as a change in an accounting estimate in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.

Wiley – IFRS 2008 Interpretation and Application explained further, that if it is determined, when reviewing the depreciation method, that the estimated life is greater or less than previously believed, the change is handled as a change in accounting estimate, not as a correction of an accounting error.

Accordingly, no restatement is to be made to previously reported depreciation; rather, the change is accounted for strictly on a prospective basis, being reflected in the period of change and subsequent periods.

Example of changes in estimated useful life of asset and implementation of Par. 51 of IAS 16 as follows :

To illustrate this concept, consider an asset costing € 100,000 and originally estimated to have a productive life of 10 years. The straight-line method is used, and there was no residual value anticipated. After 2 years, management revises its estimate of useful life to a total of 6 years. Since the net carrying value of the asset is € 80,000 after 2 years (= € 100,00 x 8/10), and the remaining expected life is 4 years (2 of the 6 revised total years having already elapsed), depreciation in years 3 through 6 will be € 20,000 (= € 80,000/4) each.

IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, the Preliminary

International Accounting Standard 8 Accounting Policies, Changes in Accounting Estimates and Errors (IAS 8 revised in December 2003) replaces IAS 8 Net Profit or Loss for the Period, Fundamental Errors and Changes in Accounting Policies (revised in 1993) and should be applied for annual periods beginning on or after 1 January 2005.

This standard also replaces SIC-2 Consistency-Capitalization of Borrowing Costs and SIC-18 Consistency-Alternative Methods.

The main changes of IAS 8 (December 2003 revised) from the previous version are described below :

Selection of accounting policies. The requirements for the selection and application of accounting policies in IAS 1 Presentation of Financial Statements (as issued in 1997) have been transferred to the Standard.

Materiality. The Standard defines material omissions or misstatements. It stipulates that :

1. The accounting policies in IFRSs need not be applied when the effect of applying them is immaterial. This complements the statement in IAS 1 that disclosures required by IFRSs need not be made if the information is immaterial;

2. Financial statements do not comply with IFRSs if they contain material errors;

3. Material prior period errors are to be corrected retrospectively in the first set of financial statements authorized for issue after their discovery.

Retrospective restatement is correcting the recognition, measurement and disclosure of amounts of elements of financial statements as if a prior period error had never occurred.

Voluntary changes in accounting policies and corrections of prior period errors. The standard requires retrospective application of voluntary changes in accounting policies and retrospective restatement to correct prior period errors. It removes the allowed alternative in the previous version of IAS 8 i.e. (a) to include in profit or loss for the current period the adjustment resulting from changing an accounting policy or the amount of a correction of a prior period error; and (b) to present unchanged comparative information from financial statements of prior periods.

As a result of the removal of the allowed alternative, comparative information for prior periods is presented as if new accounting policies had always been applied and prior period errors had never occurred.

Impracticability. The standard retains the “impracticability” criterion for exemption from changing comparative information when changes in accounting policies are applied retrospectively and prior period errors are corrected. The standard now includes a definition of “impracticable” and guidance on its interpretation.

Applying a requirement is impracticable when the entity cannot apply it after making every reasonable effort to do so.

The Standard also states that when it is impracticable to determine the cumulative effect, at the beginning of the current period, of : (a) applying a new accounting policy to all prior periods, or (b) an error on all prior periods, the entity changes the comparative information as if the new accounting policy had been applied, or the error had been corrected, prospectively from the earliest date practicable.

Prospective application of a change in accounting policy and of recognizing the effect of a change in an accounting estimate, respectively, are : (a) applying the new accounting policy to transactions, other events and conditions occurring after the date as at which the policy is changed; and (b) recognizing the effect of the change in the accounting estimate in the current and future periods affected by the change.

Fundamental errors. The Standard eliminates the concept of a fundamental error and thus the distinction between fundamental errors and other material errors. The Standard defines prior period errors.

Disclosures. The Standard now requires, rather than encourages, disclosure of an impending change in accounting policy when an entity has yet to implement a new IFRS that has been issued but not yet come into effect. In addition, it requires disclosure of known or reasonably estimable information relevant to assessing the possible impact that application of the new IFRS will have on the entity’s financial statements in the period of initial application.

The Standard requires more detailed disclosure of the amounts of adjustments resulting from changing accounting policies or correcting prior period errors. It requires those disclosures to be made for each financial statement line item affected and, if IAS 33 Earnings per Share applies to the entity, for basic and diluted earnings per share.

Source of this article : IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.

IAS 18 Revenue, the Preliminary

International Accounting Standard (IAS) 18 Revenue was issued by the International Accounting Standards Committee in December 1993. It replaced IAS 18 Revenue Recognition (issued in December 1982).

Limited amendments to IAS 18 were made as a consequence of IAS 39 (in 1998), IAS 10 (in 1999) and IAS 41 (in January 2001).

In April 2001 the International Accounting Standards Board resolved that all Standards and Interpretations issued under previous Constitutions continued to be applicable unless and until they were amended or withdrawn.

Since then IAS 18 has been amended by the following IFRSs :

· IAS 39 Financial Instruments: Recognition and Measurement (as revised in December 2003)

· IFRS 4 Insurance Contracts (issued March 2004)

IAS 1 Presentation of Financial Statements (as revised in September 2007) amended the terminology used throughout IFRSs, including IAS 18.

The following Interpretations refer to IAS 18 :

· SIC-13 Jointly Controlled Entities – Non-Monetary Contributions by Venturers (issued December 1998 and subsequently amended)

· SIC-27 Evaluating the Substance of Transactions involving the Legal Form of a Lease (issued December 2001 and subsequently amended)

· SIC-31 Revenue – Barter Transactions involving Advertising Services (issued December 2001 and subsequently amended)

· IFRIC 12 Service Concession Arrangements (issued November 2006 and subsequently amended)

· IFRIC 13 Customer Loyalty Programmes (issued June 2007)

This standard shall be applied in accounting for revenue arising from the following transactions and events : (a) the sale of goods, (b) the rendering of services, and (c) the use by others of entity assets yielding interest, royalties and dividends.

This standard does not deal with revenue arising from :

1. Lease agreements (see IAS 17 Leases);

2. Dividends arising from investments which are accounted for under the equity method (see IAS 28 Investments in Associates);

3. Insurance contracts within the scope of IFRS 4 Insurance Contracts;

4. Changes in the fair value of financial assets and financial liabilities or their disposal (see IAS 39 Financial Instruments: Recognition and Measurement);

5. Changes in the value of other current assets;

6. Initial recognition and from changes in the fair value of biological assets related to agricultural activity (see IAS 41 Agriculture);

7. Initial recognition of agricultural produce (see IAS 41); and

8. The extraction of mineral ores.

Income is defined in the Framework for the Preparation and Presentation of Financial Statements as increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.

Income encompasses both revenue and gains.

Revenue is income that arises in the course of ordinary activities of an entity and is referred to by a variety of different names including sales, fees, interest, dividends and royalties.

Revenue is recognized when it is probable that future economic benefits will flow to the entity and these benefits can be measured reliably.

In the normal sale of goods, revenue is presumed to have been realized when the significant risks and rewards have been transferred to the buyer, accompanied by the forfeiture of effective control by the seller, and the amount to be received can be reliably measured.

For most routine transactions, this occurs when the goods have been delivered to the customers.

Revenue recognition for service transactions, as set forth in revised IAS 18, requires that the percentage-of-completion method be used unless certain defined conditions are not met. Originally, reporting entities had a choice of methods – percentage-of-completion or completed contract.

For interest, royalties and dividends, recognition is warranted when it is probable that economic benefits will flow to the entity.

Specifically, interest is recognized on a time proportion basis, taking into account the effective yield on the asset. Royalties are recognized on an accrual basis, in accordance with the terms of the underlying agreement. Dividend income is recognized when the shareholder’s right to receive payment has been established.

Revenue shall be measured at the fair value of the consideration received or receivable.

Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.

(Source of this article : IAS 18 Revenue and Wiley – IFRS 2008 Interpretation and Application)

Business Combination Accounting, difference between Purchase and Pooling method

All business combinations are now, for accounting purposes under IFRS, considered to be acquisitions, whereby one entity (the parent) takes management control of another entity, or of its assets and liabilities. This is independent of the legal form of the business combination.

Thus, two entities may consolidate to create a new, third enterprise. Alternatively, one entity may purchase, for cash or for stock, the stock of another enterprise, which may or may not be followed by a formal merging of the acquired entity into the acquirer.

In yet other cases, one entity may simply purchase the assets of another, with or without assuming the debts of that enterprise. One enterprise may enter into an agreement for another to manage its assets and liabilities.

Pooling of Interests (Uniting of Interests)

Under this method of accounting for business combinations, the premerger book values of each combining entity’s assets and liabilities would simply be added together, with no re-measurement to fair value.

US GAAP eliminated pooling accounting outright (effective mid-2001) and the IASB followed suit, under IFRS 3, from early 2004.

(Business Combinations and Consolidated Financial Statements – WILEY IFRS 2008 Interpretation and Application)

Advanced Accounting Tex-book (Paul M. Fischer, William J. Taylor and Rita H. Cheng) described several major differences between pooling and purchases method of business combination accounting.

Asset valuation : under purchase accounting, assets are recorded at fair value, and goodwill may be recorded. Under pooling, assets were recorded at existing book value (which is generally lower than fair value), and no goodwill was created.

The advantage of pooling : (1) reported income is higher because depreciation expense is lower and there was no new goodwill amortization. (Goodwill was amortized over 40 years or less prior to FASB Statement No. 142); (2) return on assets is greater as a higher income is divided by a lower asset base.

Current-year income : under purchase accounting, the acquired firm’s income is added to the acquiring firm’s income statement starting on the purchase date. Under pooling, the acquired firm’s income was added as of the first day of the reporting period (no matter when the acquisition occurs).

The advantage of pooling : assuming that the acquired firm is profitable, the acquiring firm was able to include the acquired firm’s income, along with its own, for the entire year even if the pooling occurred on the last day of the reporting period.

Retained earnings : in a purchase, the acquired firm’s retained earnings cannot be added to that of the purchasing company. Under pooling, the retained earnings of the acquired firm were added to that of the acquiring firm (with some rare exceptions).

The advantage of pooling : (1) there was an instant increase in retained earnings, which made prior periods look more profitable; (2) prior-year income statements were retroactively combined, thus, the acquiring firm “pulled in” the income of the acquired firm in its prior-year statements.

Direct acquisition costs : in a purchase, these costs are added to the cost of the company purchased. They are typically included in goodwill, which used to increase goodwill amortization in later periods. Now these costs could increase impairment losses in future periods. In a pooling, these costs were expensed in the period of the purchase.

The advantage of pooling : income could have been higher on later periods, since there was no amortization of these costs. However, pooling income was decreased in the period of the acquisition, since these costs were expensed in the period of acquisition.

Total equity : in a purchase, the fair value of the shares issued to pay for the purchase must be added to the equity of the acquiring firm. In a pooling, the book value of the acquired firm’s equity was assigned to the shares issued by the acquiring firm.

The advantage of pooling : total equity was usually lower. Return on equity was greater, since a higher income was divided by a lower equity amount.

The financial statement advantages incurred by the pooling method and the increased “gaming” to use the pooling method led to its elimination in July 2001 with the issuance of FASB Statement No. 141 (Hrd) ***

Why Pooling of Interest Method was Eliminated from the Standard

In my previous article, I mentioned that Financial Accounting Standard Board (FASB) and the International Accounting Standard Board (IASB) have been working together to promote international convergence of accounting standards.

In March 2004, the IASB issued IFRS 3 Business Combinations which replaced IAS 22 and three others interpretations i.e. SIC-9, SIC-22 and SIC-28.

Further, in January 2008, the IASB issued a revised IFRS 3 as part of a joint effort by the IASB and US FASB to improve financial reporting while promoting the international convergence of accounting standards.

Previously, in June 2001, FASB issuing FASB Statement No. 141 Business Combinations which changed the method of accounting for business acquisitions by adopting the acquisition (purchase) method and eliminating the pooling of interests as an alternative.

In December 2007, FASB issued a revised standard, SFAS 141 (R), Business Combinations, and SFAS 160, Non-controlling Interests in Consolidated Financial Statements.

Prior to the issuance of FASB Statement No. 141 in 2001, there were two methods available to record the acquisition of a company. The primary method, applicable to most acquisitions, was the purchase method. And the second was the pooling of interest method.

Purchase accounting recorded all assets and liabilities at their estimated fair values. When the price exceeded the sum of the fair values for individual, identifiable assets, the excess was attributed to goodwill. Prior to July 2001, goodwill was amortized up to 40 years.

With the issuance of FASB Statement No. 142, Goodwill and Other Intangible Assets, goodwill is no longer amortized. It is now tested for, and if necessary, adjusted for impairment.

Under the pooling method, all assets and liabilities were transferred to the acquiring company at existing book values, and no goodwill could be created.

Purchase and poling were not meant to be alternative methods available for any acquisition. It was intended that pooling would apply only to a “merger of equals”. Toward this objective, in 1970, APB Opinion No. 16, Business Combinations, restricted the use of pooling to transactions that met a strict set of criteria.

The most important of the criteria required that 90 % of the acquired firm’s common stock shares be received in exchange for the acquiring company’s common stock. All shareholders had to be treated equally in the distribution of shares.

Over time, many business combinations were “managed” so that they would meet the pooling criteria. This meant that the acquiring company would receive the more favorable accounting treatment.

Several perceived advantages led firms to try to use the pooling method.

The financial statement advantages incurred by the pooling method and the increased “gaming” to use the pooling method led to its elimination in July 2001 with the issuance of FASB Statement No. 141.

The FASB held that fair values should be used in all combinations. The lack of comparability due to financial statement distortions, which resulted from companies using alternative methods, could no longer be tolerated.

Even before the statement was issued, companies were reluctant to use pooling.

In the fall of 1999, Tyco International was criticized for stimulating earnings growth through the use of the pooling method. This precipitated a significant decline in the value of Tyco’s shares.

Tyco later announced that it would no longer acquire companies as a pooling of interests.

Some foreign countries still allow the use of the pooling method when similar-size firms combine; it is difficult to determine the buyer versus the seller in such cases.

(Excerpt from Advanced Accounting Textbook - Paul M. Fischer, William J. Taylor and Rita H. Cheng)

Read for further references :

1. FASB Reconfirms Its Plans to Eliminate Pooling-of Interests Method of Accounting
2. Death to 'Pooling of Interests'?
3. Say Good-Bye to Pooling and Goodwill Amortization
4. Everyone Out of the Pool
5. Purchase and Pooling Headaches
6. Controversy continues over pooling of interest vs purchase accounting
7. Will elimination of pooling accounting reduce mergers and acquisitions?
   

IFRS 3 vs FASB 141 Business Combinations, the new reporting standards

IAS 22 Business Combinations was issued by the International Accounting Standards Committee in October 1998. It was a revision of IAS 22 Business Combinations (issued in December 1993), which replaced IAS 22 Accounting for Business Combinations (issued in November 1983).

In April 2001 the International Accounting Standards Board (IASB) resolved that all Standards and Interpretations issued under previous Constitutions continued to be applicable unless and until they were amended or withdrawn.

In March 2004 the IASB issued IFRS 3 Business Combinations. It replaced IAS 22 and three interpretations : SIC-9 (Business Combinations - Classification either as Acquisitions or Unitings of Interests), SIC-22 (Business Combinations - Subsequent Adjustment of Fair Values and Goodwill Initially Reported), SIC-28 (Business Combinations - "Date of Exchange" and Fair Value of Equity Instruments).

IFRS 3 was amended by IFRS 5 Non-current Assets Held for Sale and Discontinued Operations (issued March 2004).

In January 2008, the IASB issued a revised IFRS 3.

The revised International Financial Reporting Standard (IFRS) 3 Business Combinations is part of a joint effort by the International Accounting Standards Board (IASB) and the US Financial Accounting Standard Board (FASB) to improve financial reporting while promoting the international convergence of accounting standards.

Each board decided to address the accounting for business combinations in two phases. The IASB and the FASB deliberated the first phase separately.

The FASB concluded its first phase in June 2001 by issuing FASB Statement No. 141 Business Combinations. The IASB concluded its first phase in March 2004 by issuing the previous version of IFRS 3 Business Combinations.

The boards' primary conclusion in the first phase was that virtually all business combinations are acquisitions. Accordingly, the boards decided to require the use of one method of accounting for business combinations - the acquisition method.

The second phase of the project addressed the guidance for applying the acquisition method.

The boards decided that a significant improvement could be made to financial reporting if they had similar standards for accounting for business combinations. Thus, they decided to conduct the second phase of the project as a a joint effort with the objective of reaching the same conclusions.

The boards concluded the second phase of the project by issuing IFRS No. 3 and FASB Statement No. 141 (revised 2007) Business Combinations and the related amendments to IAS 27 Consolidated and Separate Financial Statements and FASB Statement No. 160 Noncontrolling Interests in Consolidated Financial Statements.

The IFRS replaces IFRS 3 (as issued in 2004) and comes into effect for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after 1 July 2009. Earlier application is permitted, provided that IAS 27 (as amended in 2008) is applied at the same time.

(Source : IFRS 3 Business Combinations)

FASB Statement NO. 141 Business Combinations

As mentioned above, FASB and the IASB have been working together to promote international convergence of accounting standards.

In 2001, FASB's Statement of Financial Accounting Standards (SFAS) 141, Business Combinations, changed the method of accounting for business acquisitions by adopting the acquisition (purchase) method and eliminating the pooling of interests as an alternative.

In specific areas in accounting for business acquisitions, however, convergence was not achieved.

As a result, in December 2007 FASB issued a revised standard, SFAS 141 (R), Business Combinations, and SFAS 160, Noncontrolling Interests in Consolidated Financial Statements.

The new standards significantly affect how consolidated financial statements are prepared when a Noncontrolling interest is present.

The CPA Journal in its July 2008 publication, revealed out this issue. Click here for the full story : New Reporting Standards for Noncontrolling Interests.