Get Ready for IFRS

This article was quoted from the International Financial Reporting Standards (IFRS), an AICPA Backgrounder, released by AICPA through its IFRS resources Web site : www.IFRS.com

The growing acceptance of IFRS as a basis for U.S. financial reporting represents a fundamental change for the U.S. accounting profession. Today, approximately 113 countries require or allow the use of IFRS for the preparation of financial statements by publicly held companies. In the United States, the Securities and Exchange Commission (SEC) has been taking steps to set a date to allow U.S. public companies to use IFRS, and perhaps make its adoption mandatory. In fact, on November 14, 2008, the SEC released for public comment a proposed roadmap with a timeline and key milestones for adopting IFRS beginning in 2014.

The international standard-setting process began several decades ago as an effort by industrialized nations to create standards that could be used by developing and smaller nations unable to establish their own accounting standards. But as the business world became more global, regulators, investors, large companies and auditing firms began to realize the importance of having common standards in all areas of the financial reporting chain.

The globalization of business and finance has led more than 12,000 companies in more than 100 countries to adopt IFRS. In 2005, the European Union (EU) began requiring companies incorporated in its member states whose securities are listed on an EU-regulated stock exchange to prepare their consolidated financial statements in accordance with IFRS. Australia, New Zealand and Israel have essentially adopted IFRS as their national standards. Canada, which previously planned convergence with US. GAAP, now plans to require IFRS for publicly accountable entities in 2011. The Accounting Standards Board of Japan (ASBJ) and the International Accounting Standards Board (IASB) plan convergence by 2011. On November 11, 2008, Mexico announced it would adopt IFRS for all listed entities starting in 2012.

In another part, AICPA reported that even great strides have been made by the FASB and the IASB to converge the content of IFRS and U.S. GAAP, yet several significant differences between the U.S. GAAP and IFRS still remain. For example :

1. IFRS does not permit LIFO as an inventory costing method
2. IFRS uses a single-step method for impairment write-downs rather than the two-step method used in U.S. GAAP, making write-downs more likely.
3. IFRS has a different probability threshold and measurement objective for contingencies.
4. IFRS does not permit curing debit covenant violations after year-end
5. IFRS guidance regarding revenue recognition is less extensive than U.S. GAAP and contains relatively little industry-specific instruction.

Further, it said that perhaps the greatest difference between IFRS and U.S. GAAP is that IFRS provides much less overall detail.

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Determining Fair Values in Business Combination (based on IFRS 3)

The assets acquired and liabilities assumed in the business combination should be recorded at fair values. If the acquirer obtained a 100% interest in the acquired entity, this process is straightforward. If the cost exceeds the fair value of the net identifiable assets acquired, the excess is deemed to be goodwill, which should be capitalized as an intangible asset and tested periodically for impairment.

Determining Fair Values

Accounting for acquisitions requires a determination of the fair value for each of the acquired company’s identifiable tangible and intangible assets and for each of its liabilities at the date of combination (except for assets which are to be resold and which are to be accounted for at fair value less costs to sell under IFRS 5).

IFRS 3 provides illustrative examples of how to treat certain assets, particularly intangibles, but provides no general guidance on determining fair value. The Phase II revisions to IFRS 3, promised by iASB, are expected to provide more detailed guidance on this topic. A separate project on fair value measurements is likely to result in the issuance of a new IFRS on this topic, very likely to be heavily based on the recent US GAAP standard, FAS 157.

The list below in drawn from Appendix B of IFRS 3 :

1. Financial instruments traded in an active market – Current market values.

2. Financial instruments not traded in an active market – Estimated fair values, determined on a basis consistent with relevant price-earnings ratios, dividend yields, and expected growth rates of comparable securities of entities having similar characteristics.

3. Receivables – Present values of amounts to be received determined by using current interest rates, less allowances for uncollectible accounts.

4. Inventories

a) Finished goods and merchandise inventories – Estimated selling prices less the sum of the costs of disposal and a reasonable profit

b) Work in process inventories – Estimated selling prices of finished goods less the sum of the costs of completion, costs of disposal, and a reasonable profit

c) Raw material inventories – Current replacement costs.

5. Plant and equipment – At market value as determined by appraisal; in the absence of market values, use depreciated replacement cost. Land and building are to be valued at market value.

6. Identifiable intangible assets (such as patents and licenses) – Fair values determined primarily with reference to active market as per IAS 38; in the absence of market data, use the best available information, with discounted cash flows being useful only when information about cash flows which are directly attributable to the asset, and which are largely independent of cash flows from other assets, can be developed.

7. Net employee benefit assets or obligations for defined benefit plans – The actuarial present value of promised benefits, net of the fair value of related assets (Note that an asset can be recognized only to the extent that it would be available to the enterprise as refunds or reductions in future contributions).

8. Tax assets and liabilities – The amount of tax benefit arising from tax losses or the taxes payable in respect to net profit or loss. The amount to be recorded is net of the tax effect of restating other identifiable assets and liabilities at fair values.

9. Liabilities (such as notes and accounts payable, long-term debt, warranties, claims payable) – Present value of amounts to be paid determined at appropriate current interest rates, discounting is not required for short-term liabilities where the effect is immaterial.

10. Onerous contract obligations and other identifiable liabilities – At the present value of the amounts to be disbursed.

11. Contingent liabilities – The amount that a third party would charge to assume those liabilities. The amount must reflect expectations about cash flows rather than the single most likely outcome (Note that the subsequent measurement should fall under IAS 37 and In many cases would call for de-recognition. IFRS 3 provides an exception for such contingent liabilities, in that subsequent measurement is to be at the higher of the amount recognized under IFRS 3 or the amount mandated by IAS 37).

Source : Wiley IFRS 2008 : Interpretation and Application of International Accounting and  Financial Reporting Standards 2008

How IFRS 1 rules the accounting for Business Combinations ?

IFRS 1 First-time Adoption of International Financial Reporting Standards applies to an entity that presents its first IFRS financial statements. It specifies the requirement that an entity must follow when it first adopts IFRS as the basis for preparing its general-purpose financial statements. IFRS 1 refers to these entities as first-time adopter.

How IFRS 1 rules the financial statement presentation of business combination for an entity as the first-time adopter ?

A first-time adopter need not apply IFRS 3 Business Combinations retrospectively. Should it restate any business combination to comply with IFRS 3, then all later business combinations must also be restated.

A first-time adopter may elect not to apply IFRS 3 Business Combinations retrospectively to past business combinations (business combinations that occurred before the date of transition to IFRSs). However, if a first-time adopter restates any business combination to comply with IFRS 3, it shall restate all later business combinations and shall also apply IAS 27 (as amended in 2008) from that same date. For example, if a first-time adopter elects to restate a business combination that occurred on 30 June 20X6, it shall restate all business combinations that occurred between 30 June 20X6 and the date of transition to IFRSs, and it shall also apply IAS 27 (amended 2008) from 30 June 20X6 (IFRS 1 Appendix B par. B1).

Where a first-time adopter has accounted for a business combination as an acquisition and recognized an item as an intangible asset under IAS 38 Intangible Assets that item should be reclassified as goodwill.

The carrying amount of goodwill in the opening IFRS balance sheet should be its carrying value under previous GAAP adjusted for any intangible asset that does not meet the IAS definition and additional evidence that is now available with respect to any contingent purchase consideration. In addition, irrespective of whether there is any indication of impairment, IAS 36 Impairment of Assets should be applied to test the carrying value of goodwill at the date of transition.

Where previous GAAP required or permitted goodwill to be disclosed as a deduction from equity, it should not be recognized in the opening balance sheet, nor should the goodwill be transferred to the income statement on disposal of the subsidiary.

If under previous GAAP, the first-time adopter did not consolidate a subsidiary, but IFRS would require it to be consolidated the accounting treatment is as follows :

The carrying amounts of the subsidiary’s assets and liabilities should be adjusted to those required by IFRS. The deemed goodwill will equal the difference between the parent’s cost of investment in the subsidiary and its interest in those assets and liabilities.

An entity shall apply IFRS 1 if its first IFRS financial statements are for a period beginning on or after 1 January 2004.  Earlier application is encouraged  (IFRS 1 par. 47).

How to treat the costs incurred subsequent to purchase or self-construction of PPE

IAS 16 par. 7 states that the cost of an item of Property, Plant and Equipment (PPE) shall be recognized as an asset if, and only if :

1. it is probable that future economic benefits associated with the item will flow to the entity; and
2. the cost of the item can be measured reliably.

Further, par. 12 states that under the recognition principle in par. 7, an entity does not recognize in the carrying amount of an item of PPE the costs of the day-to-day servicing of the item. Rather, these costs are recognized in profit or loss as incurred. Costs of day-to-day servicing are primarily the costs of labor and consumables, and may include the cost of small parts. The purpose of these expenditures is often described as for the 'repairs and maintenance' of the item of PPE.

Costs that are incurred subsequent to the purchase or construction of the long-lived asset, such as those for repairs, maintenance, or betterments, may involve an adjustment to the carrying value, or may be expensed, depending on the precise facts and circumstances.

To qualify for capitalization, costs must be associated with incremental benefits. Costs can be added to the carrying value of the related asset only when it is probable that future economic benefits beyond those originally anticipated for the asset will be received by the entity. For example, modifications to the asset made to extend its useful life or to increase its capacity would be capitalized.

It can usually be assumed that ordinary maintenance and repair expenditures will occur on a ratable basis over the life of the asset and should be charged to expense as incurred. Thus, if the purpose of the expenditure is either to maintain the productive capacity anticipated when the asset was acquired or constructed, or to restore it to that level, the costs are not subject to capitalization.

A partial exception is encountered if an asset is acquired in a condition that necessitates that certain expenditures be incurred in order to put it into the appropriate state for its intended use. For example, a deteriorated building may be purchased with the intention that it be restored and then utilized as a factory or office facility. In such cases, costs that otherwise would be categorized as ordinary maintenance items might be subject to capitalization, subject to the constraint that the asset not be presented at a value that exceeds its recoverable amount. Once the restoration is completed, further expenditures of similar type would be viewed as being ordinary repairs or maintenance, and thus expensed as incurred.

However, costs associated with required inspections (e.g., of aircraft) could be capitalized and depreciated. These costs would be amortized over the expected period of benefit (i.e., the estimated time to the next inspection). As with the cost of physical assets, removal of any un-depreciated costs of previous inspections would be required. The capitalized inspection cost would have to be treated as a separate component of the asset. (Hrd)

Initial recognition of self-constructed assets

Essentially the same principles that have been established for recognition of the cost of purchased assets also apply to self-constructed assets. All costs that must be incurred to complete the construction of the asset can be added to the amount to be recognized initially, subject only to the constraint that if these costs exceed the recoverable amount, the excess must be expensed currently. This rule is necessary to avoid the "gold-plated hammer syndrome," whereby a misguided or unfortunate asset construction project incurs excessive costs that then find their way into the statement of financial position, consequently overstating the entity's current net worth and distorting future periods' earnings. Of course, internal (intra-company) profits cannot be allocated to construction costs. The standard specifies that "abnormal amounts" of wasted material, labor or other resources may not be added to the cost of the asset.

Self-constructed assets should include the cost of borrowed funds used during the period of construction (as set forth by IAS 23 regarding on capitalization of borrowing costs).

The other issue that arises most commonly in connection with self-constructed fixed assets relates to overhead allocations.

While capitalization of all direct costs (labor, materials, and variable overhead) is clearly required and proper, a controversy exists regarding the treatment of fixed overhead. Two alternative views of how to treat fixed overhead are to either :

1. Charge the asset with its fair, pro rata share of fixed overhead (i.e., use the same basis of allocation used for inventory); or

2. Charge the fixed asset account with only the identifiable incremental amount of fixed overhead.

While international standards do not address this concern, it may be instructive to consider the non-binding guidance to be found in US GAAP. AICPA Accounting Research Monograph 1 has suggested that :

----- in the absence of compelling evidence to the contrary, overhead costs considered to have "discernible future benefits" for the purposes of determining the cost of inventory should be presumed to have "discernible future benefits" for the purpose of determining the cost of a self-constructed depreciable asset.

The implication of this statement is that a logical similar to what was applied to determining which acquisition costs may be included in inventory might reasonably also be applied to the costing of PPE. Also, consistent with the standards applicable to inventories, if the costs of PPE items exceed realizable values, any excess costs should be written off to expense and not deferred to future periods.

(Sources : Wiley IFRS 2008 : Interpretation and Application of International Financial Reporting Standards - Barry J. Epstein, Eva K. Jermakowicz)