International Financial Reporting Standards (IFRS) Transition

Prepared by L. Murphy Smith Professor of Accounting Texas A&M University

For permission to use or adapt this presentation, please contact Dr. Smith, Lmsmith@tamu.edu

Questions and Comments are Welcome Any Time

International Financial Reporting Standards (IFRSs) are shooting down the competition (other GAAPs)

IFRSs are now accepted or required in more than 100 countries.

U.S. Leaders Call for Acceptance of IFRSs

Among those calling for acceptance of IFRSs are John Thain, CEO of the New York Stock Exchange, and former Federal Reserve Chairman Paul Volcker.

FASB Chairman Robert Herz has expressed his expectation that US companies would eventually be required to follow a single accounting standard, which would be the IFRSs.

Why do we need IFRSs and financial reporting comparability?

Expanding world trade Proliferation of multinational corporations Increasing role of global capital markets Increased foreign direct investment Growth of multinational political organizations A way to minimize costs

Why Does GAAP Differ Among Countries?

Political/Legal System Sources of Capital Inflation Taxation Culture Accidents of History Business Complexity
Stop & Reflect: Is there one GAAP that works best everywhere?

Key Problems that Cause Resistance to IFRSs

Agreeing on who will create the rules How different the rules will be from current national GAAP Costs of changing GAAPs National sovereignty

International Financial Reporting Standards (IFRSs)

IFRSs are the accounting standards published by the International Accounting Standards Board (IASB). The IASB was established in 2001 by its forerunner, the International Accounting Standards Committee, which itself was established in 1973. In the past decade, the IFRSs went from being little used to what is now the worlds dominant set of accounting standards. Leading accounting experts anticipate that IFRSs will be accepted for financial reporting, in place of US GAAP, for all companies listed in US stock market, as early as 2016.

Pivotal Events Propelling the IFRSs Juggernaut

Financial scandals occurring in the US in the early 2000s, notably Enron, which highlighted shortcomings in US GAAP. IOSCO recommended use of IFRSs in 2000. Adoption of IFRSs for financial reporting by listed companies in the EU in 2005. U.S. Securities and Exchange Commissions announcement in 2007 to accept IFRSs for financial reporting by non-US companies listed in the US stock market (no Form 20-F reconciliation to U.S. GAAP). SEC Commissioners propose timeline for IFRS adoption by 2016.

SEC Proposed Timeline for Moving Companies to IFRSs

End of 2009: Limited group of large companies given the option to use IFRS. SEC estimates 110 U.S. companies will be able to take advantage of the offer. 2011: SEC evaluates the progress of achieving proposed milestones, and makes a decision about whether to mandate adoption of IFRS. If IFRS is mandated, the commission will develop a staged roll out, starting with the largest public companies first. 2014: Year the first wave of companies will be mandated to report financial results using international accounting standards, if IFRS requirements are adopted in 2011. 2016: Year that all public companies, big and small, will be mandated to report financial results using international accounting standards, if IFRS requirements are adopted in 2011.
Stop & Reflect: Is the timeline moving too fast?

Overview of the International Accounting Standards Board (IASB)

The London-based IASB is an independent, privately funded accounting standard-setting body. Board members are from nine countries and include a variety of functional backgrounds. The over-arching commitment of the IASB is to develop, in the public interest, one set of highquality, understandable, and enforceable global accounting standards that require transparent and comparable information in general purpose financial statements. National accounting standard-setters have worked with the IASB to converge accounting standards around the globe.

Overview of the International Accounting Standards Board (IASB) -- continued

The International Accounting Standards Committee Foundation is the parent body of the IASB. The IASBs structure and organization resulted from a strategy review undertaken by its predecessor body, the Board of the International Accounting Standards Committee. The body of standards issued by the Board of the International Accounting Standards Committee was subsequently adopted by the IASB. These older standards were issued between 1973 and 2000, and continue to be designated International Accounting Standards (IASs).

Structure of the International Accounting Standards Board (IASB)

IASB projects generally take three years or more, from formation to standard issuance. Release of an IFRS, Exposure Draft, or final SIC Interpretation requires approval by 8 of the boards 14 members.

Major Contributions of the IASB

Harmonizing accounting standards and disclosures to meet the needs of the worlds capital markets. Providing an accounting foundation for underdeveloped or newly industrialized countries to use as the accounting profession emerges in those countries. Advancing compatibility of domestic and international accounting requirements.

Principles-Based Versus Rules-Based

IFRSs are often referred to as being principlesbased. US GAAP is said to be more rules-based. This has led to about 25,000 pages of US GAAP versus about 2,000 pages of IFRSs. With fewer pages and less detail, IFRSs still address all major accounting issues, from financial statement presentation to business combinations.

Stop & Reflect: Which is better, rulesbased or principles-based?

Required Use of IFRSs by World Region 2003-2006

Region Europe North America Central and South America Africa Asia Australia Oceania Total

Total countries 47 3 19 54 49 6 178

Required for all domestic listed companies in 2003 7 0 7 3 6 1 24

Required for all domestic listed companies in 2006 33 0 8 5 11 2 59

Impact of Cultural and Economic Factors on International Financial Reporting

Accounting standards vary among countries due to the culture, economics, politics, and the legal environment that are unique to each country. For example, in economies where inflation is high set up rules to improve period to period comparability by use of inflation indices. In countries like the U.S., stockholders provide the majority of capital to businesses. Individual stockholders generally own relatively small ownership stakes and are not involved with company operations. Consequently, U.S. GAAP is geared towards full- disclosure and relative transparency. In countries where capital-providers have access to corporate financial information from sources other than financial reports, transparency and disclosure is not as critical.

Benefits to Countries with Weak Financial Reporting Requirements

In nations with weak financial disclosure requirements, investors often demand additional financial information when companies issue stock. Consequently, governments in these nations may be compelled to revise or create securities laws that require improved financial reporting disclosure. A simpler and better solution is to adopt IFRSs, which have a higher level of financial reporting disclosure than most countries GAAP.

Stop & Reflect: Will better GAAP (i.e., IFRS) lead to economic development in developing countries?

Benefits to Countries with Strong Financial Reporting Requirements

While there is lower motivation to adopt IFRSs, due to a smaller incremental benefit of investor protection, a nation with strong financial disclosure requirements in its existing GAAP can still benefit from adopting IFRSs. Such a nation benefits by participating in uniform, multinational financial reporting standards. Investors are aided by this cross-national comparability. Uniform reporting standards reduce costs of financial statement reconciliation associated with multinational stock listings.
Stop & Reflect: Do you believe that one set of GAAP (i.e., IFRS) is really the best thing for the US? For the world?

IFRSs Reduce Complexity

Subsidiary 1 (c,l,p,x,r,g,i) Subsidiary 2 (c,l,p,x,r,g,i)

InvestorS,C Parent
(c,l,p,x,r,g,i)

Financial AnalystS,C
Joint Venture (c,l,p,x,r,g,i)

Subsidiary 3 (c,l,p,x,r,g,i)

Complexity is associated with global operations resulting from subsidiary operations in cultural settings that differ substantially from the parent. This leads to complex operating, reporting, and information environments. Multinational companies do business in a more complex environment than strictly domestic firms and financial reporting differences contribute to this complexity. Use of one set of accounting standards, such as the IFRSs, will help reduce this complexity.

Examining Differences Between U.S. GAAP and IFRS

There are many areas of difference between U.S. GAAP and IFRSs, but similarities far outweigh differences. Accounting rules vary across countries and differences can be cosmetic or substantive.

Cosmetic Differences: Financial Statement Presentation Per IAS 1 IAS 1 does not prescribe a particular format for presentation of financial statements (B/S, I/S, SCF, SCE); multiple formats have evolved in practice. In the U.S., a common format has evolved. Re: Balance Sheet An illustration of a cosmetic difference is the presentation of the balance sheet in many countries that are, or were, members of the British Commonwealth. The balance sheet of a UK company is often presented (1) in the form of A L = OE rather than A = L + OE and (2) in reverse order of liquidity.

Comparing U.S. GAAP and IFRSs: Cosmetic Differences

Another example of a cosmetic difference is use of different word to refer to the same item. A few examples are as follows, international term followed by U.S. counterpart: Turnover Sales Stocks Inventory Share Capital Common Stock or Paid-in Capital Share Issue Premium Additional Paid-in Capital Debtors Accounts Receivable Creditors Accounts Payable Revenue Reserves Retained Earnings

Comparing U.S. GAAP and IFRSs: Cosmetic Differences

GlaxoSmithKline
Consolidated Balance Sheet
Notes 15 16 17 18 19 20 21 25 25 25 22 2001 m 174 1,673 6,845 3,228 11,920 185 2,090 5,591 1,415 716 9,997 (2,124) (7,306) (9,430) 567 12,487 25 22 (2,108) (190) 2000 m 170 966 6,642 2,544 10,322 171 2,277 5,399 2,138 1,283 11,268 (2,281) (6,803) (9,084) 2,184 12,506 (1,751) (143)

Goodwill Intangible Assets Tangible Assets Investments Fixed Assets Equity investments Stocks Debtors Liquid investments Cash at bank Current assets Loans and overdrafts Other creditors Creditors: amounts due within one year Net current assets Total assets less current liabilities Loans Other creditors

Comparing U.S. GAAP and IFRSs: Cosmetic Differences

GlaxoSmithKline Consolidated Balance Sheet - Continued
Creditors: amounts due after one year Provisions for liabilities and charges Net assets Called up share capital Share premium account Other reserves Profit and loss account Equity shareholders funds Non-equity minority interest Equity minority interests Capital employed Approved by the Board Sir Richard Sykes, Chairman th 12 March 2002 28 27 27 29 29 23 (2,298) (1,810) 8,379 1,543 170 1,866 3,938 7,517 621 241 8,379 (1,894) (1,657) 8,955 1,556 30 1,849 4,276 7,711 1,039 205 8,955

Note: Differences from U.S. GAAP include order of reverse liquidity and model of A - L (Net assets) = SE (Capital Employed) instead of A + L = SE.

Financial Statement Presentation Per IAS 1

Re: Income Statement No distinction between Revenues/Gains or Expenses/Losses Re: Statement of Changes in Equity Two different approaches can be used
Benchmark treatment similar to US GAAP Alternative treatment include portions e.g. capital transactions in notes

Financial Statement Presentation Per IAS 1

Re: Statement of Cash Flows Per IAS 7, the cash flow statement is a required statement. Requirements of IAS 7 are much the same as SFAS 95 in the U.S. with a few differences. In the U.S., interest paid, interest received, and dividends received are shown in the operating section, while dividends paid is shown in the financing section. Under IFRS, interest paid, interest received, and dividends received are normally accounted for as operating cash flows as well. However, interest paid may be accounted for as a financing cash flow, while interest received and dividends received may be accounted for as investing cash flows, because they are costs of obtaining financial resources or returns on investments.

Financial Statement Presentation Per IAS 1

Re: Statement of Cash Flows Non-cash transactions (e.g., issue bonds for LT assets) do not need to be disclosed on the face of the cash flow statement CF from extraordinary & discontinued items must be disclosed separately in each section

Stop & Reflect: Do you see any problems with the IFRS approach to the SCF?

Financial Statement Presentation Per IAS 1

Re: Notes IFRS requires disclosure of currency used in the FS Does not need to be the primary currency of the enterprise For example, Jardine Matheson, a diversified Bermuda-based company with operations primarily in Asia and Australia uses the U.S. dollar.
Stop & Reflect: Why is it necessary to disclose currency used under IFRS, but not US GAAP?

Comparing U.S. GAAP and IFRSs: PP&E

Under IFRS, the benchmark treatment under IAS 16 is to report PP&E at cost net of depreciation and potential impairments. IAS 16 provides for an alternative treatment, to revalue PP&E to fair value. Companies may use highest and best use to determine fair value. After a company begins to revalue PP&E, it must continue to doing so . . .with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the balance sheet date. Example: Journal entry to revalue land that cost 200,000 to FV of 240,000: Land 40,000 Revaluation Surplus

40,000

Comparing U.S. GAAP and IFRSs: PP&E Re. revaluation, downward revaluations are possible
Determined on an asset-by-asset basis, not by the class as a whole If downward revaluation, it is offset against the revaluation equity, to the extent it exists. Any excess goes to expense If subsequent upward revaluation, goes to income to extent of any prior revaluation expense taken

Construction period interest may be expensed or capitalized (US GAAP requires capitalization only) Depreciation determined similarly under IFRS & US GAAP

Comparing U.S. GAAP and IFRSs: Leases Under US GAAP, leases are classified as capital if one or more of the 4 criteria are met (title transfer, bargain purchase option, 75% of economic life, MLP >= 90% of asset FMV) Under IFRS, criteria are less rigid.

Comparing U.S. GAAP and IFRSs: Leases

Under IAS 17, a leases is classified as either an operating lease or a finance lease (U.S. GAAP refers to finance leases as capital leases). Per IAS 17 a finance lease transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred. Example situations: 1. The lease transfers ownership to the lessee, 2. The lessee has a bargain purchase option, 3. The lease term is for the major part of the economic life of the asset, 4. The present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset,

Comparing U.S. GAAP and IFRSs: Leases

Example situations continued: 5. The leased assets are of a specialized nature such that only the lessee can use them, 6. If the lease is cancelable by the lessee, the lessors costs associated with the cancellation are borne by the lessee, 7. Gains or losses associated with fluctuations in the leased asset FMV are borne by the lessee, and 8. The lessee can continue to lease the asset for a secondary period for a substantially lower rent than market rent. The first four criteria are similar to criteria under U.S. GAAP but are not identical; criteria 5 through 8 are not included in U.S. GAAP.
Stop & Reflect: Regarding leases, which do you think gives the better result, rules-based US GAAP or principles-based IFRS?

Comparing U.S. GAAP and IFRSs: Intangible Assets

Purchased intangibles
Recorded at cost Amortized finite life intangibles over useful life. Both IFRS and US GAAP have no upper amortization term

Internally-generated intangibles
Normally expensed as incurred In the case of internal R&D, IFRS splits the costs into a research phase and a development phase (similar definition to US GAAP) Research phase costs are expensed under US GAAP and IFRS

Comparing U.S. GAAP and IFRSs: Intangible Assets Accounting may differ in development phase Under US GAAP, costs are expensed Under IFRS, costs can be capitalized if ALL the following are met:
Completion is technically feasible Intention is to complete asset and use or sell Company has ability to do so Can demonstrate how asset will generate future benefit Company has resources to complete the asset Company can reliably measure development expenditures
Stop & Reflect: Do you think it makes sense to allow capitalization of some R&D, as permitted under IFRS?

Comparing U.S. GAAP and IFRSs: Accounting Changes IFRS 2, Stock-Based Payment, includes stock compensation US GAAP followed with SFAS 123 (R) (fair value)

FASB IASB Working Together

In October 2002, the FASB and the IASB issued a memorandum of understanding (referred to as the Norwalk Agreement or MoU) formally announcing their commitment to converging U.S. GAAP and IFRSs. In recent years, both the FASB and IASB have issued rules that converge (or almost converge) their accounting standards with the standards of the other body. For example, the IASB essentially conformed to U.S. GAAP for pooling and accounting for goodwill with the issuance of IFRS 3, Business Combinations. The FASB conformed to IFRS when it issued SFAS 151 on Inventory, SFAS 153 on Like-Kind Exchanges, and SFAS 154 on Accounting Changes.

If Everyone Adopts IFRSs, its Still Not a Perfect World

Uniformity in accounting standards is a gigantic step toward understanding financial statements prepared in different nations; however, uniformity alone is not a total solution. Environmental factors such as culture, language, legal system, and economic conditions affect how any GAAP, including IFRS, is applied. For example, regarding environmental factors, the litigation environment affects conservatism in financial reporting. For a company located in a nation where there is a high risk of investor lawsuits, such as the US, there will be a different perspective on conservatism than in a nation that is less litigious. Thus, IFRS will be applied differently depending on the national culture. Properly evaluating investment opportunities in any country requires that the investor understand the culture of that country.

Impact of Ethics on International Financial Reporting

No set of accounting standards, whether IFRSs, US GAAP, or other set of accounting standards, can replace the necessity for accountants to have the highest level of ethical character. Corporate financial scandals rarely ever result from deficiencies in accounting standards alone, but are frequently the result from weaknesses in the ethical character of the perpetrators, which may include top management, corporate accountants, and auditors. Greed and over-reaching ambition have led to disastrous consequences for corporations and their stakeholders. Considering the problem of greed, Solomon wrote: Whoever loves money never has money enough; whoever loves wealth is never satisfied with his income (Ecclesiastes 5:10).

Impact of Ethics on International Financial Reporting

Author, Army veteran, U.S Congress Representative from Tennessee, and hero of the Alamo, David Crockett used the following campaign slogan: Be sure youre right, then go ahead.

Winning isnt everything, but doing whats right is.

Impact of Ethics on International Financial Reporting

Without ethical character, proper professional judgment is virtually impossible. Since IFRSs are regarded as more principles-based as opposed to the more rules-based US GAAP, ethical character and professional judgment will be even more critical (if that is possible) in an IFRS-based financial reporting environment.

Take-Away Points

IFRSs are the accounting standards published by the International Accounting Standards Board (IASB). IFRSs are now accepted or required in more than 100 countries. Leading accounting experts anticipate that IFRSs will be accepted for financial reporting, in place of US GAAP, for all companies listed in US stock market, as early as 2012 or 2013. Since IFRSs are regarded as more principles-based as opposed to the more rules-based US GAAP, ethical character and professional judgment will be even more critical (if that is possible) in an IFRSbased financial reporting environment. Be sure youre right, then go ahead.