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Chapter 11 - Worldwide Accounting Diversity and International Standards

CHAPTER 11WORLDWIDE ACCOUNTING DIVERSITY

AND INTERNATIONAL STANDARDSChapter Outline

I. Accounting and financial reporting rules differ across countries. There are a variety of factors influencing a country’s accounting system.A. Legal system—primarily relates to how accounting principles are established; code

law countries generally having legislated accounting principles and common law countries having principles established by non-legislative means.

B. Taxation—financial statements serve as the basis for taxation in many countries. In those countries with a close linkage between accounting and taxation, accounting practice tends to be more conservative so as to reduce the amount of income subject to taxation.

C. Financing system—where shareholders are a major provider of financing, the demand for information made available outside the company becomes greater. In those countries in which family members, banks, and the government are the major providers of business finance, there is less demand for public accountability and information disclosure.

D. Inflation—historically, caused some countries, especially in Latin America, to develop accounting principles in which traditional historical cost accounting is abandoned in favor of inflation adjusted figures. As inflation has been brought under control in most countries, this factor is no longer of significant influence.

E. Political and economic ties—can explain the usage of a British style of accounting throughout most of the former British Empire. They also help to explain similarities between the U.S. and Canada, and increasingly, the U.S. and Mexico.

F. Culture—affects a country’s accounting system in two ways: (1) through its influence on a country’s institutions, such as its legal system and system of financing, and (2) through its influence on the accounting values shared by members of the accounting sub-culture.

II. Nobes developed a general model of the reasons for international differences in financial reporting that has only two explanatory factors: (1) national culture, including institutional structures, and (2) the nature of a country’s financing system. A. A self-sufficient Type I culture will have a strong equity-outsider financing system

which results in a Class A accounting system oriented toward providing information for outside shareholders.

B. A self-sufficient Type II culture will have a weak equity-outsider financing system which results in a Class B accounting system oriented toward protecting creditors and providing a basis for taxation.

C. Countries dominated by a country with a Type I culture will use a Class A accounting system even though they do not have strong equity-outsider financing systems.

D. Companies with strong equity-outsider financing located in countries with a Class B accounting system will voluntarily attempt to use a Class A accounting system to compete in international capital markets.

III. Differences in accounting across countries cause several problems.A. Consolidating foreign subsidiaries requires that the financial statements prepared in

accordance with foreign GAAP must be converted into the parent company’s GAAP.

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B. Companies interested in obtaining capital in foreign countries often are required to provide financial statements prepared in accordance with accounting rules in that country, which are likely to differ from rules in the home country.

C. Investors interested in investing in foreign companies may have a difficult time in making comparisons across potential investments because of differences in accounting rules across countries.

IV. The International Accounting Standards Committee (IASC) was formed in 1973 in hopes of improving and promoting the worldwide harmonization of accounting principles. It was superseded by the International Accounting Standards Board (IASB) in 2001.A. The IASC issued 41 International Accounting Standards (IAS) covering a broad range

of accounting issues. Ten IASs have been superseded or withdrawn, leaving 31 in effect.

B. The membership of the IASC was composed of over 140 accountancy bodies from more than 100 nations.

C. The IASC was not in a position to enforce its standards. Instead, member accountancy bodies pledged to work toward acceptance of IASs in the respective countries.

D. Because of criticism that too many options were allowed in its standards and therefore true comparability was not being achieved, the IASC undertook a Comparability Project in the 1990s, revising 10 of its standards to eliminate alternatives.

E. The IASC derived much of its legitimacy as an international standard setter through endorsement of its activities by the International Organization of Securities Commissions. IOSCO and the IASC agreed that, if the IASC could develop a set of core standards, IOSCO would recommend that stock exchanges allow foreign companies to use IASs in preparing financial statements. The IASC completed the set of core standards in 1998, IOSCO endorsed their usage by foreign companies in 2000, and many members of IOSCO adopted this recommendation.

V. The International Accounting Standards Board (IASB) replaced the IASC in 2001. A. The IASB originally consisted of 14 members – 12 full-time and 2 part-time. The

number of board members was increased to 16 members in 2012, at least 13 of whom must be full-time. Full-time IASB members are required to sever their relationships with former employers to ensure independence. To ensure a broad international diversity, there normally are four members from Europe; four from North America; four from the Asia/Oceania region; one from Africa; one from South America; and two from any area to achieve geographic balance.

B. IASB GAAP is referred to as International Financial Reporting Standards (IFRS) and consists of (a) IASs issued by the IASC (and adopted by the IASB), (b) individual International Financial Reporting Standards developed by the IASB, and (c) Interpretations issued by the Standing Interpretations Committee (SIC) (until 2001) and International Financial Reporting Interpretations Committee (IFRIC).

C. In addition to 31 IASs and 13 IFRSs (as of January 2013), the IASB also has a Framework for the Preparation and Presentation of Financial Statements, which serves as a guide to determine the proper accounting in those areas not covered by IFRS.

D. As of June 2012, more than 90 countries required the use of IFRS by all domestic publicly traded companies, and several important countries were to begin using IFRS in the near future. Other countries allow the use of IFRS by domestic companies. Many countries also allow foreign companies that are listed on their securities markets to use IFRS.

E. There are two primary methods used by countries to incorporate IFRS into their


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financial reporting requirements for listed companies: (1) full adoption of IFRS as issued by the IASB, without any intervening review or approval by a local body, and (2) adoption of IFRS after some form of national or multinational review and approval process.

VI. The U.S. FASB has adopted a strategy of convergence with IASB standards.

A. In 2002, the IASB and FASB signed the so-called “Norwalk Agreement” to “use their best efforts to (a) make their existing financial reporting standards fully compatible as soon as is practicable and (b) coordinate their work program to ensure that once achieved, compatibility is maintained.”

B. The FASB-IASB convergence process has resulted in changes made to U.S. GAAP, IFRS, or both in a number of areas including: Business combinations, Non-controlling interests, Acquired in-process research costs, Share-based payment, Borrowing costs, Segment reporting, and Presentation of other comprehensive income.

C. At the beginning of 2013, the FASB listed joint convergence projects with either an Exposure Draft or final standard expected to be issued in 2013 in the following areas: Leases, Insurance contracts, Financial instruments, Revenue recognition, Investment companies, and Consolidation: Policy and Procedures

VII. The U.S. SEC’s early interest in IFRS stemmed from IOSCO’s endorsement of IFRS for

cross-listing purposes. A. After considering this issue for several years, in 2007 the SEC amended its rules to

allow foreign registrants to prepare financial statements in accordance with IFRS without reconciliation to U.S. GAAP. Since 2007, foreign companies using IFRS have been able to list securities on U.S. securities markets without providing any U.S. GAAP information in their annual reports.

B. To level the playing field for U.S. companies, in July 2007, the SEC issued a concept release to determine public interest in allowing U.S. companies to choose between IFRS and U.S. GAAP in preparing financial statements. Many comment letter writers were not in favor of allowing U.S. companies to choose between IFRS and U.S. GAAP instead recommending that U.S. companies be required to use IFRS.

C. In November 2008, the SEC issued the so-called “IFRS Roadmap.” The SEC indicated it would monitor several milestones until 2011 at which time it decide whether to require U.S. companies to follow IFRS over a three-year phase-in period. The Roadmap indicated 2014 as the first year of IFRS adoption, but a subsequent SEC Release in February 2010 pushed that date back to “approximately 2015 or 2016.”

D. In 2011, the SEC Staff published a discussion paper that suggests an alternative framework for incorporating IFRS into the U.S. financial reporting system. This framework combines the existing FASB-IASB convergence project with the endorsement process followed in many countries and the EU. Some refer to this method as “condorsement.” The framework would retain both U.S. GAAP and the FASB as the U.S. accounting standard setter. At the end of a transition period, a U.S. company following U.S. GAAP also would be able to represent that its financial statements are in compliance with IFRS.

E. The 2011 deadline established by the SEC in its IFRS Roadmap came and went without the Commission making a decision whether to require the use of IFRS in the U.S. In July 2012, the SEC staff issued a Final Staff Report that summarized analysis conducted by the SEC Staff on the possible use of IFRS by U.S. companies, but it did not include conclusions or recommendation for action by the Commission and did not


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provide insight into the nature or timetable for next steps. Thus, at the time this book went to press, the SEC had not signaled when it might make a decision about whether and, if so, how IFRS should be incorporated into the U.S. financial reporting system.

VIII. IFRS 1, First-time Adoption of IFRS, established guidelines that a company must use in transitioning from previously-used GAAP to IFRS.A. Companies transitioning to IFRS must prepare an opening balance sheet at the “date

of transition.” The transition date is the beginning of the earliest period for which an entity presents full comparative information under IFRS. For example, for a company preparing its first set of financial statements for the calendar year 2017, the date of transition is January 1, 2015.

B. An entity must complete the following steps to prepare the opening IFRS balance sheet:1. Determine applicable IFRS accounting policies based on standards in force on

the reporting date.2. Recognize assets and liabilities required to be recognized under IFRS that were

not recognized under previous GAAP and derecognize assets and liabilities previously recognized that are not allowed to be recognized under IFRS.

3. Measure assets and liabilities recognized on the opening balance sheet in accordance with IFRS.

4. Reclassify items previously classified in a different manner from what is acceptable under IFRS.

IX. IAS 8, “Accounting Policies, Changes in Accounting Estimates and Errors,” establishes guidelines for determining appropriate IFRS accounting polices.A. Companies must use the following hierarchy to determine accounting polices that will

be used in preparing IFRS financial statements. 1. Apply specifically relevant standards (IASs, IFRSs, or Interpretations) dealing with

an accounting issue.2. Refer to other IASB standards dealing with similar or related issues.3. Refer to the definitions, recognition criteria, and measurement concepts in the

IASB Framework.4. Consider the most recent pronouncements of other standard-setting bodies that

use a similar conceptual framework, other accounting literature, and accepted industry practice to the extent that these do not conflict with sources in 2. and 3. above.

B. Because the FASB and IASB conceptual frameworks are similar, step 4 provides an opportunity for entities to adopt FASB standards in dealing with accounting issues where steps 1 through 3 are not helpful.

X. Numerous differences exist between IFRS and U.S. GAAP. A. Differences exist with respect to recognition, measurement, presentation, and

disclosure. Exhibit 11.8 lists several key differences.B. IAS 1, “Presentation of Financial Statements,” provides guidance with respect to the

purpose of financial statements, components of financial statements, basic principles and assumptions, and the overriding principle of fair presentation. There is no equivalent to IAS 1 in U.S. GAAP.

C. The IASB follows a principles-based approach to standard setting, rather than the so-


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called rules-based approach used by the FASB. The IASB tends to avoid the use of bright line tests and provides a limited amount of implementation guidance in its standards.

XI. Even if all countries adopt a similar set of accounting standards, two obstacles remain in achieving the goal of worldwide comparability of financial statements. A. IFRS must be translated into languages other than English to be usable by non-

English speaking preparers of financial statements. It is difficult to translate some words and phrases into other languages without a distortion of meaning.

B. Culture can affect the manner in which an accountant interprets and applies an accounting standard. Differences in culture can lead to differences in application of the same standard across countries.


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Answer to Discussion Question: Which Accounting Method Really is Appropriate?

Students in the United States often assume that U.S. GAAP is superior and that all reporting issues can (or should) be resolved by following U.S. rules. However, the reporting of research and development costs is a good example of a rule where different approaches can be justified and the U.S. rule might be nothing more than an easy method to apply. In the United States, all such costs are expensed as incurred because of the difficulty of assessing the future value of these projects. International Financial Reporting Standards require capitalization of development costs when certain criteria are met.

The issue is not whether costs that will have future benefits should be capitalized. Most accountants around the world would recommend capitalizing a cost that leads to future revenues that are in excess of that cost. The real issue is whether criteria can be developed for identifying projects that will lead to the recovery of those costs. In the U.S., the FASB felt that such decisions were too subjective and open to manipulation. Conversely, under IFRS, development costs must be recognized as an intangible asset when an enterprise can demonstrate all of the following:(a) the technical feasibility of completing the intangible asset so that it will be available for use

or sale;(b) its intention to complete the intangible asset and use or sell it;(c) its ability to use or sell the intangible asset;(d) how the intangible asset will generate probable future economic benefits. Among other

things, the enterprise should demonstrate the existence of a market for the output of the intangible asset or the existence of the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset;

(e) the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset; and

(f) its ability to measure the expenditure attributable to the intangible asset during its development reliably.

The IFRS treatment of development costs begs the question: How easy is it for an accountant to determine whether the development project will result in an intangible asset, such as a patent, that will generate future economic benefits?

In the U.S., a conservative approach has been taken because of the difficulty of determining whether an asset has been or will be created. To ensure comparability, all companies are required to expense all R&D costs. As a result, costs related to development costs that prove to be very valuable to a company for years to come are expensed immediately. Do the benefits of consistency and comparability (each company expenses all costs each year) outweigh the cost of producing financial statements that might omit valuable assets from the balance sheet? No definitive answer exists for that question. However, the reader of financial statements needs to be aware of the fundamental differences in approach that exist in accounting for development costs before making comparisons between companies from different countries.


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Answers to Questions

1. The five factors most often cited as affecting a country's accounting system are: (1) legal system, (2) taxation, (3) providers of financing, (4) inflation, and (5) political and economic ties. The legal system is primarily related to how accounting principles are established; code law countries generally having legislated accounting principles and common law countries having principles established by non-legislative means. In some countries, financial statements serve as the basis for taxation and in other countries they do not. In those countries with a close linkage between accounting and taxation, accounting practice tends to be more conservative so as to reduce the amount of income subject to taxation. Shareholders are a major provider of financing in some countries. As shareholder financing increases in importance, the demand for information made available outside the company becomes greater. In those countries in which family members, banks, and the government are the major providers of business finance, there tends to be less demand for public accountability and information disclosure. Historically, chronic high inflation caused some countries, especially in Latin America, to develop accounting principles in which traditional historical cost accounting is abandoned in favor of inflation adjusted figures. Because inflation has been brought under control in most countries of the world, this factor is no longer of much significance. Political and economic ties can explain the usage of a British style of accounting throughout most of the former British empire. They also help to explain similarities between the U.S. and Canada, and increasingly, the U.S. and Mexico.Culture also is viewed as a factor that has significant influence on the development of a country’s accounting system. This influence is described in more detail in the answer to question 3.

2. Problems caused by accounting diversity for a company like Nestle include: (a) the additional cost associated with converting foreign GAAP financial statements of foreign subsidiaries to parent company GAAP to prepare consolidated financial statements, (b) the additional cost associated with preparing Nestle financial statements in foreign GAAP (or reconciling to foreign GAAP) to gain access to foreign capital markets, and (c) difficulty in understanding and comparing financial statements of potential foreign acquisition targets.

3. Gray developed a model that hypothesizes that societal values, i.e., culture, affect the development of accounting systems in two ways: (1) societal values help shape a country’s institutions, such as legal system and financing system, which in turn influences the development of accounting, and (2) societal values influence accounting values held by members of the accounting sub-culture, which in turn influences the development of the accounting system. Gray provides specific hypotheses with respect to the manner in which specific cultural dimensions will influence specific accounting values. For example, he hypothesizes that in countries in which avoiding uncertainty is important, accountants will have a preference for more conservative measurement of profit.

4. According to Nobes, the purpose for financial reporting determines the nature of a country’s financial reporting system. The most relevant factor for determining the purpose of financial reporting is the nature of the financing system. Some countries have a culture, and accompanying institutional structure, that leads to a strong equity financing system with large numbers of outside shareholders.

A country with a self-sufficient Type I culture will have a strong equity-outsider financing system which in turn will lead that country developing a Class A accounting system oriented toward providing information for outside shareholders. A self-sufficient Type II culture will have a weak equity-outsider financing system which results in a Class B accounting system oriented toward protecting creditors and providing a basis for taxation.


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5. Several of the IASC’s original standards were criticized for allowing too many alternative methods of accounting for a particular item. As a result, through the selection of different acceptable options, the financial statements of two companies following International Accounting Standards still might not have been comparable. To enhance the comparability of financial statements prepared in accordance with International Accounting Standards, and at the urging of the International Organization of Securities Commissions, the IASC systematically reviewed its existing standards (in the so-called Comparability Project) and revised ten of them by eliminating previously acceptable alternatives.

6. A major difference between the IASB and the IASC is the composition of the Board and the manner in which Board members are selected. IASB has at least 12 and as many as 14 full-time members, the IASC had zero. Full-time IASB members must sever their employment relationships with former employers and must maintain their independence. Seven of the full-time members have a liaison relationship with a national standard setter. At least five members must have been auditors, three must have been financial statement preparers, three must have been users of financial statements, and at least one must come from academia. The most important criterion for appointment to the IASB is technical competence. (Although not stated in the body of the chapter, there was a perception that some appointments to the IASC were based on politic connections and not competence.)[Some of the common features of the IASC and IASB are that both (a) issue/d “international standards,” (b) have/had their headquarters in London, and (c) use/d English as the working language.]

7. This statement is true in that EU publicly traded companies are required to use IFRS in preparing consolidated financial statements. It is false in that non-public companies are not required to use IFRS and publicly traded companies do not use IFRS in preparing their parent company only financial statements.

8. The bottom section of Exhibit 11.6 shows the countries as of June 2012 that do not allow domestic companies to use IFRS in preparing consolidated financial statements. The two most economically important countries in this group are China and the United States.

9. The IASB and FASB have agreed to “use their best efforts to (a) make their existing financial reporting standards fully compatible as soon as is practicable and (b) coordinate their work program to ensure that once achieved, compatibility is maintained.”

10. Convergence implies a joint effort between two standard setters to reduce differences in the sets of standards for which they are responsible. Convergence could result in one standard setter adopting an existing standard developed by the other standard setter or by the two standard setters jointly developing a new standard. Convergence does not necessarily mean the two sets of standards that result from the convergence process will be the same. Indeed, the FASB and IASB acknowledge that differences between IFRS and U.S. GAAP will continue to exist even after convergence.In contrast to the approach taken by the FASB to influence future IASB standards, the European Union simply adopted IFRS as the national GAAP in member nations.


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11. Since 2007, foreign companies listed on U.S. stock exchanges may file IFRS financial statements with the U.S. SEC without providing any reconciliation to U.S. GAAP. Domestic companies listed on U.S. stock exchanges must file financial statements prepared in accordance with U.S. GAAP.The SEC’s proposed condorsement framework combines the FASB–IASB convergence process with the IFRS endorsement process followed in many countries and in the EU. The framework would retain both U.S. GAAP and the FASB as the U.S. accounting standard setter. At the end of a transition period, a U.S. company following U.S. GAAP also would be able to represent that its financial statements are in compliance with IFRS. The two components of the framework are: The FASB continues to participate in the process of developing new IFRSs and

incorporates those standards into U.S. GAAP by means of an endorsement process. The FASB would incorporate existing IFRSs into U.S. GAAP over a defined period of

time, for example, five to seven years, with a focus on minimizing transition costs for U.S. companies.

At the time this book went to press in the third quarter of 2013, the SEC still had not yet made a decision on the issue of incorporating IFRS into the U.S. financial reporting system.

12. When adopting IFRS, a company must prepare an “IFRS opening balance sheet” at the date of transition. The date of transition is the beginning of the earliest period for which comparative information must be presented, i.e., two years prior to the “reporting date.” A company must follow five steps in preparing its IFRS opening balance sheet:

1. Determine applicable IFRS accounting policies based on standards that will be in force on the reporting date.

2. Recognize assets and liabilities required to be recognized under IFRS that were not recognized under prior GAAP, and derecognize assets and liabilities recognized under prior GAAP that are not allowed to be recognized under IFRS.

3. Measure assets and liabilities recognized on the IFRS opening balance sheet in accordance with IFRS (that will be in force on the reporting date).

4. Reclassify items previously classified in a different manner from what is acceptable under IFRS.

5. Comply with all disclosure and presentation requirements.

13. The extreme approaches that a company might follow in determining appropriate accounting policies for preparing its initial set of IFRS financial statements are:1. Adopt accounting policies acceptable under IFRS that minimize change from existing

accounting policies used under current GAAP.2. Take a fresh start, clean slate approach and develop accounting policies acceptable

under IFRS that will result in financial statements that reflect the economic substance of transactions and present the most economically meaningful information possible.

14. According to the accounting policy hierarchy in IAS 8, if a company is faced with an accounting issue for which (a) there is no specific IASB standard that applies, (b) there are no IASB standards on related issues, and (c) reference to the IASB’s Framework does not help in determining an appropriate accounting treatment, then the company should consider the most recent pronouncements of other standard-setting bodies that use a similar conceptual framework. The FASB’s conceptual framework is similar to the IASB’s, so reference to FASB pronouncements would be acceptable under IAS 8 when conditions (a), (b), and (c) exist.


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15. Potentially significant differences between IFRS and U.S. GAAP related to asset recognition and measurement are: Acceptable use of LIFO under U.S. GAAP, but not IFRS. Definition of “market” in the lower of cost or market rule for inventory – replacement cost

under U.S. GAAP; net realizable value under IFRS. Reversal of inventory writedowns allowed under IFRS, but not under U.S. GAAP. Possible revaluation of property, plant, and equipment under IFRS (allowed

alternative), but not under U.S. GAAP. Capitalization of development costs as an intangible asset under IFRS, which is not

acceptable under U.S. GAAP (except for computer software development costs). Difference in the determination of whether an asset is impaired. Subsequent reversal of impairment losses allowed by IFRS, but not U.S. GAAP.

16. Even if all countries adopt a similar set of accounting standards, two obstacles remain in achieving the goal of worldwide comparability of financial statements. First, IFRS must be translated into languages other than English to be usable by non-English speaking preparers of financial statements. It is difficult to translate some words and phrases found in IFRS into non-English languages without a distortion of meaning. Second, culture can affect the manner in which accountants interpret and apply accounting standards. Differences in culture can lead to differences in how the same standard is applied across countries.


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Answers to Problems

1. B

2. C

3. D

4. C

5. D

6. D

7. D

8. A

9. A

10. C

11. B

12. D

13. A

14. C


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Problems 15-19 are based on the comprehensive illustration.

15. (15 minutes) (Carrying inventory at the lower of cost or “market”)

Historical cost $120,000Replacement cost $111,900Net realizable value $117,000Normal profit margin 20%Net realizable value less normal profit [$117,000 – (20% x$117,000)] $93,600

a. 1. Under U.S. GAAP, the company reports inventory on the balance sheet at the lower of historical cost or market, where market is defined as replacement cost (with net realizable value as a ceiling and net realizable value less a normal profit as a floor). In this case, inventory will be written down to replacement cost and reported on the December 31, 2015 balance sheet at $111,900. A $8,100 loss will be included in 2015 income.

2. In accordance with IAS 2, the company reports inventory on the balance sheet at the lower of historical cost and net realizable value. As a result, inventory will be reported on the December 31, 2015 balance sheet at its net realizable value of $117,000 and a loss on writedown of inventory of $3,000 will be reflected in 2015 net income.

b. As a result of the differing amounts of inventory loss recognized under U.S. GAAP and IFRS, Lisali will add $5,100 to U.S. GAAP income to reconcile to IFRS income, and will add $5,100 to U.S. GAAP stockholders’ equity to reconcile to IFRS stockholders’ equity.


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16. (25 minutes) (Measurement of property, plant, and equipment subsequent to acquisition)

Cost $78,400Residual value $10,000Useful life 6 yearsStraight-line depreciation $11,400 per year

a. 1. Under U.S. GAAP, the company would report the equipment at its depreciated historical cost. Straight-line depreciation expense is $11,400 per year. The equipment would be reported at $67,000, $55,600, and $44,200, respectively, on the December 31, 2015, 2016, and 2017 balance sheets.

2. Under IFRS, the equipment would be depreciated by $11,400 in 2015, resulting in a book value of $67,000 at December 31, 2015. Under IAS 16’s allowed alternative treatment, the equipment would be revalued on January 1, 2016 to its fair value of $74,500.

The journal entry to record the revaluation on January 1, 2016 would be:Dr. Equipment $7,500

Cr. Revaluation Surplus (stockholders’ equity) $7,500(To revalue equipment from carrying value of $67,000 to appraisal value of $74,500.)

Depreciation expense on a straight-line basis in 2016, 2017, and beyond would be $12,900 per year [($74,500 – $10,000) / 5 years]. The equipment would be reported on the December 31, 2016 balance sheet at $61,600 [$74,500 – $12,900], and on the December 31, 2017 balance sheet at $48,700 [$61,600 – $12,900].

The differences can be summarized as follows:

Depreciation expense 2015 2016 2017 IFRS $11,400 $12,900 $12,900U.S. GAAP $11,400 $11,400 $11,400Difference $0 $1,500 $1,500

Book value of equipment 12/31/15 12/31/16 12/31/17 IFRS $67,000 $61,600 $48,700U.S. GAAP $67,000 $55,600 $44,200Difference $0 $ 6,000 $ 4,500


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16. (continued)

b. There is no difference in net income between IFRS and U.S. GAAP in 2015, so no reconciliation adjustments are necessary in 2015.

In 2016, the additional amount of depreciation expense of $1,500 related to the revaluation surplus under IFRS must be subtracted from U.S. GAAP income to reconcile to IFRS net income. The additional depreciation taken under IFRS causes IFRS retained earnings to be $1,500 less than U.S. GAAP retained earnings at December 31, 2016. Under IFRS, the revaluation surplus causes IFRS stockholders’ equity to be $7,500 larger than U.S. GAAP stockholders’ equity. The adjustment to reconcile U.S. GAAP stockholders’ equity to IFRS is $6,000, the difference between the original amount of the revaluation surplus ($7,500) and the accumulated depreciation on that surplus ($1,500). $6,000 would be added to U.S. GAAP stockholders’ equity to reconcile to IFRS.

In 2017, $1,500 again is added to IFRS net income to reconcile to U.S. GAAP net income, and $4,500 is subtracted from IFRS stockholders’ equity to reconcile to U.S. GAAP stockholders’ equity. $4,500 is the amount of revaluation surplus ($7,500) less accumulated depreciation on that surplus for two years ($3,000).

17. (15 minutes) (Research and development costs)

Research and development costs $650,000 (30% related to development)Useful life 10 years

a. 1. Under U.S. GAAP, $650,000 of research and development costs would be expensed in 2015.

2. In accordance with IAS 38, $455,000 [$650,000 x 70%] of research and development costs would be expensed in 2015, and $195,000 [$650,000 x 30%] of development costs would be capitalized as an intangible asset. The intangible asset would be amortized over its useful life of ten years, but only beginning in 2016 when the newly developed product is brought to market.

b. In 2015, $195,000 would be added to U.S. GAAP net income to reconcile to IFRS and the same amount would be added to U.S. GAAP stockholders’ equity.

In 2016, the company would recognize $19,500 [$195,000 / 10 years] of amortization expense on the deferred development costs under IFRS that would not be recognized under U.S. GAAP. In 2016, $19,500 would be subtracted from U.S. GAAP net income to reconcile to IFRS net income. The net adjustment to reconcile from U.S. GAAP stockholders equity to IFRS at December 31, 2016 would be $175,500, the sum of the $195,000 smaller expense under IFRS in 2015 and the $19,500 larger expense under IFRS in 2016. $175,500 would be added to U.S. GAAP stockholders’ equity at


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December 31, 2016 to reconcile to IFRS. 18. (15 minutes) (Gain on sale and leaseback transaction)

Gain on sale of asset $76,000Life of leaseback 4 years

a. 1. Under U.S. GAAP, the gain of $76,000 on the sale and leaseback transaction is deferred and amortized to income over the life of the lease. With a lease period of four years, $19,000 [$76,000 / 4 years] of the gain would be recognized in 2015.

2. In accordance with IAS 17, the entire gain of $76,000 on the sale and leaseback would be recognized in income in the year of the sale when the lease is an operating lease.

b. In 2015, IFRS net income exceeds U.S. GAAP net income by $57,000, the difference ($76,000 vs. $19,000) in the amount of gain recognized on the sale and leaseback transaction. A positive adjustment of $57,000 would be made to reconcile U.S. GAAP net income and U.S. GAAP stockholders’ equity to IFRS.

In 2016, a gain of $19,000 would be recognized under U.S. GAAP that would not exist under IFRS. As a result, $19,000 would be subtracted from U.S. GAAP net income to reconcile to IFRS. By December 31, 2016, $38,000 of the gain would have been recognized under U.S. GAAP and included in retained earnings, whereas retained earnings under IFRS includes the entire $76,000 gain. Thus, $38,000 would be added to U.S. GAAP stockholders’ equity at 12/31/16 to reconcile to IFRS.


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19. (20 minutes) (Impairment of property, plant, and equipment)

Cost of equipment $135,000Salvage value zeroUseful life 5 yearsDepreciation expense, 2015 $27,000Carrying value, 12/31/15 $108,000Expected future cash flows, 12/31/15 116,000PV of expected future cash flows, 12/31/15 100,000Fair value (net selling price) less costs to dispose, 12/31/15 96,600

a. 1. Under U.S. GAAP, an asset is impaired when its carrying value exceeds the expected future cash flows (undiscounted) to be derived from use of the asset. Expected future cash flows are $116,000, which exceeds the carrying value of $108,000, so the asset is not impaired. Depreciation expense for the year is $27,000 [$135,000 / 5 years], and the equipment will be carried on the December 31, 2015 balance sheet at $108,000.

2. In accordance with IAS 36, an asset is impaired when its carrying value exceeds its recoverable amount, which is the greater of (a) value in use (present value of expected future cash flows), and (b) net selling price, less costs to dispose. The carrying value of the equipment at December 31, 2015 is $108,000; original cost of $135,000 less accumulated depreciation of $27,000 [$135,000 / 5 years]. The asset’s recoverable amount is $100,000 (the higher of value in use of $100,000 and fair value of $96,600), so the asset is impaired. An impairment loss of $8,000 [$108,000 - $100,000] would be recognized at the end of 2015, in addition to depreciation expense for the year of $27,000. The equipment will be carried on the December 31, 2015 balance sheet at $100,000.

b. An impairment loss of $8,000 was recognized in 2015 under IFRS but not under U.S. GAAP. Therefore, $8,000 must be subtracted from U.S. GAAP net income to reconcile to IFRS net income in 2015. The same amount would be subtracted from U.S. GAAP stockholders’ equity at December 31, 2015 to reconcile to IFRS stockholders’ equity.

In 2016, depreciation under IFRS will be $25,000 [$100,000 / 4 years], whereas depreciation under U.S. GAAP is $27,000. $2,000 would be added to U.S. GAAP net income to reconcile to IFRS net income in 2016. To reconcile stockholders’ equity to IFRS at December 31, 2016, $6,000 must be subtracted from U.S. GAAP stockholders’ equity. This is the difference between the impairment loss of $8,000 in 2015 taken under IFRS and the difference in depreciation expense recognized under the two sets of standards in 2016. It also is equal to the difference in the carrying value of the equipment at December 31, 2016 under the two sets of accounting rules:

IFRS U.S. GAAPCost $135,000 $135,000Depreciation, 2015 (27,000) (27,000)Impairment loss, 2015 (8,000) 0 Carrying value, 12/31/15 $100,000 $108,000Depreciation, 2016 (25,000) (27,000)Carrying value, 12/31/16 $75,000 $81,000


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Chapter 11 Develop Your Skills

Analysis Case 1—Application of IAS 16

This assignment demonstrates the effect one difference between IFRS and U.S. GAAP would have on a company's net income and stockholders' equity over a 20-year period.

Depreciation expense in Years 1 and 2 under both sets of rules: $10,000,000 / 20 years = $500,000 per year

The building has a book value of $9,000,000 on January 1, Year 3. On that date, under IFRS, Abacab would revalue the building through the following journal entry:

Dr. Building $3,000,000Cr. Accumulated Other Comprehensive Income (AOCI) $3,000,000

Under IFRS, the revalued amount of the building will be depreciated over the remaining useful life of 18 years at the rate of $666,667 per year [$12,000,000 / 18 years].

a. Depreciation Expense Year 2 Year 3 Year 4IFRS $500,000 $666,667 $666,667U.S. GAAP $500,000 $500,000 $500,000

b. Book Value of Building 1/2/Y3 12/31/Y3 12/31/Y4IFRS $12,000,000 $11,333,333 $10,666,666U.S. GAAP $9,000,000 $8,500,000 $8,000,000Difference $3,000,000 $2,833,333 $2,666,666

c. Pre-tax income will be $166,667 smaller in each year (Year 3 -Year 20) under IFRS. Cumulatively, IFRS-pretax income will be $3,000,000 smaller than U.S. GAAP pretax income over this 18-year period. Stockholders' equity will be $3,000,000 greater under IFRS at January 1, Year 3. This difference will decrease by $166,667 each year (due to greater IFRS depreciation expense), such that stockholders' equity will be the same under both sets of rules at December 31, Year 20. The difference in stockholders' equity each year is equal to the difference in the book value of the building.


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Analysis Case 2— Reconciliation of IFRS to U.S. GAAP

Quantacc Ltd.Schedule to Reconcile IFRS Net Income and Stockholders’ Equity

to U.S. GAAP 2015

Income under IFRS $ 100,000

Adjustments:

Add depreciation on revaluation amount in current year under IFRS 3,500

Add gain on sale and leaseback recognized in current year under U.S. GAAP 10,000

Add current year’s amortization of deferred development costs 16,000

Income under U.S. GAAP $ 129,500

12/31/2015

Stockholders’ equity under IFRS $ 1,000,000

Adjustments:

Subtract revaluation surplus (35,000

)Add accumulated depreciation on revaluation amount under IFRS (2015 only)

3,500

Subtract total amount of gain on sale and leaseback recognized under IFRS in 2014

(200,000)

Add cumulative amount of gain on sale and leaseback that would have been recognized under U.S. GAAP in 2014 and 2015 20,000

Subtract total amount of development costs capitalized under IFRS in 2014 (80,000

)Add cumulative amount of amortization expense on development costs recognized under IFRS (2015 only) 16,000

Stockholders’ equity under U.S. GAAP $

724,500

Explanation for adjustments:

1. Under IFRS – Quantacc recorded a Revaluation Surplus (stock equity account) of $35,000 on 1/1/2015. In 2015, $3,500 of depreciation expense was taken on the revaluation amount ($35,000 / 10 years).

Under U.S. GAAP – neither of these would have been recognized.To reconcile from IFRS to GAAP – add $3,500 to IFRS 2015 net income; subtract a


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total of $31,500 from IFRS 12/31/2015 stockholders’ equity (subtract $35,000 Revaluation Surplus and add $3,500 of accumulated depreciation on the revaluation amount).


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2. Under IFRS – Quantacc recognized a gain on sale/leaseback of $200,000 in 2014. No gain was recognized in 2015.

Under GAAP – Quantacc would recognize a gain on sale/leaseback of $10,000 in both 2014 and 2015.

To reconcile from IFRS to GAAP – add $10,000 to IFRS 2015 net income.At the end of 2015, the increase in retained earnings related to the gain on sale/leaseback under IFRS is $200,000, but would only be $20,000 under GAAP.

To reconcile from IFRS to GAAP – subtract a total of $180,000 from IFRS 12/31/2015 stockholders’ equity.

3. Under IFRS – Quantacc recognized a development cost asset of $80,000 in 2014. In 2015, amortization expense related to this asset was $16,000 ($80,000 / 5 years).

Under GAAP – Quantacc would have expensed development costs of $80,000 in 2014. In 2015, there is $16,000 more expense under IFRS than under GAAP. To reconcile from IFRS to GAAP – add $16,000 to IFRS 2015 net income. At 12/31/2015, the decrease in retained earnings is $64,000 larger under IFRS than under GAAP. To reconcile from IFRS to GAAP, subtract a total of $64,000 from IFRS 12/31/2015 stockholders’ equity.

Research Case—Reconciliation to U.S. GAAP

Note to instructors: The SEC no longer requires a U.S. GAAP reconciliation from foreign companies using IFRS. As more foreign companies adopt IFRS over time, it will become increasingly more difficult for students to find foreign companies that provide a U.S. GAAP reconciliation in their Form 20-F. Exhibit 11.6 can help in identifying countries not using IFRS.

In addition, students may find EDGAR to be of limited use in accessing foreign company annual reports because few foreign companies file electronically with the SEC. Instructors might want to emphasize to their students that they might have more luck accessing the annual report of their selected company from the company's website.

This assignment requires students to find the note in Form 20-F in which foreign companies reconcile net income and stockholders' equity from foreign GAAP to U.S. GAAP. The responses to this assignment will depend upon the company selected by the student to research. Examining the reconciliation from foreign GAAP to U.S. GAAP in Form 20-F is a good way to learn some of the major differences between foreign and U.S. GAAP. Students may be surprised to learn how few adjustments most foreign companies make in reconciling to U.S. GAAP.


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Communication Case—Voluntary Adoption of IFRS

The response to the requirement in this case will vary by student. Potential benefits and potential risks from the voluntary adoption of IFRS that students might discuss in their memo include the following:

Potential benefits.

Preparing IFRS financial statements would make it easier for analysts to compare the company with foreign competitors that use IFRS. This could result in a lower cost of capital for the company. It also would make it easier for the company to benchmark against foreign competitors.

For multinational companies with subsidiaries primarily using IFRS as their local GAAP, the use of IFRS would allow the parent company to avoid IFRS to U.S. GAAP conversions in preparing consolidated financial statements.

Potential risks.

The major risk of voluntary adoption of IFRS is that the SEC might ultimately decide not to require the use of IFRS in the United States. In that case, the company would probably be required to switch back to U.S. GAAP. The company would have incurred substantial costs in changing its systems to IFRS, without being able to reap the potential benefits over a long period of time, and it would have to incur the cost of switching back to U.S. GAAP.

Internet Case—Foreign Company Annual Report

The responses to this assignment will depend on the company selected by the student. A comparison of the findings across companies selected by students can lead to a lively classroom discussion.

The instructor might wish to complete this assignment for a non-U S. company of his/her choice to lead the discussion.


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