XYZ IFRS implementation review I. Purpose: To review the impact of adoption of IFRS on the presentation of XYZ‟s annual financial statements. Disclaimer: This review was undertaken for research purposes and does not purport to include all possible implications of the impact of IFRS on XYZ‟s financial statements or operations. This review should not be used for any purpose without the express permission of Anne-Marie Johnson. All comments relate to the published financial statements for the year ended December 31, 2008. A list of assumptions appears at Appendix A. II. Overall Conclusion Based on the current nature and scope of XYZ‟s operations, the impact on the measurement of items included in the financial statements (the accounting impact) is not expected to be material. However, there are a number of areas which will require adjustment for IFRS presentation and disclosure, including directors‟ compensation and others as noted below. Note that the statement of compliance with IFRS (see item 6 below) cannot be made unless the financial statements contain all required disclosures. In addition, accounting policies and procedures will need to be adjusted to ensure that they are consistent with IFRS requirements. Specifically, this report identifies adjustments in the following areas: Inventory (changes in valuation methodology) Property and Equipment (disclosure by class, component depreciation, revaluations) Impairment (change in calculation, reversals) Related Parties (increased disclosure) Leases (changes in disclosures) IFRS compliance statement Taxes (revised classification to non-current) IFRS is evolving rapidly, and proposed changes to several standards are in process. It is expected that some of these changes will be in force by the time the US adopts IFRS. Areas affected include revenue, leases, income tax, liabilities and financial instruments. A brief indication of their effect is given at section IV below. III. Specific areas 1. Inventory Issue 1 – Inventory Valuation US GAAP requires inventory to be carried at the lower of cost and market. Current replacement cost is usually used as the „market‟ value, provided it falls within an allowable „band‟, the upper limit of which is Net Realizable Value (NRV = selling price less cost of completion and sale) and the lower limit of which is NRV less normal sales margin. IFRS requires inventory to be carried at the lower of cost and NRV, with NRV being defined as the “estimated selling price in the ordinary course of business less the …estimated costs necessary to make the sale” (Para 6, IAS 2). NRV refers to the net amount “expected to be realized”. This is an entity specific value, based on selling and cost information specific to the entity and therefore will not necessarily equal fair value less costs to sell. Under IFRS there is no notion of an allowable band. Numerically, the US GAAP band has the effect of preserving some or all of the normal profit margin on the eventual sale of the item in question. Under IFRS the result reported on e ventual sale of the item will potentially be more volatile. That said, the two GAAPs will often yield similar results. The difference is one of emphasis, but may be important to some inventory or entities, depending on the size and nature of inventory impairment. Action required XYZ should alter its accounting policy for recognizing inventory write downs to include IFRS definitions and concepts. A suggested replacement for note X(x) is: (b) Inventories Inventories consist of materials and equipment for resale and are stated at the lower of cost and net realizable value (NRV). Cost is determined on the first-in, first-out method. The company establishes reserves for lower of cost and NRV and obsolescence issues. Management‟s methodology used …(continue from existing policy) Issue 2 – Write ups IFRS requires write up of inventory when “the circumstances that previously caused inventories to be written down below cost no longer exist or when there is clear evidence of an increase in the NRV because of changed economic circumstances” IAS 2 para 33. A write up would be necessary, therefore, in relation to inventory that is written down in one period, is still on hand at the end of the next, and circumstances have changed favorably in relation to that inventory. Although this may not be a common situation, the write up is not an option, but a requirement (similar to the requirements for impairment review of Property and Equipment – see below). Action Required XYZ should change its accounting policy to identify and account for inventory write ups. A suggested addition to the above inventory accounting policy note is as follows: “When the reason for a previously recognized write-down no longer exists the inventory is written back up to the lower of cost and new NRV.” 2. Property and Equipment Issue 1 – Disclosures by class of Property and Equipment IAS 16 requires more detailed analysis of Property and Equipment than that currently presented in XYZ‟s financial statements. Para 73 (e) of IAS16 states that „for each class’ of Property and Equipment the following is required: i) additions; ii) assets classified as held for sale…and other disposals iii) impairments recognized or reversed iv) depreciation Currently XYZ provides some of the above as a total. Action required XYZ should change its accounting policy to meet IFRS disclosure requirements. An example reconciliation appears below. Example of Asset disclosure by class Furniture Transportation Leasehold Total and equipment improvements equipment Useful life 3-5 yrs 3-5 yrs 3-10 yrs Gross Value January 1 X X X X Additions X X X X Disposals (X) (X) (X) (X) Reclassified as held for sale (X) (X) (X) (X) December 31 X X X X De pre ciation and impairments January 1 X X X X Depreciation X X X X Impairments X X X Disposals X X X Reclassified as held for sale X X X December 31 X X X X Net at December 31 X Issue 2 – Component depreciation IFRS requires that “each part of an item of property, plant and equipment with a cost that is significant in relation to the total cost of the item shall be depreciated separately” IAS 16, para 43. The requirement that each significant part of an asset be treated separately is often referred to as the component approach. Determining components requires management judgement, and is based on a review of, for example, patterns of consumption and useful lives of parts of assets. Examples commonly cited are the separate treatment of air conditioning units, or roofs, from the buildings themselves, or of aircraft engines from frames. Action Required XYZ should change its accounting policy to incorporate the component approach if material. A suggested addition to the existing accounting policy note appears below: “When a tangible asset comprises significant components with different useful lives, each component is analyzed separately.” Issue 3 – Revaluation IFRS allows revaluation of long lived assets, whereby entities may elect to revalue classes of assets to fair value, with subsequent depreciation based on revalued amount. In practice, among overseas adopters of IFRS, few entities have chosen to adopt a policy of revaluation, presumably due to the increased effort required to keep valuations up to date, and the additional hit to income from increased depreciation. However, as noted below, IFRS 1 First Time Adoption, affords an opportunity to include a „one off‟ revaluation on initial adoption of IFRS. Action Required Unless XYZ has reason to believe there would be significant advantage to reporting higher asset values, no action is required. Issue 4 - Borrowing Costs Borrowing costs associated with the construction of a long lived asset are required to be capitalized rather than expensed. It does not appear that XYZ is affected by this requirement as it purchases its assets ready to use. Action Required None 3. Impairment Issue 1 – Impairment calculation IFRS defines impairment in a similar way to US GAAP, with the important difference that it uses discounted rather than undiscounted cashflows in the initial computation. IFRS‟s use of discounted cashflows removes the “buffer‟ provided under the US GAAP gross computation and may result in earlier recognition of impairments. Action required XYZ will need to modify its impairment accounting policy and review process to bring them in line with IFRS impairment methodology. The financial statement disclosure note X(x) will consequently change. A suggested note, based on XYZ‟s current disclosure is as follows (f) Impairment of Long-Lived Assets The Company reviews long lived assets for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the amount expected to be recovered through use or sale. Any excess of carrying amount over recoverable amount is recognized as an impairment. Impairment losses are reversed when conditions indicate the impairment may no longer exist or may have decreased. Issue 2 – Reversals Of Impairment As noted in the inventory section above, impairments under IFRS (with the exception of goodwill) are required to be reversed if conditions change favorably. Action required Incorporate reversal of impairment in accounting policies and procedures. 4. Related Parties Issue – Executive Compensation Disclosure IAS 24 “Related Party Disclosures” includes key management personnel in the definition of related party, thereby making transactions with them subject to the disclosure requirements of the standard. The standard requires disclosure of total management compensation for the period, and totals for the following in relation to the executive group short term employee benefits (salaries etc) post-employment benefits other long term benefits termination benefits share based payment Action required XYZ will need to expand the disclosure currently given in the commitments and contingencies note to include the above. 5. Leases Under existing IFRS, the total amounts reported for lease commitments will not change (expected future changes to IFRS are discussed at the end of this section). However, the current disclosures will need to be expanded to include the following 1. Total future minimum lease payments under non cancelable operating leases for each of the following periods within one year 2 – 5 years More than 5 years 2. Description of contingent rental terms and contingent rent paid in the period, (if any). Future developments The IASB has issued a discussion paper as part of its joint project with FASB on leasing. Under the proposals, all leases would be recognized on balance sheet (ie the distinction between operating and capital leases is eliminated). This would require XYZ to recognize a leased asset and related lease obligation for its operating leases, with the attendant impact on financial ratios. 6. Specific Disclosures and Presentation Issues Issue IFRS requires an explicit statement of compliance with IFRS as well as a statement of basis of preparation within the accounting policies note. Action Required XYZ should include notes in its financial statements to address the disclosure requirements. Suggested wording is as follows, to replace the introductory comments under Note 2 – Summary of Significant Accounting Policies: “The consolidated financial statements of the Company have been prepared in accordance with International Financial Reporting Standards (IFRS), using the historical cost convention (as modified by revaluation of assets if chosen by XYZ). The preparation of financial statements in conformity with IFRS requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates. Areas where judgments are significant to the financial statements are discussed in more detail in the relevant note item.” 7. Taxes Note that the IASB has a current Exposure Draft on Taxes, which may alter accounting for taxes under IFRS, largely bringing it in line with existing US GAAP requirements. An exception is the treatment of uncertain tax positions, where IFRS is likely to require calculation based on the probability weighted average of the possible outcomes. This probability weighted average approach is in line with the IASB‟s proposals on liabilities generally, and is therefore unlikely to change, despite its divergence from US GAAP. Issue Under existing IFRS all deferred tax balances are presented as non current in the balance sheet. Action required XYZ should present deferred tax balances as non current in the balance sheet. IV. First Time Adoption of IFRS When an entity transitions from its existing GAAP to IFRS, the basic rule is that financial statements are produced as if IFRS had always been used by the entity. However, in an effort to balance costs and benefits, the IASB issued IFRS1 First Time Adoption, which sets out a number of exemptions and exceptions to the full retrospective application rule. IFRS 1 is fairly complex, containing a combination of mandatory and optional provisions covering many accounting areas. The most relevant to XYZ are the following: Probably the most important exemption allows an entity to choose not to restate business combinations made prior to its date of transition to IFRS (note that the transition date is the start date of the earliest period for which comparatives are given in the financial statements). For XYZ this means that the amounts included with respect to SUB1 will not need to be restated. Another voluntary exemption relates to long-lived assets, where full retrospective application of IFRS would requires potentially onerous recalculations of asset and depreciation balances. The IASB therefore allows assets to be accounted for at transition date fair value, if wished, and is referred to as „deemed cost‟. This has a number of implications:- It essentially allows a one off revaluation, without the need for updated valuations in future periods The election can be made on an asset by asset basis, not for the entire class Depreciation going forward will be based on this deemed co st The election does not count as adoption of a revaluation policy, as it only occurs on initial transition to IFRS. XYZ should therefore evaluate whether the balance sheet benefit of electing to fair value any of its Property and Equipment outweighs the extra future depreciation charge which would result. IFRS1 also requires reconciliations of previous GAAP financial statements to IFRS financial statements at the transition date. If changes to the numbers reported by XYZ when moving from existing GAAP to IFRS prove not to be material, this requirement would not be relevant. However, the financial statements would still need to identify and explain any material reclassifications (e.g. deferred tax, PP&E), along with detailed of the exemptions and exceptions used, if any. IV. Future IFRS developments The IASB current work plan is extensive, and changes are likely in significant areas, including accounting for Revenue, Liabilities, Leases, Taxes, Financial Instruments and others. Some of these projects are joint projects with FASB, and convergence of the two GAAPs remains a key goal. The leases and taxes projects were discussed in the relevant sections above. The financial instruments project is multi-part, and being developed jointly with FASB, and the eventual outcome is not clear, making it premature to predict likely impacts. Revenue The IASB‟s project on Revenue has resulted in a Discussion Paper issued jointly with FASB. Under the proposals, revenue recognition would follow a concept of “rights and obligations”. This would mean that revenue would be broken down into separate streams, based on the series of obligations to provide goods or service and rights to receive payment. For XYZ this may mean separate recognition and disclosure of, for example, revenue from sale of goods, and revenue from provision of shipping services. Liabilities The IASB continues to develop and refine its approach to liabilities. Work continues in the area of accounting for a constructive obligation (as opposed to a legal one). A theme emerging in IFRS is that the measurement basis for liabilities of uncertain amount should be the „expected‟ outcome, a concept which requires the calculation of the probability weighted average of the range of possible outcomes. At present, US practice tends to favor a „most likely outcome‟, and „lower end of a range of possible outcomes‟ approach. This IFRS project will likely affect XYZ‟s calculation of provisions for self insured health costs, and deferred taxes. Appendix A Assumptions The following assumptions have been made in the review of XYZ‟s financial statements. 1. The accounting policies of XYZ and SUB1 are the same. 2. Purchase accounting was used to incorporate SUB1‟s financial statements, and no goodwill remains in the consolidated financial statements. 3. The ESOP allocates a fixed amount of stock between eligible parties (thus giving a readily determinable cost of the award).