IFRS vs. U.S. GAAP- Key Differences INTERNATIONAL FINANCIAL REPORTING STANDARDS Balance Sheet Presentation. There are more similarities than differences in balance sheets prepared according to U.S. GAAP and those prepared applying IFRS. Some of the differences are: International standards specify a minimum list of items to be presented in the balance sheet. U.S. GAAP has no minimum requirements. IAS No.1, revised, changed the title of the balance sheet to statement of financial position, although companies are not required to use that title. Some U.S. companies use the statement of financial position title as well. Under U.S. GAAP, we present current assets and liabilities before noncurrent assets and liabilities. IAS No. 1 doesn’t prescribe the format of the balance sheet, but balance sheets prepared using IFRS often report noncurrent items first. For example, the balance sheets of Sanofi-Aventis, a French pharmaceutical company, included in a recent half-year report, presented assets, liabilities and equity in the following order: Sanofi-Aventis Balance Sheet (condensed) At June 30 (€ in millions) 2009 Noncurrent assets (including property, plant and equipment) € 58,233 Current assets 18,525 Total assets € 76,758 Shareholders’ equity € 44,784 Noncurrent liabilities 21,187 Current liabilities 10,787 Total liabilities and equity € 76,758 INTERNATIONAL FINANCIAL REPORTING STANDARDS Income Statement Presentation. There are more similarities than differences between income statements prepared according to U.S. GAAP and those prepared applying international standards. Some of the differences are: International standards require certain minimum information to be reported on the face of the income statement. U.S. GAAP has no minimum requirements. International standards allow expenses to be classified either by function (e.g., cost of goods sold, general and administrative, etc), or by natural description (e.g., salaries, rent, etc.). SEC regulations require that expenses be classified by function. In the U.S., the “bottom line” of the income statement usually is called either net income or net loss. The descriptive term for the bottom line of the income statement prepared according to international standards is either profit or loss. As we discuss later, we report “extraordinary items” separately in an income statement prepared according to U.S. GAAP. International standards prohibit reporting “extraordinary items.” INTERNATIONAL FINANCIAL REPORTING STANDARDS Inventory Cost Flow Assumptions. IAS NO. 2 does not permit the use of LIFO. Because of this restriction, many U.S. multinational companies employ the use of LIFO only for all or most of their domestic inventories and FIFO or average cost for their foreign subsidiaries. General Mills provides an example with a disclosure note included in a recent annual report: Inventories (in part) All inventories in the United States other than grain are valued at the lower of cost, using the last-in, first-out (LIFO method, or market… Inventories outside of the United States are valued at the lower of cost, using the first-in, first-out (FIFO) method, or market. This difference could prove to be a significant impediment to U.S. convergence to international standards. Unless the U.S. Congress repeals the LIFO conformity rule, convergence would cause many corporations to lose a valuable tax shelter, the use of LIFO for tax purposes. If these companies were immediately taxed on the difference between LIFO inventories and inventories valued using another method, it would cost companies billions of dollars. Some industries would be particularly hard hit. Most oil companies and auto manufacturers, for instance, use LIFO. As an example, it would cost Exxon Mobil over $4 billion. The companies affected most certainly will lobby heavily to retain the use of LIFO for tax purposes. INTERNATIONAL FINANCIAL REPORTING STANDARDS Lower of cost or market. International standards also require inventory to be valued at the lower of cost or market. You just learned that in the United States, market is defined as replacement cost with a ceiling of net realizable value (NRV) and a floor of NRV less a normal profit margin. However, the designated market value according to IAS No. 2 always is net realizable value. IAS No. 2 also specifies that if circumstances indicate that an inventory write-down is no longer appropriate, it should be reversed. Reversals are not permitted under U.S. GAAP. Under U.S. GAAP, the LCM rule can be applied to individual items, logical inventory categories, or the entire inventory. Using the international standard, the LCM assessment usually is applied to individual items, although using logical inventory categories is allowed under certain circumstances. Consider the following illustration: Biddle and White, LTD. prepares its financial statements according to IFRS. Using the data in Illustrations 9-1 and 9-1A, the company would determine the inventory carrying value at year-end, assuming the LCM rule is applied to individual items, as $377,000. Item Cost NRV LCM A $ 50,000 $ 85,000 $ 50,000 B 100,000 100,000 100,000 C 80,000 65,000 65,000 D 90,000 76,000 76,000 E 95,000 86,000 86,000 Totals $415,000 $377,000 Notice that the carrying value of $377,000 is larger than the $347,000 determined using U.S. GAAP. This normally will be the case because replacement cost usually is less than NRV. The entry to record the write-down is as follows: Inventory write-down expense ($415,000-377,000) 38,000 Inventory valuation allowance 38,000 Because IFRS allows companies to reverse write-downs later if NRV increases, it’s convenient to use an inventory valuation account in the above entry rather than reducing inventory directly. Reversals, then, are recorded by debiting the allowance account. IFRS does not require the write- down to be recorded in any specific income statement account. Cadbury Schweppes, Plc., a U.K. company, prepares its financial statements according to IFRS. The following disclosure note illustrates the designation of market as net realizable value. Inventories (in part) Inventories are recorded at the lower of average cost and estimated net realizable value. INTERNATIONAL FINANCIAL REPORTING STANDARDS Research and Development Expenditures. Other than software development costs incurred after technological feasibility has been established, U.S. GAAP requires all research and development expenditures to be expensed in the period incurred. IAS No. 38 draws a distinction between research activities and development activities. Research expenditures are expensed in the period incurred. However, development expenditures that meet specified criteria are capitalized as an intangible asset. Under both U.S. GAAP and IFRS, any direct costs to secure a patent, such as legal and filing fees, are capitalized. Heineken, a company based in Amsterdam, prepares its financial statements according to IFRS. The following disclosure note describes the company’s adherence to IAS No. 38. The note also describes the criteria for capitalizing development expenditures. Software, research and development and other intangible assets (in part) Expenditures on research activities, undertaken with the prospect of gaining new technical knowledge and understanding, is recognized in the income statement when incurred. Development activities involve a plan or design for the production of new or substantially improved products and processes. Development expenditures are capitalized only if development costs can be measured reliably, the product or process is technically and commercially feasible, future economic benefits are probable, and Heineken intends to and has sufficient resources to complete development and to use or sell the asset. The expenditures capitalized include the cost of materials, direct labor and overhead costs that are directly attributable to preparing the asset for its intended use. Amortization of capitalized development costs begins when development is complete and the asset is available for use. Heineken disclosed that it amortizes its capitalized development costs using the straight-line method over an estimated 3-year useful life. INTERNATIONAL FINANCIAL REPORTING STANDARDS Software Development Costs. The percentage we use to amortize computer software development costs under U.S. GAAP is the greater of (1) the ratio of current revenues to current and anticipated revenues or (2) the straight-line percentage over the useful life of the software. This approach is allowed under IFRS, but not required. INTERNATIONAL FINANCIAL REPORTING STANDARDS Depreciation. IAS No. 16 requires that each component of an item of property, plant, and equipment must be depreciated separately if its cost is significant in relation to the total cost of the item. In the U.S., component depreciation is allowed but is not often used in practice. Consider the following illustration: Cavandish LTD. purchased a delivery truck for $62,000. The truck is expected to have a service life of six years and a residual value of $12,000. At the end of three years, the over-sized tires, which have a cost of $6,000 (included in the $62,000 purchase price), will be replaced. Under U.S. GAAP, the typical accounting treatment is to depreciate the $50,000 ($62,000 – 12,000) depreciable base of the truck over its six-year useful life. Using IFRS, the depreciable base of the truck is $44,000 ($62,000 – 12,000 – 6,000) and is depreciated over the trucks six-year useful life, and the $6,000 cost of the tires is depreciated separately over a three-year useful life. U.S. GAAP and IFRS determine depreciable base in the same way, by subtracting estimated residual value from cost. However, IFRS requires a review of residual values at least annually. Sanofi-Aventis, a French pharmaceutical company, prepares its financial statements using IFRS. In its property, plant, and equipment note, the company discloses its use of the component–based approach to accounting for depreciation. Property, plant, and equipment (in part) The component-based approach to accounting for property, plant, and equipment is applied. Under this approach, each component of an item of property, plant, and equipment with a cost which is significant in relation to the total cost of the item and which has a different useful life from the other components must be depreciated separately. INTERNATIONAL FINANCIAL REPORTING STANDARDS Biological Assets. Living animals and plants, including the trees in a timber tract or in a fruit orchard, are referred to as biological assets. Under U.S. GAAP, a timber tract is valued at cost less accumulated depletion and a fruit orchard at cost less accumulated depreciation. Under IFRS, biological assets are valued at their fair value less estimated costs to sell. INTERNATIONAL FINANCIAL REPORTING STANDARDS Valuation of Property, Plant, and Equipment. As we’ve discussed, under U.S. GAAP a company reports property, plant, and equipment (PP&E) in the balance sheet at cost less accumulated depreciation (book value). IAS No. 16 allows a company to report property, plant, and equipment at that amount or, alternatively, at its fair value (revaluation). If a company chooses revaluation, all assets within a class of PP&E must be revalued on a regular basis. U.S. GAAP prohibits revaluation. If the revaluation option is chosen, the way the company reports the difference between fair value and book value depends on which amount is higher: If fair value is higher than book value, the difference is reported as other comprehensive income (OCI) which then accumulates in a “revaluation surplus” (sometimes called revaluation reserve) account in equity. If book value is higher than fair value, the difference is reported as an expense in the income statement. An exception is when a revaluation surplus account relating to the same asset has a balance from a previous increase in fair value, that balance is eliminated before debiting revaluation expense. Consider the following illustration: Candless Corporation prepares its financial statements according to IFRS. At the beginning of its 2011 fiscal year, the company purchased equipment for $100,000. The equipment is expected to have a five-year useful life with no residual value, so depreciation for 2011 is $20,000. At the end of the year, Candless chooses to revalue the equipment as permitted by IAS No. 16. Assuming that the fair value of the equipment at year-end is $84,000, Candless records depreciation and the revaluation using the following journal entries: (a) Depreciation expense ($100,000 5 years) 20,000 Accumulated depreciation 20,000 After this entry, the book value of the equipment is $80,000; the fair value is $84,000. We use the ratio of the two amounts to adjust both the equipment and the accumulated depreciation accounts (and thus the book value) to fair value ($ in thousands): December 31, 2011 Before After Revaluation Revaluation Equipment $100 x 84/80 = $105 Accumulated depreciation 20 x 84/80 = 21 Book value $ 80 x 84/80 = $ 84 The entries to revalue the equipment and the accumulated depreciation accounts (and thus the book value) are: (b) Equipment ($105,000 – 100,000) 5,000 Accumulated depreciation ($21,000 – 20,000) 1,000 Revaluation surplus–OCI ($84,000 – 80,000) 4,000 The new basis for the equipment is its fair value of $84,000 ($105,000 – 21,000), and the following years’ depreciation is based on that amount. Thus, 2012 depreciation would be $84,000 divided by the four remaining years, or $21,000: (a) Depreciation expense ($84,000 4 years) 21,000 Accumulated depreciation 21,000 After this entry, the book value of the equipment is $63,000. Let’s say the fair value now is $57,000. We use the ratio of the two amounts to adjust both the equipment and the accumulated depreciation accounts (and thus the book value) to fair value ($ in thousands): December 31, 2012 Before After Revaluation Revaluation Equipment $105 x 57/63 = $95 Accumulated depreciation ($21 + 21) 42 x 57/63 = 38 Book value $ 63 x 57/63 = $57 The entries to revalue the equipment and the accumulated depreciation accounts (and thus the book value) are: (b) Revaluation surplus–OCI ($57,000 – 63,000 = $6,000; limit: $4,000 balance) 4,000 Revaluation expense (to balance) 2,000 Accumulated depreciation ($38,000 – 42,000) 4,000 Equipment ($95,000 – 105,000) 10,000 A decrease in fair value, as occurred in 2012, is expensed unless it reverses a revaluation surplus account relating to the same asset, as in this illustration. So, of the $6,000 decrease in value ($63,000 book value less $57,000 fair value), $4,000 is debited to the previously created revaluation surplus and the remaining $2,000 is recorded as revaluation expense in the income statement. Investcorp, a provider and manager of alternative investment products headquartered in London, prepares its financial statements according to IFRS. The following disclosure note included in a recent annual report discusses the company’s decision to change its method of valuing its premises and equipment. Change in Accounting Policy During the current period, the Group changed its policy with respect of carrying value of premises and equipment. These assets have been revalued to their fair value in the current period and shall be carried at their revalued amount less any accumulated depreciation and cumulative impairment losses. The revaluation surplus has been recognized in other comprehensive income and included as separate component of equity as revaluation surplus. INTERNATIONAL FINANCIAL REPORTING STANDARDS Valuation of Intangible Assets. IAS No. 38 allows a company to value an intangible asset subsequent to initial valuation at (1) cost less accumulated amortization or (2) fair value, if fair value can be determined by reference to an active market. If revaluation is chosen, all assets within that class of intangibles must be revalued on a regular basis. Goodwill, however, cannot be revalued. U.S. GAAP prohibits revaluation of any intangible asset. Notice that the revaluation option is possible only if fair value can be determined by reference to an active market, making the option relatively uncommon. However, the option possibly could be used for intangibles such as franchises and certain license agreements. If the revaluation option is chosen, the accounting treatment is similar to the way we applied the revaluation option for property, plant, and equipment earlier in this chapter. Recall that the way the company reports the difference between fair value and book value depends on which amount is higher. If fair value is higher than book value, the difference is reported as other comprehensive income (OCI) and then accumulates in a revaluation surplus account in equity. On the other hand, if book value is higher than fair value, the difference is expensed. Consider the following illustration: Amershan LTD. prepares its financial statements according to IFRS. At the beginning of its 2011 fiscal year, the company purchased a franchise for $500,000. The franchise has a 10-year contractual life and no residual value, so amortization in 2011 is $50,000. The company does not use an accumulated amortization account and credits the franchise account directly when amortization is recorded. At the end of the year, Amershan chooses to revalue the franchise as permitted by IAS No. 38. Assuming that the fair value of the franchise, determined by reference to an active market, at year-end is $600,000, Amershan records amortization and the revaluation using the following journal entries: Amortization expense ($500,000 10 years) 50,000 Franchise 50,000 Franchise ($600,000 – 450,000) 150,000 Revaluation surplus–OCI 150,000 With the second entry Amershan increases the book value of the franchise from $450,000 ($500,000 – 50,000) to its fair value of $600,000 and records a revaluation surplus for the difference. The new basis for the franchise is its fair value of $600,000, and the following years’ amortization is based on that amount. Thus, 2012 amortization would be $600,000 divided by the nine remaining years, or $66,667. INTERNATIONAL FINANCIAL REPORTING STANDARDS Impairment of Value: Property, Plant, and Equipment and Finite-Life Intangible Assets. Highlighted below are some important differences in accounting for impairment of value for property, plant, and equipment and finite-life intangible assets between U.S. GAAP and IAS No. 36. U.S. GAAP IFRS When to Test When events or changes in Assets must be assessed for indicators of circumstances indicate that impairment at the end of each reporting book value may not be period. Indicators of impairment are similar recoverable. to U.S. GAAP. Recoverability An impairment loss is There is no equivalent recoverability test. required when an asset’s An impairment loss is required when an asset’s book value exceeds book value exceeds the higher of the asset’s the undiscounted sum of value-in- use (present value of estimated the asset’s estimated future future cash flows) and fair value less costs to cash flows. sell. Measurement The impairment loss is the The impairment loss is the difference between difference between book book value and the “recoverable amount” (the value and fair value. higher of the asset’s value-in-use and fair value less costs to sell). Subsequent Prohibited. Required if the circumstances that caused the Reversal of Loss impairment are resolved. Let’s look at an illustration highlighting the important differences described above. The Jasmine Tea Company has a factory that has significantly decreased in value due to technological innovations in the industry. Below are data related to the factory’s assets: ($ in millions) Book value $18.5 Undiscounted sum of estimated future cash flows 19.0 Present value of cash flows 16.0 Fair value less cost to sell (determined by appraisal) 15.5 What amount of impairment loss should Jasmine Tea recognize, if any, under U.S. GAAP? Under IFRS? U.S. GAAP There is no impairment loss. The sum of undiscounted estimated future cash flows exceeds the book value. IFRS Jasmine should recognize an impairment loss of $2.5 million. Indicators of impairment are present and book value exceeds both value-in-use (present value of cash flows) and fair value less costs to sell. The recoverable amount is $16 million, the higher of value-in-use ($16 million) and fair value less costs to sell ($15.5 million). The impairment loss is the difference between book value of $18.5 million and the $16 million recoverable amount. Cadbury Schweppes, Plc., a U.K. company, prepares its financial statements according to IFRS. The following disclosure note describes the company’s impairment policy: Impairment review (in part) The Group carries out an impairment review of its tangible assets when a change in circumstances or situation indicates that those assets may have suffered an impairment loss…. Impairment is measured by comparing the carrying amount of an asset … with the “recoverable amount,” that is the higher of its fair value less costs to sell and its “value in use.” Value in use is calculated by discounting the expected future cash flows… INTERNATIONAL FINANCIAL REPORTING STANDARDS Impairment of Value: Indefinite-Life Intangible Assets Other than Goodwill. Similar to U.S. GAAP, IFRS requires indefinite-life intangible assets other than goodwill to be tested for impairment at least annually. However, under U.S. GAAP, the impairment loss is measured as the difference between book value and fair value, while under IFRS the impairment loss is the difference between book value and the recoverable amount. The recoverable amount is the higher of the asset’s value-in-use (present value of estimated future cash flows) and fair value less costs to sell. IFRS requires the reversal of an impairment loss if the circumstances that caused the impairment are resolved. Reversals are prohibited under U.S. GAAP. Also, indefinite-life intangible assets may not be combined with other indefinite-life intangible assets for the required annual impairment test. Under U.S. GAAP, though, if certain criteria are met, indefinite-life intangible assets should be combined for the required annual impairment test. INTERNATIONAL FINANCIAL REPORTING STANDARDS Impairment of Value: Goodwill. Highlighted below are some important differences in accounting for the impairment of goodwill between U.S. GAAP and IAS No. 36. U.S. GAAP IFRS Level of testing Reporting unit – a Cash-generating unit (CGU) – the smallest segment or a component identifiable group of assets that generates cash of an operating segment flows that are largely independent of the cash for which discrete financial flows from other assets. A CGU can’t be lower information is available. than a segment. Measurement A two-step process: A one-step process: 1. Compare the fair value Compare the recoverable amount of the CGU of the reporting unit with to book value. If the recoverable amount is its book value. A loss is less, reduce goodwill first, then other assets indicated if fair value is The recoverable amount is the higher of fair less than book value. value less costs to sell and value-in-use 2. The impairment loss is (present value of estimated future cash flows). the excess of book value over implied fair value. U.S. GAAP and IAS No. 36 both require goodwill to be tested for impairment at least annually, and both prohibit the reversal of goodwill impairment losses. Let’s look at an illustration highlighting the differences described above. Canterbury LTD. has $38 million of goodwill in its balance sheet from the 2009 acquisition of Denton, Inc. At the end of 2011, Canterbury’s management provided the following information for the year-end goodwill impairment test ($ in millions): Fair value of Denton (determined by appraisal) $132 Fair value of Denton’s net assets (excluding goodwill) 120 Book value of Denton’s net assets (including goodwill) 150 Present value of Denton’s estimated future cash flows 135 Assume that Denton is considered a reporting unit under U.S. GAAP and a cash-generating unit under IFRS, and that its fair value approximates fair value less costs to sell. Determine the amount of goodwill impairment loss that Canterbury should recognize, if any, under U.S. GAAP? Under IFRS? U.S. GAAP Fair value of Denton $132 Fair value of Denton’s net assets (excluding goodwill) 120 Implied value of goodwill $ 12 Book value of goodwill $38 Implied value of goodwill 12 Impairment loss $26 IFRS The recoverable amount is $135 million, the higher of the $135 million value-in-use (present value of estimated future cash flows) and the $132 million fair value less costs to sell. Denton’s book value $150 Recoverable amount 135 Impairment loss $ 15 Royal Philips Electronics of the Netherlands is a world leader in healthcare, lifestyle and lighting. The company prepares its financial statements according to IFRS. The following disclosures describe the company’s goodwill impairment policy and a $301 million EUR goodwill impairment loss. Impairment of Goodwill (in part) Goodwill is not amortized but tested for impairment annually and whenever impairment indicators require. In most cases the Company identified its cash- generating unit as one level below that of an operating sector…. A goodwill impairment loss is recognized in the statement of income whenever and to the extent that the carrying amount of a cash-generating unit exceeds the recoverable amount of that unit. Goodwill (in part) Due to deteriorating economic circumstances and the decline of the market capitalization of the company, impairment tests were performed in the latter half of the year using updated assumptions. The tests resulted in goodwill impairment charges of EUR 301 million,… INTERNATIONAL FINANCIAL REPORTING STANDARDS Costs of Defending Intangible Rights. Under U.S. GAAP, litigation costs to successfully defend an intangible right are capitalized and amortized over the remaining useful life of the related intangible. Under IFRS, these costs are expensed, except in rare situations when an expenditure increases future benefits.
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