Chapter 11 - Worldwide Accounting Diversity and International Standards

CHAPTER 11 WORLDWIDE ACCOUNTING DIVERSITY AND INTERNATIONAL STANDARDS

Chapter Outline
I. Accounting and financial reporting rules differ across countries. There are a variety of factors influencing a countrys accounting system. A. Legal systemprimarily 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. Taxationfinancial 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 systemwhere 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 tends to be less demand for public accountability and information disclosure. D. Inflationhas 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. E. Political and economic tiescan 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. Cultureaffects a countrys accounting system in two ways: (1) through its influence on a countrys 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. 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 countrys 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.

II.

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 companys GAAP. B. Companies interested in obtaining capital in foreign countries often are required to

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C.

provide financial statements prepared in accordance with accounting rules in that country, which are likely to differ from rules in the home country. Investors interested in investing in foreign companies may have a difficult time in making comparisons across potential investments because of differences in accounting rules

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across countries. IV. Harmonization is the process of reducing differences in financial reporting practices across countries. A. The European Union attempted to harmonize accounting through the 4th and 7th Directives. 1. The 4th Directive dealt with valuation rules, disclosure, and formats of financial statements. 2. The 7th Directive dealt with the consolidation of financial statements. 3. The EU Directives caused significant change in accounting practice across Europe and reduced previous differences. However, because of considerable flexibility associated with allowed alternatives, the Directives did not achieve complete comparability across EU countries. 4. Since 2005, EU publicly traded companies have been required to use International Financial Reporting Standards issued by the International Accounting Standards Board in preparing consolidated financial statements. Parent company statements continue to be prepared in accordance with national accounting standards based on the EU Directives. B. 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. 1. The IASC issued 41 International Accounting Standards (IAS) covering a broad range of accounting issues. Twelve IASs have been superseded or withdrawn, leaving 29 in effect. 2. The membership of the IASC was composed of over 140 accountancy bodies from more than 100 nations. 3. 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. 4. 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. 5. 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 in 2009. Full-time IASB members are required to sever their relationships with former employers to ensure independence. However, seven of the IASB members have a formal liaison responsibility with a national standard setter, such as the U.S. FASB. Technical competence is the most important criterion for selection as a Board member. 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

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C.

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). In addition to 29 IASs and 9 IFRSs (as of January 1, 2010), 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.

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D.

As of July 2009, more than 80 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 (Brazil 2010, Canada, 2011, India 2011, Mexico 2012, South Korea 2010). 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.

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 has six key initiatives to further convergence between IFRS and U.S. GAAP including a short-term convergence project and joint projects on broader accounting issues. As a result of the short-term convergence project, the FASB has revised several authoritative pronouncements that are part of U.S. GAAP, adopting the IASB treatment in those areas. For its part, the short-term convergence project has resulted in the IASB adopting several accounting practices used in U.S. GAAP. C. The FASB and IASB also are engaged in several longer-term joint projects with the objective of developing a common standard to become part of both IFRS and U.S. GAAP. A joint project on Business Combinations resulted in the issuance of new FASB and IASB standards on this topic in 2007-2008. VII. The U.S. SECs early interest in IFRS stemmed from IOSCOs 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 Roadmap outlines several milestones that the SEC will monitor until 2011. At that time, the SEC will assess the progress made on these milestones and will make a decision whether to require the use of IFRS by U.S. publicly traded companies over a threeyear phase-in period beginning in 2014. D. The IFRS Roadmap also contemplates allowing U.S. companies to early adopt IFRS on a voluntary basis if the company is (1) among the 20 largest publicly-traded companies in its industry worldwide and (2) more companies among the 20 largest companies in the industry use IFRS than any other set of accounting standards. 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 a company preparing its first set of financial statements for the calendar year 2014, the date of transition is January 1, 2013.

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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.

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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 11.9 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 socalled 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. B. IFRS must be translated into languages other than English to be usable by nonEnglish speaking preparers of financial statements. It is difficult to translate some words and phrases into other languages without a distortion of meaning. 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.

Learning Objectives
Having completed Chapter Eleven, Accounting Diversity and International Financial Reporting

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Standards, students should be able to fulfill each of the following learning objectives: 1. 2. Explain the major factors influencing the international development of accounting systems. Understand the problems created by differences in accounting standards across countries and

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the reasons to develop a set of internationally accepted accounting standards. 3. 4. 5. 6. 7. List the authoritative pronouncements that constitute International Financial Reporting Standards (IFRS). Describe the ways and the extent to which IFRS are used around the world. Describe the FASB-IASB convergence process and the SECs IFRS Roadmap. Recognize acceptable accounting treatments under IFRS and identify key differences between IFRS and U.S. GAAP. Determine the impact that specific differences between IFRS and U.S. GAAP have on the measurement of income and stockholders equity.

Answer to Discussion Question

Which Accounting Method Really is Appropriate? Students 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. 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

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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

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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.

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. Chronic high inflation has 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. 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 countrys accounting system. This influence is described in more detail in the answer to question 3. 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. 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 countrys 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. According to Nobes, the purpose for financial reporting determines the nature of a countrys 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.

2.

3.

4.

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5.

Several of the IASCs 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

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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.] 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. The bottom panel of Exhibit 11.6 shows the countries as of July 2009 that (after 2012) do not allow domestic companies to use IFRS in preparing consolidated financial statements. The three most economically important countries in this group are China, Japan, and the United States. 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.

7.

8.

9.

10. The six key initiatives are: Short-term convergence project to eliminate differences where convergence is likely in the short-term. Joint projects on broader issues in which FASB and IASB share resources and work on a similar time schedule. Convergence research project to identify all substantive differences between IFRS and U.S. GAAP. Liaison IASB member on site at FASB offices. Monitoring of IASB projects. Explicit consideration of convergence potential in FASB agenda decisions. 11. 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

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European Union simply adopted IFRS as the national GAAP in member nations. 12. Since 2007, foreign companies listed on U.S. stock exchanges may file IFRS financial

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statements with the U.S. SEC without providing any reconciliation to U.S. GAAP. The SECs IFRS Roadmap proposes the phased-in use of IFRS by U.S. publicly-traded domestic companies beginning in 2014. The SEC will monitor progress on several milestones and make a decision on mandatory IFRS adoption in 2011. 13. 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. 14. 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. 15. 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 IASBs 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 FASBs conceptual framework is similar to the IASBs, so reference to FASB pronouncements would be acceptable under IAS 8 when conditions (a), (b), and (c) exist. 16. 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. 17. Even if all countries adopt a similar set of accounting standards, two obstacles remain in

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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-

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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.

Answers to Problems 1. 2. 3. 4. 5. 6. 7. 8. 9. B (LO1) C (LO2) D (LO2) C (LO3) D (LO4) D (LO5) C (LO5) B (LO5) D (LO5)

10. B (LO6) 11. C (LO6) 12. A (LO6) 13. A (LO5) 14. C (LO5) Problems 15-19 are based on the comprehensive illustration. Note to instructors: Problems 15-19 have changed from Problems 11-15 in the Ninth Edition of the book in that they now ask for the adjustments to reconcile from U.S. GAAP to IFRS, whereas in the previous edition the reconciliation was from IFRS to U.S. GAAP. This change is consistent with the nature of the reconciliation that U.S. companies will make if the SEC requires the IFRS as proposed under the IFRS Roadmap. 15. Carrying inventory at the lower of cost or market (LO7) (15 minutes) a. 1. Under U.S. GAAP, the company reports inventory on the balance sheet at the lower of 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

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cost and

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reported on the December 31, 2011 balance sheet at $95,000. A $5,000 loss will be included in 2011 income. 2. In accordance with IAS 2, the company reports inventory on the balance sheet at the lower of cost and net realizable value. As a result, inventory will be reported on the December 31, 2011 balance sheet at its net realizable value of $98,000 and a loss on writedown of inventory of $2,000 will be reflected in 2011 net income. b. As a result of the differing amounts of inventory loss recognized under U.S. GAAP and IFRS, Lisali will add $3,000 to U.S. GAAP income to reconcile to IFRS income, and will add $3,000 to U.S. GAAP stockholders equity to reconcile to IFRS stockholders equity. 16. Measurement of property, plant, and equipment subsequent to acquisition (LO7) (25 minutes) a. 1. Under U.S. GAAP, the company would report the equipment at its depreciated historical cost. Straight-line deprecation expense is $8,000 per year [($100,000 $20,000) / 10 years]. The equipment would be reported at $92,000, $84,000, and $76,000, respectively, on the December 31, 2011, 2012, and 2013 balance sheets. 2. Under IFRS, the equipment would be depreciated by $8,000 in 2011 [($100,000 - $20,000) / 10 years], resulting in a book value of $92,000 at December 31, 2011. Under IAS 16s allowed alternative treatment, the equipment would be revalued on January 1, 2012 to its fair value of $101,000. The journal entry to record the revaluation on January 1, 2012 would be: Dr. Equipment $9,000 Cr. Revaluation surplus (stock. equity) $9,000 (To revalue equipment from carrying value of $92,000 to appraisal value of $101,000.) Depreciation expense on a straight-line basis in 2012, 2013, and beyond would be $9,000 per year [($101,000 $20,000) / 9 years]. The equipment would be reported on the December 31, 2012 balance sheet at $92,000 [$101,000 $9,000], and on the December 31, 2013 balance sheet at $83,000 [$92,000 $9,000]. The differences can be summarized as follows: Depreciation expense IFRS U.S. GAAP 2011 $8,000 $8,000 2012 $9,000 $8,000 2013 $9,000 $8,000

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Difference Book value of equipment IFRS U.S. GAAP Difference

$0 12/31/11 $92,000 $92,000 $0

$1,000 12/31/12 $92,000 $84,000 $ 8,000

$1,000 12/31/13 $83,000 $76,000 $ 7,000

b. There is no difference in net income between IFRS and U.S. GAAP in 2011, so no reconciliation adjustments are necessary in 2011. In 2012, the additional amount of depreciation expense of $1,000 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 $1,000 less than U.S. GAAP retained earnings at December 31, 2012. Under IFRS, the revaluation surplus causes IFRS stockholders equity to be $9,000 larger than U.S. GAAP stockholders equity. The adjustment to reconcile U.S. GAAP stockholders equity to IFRS is $8,000, the difference between the original amount of the revaluation surplus ($9,000) and the accumulated depreciation on that surplus ($1,000). $8,000 would be added to U.S. GAAP stockholders equity to reconcile to IFRS. In 2013, $1,000 again is added to IFRS net income to reconcile to U.S. GAAP net income, and $7,000 is now subtracted from IFRS stockholders equity to reconcile to U.S. GAAP stockholders equity. $7,000 is the original amount of revaluation surplus ($9,000) less accumulated depreciation on that surplus for two years ($2,000). 17. Research and development costs (LO7) (15 minutes) a. 1. Under U.S. GAAP, $500,000 of research and development costs would be expensed in 2011. 2. In accordance with IAS 38, $350,000 [$500,000 x 70%] of research and development costs would be expensed in 2011, and $150,000 [$500,000 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 2012 when the newly developed product is brought to market. b. In 2011, $150,000 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 2012, the company would recognize $15,000 [$150,000 / 10 years] of amortization expense on the deferred development costs under IFRS that would not be recognized under U.S. GAAP. In 2012, $15,000 would be subtracted from U.S.

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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, 2012 would be $135,000, the sum of the $150,000 smaller expense under IFRS in 2011 and the $15,000 larger expense under IFRS in 2012. $135,000 would be added to U.S. GAAP stockholders equity at December 31, 2012 to reconcile to IFRS. 18. Gain on sale and leaseback transaction (LO7) (15 minutes) a. 1. Under U.S. GAAP, the gain of $50,000 on the sale and leaseback transaction of is deferred and amortized to income over the life of the lease. With a lease period of five years, $10,000 of the gain would be recognized in 2011. 2. In accordance with IAS 17, the entire gain of $50,000 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 2011, IFRS net income exceeds U.S. GAAP net income by $40,000, the difference in the amount of gain recognized on the sale and leaseback transaction. A positive adjustment of $40,000 would be made to reconcile U.S. GAAP net income and U.S. GAAP stockholders equity to IFRS. In 2012, a gain of $10,000 would be recognized under U.S. GAAP that would not exist under IFRS. As a result, $10,000 would be subtracted from U.S. GAAP net income to reconcile to IFRS. By December 31, 2012, $20,000 of the gain would have been recognized under U.S. GAAP and included in retained earnings, whereas retained earnings under IFRS includes the entire $50,000 gain. Thus, $30,000 would be added to U.S. GAAP stockholders equity at 12/31/12 to reconcile to IFRS. 19. Impairment of property, plant, and equipment (LO7) (20 minutes) 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 $85,000, which exceeds the carrying value of $80,000, so the asset is not impaired. Depreciation expense for the year is $20,000 [$100,000 / 5 years], and the equipment will carried be on the December 31, 2011 balance sheet at $80,000. 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, 2011 is $80,000; original cost of $100,000 less accumulated depreciation of $20,000 [$100,000 / 5 years]. The assets recoverable amount is $75,000 (the higher of value in use of $75,000 and fair value of $72,000), so the asset is impaired. An impairment loss of $5,000 [$80,000 - $75,000] would be recognized at the end of 2011, in addition to depreciation expense for the year of $20,000. The equipment will be carried on the December 31, 2011 balance sheet at $75,000. b. An impairment loss of $5,000 was recognized in 2011 under IFRS but not under

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U.S. GAAP. Therefore, $5,000 must be subtracted from U.S. GAAP net income to reconcile to U.S. GAAP net income in 2011. The same amount would be subtracted from U.S. GAAP stockholders equity at December 31, 2011 to reconcile to IFRS. In 2012, depreciation under IFRS will be $18,750 [$75,000 / 4 years], whereas depreciation under U.S. GAAP is $20,000. $1,250 would be added to U.S. GAAP net income to reconcile to IFRS net income in 2012. To reconcile stockholders equity to IFRS at December 31, 2012, $3,750 must be subtracted from U.S. GAAP stockholders equity. This is the difference between the impairment loss of $5,000 in 2011 taken under IFRS and the difference in depreciation expense recognized under the two sets of standards in 2012. It also is equal to the difference in the carrying value of the equipment at December 31, 2012 under the two sets of accounting rules: Cost Depreciation, 2011 Impairment loss, 2011 Carrying value, 12/31/11 Depreciation, 2012 Carrying value, 12/31/12 Answers to Develop Your Skills Cases Analysis Case 1Application 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 Cr. Accumulated Other Comprehensive Income $3,000,000 $3,000,000 IFRS $100,000 (20,000) (5,000) $75,000 (18,750) $56,250 U.S. GAAP $100,000 (20,000) 0 $80,000 (20,000) $60,000

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 IFRS U.S. GAAP Book Value of Building Year 2 $500,000 $500,000 1/2/Y3 Year 3 $666,667 $500,000 12/31/Y3 Year 4 $666,667 $500,000 12/31/Y4

b.

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IFRS U.S. GAAP Difference c.

$12,000,000 $9,000,000 $3,000,000

$11,333,333 $8,500,000 $2,833,333

$10,666,666 $8,000,000 $2,666,666

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.

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
2011 Income under IFRS Adjustments: Add depreciation on revaluation amount in current year under IFRS Add gain on sale and leaseback recognized in current year under U.S. GAAP Add current years amortization of deferred development costs Income under U.S. GAAP $ 3,500 10,000 16,000 129,500 12/31/2011 Stockholders equity under IFRS Adjustments: Subtract revaluation surplus Add accumulated depreciation on revaluation amount under IFRS (2011 only) Subtract total amount of gain on sale and leaseback recognized under IFRS in 2010 Add cumulative amount of gain on sale and leaseback that would have been recognized under U.S. GAAP in 2010 and 2011 Subtract total amount of development costs capitalized under IFRS in 2010 Add cumulative amount of amortization expense on development costs recognized under IFRS (2011 only) Stockholders equity under U.S. GAAP $ (35,000 ) 3,500 (200,000 ) 20,000 (80,000 ) 16,000 724,500 $ 1,000,000 $ 100,000

Explanation for adjustments:

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1. Under IFRS Quantacc recorded a Revaluation Surplus (stock equity account) of $35,000 on 1/1/11. In 2011, $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 2011 net income; subtract a total of $31,500 from IFRS 12/31/11 stockholders equity (subtract $35,000 Revaluation Surplus and add $3,500 of accumulated depreciation on the revaluation amount). 2. Under IFRS Quantacc recognized a gain on sale/leaseback of $200,000 in 2010. No gain was recognized in 2011. Under GAAP Quantacc would recognize a gain on sale/leaseback of $10,000 in both 2010 and 2011. To reconcile from IFRS to GAAP add $10,000 to IFRS 2011 net income. At the end of 2011, 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 12/31/11 stockholders equity. 3. Under IFRS Quantacc recognized a development cost asset of $80,000 in 2010. In 2011, 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 2010. In 2011, there is $16,000 more expense under IFRS than under GAAP. To reconcile from IFRS to GAAP add $16,000 to IFRS 2011 net income. At 12/31/11, 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 12/31/11 stockholders equity. Research CaseReconciliation 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 20F. 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

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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. Communication CaseSEC IFRS Roadmap The responses to these questions will vary by student. Issues that might be discussed for each question are listed below.

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 from early use 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 have incurred substantial costs in changing its systems to IFRS without being able to reap the benefit from incurring those costs over the long-term.

Internet CaseForeign 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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