Contemporary Global Accounting Topics paper

I FRS has become the required or permitted accounting frame- work for financial reporting in many of the world’s financial markets, whether explicitly endorsed or integrated into nation- al regimes based on IFRS. Even though IFRS is not current-

ly permitted by the SEC for U.S. registrants, U.S. accountants need to know IFRS—and how it differs from U.S. GAAP—

because they will encounter it in the financial statements of for- eign companies whose securities trade in the United States, for- eign subsidiaries of U.S. companies, and U.S. subsidiaries of foreign companies. Although the IASB and FASB have reduced the differences between these sets of standards over the past decade, several remain.

Converting Financial Statements from U.S. GAAP to IFRS

A C C O U N T I N G & A U D I T I N G i n t e r n a t i o n a l a c c o u n t i n g

JANUARY 2014 / THE CPA JOURNAL20

By Peter Harris, Eva K. Jermakowicz, and Barry Jay Epstein

A Comprehensive Illustration

Coverage of IFRS in college accounting curricula and professional-licensing exami- nations has expanded in the past decade, making newly minted practitioners at least partially conversant with the remaining dif- ferences between GAAP and IFRS. Practitioners who were educated and trained before IFRS became widely employed, how- ever, might benefit from a comprehensive illustration of the GAAP-to-IFRS conversion process.

To assist such CPAs, the authors have developed a comprehensive illustration of the process to be employed when convert- ing U.S. GAAP–based financial statements to conform with IFRS, as these sets of standards exist today. The goal is to intro- duce the major differences between U.S. GAAP and IFRS, with their resulting divergent effects on the financial statements. The illustration presents a U.S. GAAP–pre- pared statement of financial position and an income statement; then, based on a set of specific facts affecting financial reporting by the entity, it details the conversion to IFRS- compliant financial statements. The process begins with the recording of IFRS compli- ance worksheet adjustments, continues with worksheet reconciliation from U.S. GAAP to IFRS, and concludes with the preparation of IFRS-based statements.

Most of the more significant and likely differences between the two frameworks are highlighted. These matters pertain to the capitalization of qualifying develop- ment costs; allowable inventory costing methods (i.e., use of the last-in, first-out [LIFO] method is prohibited under IFRS); permissible use of the revaluation model for property, plant, and equipment (PP&E); use of component depreciation; and the allowable reversal of impairment losses. This example also addresses the more conservative approach of IFRS regarding the recognition of contingent losses and the different finance (capital) lease requirements. Finally, this example illustrates the different requirements for presenting compound financial instruments (e.g., convertible debt securities), given that IFRS requires that the equity component embedded in such securities be accounted for and presented as equity.

The presentation of the statement of financial position differs between the two frameworks. Under U.S. GAAP, the statement begins with the most liquid assets

and liabilities, followed by noncurrent and longer-term assets and liabilities, and concludes with shareholders’ equity, whereas IFRS often (albeit not mandato- rily) begins with the most illiquid accounts. Presentation in the income statement also varies; for example, IFRS does not allow for the characterization of gains or losses as extraordinary.

IFRS allows for greater flexibility on the cash flow statement for categorizing cer- tain items, such as for interest and dividend income, as well as for interest expense. The present demonstration will only address

recognition and measurement issues affect- ing the statement of financial position and the income statement, because the cash flow display options under IFRS are prin- cipally elective alternatives, not required differences.

Hypothetical Case Study A hypothetical company, JCL, is a man-

ufacturer of prescription drugs. Its main headquarters are in Newark, New Jersey, where the company has operated since 1981. The company sells its products to the retail market on a worldwide basis. Its financial statements, presented in Exhibit 1 and Exhibit 2 for the ye a r e nding December 31, 2012, have been prepared using U.S. GAAP. JCL’s management would like to preview the effects of using IFRS on the statement of financial position and income statement. The company would like to be able to report under IFRS by as

early as the next year, as it is considering a new stock issue to be offered in Hong Kong, which requires IFRS compliance. The following paragraphs provide more background information needed to under- stand the company’s financial statements and convert them to IFRS.

During 2012, JCL incurred costs of $2,000 to develop new prescription drugs requiring high levels of technical knowl- edge. The drugs under development, hav- ing been heavily researched for several years, reached technical and economic fea- sibility at the beginning of 2012, and the regulatory approval process has been recently completed. The drugs will be test- ed in 2013 on a much larger patient pop- ulation before making them available to customers.

JCL uses the LIFO method to value its inventory. The LIFO reserve (as used to adjust from first-in, first-out [FIFO]) was $5,000 at the beginning of the year and $7,000 as of year-end.

Management has determined that the fair value of PP&E, as of December 31, 2012, is $78,571—an $8,571 increase above book value. These assets are, on a going-forward basis, to be depreciated over a 10-year period using the straight-line depreciation method. There is no residual value. Depreciation for 2012 was record- ed as $12,000 for U.S. GAAP financial reporting purposes.

The patent is the only amortizable intan- gible asset; it is expensed over a five-year period using the straight-line method. The half-year convention is applied for all assets placed in service during the year. For the year ended December 31, 2012, amortiza- tion expense is $1,200.

In 2011, there was a goodwill impair- ment recognized in the amount of $2,000, thereby reducing the carrying value from $7,000 to $5,000. During 2012, the com- pany tested for goodwill impairment and found that the goodwill’s fair value had actually increased to $6,000.

Investments consist of available-for-sale (AFS) securities with a fair value of $20,000 at the end of the year. The value at the beginning of the year was $15,000. Exchange-rate currency gains accounted for $2,800 of the gain recognized during the year. For simplicity, assume that there was no interest or dividend income earned on these investments during the

21JANUARY 2014 / THE CPA JOURNAL

Significant differences

pertain to the capitalization

of development costs,

inventory costing methods,

revaluation for PP&E, and

component depreciation.

JANUARY 2014 / THE CPA JOURNAL22

year, and any related income tax effects have been disregarded. Furthermore, this is the only item reflected in the share- holders’ equity–accumulated comprehen- sive income account.

The company suffered a loss of $4,000 due to a hurricane, which is considered to be both an unusual and infrequent occurrence. Accordingly, under U.S. GAAP, it was reported net of tax as an extraordinary item.

There are long-term contingencies of $3,000 stemming from civil lawsuits, concerning customer personal injuries arising from use of JCL’s products. Legal counsel considers the payout slightly “more likely than not” to occur. In an unrelated case where the company is a plaintiff, counsel considers the recovery

of $10,000 in a patent infringement case to be probable. Both cases are expected to settle in a time frame of greater than one year.

JCL issued 50 convertible bonds on December 31, 2012, at par value of $1,000 each, in exchange for $50,000 in proceeds. The bonds have a 10-year term and a coupon rate of 6%, to be paid semi-annually. The bonds are convertible at the option of the holder, at any time until maturity, at a rate of 100 shares per bond. The prevailing market rate of similar bonds without the con- version option is 8% per year.

JCL entered into a lease on January 1, 2012, with the following terms: JCL leased specialized machinery from Bell Corp. that will enable JCL to manufacture its phar-

maceuticals in a much more efficient man- ner. This machinery was made specifical- ly for JCL to meet its unique production needs. The lease term is for three years, with a minimum annual lease payment of $2,500; payments are due on December 31 of each year, with the first payment due on December 31, 2012. At the end of the lease term, JCL has the option to buy the equipment for the then-prevailing market value, which will be established by an inde- pendent third-party expert appraiser, or to negotiate a lease extension, also at a mar- ket lease rate as determined by indepen- dent parties. Furthermore: n The lessee will pay all executory costs. n The estimated useful life of the leased asset is 50 months (41⁄6 years).

EXHIBIT 1 Statement of Financial Position Prepared under U.S. GAAP

JCL Inc.: Statement of Financial Position

as of December 31, 2012

(Amounts in Thousands of Dollars)

ASSETS LIABILITIES AND SHAREHOLDERS’ EQUITY

Current Assets Current Liabilities

Cash 33,000 Accounts payable 40,000 Accounts receivable 47,000 Accrued expenses 25,000 Inventory (LIFO basis) 60,000 Taxes payable 15,000 Total Current Assets 140,000 Total Current Liabilities 80,000

Investments (Available for Sale) 20,000 Noncurrent Liabilities Bonds payable 6%, convertible 50,000

Property, Plant, and Equipment

Assets (at cost) 120,000 Total Liabilities 130,000 Less: accumulated depreciation (50,000) 70,000

Shareholders’ Equity

Intangible Assets Common stock ($1 par) 60,000 Trade name 4,000 Accumulated other 5,000

comprehensive income

Patent (net of 3,000 6,000 accumulated amortization) Retained earnings 50,000 115,000 Goodwill 5,000 15,000

Total Assets 245,000 Total Liabilities and 245,000 Shareholders’ Equity

JANUARY 2014 / THE CPA JOURNAL 23

n The market value of the equipment at the inception of the lease is $7,500. n The interest rate implicit in the lease is not known by JCL. n The incremental borrowing rate of JCL is 8%, the same rate it would currently pay on straight (i.e., nonconvertible) debt issuances. n The effective tax rate for JCL is 25%.

For the sake of simplicity, with the exception of the inventory facts mentioned above, the income tax effects have been disregarded in this case study.

Based on the information above, the authors detail the following steps in the conversion of the financial statements from U.S. GAAP to IFRS. First, all significant accounts and balances affected by the tran- sition will be analyzed. Then, worksheet adjustments for these items will be pre- pared to effect the conversion. Finally, the IFRS-based statements of financial posi- tion and income will be presented.

Following this conversion, the major dif- ferences in cash flow reporting between U.S. GAAP and IFRS will be briefly dis- cussed, as will the likely impact on com- monly cited financial ratios.

Significant Differences The following sections analyze the sig-

nificant differences between U.S. GAAP and IFRS—that is, the financial statement items requiring worksheet adjustment to conform to IFRS—in this case study.

Capitalization of certain development costs under IFRS. IAS 38, Intangible Assets, requires the capitalization of devel- opment costs when technical and eco- nomic feasibility of a project can be demonstrated in accordance with six specific criteria. An intangible asset aris- ing from development (or from the devel- opment phase of an internal project) is recognized if, and only if, an entity can satisfy all of the following criteria: 1) the technical feasibility of completing the development project; 2) the reporting entity’s intention to complete the pro- ject; 3) the entity’s ability to use it or sell it; 4) the probability that the project will generate future economic benefits; 5) the availability of adequate technical, financial, and other resources to complete the project; and 6) the ability to measure the expenditure related to the intangible asset during its development.

The capitalization of development costs is not permitted under U.S. GAAP (Accounting Standards Codification [ASC] 985-20), with limited exceptions, such as for internal-use software, website devel- opment, developed technology acquired in business combinations, and certain indus- try-specific situations. Therefore, two work- sheet adjustments are required to transition to IFRS: first, to capitalize development costs as an intangible asset on the state- ment of financial position, and then to amortize this asset over a five-year peri- od. (Using a half-year convention, and the straight-line method of amortization, requires recognition of $200 of accumu- lated amortization at year-end.) JCL accordingly makes the following worksheet adjustments: (1) Dr. Development costs 2,000

Cr. Development expense (SG&A expenses) 2,000

(2) Dr. Amortization expense 200

Cr. Accumulated amortization— development costs 200

LIFO is not permitted under IFRS. Under the provisions of IAS 2, Inventories, apart from specified classes of inventories, JCL has a choice between the FIFO or the weighted-average cost formulas. For this illustration, assume that JCL is switch- ing from LIFO to FIFO for its IFRS finan- cial reporting. In this case, the result will be a $2,000 decrease in 2012’s cost of goods sold by virtue of a greater invento- ry total under FIFO (measured by the increase in the LIFO reserve, from $5,000 to $7,000). In addition, there will be anoth- er increase in FIFO inventory to reflect the extra beginning-of-year reserve of $5,000, bringing the total increase in inventory to $7,000. Assuming, for the moment, that JCL will continue to be a GAAP-report- ing entity in the United States, and thus able to utilize LIFO for both financial and tax reporting purposes, there will be an increase in income tax expense of $500 (25% of $2,000). There will also be recog- nition of a deferred tax liability account for IFRS-basis reporting in the amount of $1,750 (25% of $7,000). The worksheet adjustments are as follows: (3) Dr. Inventory 2,000

Cr. Cost of Goods Sold 2,000

(4) Dr. Income Tax Expense 500

Cr. Deferred Tax Payable 500 (5) Dr. Inventory 5,000

Cr. Deferred Tax Payable 1,250 Cr. Retained Earnings 3,750

Note that the increase to retained earn- ings represents the increased earnings attributable to prior years, net of tax, under the assumption that FIFO had been con- sistently applied ($5,000 × [1 – 0.25]).

R e v aluation mode l. U.S. GAAP requires that PP&E assets be reported at cost less accumulated depreciation. IFRS permits an accounting policy alternative to this cost model, called the revaluation model. In accordance with IAS 16, Property, Plant and Equipment, after ini- tial recognition, an item of PP&E which has a fair value that can be measured reli- ably may be carried at a revalued amount, which is defined by its fair value at the date of the revaluation, less any subsequent

JANUARY 2014 / THE CPA JOURNAL24

accumulated depreciation and subsequent accumulated impairment losses. If an item is revalued, the entire class of PP&E to which the asset belongs should be reval- ued. Revaluations should be made with suf- ficient regularity to ensure that the carry- ing amount is not materially different from fair value at each reporting date.

Using the revaluation model, an increase in an asset’s carrying amount will increase other comprehensive income and will be accumulated in a revaluation sur- plus account within equity (unless the increase reverses a revaluation decrease previously recognized in profit or loss). A decrease is recognized in profit or loss, except to the extent that it reverses a pre- vious revaluation surplus on the same asset, in which case it is recognized in other com- prehensive income (OCI).

Under the revaluation model, there are two available methods of accounting for accumulated depreciation: n Restate the accumulated depreciation pro- portionately with the change in the gross carrying amount of the asset, so that the net

carrying amount of the asset after revalua- tion equals its revalued amount. IAS 16 states that this method is often used when an asset is revalued by applying an index to restate the asset to its depreciated replacement cost. n Eliminate the accumulated depreciation against the gross carrying amount of the asset and then restate the net amount to the revalued amount of the asset.

Under either approach, the adjusted net carrying value of the asset after revalua- tion is the same as its revalued amount. The worksheet adjustments under two approaches are as follows: n Under the first approach, to recognize the revaluation amounts for both PP&E and accumulated depreciation such that the net value is increased by $8,571, the fol- lowing computations are necessary: for the gross amount, $78,571 ÷ $70,000 × $120,000 = $134,693; for accumulated depreciation, $78,571 ÷ $70,000 × $50,000 = $56,122. This results in an additional depreciation expense of $857 ($8,571 divided by the revised projected remaining life of 10 years), which is already incorpo-

rated into the year-end revaluation adjust- ment. The worksheet adjustment is as fol- lows: (6a) Dr. PP&E 14,693

Cr. Accumulated depreciation 6,122 Cr. Revaluation surplus— Comprehensive income 8,571

Under the second approach, the work- sheet adjustments to eliminate accumulat- ed depreciation and revalue the carrying amount of PP&E are as follows: (6b) Dr. Accumulated depreciation 50,000

Cr. PP&E 50,000 Dr. PP&E 8,571

Cr. Revaluation surplus—OCI 8,571 Assume that JCL chooses to use the first

approach for its IFRS-basis financial reporting. Two other aspects of accounting for long-lived assets under IFRS are also important to understand, although not perti- nent to the present illustrative example.

Component depreciation. Under IFRS, each constituent part of an item of PP&E that is material with respect to the total cost of the asset must be depreciated separate- ly—a process known as component depre- ciation. Consequently, if warranted by the facts, an asset may be considered to have multiple parts (e.g., a roof and heating plant distinct from the building itself), with each part depreciated over its appropriate esti- mated useful life. For example, consider a new truck purchased by a company for $55,000 that has $10,000 in tires ($2,500 per tire). The truck ($45,000) will have a 10-year life, but the tires ($10,000) will have a three-year life, with no residual value. In this example, annual depreciation under IFRS would be $7,833 ([$45,000 ÷ 10)] + [$10,000 ÷ 3]). Although this approach is permitted under U.S. GAAP, it is rarely used in practice, and instead depreciation of $5,500 ($55,000 ÷ 10) would generally be recognized. This detail has been omitted from this case study, inasmuch as there is insufficient information to make such judgments.

Impairments. When determining whether an item of PP&E is impaired, an entity applies IAS 36, Impairment of Assets, to ensure that such assets are not carried at more than their recoverable amounts. The recov- erable amount is the greater of the fair value less disposal costs, or the value-in- use (the discounted net present value of

EXHIBIT 2 Statement of Income, Prepared under U.S. GAAP

JCL Inc.: Statement of Income

Year Ended December 31, 2012

(Amounts in Thousands of Dollars)

Sales 450,000

Cost of Goods Sold 375,000

Gross Profit 75,000

SG&A Expenses 47,000

Earnings before Interest and Taxes 28,000

Interest Expense 4,000

Income Before Tax 24,000

Tax Expense (at 25 %) 6,000

Income from Continuing Operations (before Extraordinary Item) 18,000

Extraordinary Item: Loss from Hurricane (Net of $1,000 Income Tax) (3,000)

Net Income 15,000

JANUARY 2014 / THE CPA JOURNAL 25

expected future cash flows from the asset). An impairment loss is recognized in profit or loss if an asset’s carrying value is more than its recoverable amount.

In general, an impairment loss can be reversed under IFRS—contrary to U.S. GAAP (ASC 360-10)—when the facts and circumstances warrant doing so, but this action is limited to an increase to what the carrying amount of the asset that would have been, net of depreciation, if the impairment had not been recognized for the asset in prior years. This limitation on

the reversal of impairment losses does not apply if the asset is carried under the reval- uation model. In those cases, the full impairment reversal to fair value is accounted for as a revaluation increase.

There is no prior impairment in this case study that needs to be reversed in the cur- rent period.

Impairment of intangibles other than goodwill. Using U.S. GAAP (ASC 350- 30-35), intangibles other than goodwill (i.e., patents) are tested whenever impairment indicators exist. Under IFRS (IAS 36),

the existence of impairment indicators must be assessed annually. If appropriate, a loss may be reversed up to the newly estimated recoverable amount, but it may not exceed the initial carrying amount (adjusted for amortization) that would have already been recognized. This amount is recorded in income. Under U.S. GAAP, the reversal of impairment losses is pro- hibited for all intangible assets. In the tran- sition to IFRS, JCL’s patent was tested for possible impairment, and no such evi- dence was detected.

EXHIBIT 3 Statement of Financial Position, IFRS Basis

JCL Inc.: Statement of Financial Position

as of December 31, 2012

(Amounts in Thousands of Dollars)

ASSETS LIABILITIES AND SHAREHOLDERS’ EQUITY

Current Assets Current Liabilities

Cash 33,000 Accounts payable 40,000 Accounts receivable 47,000 Accrued expenses 28,000 Inventory (FIFO basis) 67,000 Lease obligation 2,143 Total Current Assets 147,000 Taxes payable 15,000

Total Current Liabilities 85,143 Investments (Available for Sale) 20,000

Deferred income tax liability 1,750 Property, Plant, and Equipment Noncurrent Liabilities

Assets (at cost) 134,693 Lease obligation 2,315 Less: accumulated depreciation (56,122) 78,571 Bonds payable 6%, convertible 43,205 45,520 Leased assets 6,443 Total Liabilities 132,413 Less: accumulated depreciation (2,148) 4,295

Intangible Assets Trade name 4,000 Shareholders’ Equity Patent (net of 3,000 6,000 Common stock ($1 par) 60,000 accumulated amortization) Development costs (net of 200 1,800 Additional paid-in capital— 6,795 accumulated amortization) conversion feature Goodwill 5,000 16,800 Accumulated other 2,200

comprehensive income Revaluation surplus 8,571 Retained earnings 56,687 134,253

Total Assets 266,666 Total Liabilities and 266,666 Shareholders’ Equity

JANUARY 2014 / THE CPA JOURNAL26

Goodwill impairment. Under U.S. GAAP (ASC 350-20-35), impairment test- ing for goodwill is determined at the level of a reporting unit (RU). Using IFRS (IAS 16), goodwill is tested for impairment at the level of a cash-generating unit (CGU) or a group of CGUs, which may differ from RU. Under both U.S. GAAP and IFRS, a goodwill impairment loss, once recognized, cannot be reversed in a sub- sequent period.

Financial instruments. Under U.S. GAAP, the income or loss attributed to changes in the fair value of AFS securi- ties (ASC 320-10) is part of comprehen- sive income in its entirety (except to the extent that the AFS security is designated as being in a fair value hedge arrangement, in which case changes in fair value are rec- ognized in income). Under IFRS, howev- er, a foreign currency exchange gain or loss component of the change experienced in the fair value of financial instruments

attributable to the selection of a different functional currency (as described by IAS 21, The Effects of Changes in Foreign Exchange Rates) is considered part of prof- it or loss to be reported in the income state- ment. Thus, the worksheet adjustment for the transition to IFRS is as follows: (7) Dr. Accumulated OCI 2,800

Cr. Currency exchange rate gain 2,800

No reporting of extraordinary items under IFRS. Unlike U.S. GAAP, which permits separate classifications of an extraordinary item on the income statement as a separate caption below the operating income (loss) section, IAS 1, Presentation of Financial Statements, prohibits a sepa- rate presentation of extraordinary gains or losses in the statement of profit or loss and OCI (i.e., the statement of comprehensive income under U.S. GAAP). Consequently, this item must be included in the operat-

ing income (loss) section of the income statement. IFRS, however, requires the sep- arate disclosure of any item that material- ly impacts the financial statements. Unusual and infrequent items that are material meet this definition. Such items may be report- ed as a separate component of continuing operations and denoted as unusual, nonre- curring, or some similar term (but not extraordinary).

The gross amount of JCL’s hurricane loss is $3,000, net of tax ($4,000 before the 25% tax rate). The worksheet reclassi- fication adjustment is as follows: (8) Dr. Hurricane loss—unusual operating item 4,000

Cr. Extraordinary hurricane loss 3,000 Cr. Tax expense—current* 1,000

*The tax benefit would exist with an ordinary loss as well, but it is achieved through lower “income before tax.”

Loss contingencies. Both U.S. GAAP and IFRS require that loss contingencies be recognized when a future economic out- flow is probable; however, this definition of probable differs significantly between the two frameworks. U.S. GAAP defines probable as “likely” (this has been gener- ally interpreted as greater than a 70% chance of occurring). Under IAS 37, Provisions, Contingent Liabilities, and Contingent Assets, probable is defined as “more likely than not.” (This has been defined as a more than a 50% chance of occurring; see Ernst & Young Academic Resource Center: “Current Liabilities and Contingencies,” Lecture notes, 2012, p. 5.) Consequently, IFRS has a lower recogni- tion threshold for loss contingencies than U.S. GAAP.

In JCL’s case, the loss is recorded only under IFRS. The worksheet adjustment is as follows: (9) Dr. Contingency loss 3,000

Cr. Contingency liability payable 3,000 Neither U.S. GAAP nor IAS 37 recog-

nizes contingent gains until the date when recovery is virtually certain. As such, no contingency gain was realized in the cur- rent illustrative case for the U.S. GAAP financial statements; in addition, none is recognized for IFRS reporting purposes.

Compound financial instruments. From the issuer’s perspective, a convertible bond typically consists of a liability component

EXHIBIT 4 Statement of Comprehensive Income, IFRS Basis

JCL Inc.: Statement of Income

Year Ended December 31, 2012

(Amounts in Thousands of Dollars)

Sales 450,000 Cost of Goods Sold 372,648 Gross Profit 77,352 Contingency Loss 3,000 Unusual Loss—Hurricane Damages 4,000 Currency (Gains) (2,800) Other SG&A Expenses 45,200

49,400 Earnings before Interest and Taxes 27,952 Interest Expense 4,515 Income Before Tax 23,437 Tax Expense (5,500) Net Income 17,937 Other Comprehensive Income: Revaluation Surplus 8,571 Gain on Financial Instruments 2,200 Total Comprehensive Income 28,708

JANUARY 2014 / THE CPA JOURNAL 27

(a contractual obligation to deliver cash or other financial asset) and an equity instrument (the holder’s option [i.e., a call option] to convert the bond into a fixed number of common shares within a spec- ified period of time). The principle of substance over legal form is applied to compound financial instruments under IAS 32, Financial Instruments: Presentation. Thus, the component parts are accounted for and presented separately according to their substance, based on the definitions of liability and equity (referred to as “split accounting”). The split is made when the instruments are issued, and is not revised for subsequent changes in share prices, market interest rates, or other factors that might affect the likelihood that the con- version option will be exercised.

When splitting the initial carrying amount of a compound financial instru- ment into its equity and liability compo- nents, the equity component is the residu- al amount; that is, it is equal to the fair value of the instrument as a whole, less the fair value of the liability component. Therefore, the issuer of a bond convert- ible into common shares first measures the liability component at the fair value of a similar liability that does not have an equi- ty component, and the carrying amount of an equity instrument is then calculated as the difference between the fair value of a financial instrument as a whole and the fair value of the liability.

JCL issued bonds carrying a 6% coupon and a conversion feature at par. Based on an expert appraisal of JCL’s creditworthi- ness at the date the bonds were first issued and market rates of interest pre- vailing at that date for similarly risky issuers, it is determined that these bonds would have commanded a 8% yield absent the conversion feature. If bonds carrying a 6% coupon were priced to yield 8%, the JCL bonds would have brought pro- ceeds of only $43,205. To comply with IFRS, therefore, JCL must restate the lia- bility for bonds payable to reflect their intrinsic value, without the conversion fea- ture, and allocate the additional proceeds to an equity account. The discount on the bonds will be amortized, per the usual effective yield method, over their term.

If the bonds are paid off at maturity, the amount originally allocated to the conver- sion feature will remain in paid-in capital in

the equity section of the statement of finan- cial position. If the bond conversion feature is exercised, the carrying value of the bonds at the date of exercise (i.e., taking into account the amortized portion of the dis- count) will be moved to paid-in-capital, also. The worksheet adjustment is as follows: (10) Dr. Bonds payable—discount 6,795

Cr. Equity—conversion feature 6,795 Note that this bond discount of $6,795

will be accreted as additional interest expense over the life of the bonds. If the bondholder does not exercise the option, the bonds will be redeemed for cash, at full-face (par) value. If the conversion feature is not exercised, the amount allo- cated to paid-in-capital will remain as an additional paid-in capital account associ- ated with the forfeited conversion privilege.

Leases. In accordance with U.S. GAAP (ASC 840-10), if the lessee meets any of the four tests indicated below, the transaction must be accounted for as a cap- ital lease. If none of the conditions are satisfied, it will be classified as an operat- ing lease. n Test 1—Lease term is equal to or greater than 75% of the economic life of the asset. Given the facts of this case, 36 months ÷ 50 months = 72%; therefore, the 75% threshold is not met. n Test 2—Transfer of title to lessee. Not met in this case. n Test 3—Bargain purchase option. Not met; in this case, the transfer option is at market value, not bargain value. n Test 4—Present value of the minimum lease payments is equal or greater than 90% of the asset’s fair market value, using

EXHIBIT 5 Differences in Cash Flows

Account U.S. GAAP IFRS

Differences Between U.S. GAAP and IFRS Cash Flow Presentations

Interest income CFO CFO or CFI Interest expense (CFO) (CFO) or (CFF) Dividend income CFO CFO or CFI Cash dividends paid (CFF) (CFO) or (CFF)

No Changes in Cash Flows, but Reclassifications for Cash Flow Presentations

Development costs Expense (CFO) When capitalized (CFI) Lease payments If operating (CFO) If financing, (CFF)

for principal Option embedded liabilities Issuance of debt (CFF) Issuance of debt and

option for conversion (CFF)

No Effect on Cash Flows

Revaluation of assets Asset impairment losses Reversal of impairment losses Added depreciation and amortization from revalued assets Reduced depreciation and amortization from impaired assets Contingent losses accrued but unpaid Unrealized gains and losses on marketable securities Split accounting reclassification from liability to equity for compound instruments issued

Notes: CFO = cash flows from operations; CFI = cash flows from investing; CFF = cash flows from financing. Cash payments noted by parentheses.

JANUARY 2014 / THE CPA JOURNAL28

the lessee’s incremental borrowing rate as the discount factor or the implicit rate of the lease, if it is lower and is known to the lessee. In this case, the minimum lease payments are $2,500, discounted as an ordinary annuity over 3 years at the 8% interest rate (the implicit rate is not known by the lessee, so its incremental bor- rowing rate, discussed previously, is used), which yields a value of $6,443. This is slightly lower (85.9%), than 90% of the asset’s $7,500 value. Thus, Test 4 is also not met.

The facts support the conclusion that this is an operating lease (i.e., an off–balance sheet transaction), and lease payments should be accounted for as rent which, given the nature of the equipment, will probably be included in manufacturing costs, and thus in the cost of sales and in inventory, depending upon the extent to which the final sale of the goods pro- duced has occurred. For the sake of sim- plicity, it is assumed that the gross rental expense, amounting to $2,500, was includ- ed in cost of goods sold in the U.S. GAAP financial statements, with no allocation to inventory, and for the sake of consisten- cy, the non-interest (i.e., depreciation) por- tion of periodic lease expense will also be fully assigned to the cost of goods sold in the IFRS financial statements.

Under IAS 17, Leases, more general cri- teria based on the substance of the lease are used to determine whether a lease is a capi- tal/finance lease. If the lessee assumes the substantial economic benefits and the risks associated with the leased asset, then the

transaction is treated as a capital/finance lease. Specifically, because this machine is spe- cialized for JCL’s use, it is likely that JCL will elect to either purchase the asset or extend the lease when the three-year term is completed. In addition, because many of the tests under GAAP are nearly met, there are strong indications that a capital/finance clas- sification is warranted, rather than an oper- ating lease classification. Presumably, JCL would be able to circumvent the capital lease rules under U.S. GAAP by making arguable and favorable assumptions and estimates, such as the 50-month useful life of the leased assets—but the more “principles-based” IFRS requirement would seemingly preclude this result.

If classified as a capital/finance lease, the lease is amortized as shown in the side- bar, Amortization Table.

The worksheet adjustments to reclassi- fy this as a financing lease under IFRS are as follows: (11) Dr. Leased asset 6,443

Cr. Minimum lease obligation 6,443 (12) Dr. Depreciation expense 2,148

Cr. Accumulated depreciation 2,148 (13) Dr. Interest expense 515 Dr. Minimum lease obligation 1,985

Cr. Rent expense/ manufacturing costs 2,500

The balance of the minimum lease obligation at the year-end is $4,458 ($6,443 less $1,985); of this total obligation, $2,143 is current and $2,315 is long term.

IFRS Basis Given the above adjustments, JCL’s

IFRS-compliant statement of financial posi- tion as of December 31, 2012, and the income statement for the year then ended are show in Exhibit 3 and Exhibit 4. Note that this case study employs the com- bined statement of income and compre- hensive income approach, with a functional classification of expenses. Alternatively, separate statements of income and of com- prehensive income could be provided, and expenses could be classified by their nature rather than function.

Impact on Cash Flows The different treatments noted above in

the discussion of the statements of finan- cial position and the income statements will necessarily lead to differing statements of cash flows. With regard to the cash flow, there are several differences between U.S. GAAP and IFRS. Exhibit 5 presents the following differences: n Classification of cash flows (only) between IFRS and U.S. GAAP; n Items connoting no change in cash flows, but reclassifications resulting from IFRS–U.S. GAAP accounting differ- ences; n IFRS–U.S. GAAP differences that have no effect on cash flows or presentation; and n C a sh flow c ha nge s c re a ted by IFRS–U.S. GAAP differences.

Effect of Tax Obligations The final category of differential

treatment under U.S. GAAP and IFRS pertains to those situations where the dis- parity in accounting has consequential effects, most typically in the form of higher or lower tax obligations. This is illustrated by the disallowance of the LIFO inventory costing method under IFRS, which has corresponding implica- tions for tax payments due currently. In the general case of rising prices, an enti- ty’s gross profits will be higher under IFRS (versus using LIFO under U.S. GAAP), resulting in higher cash tax pay- ments. If FIFO is used, the added tax pay- ment will equal the difference in the LIFO reserve created during the year (meaning a higher pre-tax income), multiplied by the tax rate. In the case of JCL, the added cash tax payment will be $500 ($2,000 × .25).

AMORTIZATION TABLE

Minimum Lease

Obligation Balance

Date Payment Interest (8%) Principal (Present Value)

Jan. 1, 2012 $6,443

Dec. 31, 2012 $2,500 $515 $1,985 4,458

Dec. 31, 2013 2,500 357 2,143 2,315

Dec. 31, 2014 2,500 185 2,315 0

Totals $7,500 $817 $6,443

JANUARY 2014 / THE CPA JOURNAL 29

Effects on Financial Ratios Any changes made to the statement

of financial position and income state- ment will inevitably affect some of the ratios commonly used by analysts, lenders, and even management. The direction of the changes will depend on many factors, some of which are very sit- uation-specific. The following changes would be experienced by JCL when con- verting to IFRS (effects that would commonly be perceived to be improve- ments are shown in bold):

U.S. Ratio GAAP IFRS Current ratio 1.75 1.73 Debt ratio .53 .497 Debt to equity 1.13 .99 Times interest earned 7.0 6.19 Inventory turnover 6.25 5.56 Return on assets 6.12% 6.73% Gross profit 16.67% 17.20% Net profit margin 3.33% 3.99% Asset turnover 1.838 1.688 Leverage ratio 2.13 1.99 Return on equity 13.04% 13.36%

Although the effects are modest, it is important to appreciate the fact that some mandatory changes when adopting IFRS will have impacts on the financial ratios that many third parties (i.e., investors and lenders) rely upon to make credit or investing deci- sions. Some of the expected impacts flow directly, and intuitively, from the different requirements imposed by IFRS.

For example, under IFRS, inventory and earnings will be greater than under U.S. GAAP if LIFO is employed by the reporting entity. In addition, because of IFRS rules pertaining to the capitalization of development expenses, assets and earnings will tend to be enhanced, at least in the years when those costs are being incurred (which then must be amortized in future years, lowering earnings, holding other factors constant).

If a reporting entity avails itself of the option to revalue long-lived assets, this will also enhance the statement of financial position, and accordingly improve certain financial ratios. Nevertheless, financial statement users are alert to these effects, particularly in the case of items, such as revaluations, that have no current or future salutary effects on cash flows.

Some critics might say that, given the somewhat greater accounting flexibility it

provides, IFRS presents more prospects for earnings management and income volatil- ity. This possibility is constrained, if not fully eliminated, by the need for consistent application of chosen accounting princi- ples, which is as much an imperative under IFRS as it is under U.S. GAAP.

Limitations The above case study ignores the fact

that entities adopting IFRS must follow the requirements set out in IFRS 1. In accor- dance with IFRS 1, entities initially adopting IFRS must present at least one year of comparative information, disclos- ing all applicable exemptions, explanations of the transition, IAS 36 disclosures for impairments identified during the transi- tion, and historical summaries under pre- vious GAAP. In principle, IFRS 1 stipu- lates that an entity should apply the current version of IFRS for all periods presented in its first set of IFRS financial statements, as well as in its opening IFRS statement of financial position (at the beginning of the earliest period presented), without con- sidering superseded or amended versions.

Thus, IFRS 1 requires retrospective application of the standards effective as of the reporting date of an entity’s first IFRS-compliant financial statements. But IFRS 1 prohibits retrospective application of some aspects of other standards (“mandatory exceptions”), and permits elective exemptions from some require- ments of other standards (“optional exemp- tions”). An entity will thus have choices between different options of accounting policies within IFRS 1, as well as within other standards, that must be resolved when preparing its first IFRS financial statements.

Conclusion Consequent to the SEC report issued in

July 2012, it seems unlikely that full-scale adoption of IFRS in the United States will occur in the foreseeable future (see Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. Issuers, and the IASB’s response in IFRS Foundation Staff Analysis of the SEC Final Staff Report—Work Plan for the consideration of incorporating IFRS into the financial reporting system for U.S. issuers, October 2012). Nevertheless, IFRS comprehen-

sion is critical for U.S. preparers and users of financial information, as most non- U.S. countries, as well as many foreign- domiciled subsidiaries of U.S. entities, require its use. In today’s ever continuing expanding global economy, it is highly likely that CPAs will undertake engage- ments that require IFRS knowledge. Equally important is the need for future CPAs to obtain a solid understanding of IFRS during their education. The above case study is intended to help further these goals. q

Peter Harris, CPA, CFA, is a professor at the New York Institute of Technology, New York, N.Y. Eva K. Jermakowicz, PhD, CPA, is a professor and head of the department of accounting at Tennessee State University, Nashville, Tenn. Barry Jay Epstein, PhD, CPA/CFF, is a prin- cipal at Cendrowski Corporate Advisors LLC, Chicago, Ill.

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