OBSTACLES TO WORLDWIDE COMPARABILITY OF FINANCIAL- 123docz.net

IFRS and U.S. GAAP are the dominant accounting standards worldwide. In January 2007, a study conducted by the Financial Timesdetermined that U.S. GAAP was used by companies comprising 35 percent of global market capitalization; companies making up 55 percent of global market capitalization were using or planning to use IFRS; and only 10 percent were using some other set of rules for financial reporting purposes.34If the FASB–IASB convergence project progresses to the point where most substantive differences between the two sets of standards have been eliminated, or the SEC requires adoption of IFRS by U.S. companies, some day most major companies worldwide could use similar accounting rules. When that day arrives, will the objective of accounting harmonization have been achieved? Will financial statements truly be comparable across countries? The use of a common set of accounting standards is a necessary but perhaps not a sufficient condition for ensuring worldwide comparability. Several obstacles stand in the way of a common set of standards being interpreted and applied in a consistent manner across all countries.35

Translation of IFRS into Other Languages

IFRS are written in English and therefore must be translated into other languages for use by non-English-speaking accountants. The IASB created an official translation process in 1997, and by the end of 2006, IFRS had been translated into more than 40 other languages. Most translations are into European languages because of the European Union’s required usage of IFRS. However, IFRS also have been translated into Chinese, Japanese, and Arabic. Despite the care the IASB took in the translation process, several research studies suggest that certain English-language expressions used in IFRS are difficult to translate without some distortion of meaning. In one study, Canadian researchers examined English-speaking and French- speaking students’ interpretations of probability expressions such as probable, not likely, andreasonable assuranceused to establish recognition and disclosure thresholds in IASs.36 English-speaking students’ interpretations of these expressions differed significantly from the interpretations made by French-speaking students of the French-language translation. In another study, German accountants fluent in English assigned values to both the English original and the German translation of probability expressions used in IFRS.37For several expressions, the original and translation were interpreted differently, suggesting that the German translation distorted the original meaning.

As an example, IFRS (and U.S. GAAP) use the term remotethat appears particularly difficult to translate in a consistent fashion. IAS 37,“Provisions, Contingent Liabilities and Con- tingent Assets,” indicates that a contingent liability is disclosed “unless the possibility of an outflow of resources embodying economic benefits is remote” (para. 28), and IAS 31,“Inter- ests in Joint Ventures,” requires separate disclosure of specific types of contingent liabilities

33Katrin Burkhardt and Silvia Schütte, representing the Bundesverband deutscher Banken, in a letter written to Sir David Tweedie, chairman of the IASB, dated October 21, 2003, and cataloged by the IASB as CL59 Bundesverband deutscher Banken.

34Financial Times, “IFRS vs US GAAP,” January 9, 2007, www.ft.com.

35The following discussion is based on George T. Tsakumis, David R. Campbell Sr., and Timothy S. Doupnik,

“IFRS: Beyond the Standards,” Journal of Accountancy, February 2009, pp. 34–39.

36Ronald A. Davidson and Heidi Hadlich Chrisman, “Interlinguistic Comparison of International Accounting Standards: The Case of Uncertainty Expressions,” The International Journal of Accounting28 (1993), pp. 1–16.

37Timothy S. Doupnik and Martin Richter, “Interpretation of Uncertainty Expressions: A Cross-National Study,”

Accounting, Organizations and Society28 (2003), pp. 15–35.

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“unless the probability of loss is remote” (para. 54). It would appear that remoteis intended to establish a similar threshold for disclosure in both standards.

French translations of remotein both IAS 31and IAS 37use the word faible (weak). How- ever, the adjective trés (very)is added to form the expression trés faiblein IAS 31. Thus, remoteis literally translated as “weak” (faible)in IAS 37and “very weak” (trés faible)in IAS 31. Preparers of financial statements using the French translation of IFRS might interpret IAS 31as establishing a stronger test than IAS 37for avoiding disclosure.

Translating remoteinto German presents even greater difficulty. IAS 31uses the German word unwahrscheinlich (improbable),and IAS 37uses the phrase ọu␤erst gering (extremely remote). The German translation of IAS 31appears to establish a more stringent threshold for nondisclosure of contingent liabilities than does the German translation of IAS 37,and it is questionable whether either threshold is the same as the original in English. The SEC im- plicitly acknowledged the potential problem in translating IFRS to other languages in its rule eliminating the U.S. GAAP reconciliation requirement for foreign registrants. That rule applies only to those foreign companies that prepare financial statements in accordance with the English language version of IFRS.

The Impact of Culture on Financial Reporting

Even if translating IFRS into languages other than English was not difficult, differences in national culture values could lead to differences in the interpretation and application of IFRS.

As described earlier in this chapter, Gray proposed a model that hypothesizes a relationship between cultural values, accounting values, and the financial reporting rules developed in a country. More recently, Gray’s model was extended to hypothesize that accounting values not only affect a country’s accounting rules but also the manner in which those rules are applied.38 This hypothesis has important implications for a world in which countries with different national cultures use the same accounting standards. It implies that for accounting issues in which accountants must use their judgment in applying an accounting principle, culturally based biases could cause accountants in one country to apply the standard differently from accountants in another country.

Several research studies support this hypothesis.39For example, one study found that, given the same set of facts, accountants in France and Germany estimated higher amounts of war- ranty expense than did accountants in the United Kingdom.40This result was consistent with differences in the level of the accounting value of conservatism across these countries resulting from differences in their cultural values. Financial statement users need to be aware that the use of a common set of accounting standards will not lead to complete financial statement comparability across countries. However, a greater degree of comparability will exist than if each country were to continue to use a different set of standards.

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38Doupnik and Tsakumis, “A Critical Review of Gray’s Theory.”

39See Joseph J. Schultz and Thomas J. Lopez, “The Impact of National Influence on Accounting Estimates:

Implications for International Accounting Standard-Setters,” The International Journal of Accounting36 (2001), pp. 271–90; Timothy S. Doupnik and Martin Richter, “The Impact of Culture on the Interpretation of ‘In Context’ Verbal Probability Expressions,” Journal of International Accounting Research3(1), 2004, pp. 1–20; and George T. Tsakumis, “The Influence of Culture on Accountants’ Application of Financial Reporting Rules,” Abacus, March 2007, pp. 27–48.

40Schultz and Lopez, “The Impact of National Influence on Accounting Estimates.”

Summary 1. Historically, considerable diversity existed with respect to financial reporting across countries. Dif- ferences include the format and presentation of financial statements, the measurement and recognition rules followed in preparing financial statements, disclosures provided in the notes to financial statements, and even in the terminology used to describe items reported on financial statements.

2. Accounting systems differ across countries partially because of differences in environmental factors such as the type of legal system followed in the country, the importance of equity as a source of financing, and the extent to which accounting statements serve as the basis for taxation. Culture also plays a role in the development of accounting systems and can influence the manner in which accountants interpret and apply accounting standards.

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Worldwide Accounting Diversity and International Standards 523 3. Nobes argues that the primary cause for differences in accounting systems involves differences in the extent to which countries use an equity-outsider financing system. Countries with a strong equity-outsider financing system have a Class A accounting system geared toward providing information that is useful in making investment decisions. Weak equity-outsider financing system countries have a Class B accounting system oriented more toward creditors and provides a basis for taxation.

Empirical research supports Nobes’s notion of two dominant classes of accounting system.

4. The worldwide diversity in accounting practices causes problems that can be quite serious for some parties. Parent companies with foreign subsidiaries must convert from foreign GAAP to parent company GAAP to prepare worldwide consolidated financial statements. To gain access to a foreign capital market, companies often find it necessary to prepare information based on foreign GAAP. This is especially true for foreign companies wishing to gain access to the U.S. capital market. Account- ing diversity makes it difficult for potential investors to compare financial statements between companies from different countries in making international investment decisions.

5. Harmonizationis the process of reducing differences in financial reporting across countries, thereby increasing the comparability of financial statements. The ultimate form of harmonization would be the use of similar financial reporting standards by all companies in the world.

6. The European Union attempted to harmonize accounting standards across its member nations through the issuance of the Fourth and Seventh Directives. Although these directives significantly reduced the differences that had existed previously, they did not result in complete comparability of financial statements across the European Union.

7. The International Accounting Standards Committee (IASC) was formed in 1973 to develop international accounting standards (IASs) universally acceptable in all countries. The so-called IOSCO agreement significantly enhanced the IASC’s legitimacy as the international accounting standard setter.

8. In 2001, the International Accounting Standards Board (IASB) replaced the IASC and adopted the IASs developed by its predecessor. The IASB creates its own international financial reporting standards (IFRSs). Together, IASs, IFRSs, and Interpretations make up IASB GAAP and are referred to collectively as IFRS.

9. The IASB does not have the ability to require the use of its standards. However, a relatively large number of countries either require or allow domestic companies to use IFRS. Since 2005, all publicly traded companies in the European Union have been required to use IFRS in preparing their consolidated financial statements.

10. In 2002, the FASB and the IASB announced the Norwalk Agreement to converge their financial reporting standards as soon as is practicable. The FASB’s initiatives to further convergence include a short-term project to eliminate differences in which convergence is likely to be achievable in the short term by selecting either existing U.S. GAAP or IASB requirements. The FASB and IASB also are jointly working on several projects that deal with broader issues, including a project to create a common conceptual framework. In addition, a full-time member of the IASB serves as a liaison with the FASB.

11. In 2007, the U.S. SEC eliminated the U.S. GAAP reconciliation requirement for foreign companies that use IFRS, and in 2008, it issued an IFRS Roadmap that proposes the use of IFRS by U.S. companies. The SEC will monitor several milestones until 2011 and then make a decision whether to require U.S. publicly traded companies to use IFRS beginning as early as 2014.

12. IFRS 1establishes procedures to be followed in the first-time adoption of IFRS. IFRS 1requires the preparation of an opening IFRS balance sheet two years prior to when a company publishes its first set of IFRS financial statements. In preparing the opening IFRS balance sheet a company would need to (a) recognize assets and liabilities required by IFRS but not by previous GAAP and derec- ognize items previously recognized that are not allowed under IFRS, (b) measure assets and liabilities in accordance with IFRS, (c) reclassify items previously classified in a different manner from what it required by IFRS, and (d) comply with all disclosure and presentation requirements.

13. Numerous differences between IFRS and U.S. GAAP exist. These differences can be categorized as re- lating to (a) recognition, (b) measurement, (c) presentation, and (d) disclosure. Recognizing development costs as an asset when certain criteria are met under IFRS while requiring they be expensed under U.S. GAAP is an example of a recognition difference. Carrying fixed assets on the balance sheet at revalued amounts under IFRS versus depreciated historical cost under U.S. GAAP is a measurement difference. Presenting certain gains and losses on the income statement as extraordinary items under U.S. GAAP, which is not acceptable under IFRS, is an example of a presentation difference.

14. The IASB has taken a principles-based approach to standard setting rather than the rules-based approach of the FASB. IASB standards provide a general principle with some guidance but try to avoid overly detailed guidance and bright-line tests. The classification of leases is an area that highlights hoy36628_ch11_489-532.qxd 1/23/10 7:53 PM Page 523

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the difference in standard-setting approach. Some have expressed concern that the FASB–IASB convergence process may result in IASB standards becoming more rules based.

15. The use of the same set of accounting standards by all companies is a necessary but possibly insuf- ficient condition for achieving the goal of worldwide comparability of financial statements. Trans- lation and culture are two obstacles in achieving this goal. It might not be possible to translate IFRS into non-English languages without some distortion of meaning. Differences in societal values across countries might lead to culturally determined biases in interpreting and applying a common set of standards. However, although these obstacles exist, worldwide adoption of a single set of standards results in a greater degree of comparability than would exist with a different set of standards used by each country.

Comprehensive Illustration PROBLEM

(Estimated Time: 60 minutes) Bastion Company is a U.S.-based company that prepares its consolidated financial statements in accordance with U.S. GAAP. The company reported income in 2010 of $2,000,000 and stockholders’ equity at December 31, 2010, of $15,000,000.

Bastion is aware that the U.S. Securities and Exchange Commission might require U.S. companies to use IFRS in preparing consolidated financial statements. The company wishes to determine the impact that a switch to IFRS would have on its financial statements and has engaged you to prepare a reconciliation of income and stockholders’ equity from U.S. GAAP to IFRS. You have iden- tified the following six areas in which Bastion’s accounting principles based on U.S. GAAP differ from IFRS.

1. Inventory—lower of cost or market.

2. Property, plant, and equipment—measurement subsequent to initial recognition.

3. Intangible assets—research and development costs.

4. Sale and leaseback—gain on sale.

5. Pension plan—past service costs.

6. Property, plant, and equipment—impairment.

Bastion provides the following information with respect to each of these accounting differences.

Inventory

At year-end 2010, inventory had a historical cost of $400,000, a replacement cost of $360,000, and a net realizable value of $380,000; the normal profit margin was 20 percent.

Property, Plant, and Equipment

Bastion acquired a building at the beginning of 2009 at a cost of $5,000,000. The building has an estimated useful life of 25 years, has an estimated residual value of $1,000,000, and is being depreciated on a straight-line basis. At the beginning of 2010, the building was appraised and determined to have a fair value of $5,440,000. There is no change in estimated useful life or residual value. In a switch to IFRS, the company would use the revaluation model in IAS 16to determine the carrying value of property, plant, and equipment subsequent to acquisition.

Research and Development Costs

Bastion incurred research and development costs of $2,000,000 in 2010. Of this amount, 40 percent related to development activities subsequent to the point at which criteria indicating the creation of an intangible asset had been met. As of the end of the year, development of the new product had not been completed.

Sale and Leaseback

In January 2008, Bastion realized a gain on the sale and leaseback of an office building in the amount of

$3,000,000. The lease is accounted for as an operating lease and the term of the lease is five years.

Pension Plan

In 2009 the company amended its pension plan creating a prior service cost of $240,000. The average remaining number of years to be worked by the employees affected by the amendment is 15 years. Half of the prior service cost was attributable to already vested employees and half of the prior service cost was hoy36628_ch11_489-532.qxd 1/23/10 7:53 PM Page 524

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Worldwide Accounting Diversity and International Standards 525 attributable to nonvested employees who on average had three more years until vesting. The company has no retired employees.

Property, Plant, and Equipment

Bastion owns machinery on December 31, 2010, that has a book value of $440,000, an estimated salvage value of $40,000, and an estimated remaining useful life of 10 years. On that date, the machinery is expected to generate future cash flows of $450,000 and it is estimated to have a fair value, after deducting costs to sell, of $360,000. The present value of expected future cash flows is $375,000.

Required

Prepare a schedule reconciling U.S. GAAP net income and stockholders’ equity to IFRS.

SOLUTION

Bastion Company Reconciliation from U.S. GAAP to IFRS

2010 Income under U.S. GAAP . . . $2,000,000 Adjustments:

1. Inventory writedown . . . 20,000 2. Building revaluation . . . (25,000) 3. Deferred development costs . . . 800,000 4. Gain on sale and leaseback . . . (600,000) 5. Past service cost . . . (24,000) 6. Impairment loss on machinery . . . 65,000) Income under IFRS . . . $2,106,000

2010 Stockholders’ equity under U.S. GAAP . . . $15,000,000 Adjustments:

1. Inventory writedown . . . 20,000 2. Building revaluation . . . 575,000 3. Deferred development costs . . . 800,000 4. Gain on sale and leaseback . . . 1,200,000 5. Past service cost . . . (168,000) 6. Impairment of machinery . . . (65,000) Stockholders’ equity under IFRS . . . $17,362,000

Explanation

1. Inventory Writedown. 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 ($360,000), with net realizable value ($380,000) as a ceiling and net realizable value less a normal profit ($380,000 ⫻80% ⫽$304,000) as a floor. In this case, inventory was written down to replacement cost and reported on the December 31, 2010, balance sheet at $360,000. A $40,000 loss was included in 2010 income.

In accordance with IAS 2,the company would report inventory on the balance sheet at the lower of cost ($400,000) and net realizable value ($380,000). The inventory would have been reported on the December 31, 2010, balance sheet at net realizable value of $380,000 and a loss on writedown of inventory of $20,000 would have been reflected in net income. As a result, IFRS income would be $20,000 larger than U.S. GAAP net income. IFRS retained earnings would be larger by the same amount.

2. Building Revaluation. Under U.S. GAAP, the company reports depreciation expense of $160,000 [($5,000,000 ⫺$1,000,000)/25 years] in 2009 and in 2010.

UnderIAS 16’s revaluation model, depreciation expense on the building in 2009 was $160,000, resulting in a book value at the end of 2009 of $4,840,000. The building then would have been revalued hoy36628_ch11_489-532.qxd 1/23/10 7:53 PM Page 525

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upward at the beginning of 2010 to its fair value of $5,440,000. The appropriate journal entry to recognize the revaluation would be:

Building . . . . 600,000

Revaluation Surplus (a stockholders’ equity account) . . . . 600,000 In 2010, depreciation expense would be $185,000 [($5,440,000 ⫺$1,000,000)/24 years].

The additional depreciation under IFRS causes IFRS-based income in 2010 to be $25,000 smaller than U.S. GAAP income. IFRS-based stockholders’ equity is $575,000 larger than U.S. GAAP stockholders’ equity. This is equal to the amount of the revaluation surplus ($600,000) less the additional depreciation in 2010 under IFRS ($25,000), which reduced retained earnings.

3. Deferred Development Costs. Under U.S. GAAP, research and development expense in the amount of $2,000,000 would be recognized in determining 2010 income.

Under IAS 38,$1,200,000 (60% ⫻$2,000,000) of research and development costs would be expensed in 2010, and $800,000 (40% ⫻$2,000,000) of development costs would be capitalized as an intangible asset (deferred development costs). IFRS income in 2010 would be $800,000 larger than U.S.

GAAP income. Because the new product has not yet been brought to market, there is no amortization of the deferred development costs under IFRS in 2010. Stockholders’ equity under IFRS at the end of 2010 would be $800,000 larger than under U.S. GAAP.

4. Gain on Sale and Leaseback. Under U.S. GAAP, the gain on the sale and leaseback (operating lease) is recognized in income over the life of the lease. With a lease term of five years, $600,000 of the gain would be recognized in 2010. $600,000 also would have been recognized in 2008 and 2009, resulting in a cumulative amount of retained earnings at year-end 2010 of $1,800,000.

Under IAS 13,the entire gain on the sale and leaseback of $3,000,000 would have been recognized in income in 2008. This resulted in an increase in retained earnings of $3,000,000 in that year. No gain would be recognized in 2010. IFRS income in 2010 would be $600,000 smaller than U.S. GAAP income, but stockholders’ equity at December 31, 2010, under IFRS would be $1,200,000 ($3,000,000 ⫺

$1,800,000) larger than under U.S. GAAP.

5. Prior Service Costs. Under U.S. GAAP, the prior service cost of $240,000 is amortized over the remaining service period (number of years to be worked) of the employees. Expense recognized in 2010 is

$16,000 [$240,000/15 years]. The cumulative expense recognized since the plan was changed in 2009 is

$32,000 [$16,000 ⫻2 years].

Under IAS 19,the prior (past) service cost attributable to the vested employees would have been expensed in 2009—$120,000 [50% ⫻$240,000]. The past service cost attributable to nonvested employees would be expensed over the three remaining years until vesting. Expense recognized in 2010 would be $40,000 [$120,000/3 years]. The cumulative expense recognized since the plan was changed is $200,000 [$120,000 ⫹($40,000 ⫻2 years)]. IFRS income in 2010 would be $24,000 less than U.S. GAAP income [$40,000 ⫺$16,000], and stockholders’ equity at year-end 2010 under IFRS would be $168,000 less than under U.S. GAAP [$200,000 ⫺$32,000].

6. Impairment of Machinery. Under U.S. GAAP, an impairment occurs when an asset’s carrying value exceeds its undiscounted expected future cash flows. In this case, the expected future cash flows are $450,000, which is higher than the machinery’s carrying value of $440,000, so no impairment occurred.

Under IAS 36,an asset is impaired when its carrying value exceeds the higher of (1) its value in use (present value of expected future cash flows) and (2) its fair value less costs to sell. The machinery has a value in use of $375,000 and its fair value less costs to sell is $360,000. An impairment loss of

$65,000 [$440,000 ⫺$375,000] would be recognized in determining 2010 net income, with a corre- sponding reduction in retained earnings. IFRS income in 2010 is $65,000 smaller than U.S. GAAP income, and stockholders’ equity at year-end 2010 under IFRS would be $65,000 smaller than under U.S. GAAP.

Questions 1. What factors contribute to the diversity of accounting systems worldwide?

2. Nestlé S.A.is a very large company headquartered in a very small country (Switzerland). It has op- erations in more than 50 different countries around the world. Much of the company’s international expansion has been through the acquisition of local (i.e., foreign) companies. What major problems does worldwide accounting diversity cause for a company like Nestlé?

3. According to Gray, how do societal values affect national accounting systems?

4. According to Nobes, what is the relationship between culture, type of financing system, and class of accounting?

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OBSTACLES TO WORLDWIDE COMPARABILITY OF FINANCIAL STATEMENTS

ACCOUNTING PROCEDURES USED IN APPLYING THE EQUITY METHOD

EXCESS OF INVESTMENT COST OVER BOOK VALUE ACQUIRED