US GAAP versus IFRS Standards
A deeper look into the differences between US and
International Accounting Standards for Business
Combinations and Foreign Exchange Transactions
Writers:
Alan Howitt
Kevin Johnson
Andrew Meek
Matthew Mong
ACC 401
Professor Mohammad S. Bazaz
April 12, 2007
Contributions
Name
Contribution %
Alan Howitt
0%*
Kevin Johnson
33.33%
Andrew Meek
33.33%
Matt Mong
33.33%
*Kevin, Andrew, and Matt do not accept Alan's work as part of their paper. Included in this paper is the work of Kevin, Andrew, and Matt.
Executive Summary
During the past few years the topic of converging accounting standards in the United States has become increasingly relevant given the greater level of globalization in modern day business. For the purpose of this paper, we will be focusing on the comparison of US Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) that pertain specifically to business combinations and consolidations. The major points of interest will include business combinations and consolidations, goodwill, minority interest, and foreign currency transactions and translation.
We will discuss when a business is required to prepare consolidated financial statements under GAAP and IFRS and the reporting requirements for an investment in another company to be considered a subsidiary. Some potential differences are the date when a company recognizes a business combination, how to treat research and development costs, and two different methods of accounting for business combinations and why one of these methods has recently been disallowed among international and US accounting standards.
Goodwill is an area in which the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) have worked hard to try and standardize the reporting rules in order to make it easier to account for goodwill. In the past few years the IASB has created IFRS 3 and IAS 36, which made an attempt to align with SFAS 141 and SFAS 142. Some of the important issues affecting goodwill that have not been agreed upon include methods of testing for impairment and accounting for negative goodwill.
There are differences in the way the United States, under GAAP, and other countries, follow international accounting standards representing minority interest. The main differences include where minority interest appears on the consolidated balance sheet and the method used to determine the amount of minority interest reported.
Foreign currency transactions and translation still remain an area with many sizeable differences between GAAP and IFRS. There are differences between how foreign subsidiaries determine their functional currency and how that currency is translated or remeasured into the reporting currency of the parent organization. A major difference between the two sets of standards is how each account for foreign subsidiaries operating in a hyperinflationary economy. A second significant difference is how each deals with gains and losses from foreign currency transactions and translates them to the parents reporting currency.
Both the IASB and the FASB realize the importance of converging their standards, and will continue to work together to harmonize their standards in order to create global efficiency pertaining to financial accounting. In an effort to facilitate the process, the IASB has stated that it will not issue any major standards until 2009. This will give many countries that currently do not use IASB standards a chance to become compliant with the current standards.
Table of Contents
INTRODUCTION 1
BUSINESS COMBINATIONS 1
Goodwill: FASB Issues SFAS 142 2
The Test for Impairment of Goodwill - U.S. Standard 3
IASB Addresses Goodwill with IFRS 3 3
The Test for Impairment of Goodwill - International Standard 5
Effects on Earnings 5
Other Effects of Incurring Impairment Loss 6
Negative Goodwill 6
Reversal of Impairment Loss 7
Minority Interest 7
Consolidated Financial Statements 8
Foreign Currency Translation - Functional Currency 9
Hyperinflation 9
The Argentine Peso and Inflation Rates 11
Foreign Currency Transactions 12
Financial Instruments, Derivatives, and Hedging 13
Conclusion 16
Reflection 17
Works Cited 18
Introduction
In today's modern business world, the term 'globalization' has become the norm. Businesses are taking more risks to expand their operations for many reasons, including the potential for increased market share, brand recognition, and lower production and labor costs. With each business taking on a more global identity, there has been a movement to converge US accounting standards with global standards. In April of 2001, the International Accounting Standards Committee (IASC) formed the International Accounting Standards Board (IASB). The IASB has taken the responsibility of setting international accounting standards. A major goal of the IASB is to work towards greater comparability of financial statements between different countries. A major area that the IABS has been working on is revising standards for business combinations and consolidations.
Business Combinations
In the past, International Accounting Standard 22 (IAS 22) was one of the major sections on business combinations, which focused on a number of subtopics important in helping to compare US and international standards. On January 1, 2005, IAS 22 was superseded by International Financial Reporting Standard 3 (IFRS 3), a new standard to account for business combinations. This was one of the first issues taken on by the IASB to progress its goal of working towards convergence of international standards with US standards.
A business combination is a general term for combining all forms of previously separate business entities. This includes acquisitions, mergers, and consolidations. Two methods have been used to account for business combinations in the past. These two methods are the purchases method and the pooling of interests method. Over the past decade, questions have arisen as to which method to use. The purchases method measures the cost of the acquired entity by taking into account its historical cost and any differences in the fair market value of its net assets. The purchases method assigns any portion of excess fair market value over the purchase price to goodwill. The pooling of interests method uses book values to record combinations rather than fair values. The main difference regarding the pooling of interest method is that it does not recognize goodwill.
The main advantage of using the pooling of interests method is that it increases earnings for companies, since they do not have to recognize goodwill. The main disadvantages of the pooling of interests method is that it provides less relevant information to stakeholders, ignores value exchanged in transactions, making it difficult to evaluate company performance, and using two different methods, in general, makes it difficult for financial statement users to compare financial statements of different companies.
The IASB has come a very long way in its development of its standards pertaining to the two methods used in business combinations. The IASB relinquished the use of the pooling of interests method on July 5, 2001, and international business combination standards were further revised when IFRS 3 came out in 2005.
Along with the decision to eliminate the pooling of interests method in IFRS 3, there was also a change in the measurement of restructuring liabilities relating to business combinations. In business combinations, the acquiring company currently cannot recognize future losses or restructuring costs as part of the combination. Instead, these costs must be treated as an expense after the combination takes place. Also, these costs are only recognized if a liability exists at the acquisition date.
In 2005, the European Union mandated that all 25 of its nations must comply with International Financial Reporting Standards and International Accounting Standards (Struffert 2006 22). While there was much criticism since the issuance of IFRS 3, this change was later regarded as positive in converging US standards with international standards.
Goodwill: FASB Issues SFAS 142
One of the major changes in accounting for goodwill in the United States was made with the issuance of SFAS 142 in June of 2001. The key changes in SFAS 142 regarding goodwill involve the amortization of goodwill and the useful life of goodwill. Previously, goodwill was assigned a useful life of forty years and amortized over that time period. However, it was deemed that goodwill was not a wasting asset, but rather an asset with an infinite life. In addition, amortization for goodwill was eliminated. Instead of amortizing goodwill over its useful life, under SFAS 142, goodwill is to be tested for impairment at least annually and not amortized. With regard to other intangible assets that do have useful lives, they will still be amortized, but not over the previous life of forty years, as this was deemed too arbitrary.
Furthermore, SFAS 142 provides additional requirements for disclosure of goodwill and intangible assets in the years after the acquisition. These requirements include, "information about the changes in the carrying amount of goodwill from period to period, the carrying amount of intangible assets by major intangible asset class for those assets subject to amortization and for those not subject to amortization, and the estimated intangible asset amortization expense for the next five years" (FASB 142).
The overriding goals from the issuance of SFAS 142 include a better reflection of the underlying economic factors on the financial statements ...
This is a preview of the whole essay
Furthermore, SFAS 142 provides additional requirements for disclosure of goodwill and intangible assets in the years after the acquisition. These requirements include, "information about the changes in the carrying amount of goodwill from period to period, the carrying amount of intangible assets by major intangible asset class for those assets subject to amortization and for those not subject to amortization, and the estimated intangible asset amortization expense for the next five years" (FASB 142).
The overriding goals from the issuance of SFAS 142 include a better reflection of the underlying economic factors on the financial statements of any acquired goodwill as well as the benefit of a better understanding of the expectations about changes in the intangible assets from the enhanced disclosures.
The Test for Impairment of Goodwill - U.S. Standard
SFAS 142 provides a two step process of testing for impairment of goodwill. After determining the fair value of the reporting unit, the first step tests for whether impairment exists and the second step determines the amount of the impairment. "Certain criteria are the requirement to test goodwill for impairment annually and can be satisfied without a remeasurement of the fair value of a reporting unit" (FASB 142).
In testing for impairment, one begins by assigning recorded goodwill to reporting units (Huefner and Largay 2004 32). Huefner and Largay state that reporting units "could be the company's operating segments identified under SFAS 131, or a 'component' of a reportable operating segment as defined in paragraph 30 of SFAS 142" (2004 32). In the first step of this process, the fair value of the reporting unit is compared with the book value of the reporting unit, and if the fair value is greater than the book value, no impairment exists (Huefner and Largay 2004 32). The second step is implemented when the reporting unit's book value exceeds its fair value (Huefner and Largay 2004 32).
In the second step, the implied fair value of reporting unit's goodwill is estimated (Huefner and Largay 2004 32). This is done by subtracting the reporting unit's identifiable net assets at fair value from the unit's estimated fair value to give the fair value of the goodwill (Huefner and Largay 2004 32). This figure is then compared with the current book value of the goodwill. When the book value of the goodwill exceeds the fair value, there is impairment loss, and the company must record the difference as an impairment loss (Huefner and Largay 2004 32). Also included in SFAS 142 is guidance for the impairment test on other intangible assets that will not be amortized. For these assets, an impairment test will be conducted at least annually, as long as it is at the same time each year, by comparing fair values to recorded amounts.
IASB Addresses Goodwill with IFRS 3
One of the additional major changes brought about by IFRS 3 follows the changes made in the United States with SFAS 142. Previously recorded goodwill was accounted for under many different methods. For a summary of these methods please refer to Figure 1. Under IFRS 3, goodwill is no longer to be assigned a fixed, arbitrary useful life and amortized over this useful life. Amortization of goodwill is eliminated. Instead goodwill and other intangibles with an indefinite useful life are tested for impairment at least once a year at the same time each year, as stated in International Accounting Standard IAS 36. This change follows SFAS 142 in the United States and works towards the goal of greater comparability of financial statements.
Figure 1 - The International Treatment of Goodwill
COUNTRY
TREATMENT OF GOODWILL AS OF 2001
Argentina
No specific regulations
Australia
Amortized to income over the expected period of benefit, not to exceed 20 years.
Austria
May be immediately deducted from equity. Amortization period should not be more than the useful life, usually five years.
Belgium
No maximum period, but a period of more than five years must be justified.
Brazil
Capitalized and amortized over the expected useful life.
Canada
Amortized to income using the straight-line method over the expected useful life, not to exceed 40 years.
China
The treatment of purchased goodwill is not currently addressed.
Denmark
Usually charged to equity, but, if capitalized, goodwill is amortized over a maximum period of five years; however, if the economic life is longer, then the amortization period may be extended.
Finland
Amortized over a maximum period of five to 20 years.
France
No specific regulations: usually amortized over 20 years; however, no maximum period is specified.
Germany
Usually amortized over four years on a straight-line basis, or over its useful life (not to exceed 20 years) using the straight-line method, unless another method is more appropriate. It is permissible to charge goodwill to equity.
Hong Kong
Charged to equity, but capitalization and amortization is permitted.
India
Capitalized and amortized over the expected period of benefit, or charged against any available capital reserve account.
Italy
Amortized over five years, up to 20 years if justified.
Japan
Amortized over a period of up to 20 years.
Mexico
Capitalized and amortized to income over the expected period of benefit, not to exceed 20 years
Netherlands
No specific regulations: may be charged directly to the income statement or equity, or capitalized. If capitalized, it is amortized over the expected useful life, usually 5-10 years.
New Zealand
Capitalized and amortized, usually over a period of 10 to 20 years.
Norway
Amortized over expected useful life; the reasons behind an amortization period longer than five years must be disclosed.
Portugal
Amortized over expected period of benefit, usually five years but not more than 20.
South Korea
Capitalized and amortized over five years using the straight-line method.
Spain
Capitalized and amortized, usually over a five-year period with a 10-year maximum.
Switzerland
No specific regulations: normally written off to equity. If capitalized, goodwill is usually amortized over five years, but may be amortized up to 20 years if justified.
Sweden
Capitalized and amortized over five years, unless a longer period is justified.
* *This information was quoted from Robert N. Waxman's 2001 article titled "Goodwill Convergence" which appeared in a 2001 article in the CPA Journal.
The Test for Impairment of Goodwill - International Standard
There is one major aspect of SFAS 142 that was not adopted in IFRS 3/IAS 36 by the IASB and it involves the test for impairment. The exposure draft for IAS 36 initially suggested a two step impairment test, which follows SFAS 142. However, the IASB deemed that a two step impairment test was not necessary as it only provided marginal benefits. Under IAS 36, an allocation of goodwill to each cash generating unit of the acquirer (Struffert 2006 23). A cash generating unit is defined as "the smallest group of assets that includes the asset and generated cash inflows that are largely independent of the cash inflows from other assets or groups of assets" (Struffert 2006 23). Ralf Struffert from the University of Muenster, in an article titled "The Joint Business Combinations Project" appearing in the January 2006 edition of the CPA Journal, identifies the process for impairment under IAS 36. This is only a one-step process, unlike the two-step process under found in SFAS 142. Struffert writes:
"Impairment testing requires the comparison of the carrying amount of the unit, including goodwill, with the recoverable amount of the unit. No impairment exists when the recoverable amount exceeds the carrying amount. In the opposite case, the impairment will be recognized as a loss. Therefore, the carrying amount of any goodwill allocated to the cash-generating unit will be reduced. Then, the loss will be allocated to the other assets of the unit pro rata on the basis of the carrying amount of each asset in the unit under IAS 36. However, the reduction of the carrying amount will not be lower than the highest of its fair value less costs to sell, its value in use, and zero" (23).
Effects on Earnings
While for the most part the changes which move international accounting towards convergence in the area of business combinations have been welcomed, there are still some concerns among professionals. One concern is the impact not amortizing goodwill or intangibles with an indefinite life will have on earnings per share figures, a measurement of the success of a company. Previously, when an acquisition was made, a portion of that cost would be put into goodwill according to Richard Winter of PWC in a 2004 interview with Corporate Finance (42). Essentially, a significant portion of the costs of acquisition would be amortized over the assigned useful life of goodwill. Initially, the elimination of amortization of goodwill will reduce expenses and cause earnings per share to rise (Winter qtd. in Corporate Finance 2004 43). However, in the long-term, as new acquisitions are made, the inability to allocate these costs to goodwill and amortizing them will bring about a reduction in earnings per share (Winter qtd. in Corporate Finance 2004 43).
When the IASB included the changes in accounting for goodwill in IFRS 3, the effects these changes could be observed by analyzing the effects of SFAS 142 in the United States. An extensive analysis of this topic was performed by Ronald J. Huefner, professor of accounting at the State University of New York at Buffalo, and James A. Largay, professor of accounting at Lehigh University, which appeared in a 2004 article titled "The Effect of the New Goodwill Accounting Rules on Financial Statements" in the CPA Journal. Huefner and Largay analyzed the effects the changes in accounting for goodwill had on 100 companies. Only 33 of the 100 companies analyzed reported an impairment loss from the impairment test of goodwill (Huefner and Largay 2004 33). However, this impairment loss totaled $135 billion, an average of $4.1 billion per company (Huefner and Largay 2004 33). In the first quarter of reporting, net income was reduced by 95% due to the impairment write-offs and by 22% in the second quarter (Huefner and Largay 2004 33). In fact, Fortune magazine cites accounting changes, in particular the change in accounting for goodwill, as one of the mitigating factors for such a poor earnings year for Fortune 500 companies (Huefner and Largay 2004 34). Through this analysis one is able to observe the potential for great volatility in earnings for those companies reporting a goodwill impairment loss. However, the elimination of amortization of goodwill works to increase earnings which aids in offsetting impairment losses due to goodwill. These changes to goodwill, while having an effect on earnings, will not affect cash flow.
Other Effects of Incurring an Impairment Loss
Earnings are not the only figure impacted by an impairment loss. When an impairment loss is incurred, the book value is subtracted by the amount of the loss. This decreased asset base will cause an increased asset turnover ratio. Additionally, retained earnings are "reduced by the difference between the impairment loss and any associated reduction in the deferred tax liability" (Van Greuning 2005 186). Consequently, the debt equity ratio will increase due to this declining asset base. Also, since the asset base is declining, there will be decreased future depreciation expensed, which aids in generating future profitability, and with increased profits and lower asset values, one can expect an increase to future returns on assets (Van Greuning 2005 186-7).
Negative Goodwill
With the issuance of these new standards there have been changes in accounting for negative goodwill. Prior to SFAS 142, negative goodwill was "was recorded as a deferred credit after reducing proportionately to zero the values of assets that would have otherwise been assigned to non-current assets" (Waxman 2001 19). Under the current standard, negative goodwill is still allocated to non-current assets, but the excess beyond these allocations gets recorded as an extraordinary gain on the income statement (Waxman 2001 19). Internationally speaking, prior to IFRS 3, negative goodwill was offset on the balance sheet (Corporate Finance, 2004, 42). Under IFRS 3, negative goodwill must be included on the income statement, and its inclusion on the balance sheet has been prohibited (Corporate Finance, 2004, 42).
Reversal of Impairment Loss
While impairment losses may be reversed under certain conditions, both international and US standards have disallowed the reversal of any impairment losses recognized for goodwill.
Minority Interest
Both US GAAP and IFRS require minority interest to be disclosed in the consolidated balance sheet, however, each has a different presentation. US GAAP requires minority interest to be presented outside of equity, either as a non-current liability or more commonly disclosed separately in between the liability and equity of the consolidated balance sheet. IRFS require that minority interest be reported separately in the equity section of the consolidated balance sheet, although it's commonly reported in between the liability and equity section, similar to many US companies.
Another difference between US GAAP and IFRS is the method used to determine the minority interest amount to be reported on the consolidated balance sheet. US GAAP generally requires minority interest to be reported at the carrying value of the minority's share of the subsidiaries assets before acquisition date, or at historical cost. IFRS 3 states that minority interest at acquisition should be presented at the fair value of the minority's percentage of ownership in the subsidiary's net assets. In some instance it is also acceptable under IFRS to use historical cost to determine the amount of minority interest.
One other difference is when a parent company purchases additional shares of its subsidiary. Under GAAP when a parent makes an additional investment in a subsidiary the purchase method must be used. IFRS does not designate that the purchase method must be used, but rather lists numerous approaches that are considered to be acceptable.
The subject of minority interest is currently on the Business Combinations project of the IASB and the FASB and changes converging the two standards is likely occur over the next few years.
Consolidated Financial Statements
According to GAAP, the parent company only needs to disclose to the public its consolidated financial statements. IAS 27 requires the parent to disclose its financial statements, as well as its consolidated financial statements. Also included in this standard is a list of reasons in which the parent does not need to prepare consolidated financial statements. The parent does not need to prepare these statements if:
* It is a wholly owned subsidiary
* The parent's debt or equity instruments are not traded in the public market
* The parent ID is not file, nor is in the process of being filed, its financial statements with a securities commission or another regulatory body for the purpose of issuing any class of instruments in a public market
* The ultimate or any intermediate parent of the subsidiary produces consolidated financial statements available for public use that comply with IFRS
Accounting Principles Board Opinion 18 (APB Opinion 18) defines a subsidiary as "a corporation that is controlled, directly or indirectly by another corporation" (Ernst & Young 145). Control usually means ownership of more than 50% of the subsidiary's voting stock. There are also other circumstances where a parent has the ability to control a subsidiary while owning less than 50% of the voting stock. Some of these circumstances include by a contractual lease, or agreement with other shareholders. All subsidiaries must appear on the parent's consolidated financial statements. The SEC Regulation S-X has a more detailed definition of a subsidiary, based on control and risk, which applies to all publicly traded companies in the US.
IAS 27 has a similar definition of a subsidiary and also includes the word "control." The parent is said to have control when it attains the ability to govern and obtain benefits from the operations of the subsidiary (Van Greuning 60). Control exists if the parent:
* Holds ownership of more than 50% of the voting power of an entity, unless, in rare circumstances, it can be clearly demonstrated that such ownership does not constitute control
* Has the majority of voting power, reached by an agreement with other investors
* Has the power to govern the financial and operating policies of an entity under a contractual agreement
* Has the power to appoint or remove the majority of the board of directors
* Has the power to cast the majority of votes at a meeting of the board of directors
Foreign Currency Translation - Functional Currency
Both US GAAP and IFRS require business entities to identify and report in a functional currency. FAS 52 and IAS 21 have a similar definition of functional currency, stating that functional currency is the currency of the primary economic environment in which the entity operates (Ernst & Young 232).
If a foreign subsidiary's books are maintained in the local currency, but the local currency is not the functional currency on the consolidated entity, then GAAP requires the temporal method be used to remeasure the subsidiary's books to the functional currency of the parent. The temporal method uses current exchange rates for monetary assets, liabilities, and non-monetary items kept at fair value, and uses historical rates for all other items (Beams 467). If a foreign subsidiary's books are maintained in its functional currency, but the functional currency is not the reporting currency of the parent, the current rate method must be used to translate the financial statements. The current rate method transfers everything using the current exchange rate, except for stockholders equity, which is transferred at an average rate. Gains or losses under the current rate method are recorded in other comprehensives income, under the equity section of the balance sheet (Beam 458).
International standards differ from FASB standards because the IASB does not use the temporal or current rate methods. IAS 21 states that if an entity is using a functional currency that is not its reporting currency, then the entity must translate its functional currency into the reporting currency by using closing rates for all assets and liabilities, and exchange rates at the transaction dates for all income and expenses. Average rates can also be used to translate income and expenses. All gains and loses due to changes in exchange rates are book-to-equity, until the foreign operation is disposed of. Then the gains or losses are moved to the income statement.
Hyperinflation
One of the most important differences in currency translation between US GAAP and IASB standards is in the area of hyperinflationary economies. FAS 52 defines a highly inflationary economy as one that has a cumulative inflation rate of approximately 100% or more over a three-year period (Beam 460). IAS 29 takes a slightly more relaxed approach. Instead of a precise definition, it lists the characteristics of a hyperinflationary economy (Van Greuning 252):
* The general population prefers to keep its wealth in non-monetary assets or in a relatively stable foreign currency
* Prices are normally quoted in a stable foreign currency
* Credit transactions take place at prices that compensate for the expected loss of purchasing power
* Interest, wages, and prices are linked to price indexes
* The cumulative inflation rate over three years is approaching, or is greater than 100%
Also, US GAAP and IFRS have different methods of reporting the results of an entity whose financials are denominated in a hyperinflationary currency. FAS 52 states that if an entity uses a foreign currency that is deemed to be hyperinflationary, the assets, liabilities and income statement must be translated into a stable currency, as if the stable currency resembles the functional currency. If a foreign subsidiary is reporting in a hyperinflationary currency, the temporal method must be used to remeasure the financial statements to the reporting currency of the parent, which is usually the US dollar (Ernst & Young 241). In effect, the subsidiary is taking the reporting currency of its parent as its own functional currency. The AICPA International Practices Task Force reviews inflation rates and publishes a list of countries it deems hyperinflationary. Any exchange gains or losses resulting from remeasurement are recognized in income for that period, showing the effects of hyperinflation on the consolidated financial statements.
IAS 21 states that if a foreign subsidiary is using a hyperinflationary currency, then the financial statements must be restated. The non-monetary balance sheet items and the income statement are restated in terms of the measuring unit current at the balance sheet date. This is accomplished by applying a general price index. Non-monetary assets are not restated if they are shown at their fair values. Monetary items are not restated, as they are already expressed in the current measurement unit at the closing date. After the financial statements are adjusted using the general price index, the statements are translated from the hyperinflationary currency to the reporting currency of the parent company. Like US GAAP, any gains or losses should be disclosed separately in the income statement. IAS do not allow an entity using a hyperinflationary currency to use a stable currency for reporting. Instead, they must apply the general price index to adjust their financial statements for the effects of inflation (Van Greuning 252). Figure 2 is an example of how the general price index is used to restate the financials of a country that uses a currency that is hyperinflationary.
Figure 2 - Financials of a Hyperinflationary Company
The Argentine Peso and Inflation Rates
Argentina and the US are two geographical areas that each have their own currencies. Argentina uses the Argentine peso, while America uses the US dollar. Argentina has developed its own accounting standards, with some influence from IASB standards, while the United States uses US GAAP, developed by the FASB and other US accounting regulatory bodies. Over the past few years, Argentina has had a very high inflation rate, which is currently down to approximately 10% (CIA). The United States currently has an inflation rate of 2.5% (CIA). When Argentina fixed the value of its peso to the US Dollar, its inflation rate dramatically decreased, and many investors invested in the Argentine peso. Because of political corruption, running up excessive amounts of debt without collecting taxes, and giving out kickbacks, Argentina found itself in a recession that lasted over three years. Investors stopped investing, the inflation rate again rose, and Argentina found itself with a very weak currency. The important thing to note is that governmental stability, inflation rates, trade deficits and surpluses, federal deficits, governmental restrictions on currency transfers, and political corruption all have a very large impact on exchange rates and the value of currency. The effects of the Argentine peso to the US dollar are portrayed in Figure 3. Notice that the Argentine peso was fixed to the US dollar until 2002.
Figure 3 - History of Argentine Inflation Rate
Source: Latin Focus 2006
Foreign Currency Transactions
Both FAS 52 and IAS 21 require all transactions not denominated in a company's functional currency to be converted into the functional currency using the spot rate at the time of the transaction. One difference between GAAP and IFRS is how each accounts for the transaction at the balance sheet date.
FAS 52 requires foreign currency monetary balances to be translated into functional currency using the current exchange rate at the balance sheet date. IAS 21 translates the functional currency at balance sheet in a different manner. The foreign currency monetary items should be translated using the closing rate. Non-monetary items measured at historical cost in a foreign currency should be translated to the exchange rate at the date of the transaction. Non-monetary items that are measured at fair value in a foreign currency should be translated using the exchange rates when the fair value was determined.
Both GAAP and IFRS report for gains or losses on transactions with foreign currencies in a similar manner. GAAP accounts for any gains or losses as a result of changes in exchange rates by putting the gains or losses in income for the period for which the gains or losses actually occurred. IASB accounts for differences in exchange rates in a different manner. Any gains or losses from changes in exchange rates for monetary items should be recognized in the income statement for the period for which the gains or losses occur. When an exchange rate changes for a non-monetary item, the gain or loss can either be put on the income statement or on the equity section of the balance sheet, depending on the nature of the transaction. IAS may require the gains or losses resulting from revaluation of certain assets to be recognized into equity. Some specific plant assets require the revaluation gains or losses to be recognized in equity. For those assets the gains or losses from the exchange rates should also be recognized in the equity portion of the balance sheet. For all other exchange gains or losses on non-monetary items, they should be recognized in the income statement.
Financial Instruments, Derivatives, and Hedging
IAS 39, the international standard pertaining to the recognition and measurement of financial instruments, is another important area where differences arise between US GAAP and IASB standards. Like most accounting standards, IAS 39 has gone through many developments over the past two decades. The last major amendments to IAS 39, all of which occurred in 2005, revised accounting for cash flow hedges of forecast intragroup transactions and guarantee contracts, and added an option to account for certain hedges at fair value.
A financial instrument is a term used to describe any form of funding medium. Derivatives, a type of financial instruments, are the focus of this paper. Derivatives encompass a broad range of categories, specifically options, interest rate swaps, futures and forward contracts, and warrants. The common theme is that there are changes in characteristics such as price, or other variables, that determine the contract's importance to investors. International accounting standards require derivatives to be measured at fair market value with several exceptions. An example of an exception is that loans and receivables, or investments with no accurate fair value measure, should be measured at amortized cost. If a financial asset or liability is measured at historical cost at the time of acquisition, the latest revision of IAS 39 gives the entity the option to measure it at fair value. US standards, however, do not allow this option. Instead, historical cost generally is the measurement requirement for financial instruments per FAS 133.
A current issue that plagues the international derivatives market is accounting for complex derivative investments. The problem is that the IASB requires that these complex derivatives be measured at fair value. Complex derivatives may involve variables not common to simple derivatives that hinder the correct measurement of these derivatives. Tony Clifford, a partner at Ernst & Young, comments "one of the rules in IAS 39 is that you're only allowed to take profit on day one, when you first enter into a trade, to the extent that all inputs in your model are observable." Clifford argues that the valuation of these derivatives should be measured over its life and not just up front. Traders are resistant to this idea because they want to be paid for the transactions they process. The international rules state that gains and losses on derivatives should be reported in earnings, except if they qualify for hedging. Unfortunately, Clifford feels that the IASB would rather focus its time on other issues, which leaves possible problems in accounting for complex derivatives (Ferry 39).
There are also differences in hedge accounting between international and US standards concerning the methods in which they are measured. There are two main categories of hedges that must be defined before comparing the US and international standards. These methods are fair value hedges and cash flow hedges. Fair value hedges are hedges that are exposed to changes in fair market value of currently recognized assets or liabilities, or a previously unrecognized commitment to buy or sell an asset at a fixed price, which is the result of a potential risk that could affect profit or loss. This method adjusts the hedged item to fair value at the end of the reporting period. Cash flow hedges are more concerned with the inflows and outflows of cash associated with the risk of a recognized asset or liability or a future transaction that could affect profit or loss. The hedged item is marked up to fair value at the reporting period and recorded as an asset or liability. However, a portion or all of the gain or loss is deferred until a future transaction affects income. Instead of recognizing the gain or loss in net income, no transaction is recorded at the beginning of the contract. The amounts are recorded in other comprehensive income, which affects stockholders equity, and the change in value of firm commitment account, which is an asset or liability account. A cash flow hedge also takes into account the amortization of discounts or premiums during the period before the contract expires.
The main differences between US and international accounting standards in this area is that IFRS 3 allows for use of a fair value hedge, cash flow hedge that results in a financial asset or liability, or a cash flow hedge that does not result in a non-financial asset or liability. For US standards, a fair value hedge for basis adjustment is required, as well as a cash flow hedge resulting from a transaction in an asset or liability. The difference is that US standards give the option to adjust a cash flow hedge of a transaction that has resulted from a non-financial asset or liability. FAS 133 requires that hedged items be measured at fair value. Gains or losses should adjust the carrying amounts of the hedged items. IFRS 3 requires any gains or losses on hedged items reported in equity become an adjustment to the carrying amount of the asset. FAS 133 requires that gains or losses on hedged items reported in equity be amortized over a period equal to the useful life of the asset. Figure 4 depicts the differences in measurement between that of US and international reporting of derivatives. The left side pertains to international standards, and the right side to US standards.
Figure 4 - Differences between US and International Reporting of Derivatives
IASB US GAAP
Figure 5 is a pie chart that shows that foreign currency derivatives make up the second largest portion of all derivatives.
Figure 5 - Makeup of All Derivatives in US and Foreign Markets
Conclusion
In conclusion, the efforts made to converge international standards with those in the United States are evident in the accounting for business combinations and foreign currency transactions and translation. The issuance of IFRS 3 demonstrates the desire of the international community to conform their standards to those used in the United States. The IASB also recognizes the impact of the globalization of modern business and the benefits of increased comparability to financial statement users. There is still much room for improvement on this convergence project, but the benefits of convergence are clear and will ultimately provide investors with the utmost understandability and representative data possible.
Reflection
Overall our experience working on this project was a positive one. Most of us have little, if any experience dealing with International accounting standards, and when conducting research we were able to learn a great deal. Also from researching on international standards we were able to learn much about the history of international standards, including the formation of the International Accounting Standards Board (IASB). By identifying the similarities and differences between US GAAP and International Financial Reporting Standards (IFRS) it will help us track and understand the upcoming changes to each, in order to converge the two standards and better prepare us for the future.
Over the course of this project we did have some trouble gathering updated information on the international standards. The IASB website was not very user friendly or helpful in identifying the recent changes. The most of our sources were from 2005 or earlier, so it was hard distinguish if there have been any updates to the standards since then.
Overall this project was very useful and increased our understanding of not only international accounting standards but also US GAAP. As the business world continues to globalize, this project will benefit our careers and better prepare us for the future.
Works Cited
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Ferry, John "IASB Rules Could Curtail Sales of Complex Derivatives." Euromoney 37. (2006): 39-40.
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