Chapter 8
Global Accounting and Auditing Standards
Discussion Questions
1. Argument for measurement:
∙ Discrepancies in international measurement may produce accounting amounts that are vastly different (even where financial transactions and position are identical), leading to incorrect comparisons. Here it doesn’t matter what is disclosed; no reliable comparisons are possible anyway.
Arguments for disclosure:
∙ If companies do not disclose complete information, they can hide losses or future problems from financial statement users. For example, losses can be hidden by offsetting them against gains. Expected future problems related to loss contingencies can be hidden simply by not disclosing them. Thus, if disclosure is incomplete, even the application of similar measurement principles will lead to incorrect comparisons.
Clearly, international accounting convergence requires that both measurement and disclosure be made comparable.
2. The term convergence is associated with the International Accounting Standards Board. Before the IASB, harmonization was the commonly used term. Harmonization means that standards are compatible; they do not contain conflicts. Harmonization was generally taken to mean the elimination of differences in existing accounting standards, in other words, finding a common ground among existing standards. Convergence means the gradual elimination of differences in national and international accounting standards. Thus, the terms harmonization and convergence are closely aligned. However, convergence might also involve coming up with a new accounting treatment not in any current standards.
3.a. Reciprocity, or mutual recognition, exists when regulators outside of the home country accept a foreign firm’s financial statements based on the home country’s principles, or perhaps IFRS. For example, the London Stock Exchange accepts U.S. GAAP-based financial statements in filings made by non-U.K. foreign companies. Reciprocity does not increase cross-country comparability of financial statements, and it can create an unlevel playing field in that foreign companies may be allowed to apply standards that are less rigorous than those used by domestic companies.
b. With reconciliation, foreign firms can prepare financial statements using the accounting standards of their home country or IFRS, but also must provide a reconciliation between accounting measures (such as net income and shareholders’ equity) of the home country and the country where the financial statements are being filed. Reconciliations are less costly than preparing a full set of financial statements under a different set of accounting principles, but provide only a summary, not the full picture of the enterprise.
c. International standards are a result of either international or political agreement, or voluntary (or professionally encouraged) compliance. When accounting standards are applied through political, legal, or regulatory procedures, statutory rules typically govern the process. All other international standards efforts in accounting are voluntary in nature.
4. Key rationales supporting the development and widespread application of IFRS include:
a. A growing body of evidence indicates that the goal of international convergence of accounting, disclosure and auditing has been widely accepted.
b. All dimensions of accounting are becoming converged worldwide.
c. Increasing numbers of highly credible organizations strongly support the goals of the IASB.
d. National differences in the underlying factors that lead to variation in accounting, disclosure, and auditing practices are narrowing as capital and product markets become more international.
e. International standards will improve the comparability of international financial information.
f. Time and money will be saved on international consolidations, the components of which now are subject to different national laws and practices.
g. There may be a tendency for accounting standards throughout the world to be raised to the highest possible level.
h. Widespread application of IFRS might also result in:
∙ Improved managerial decision making within multinational enterprises.
∙ Improved allocations of corporate investment money worldwide.
∙ Better international understandability of financial statements.
∙ Cost reductions in accounting information processing and financial disclosure costs for multinational enterprises.
∙ Greater international credibility for published financial statements.
5. Key rationales against the development and widespread application of IFRS include:
a. Accounting has built-in flexibility. Its ability to adapt to widely different situations is one of its most important features. Critics doubt that international standards can be flexible enough to handle differences in national backgrounds, traditions, and economic environments, and may be a politically unacceptable challenge to sovereignty.
b. It is claimed that international accounting standard setting is a tactic of the large international accounting service firms to expand their market share.
c. International standards may create standards overload for companies that do business internationally.
d. National political concerns frequently intrude on accounting standards. International political influences would compromise international accounting standards.
e. International standards are not suitable for small and medium-sized companies, particularly unlisted ones with no public accountability.
f. Risks of misinformation — uniform standards may give the appearance of similarities when in fact countries and companies may be highly dissimilar.
g. Political costs of the necessary international treaties on financial accounting and reporting which would have to be negotiated to enforce the use of IFRS.
6. Evidence indicating wide acceptance of IFRS around the world:
a. Growing numbers of companies are adopting IFRS voluntarily and refer to their use of IFRS in their annual reports.
b. Dozens of countries base their national accounting standards on IFRS.
c. Some 7,000 EU listed companies now use IFRS in their consolidated financial statements.
d. Many international organizations, such as IOSCO, endorse the use of IFRS.
e. IFRS are used as an international benchmark in many major industrialized countries.
f. IFRS are accepted by many stock exchanges and securities regulators.
g. IFRS are recognized by the European Commission (EC) and other supranational bodies.
h. Norwalk Agreement committed FASB and IASB to convergence.
7. The International Accounting Standards Board is overseen by the International Accounting Standards Committee, consisting of 22 trustees: six from North America, six from Europe, six from the Asia-Pacific region, and four from any area. The trustees appoint the members of the IASB. The IASB receives advice from the Standards Advisory Council on its agenda and priorities. The SAC consists of around 30 members appointed by the IASC trustees and they represent a diversity of geographic and professional backgrounds.
The IASB consists of 14 members, 12 full-time and two part-time. It follows a due process in setting accounting standards. For each standard, the board normally publishes a discussion paper that sets out the various possible requirements for the standard and the arguments for and against each one. Later, the board publishes an exposure draft for public comment, and it then examines the arguments put forward in the comment process. A final standard is issued when nine of the 14 board members have voted in its favor.
8. Accounting harmonization in the EU is just one element of the overall project of harmonizing the legal and economic systems of the member states, and is part of the process of harmonizing company law.
The Fourth Directive illustrates the concept of harmonization, and specifies accounting measurement (valuation) and disclosure requirements. It provides format rules for the balance sheet and the profit and loss account. The true and fair view is the overriding requirement and holds for footnote disclosures as well as the financial statements. The Fourth Directive also sets out the requirements for financial statement audits.
The Seventh Directive addresses consolidated financial statements. It requires consolidations for groups of companies above a certain size, specifies disclosures and notes, and requires a directors’ report. When it was issued in 1983, consolidated financial statements were the exception rather than the rule in Europe.
The Eighth Directive addressed various aspects of the qualifications of professionals authorized to carry out legally required (statutory) audits. Now referred to as the Statutory Audit Directive, it was substantially amended in 2006. The new directive tightens oversight of the audit profession and has standards for, among other points, auditor appointment and rotation, and continuing professional education.
The EU abandoned its approach to harmonization to one favoring the IASB for practical and political reasons. The Fourth and Seventh Directives were incomplete and essentially remained as they were issued. Improvements to them proved difficult to achieve and the directives did not achieve the comparability expected. Some saw a set of Europe-wide standards as an unnecessary redundancy given the emergence of comprehensive IFRS. Others saw U.S. GAAP as a rival to IFRS. The EU cannot influence U.S. GAAP, but can influence IFRS. By putting its weight behind the IASB, the EU could serve as a counterweight to U.S. GAAP.
9. International accounting harmonization/convergence should address many, if not most, investor concerns about cross-national differences in accounting practices. The key issue here is comparability – investors want to make “apples to apples” comparisons of financial statements of companies from countries around the world. However, converged standards are only the beginning. Standards must also be comparably applied and they must be rigorously enforced. The financial statements must also be similarly audited to ensure comparable reliability.
10. Convergence of auditing standards will help ensure that audit quality will reach acceptable levels worldwide. Auditing convergence may be less difficult to achieve than accounting convergence because auditing is more technically oriented and there is wider agreement as to what constitutes best practices in auditing than there is for accounting principles.
IFAC is a worldwide organization of over 160 member organizations in 120 countries. Its mission includes establishing and promoting adherence to high-quality auditing and other professional standards, and furthering the international convergence of such standards. Its work is done through standard setting boards and standing committees. Among its standard setting boards are:
∙ International Accounting Education Standards Board
∙ International Auditing and Assurance Standards Board
∙ International Ethics Standards Board for Accountants
Its work spans the entire array of professional responsibilities of auditors and includes standards covering professional education, the conduct of the audit, and professional ethics.
11. IOSCO consists of securities regulators from more than 100 countries. Together, IOSCO members are responsible for regulating more than 90 percent of global securities markets. One of IOSCO’s objectives is promoting “high standards of regulation in order to maintain just, efficient, and sound markets.” IOSCO has worked extensively on international disclosure and accounting standards to facilitate the ability of companies to raise capital efficiently in global securities markets. It has a technical committee whose sole focus is multinational disclosure and accounting. Model disclosure standards were published in 1998 and 2002.
IOSCO’s disclosure harmonization work is important because it has established a set of high quality disclosure standards, globally recognized, that serves as a model for nations around the world as they develop national requirements for cross-border offerings and initial listings.
12. The UN and OECD now play supporting roles in harmonizing accounting and auditing standards. The IASB and IFAC are now the clear leaders in this endeavor, but in the 1970s and 1980s, both the UN and OECD were potential rivals. Most of the effort of the UN and OECD is directed toward providing technical accounting assistance to developing countries. For example, the UN has focused much attention on Russia and countries of the former Soviet bloc, and on African countries.
Exercises
1. One of the main problems with mutual recognition (or reciprocity) is that it actually may make financial statements within the home market noncomparable. If many different accounting standards are acceptable, then companies domiciled in countries with rigorous standards (such as the United States) would be at a disadvantage to companies whose home country standards are not as stringent, but still would be acceptable. Investors also would face the difficult task of having to master many sets of accounting principles in order to be able to understand the associated financial statements.
The U.S. SEC considers reconciliation to be a cost-effective means to allow foreign firms to list on a domestic exchange. With reconciliation, differences between accounting standards are identified and quantified without the need to prepare a second set of financial statements. However, significant differences between domestic and foreign accounting principles can increase the burdens associated with reconciliation, and reconciliations do not provide a full picture of the enterprise as would result from a second set of financial statements.
The use of International Financial Reporting Standards would provide many benefits for cross-border listings. Companies would have to provide only one set of financial statements for all nondomestic capital markets, and investors would have to be familiar with only one set of accounting principles to properly understand and interpret nondomestic financial statements. However, as with reconciliation, domestic companies required to comply with domestic standards still would compete for capital with nondomestic companies that would be required to comply with a different (and possibly less stringent) standard.
Preferred approaches from perspectives of different groups:
a. Investors might prefer international standards, as they would increase the ease in understanding information from nondomestic companies. Knowledge of only one set of standards would be required to understand all nondomestic statements. However, there is also a case for reconciliation, which presents in an economical manner the significant differences between nondomestic and domestic financial statements and does not require investors to be familiar with any set of accounting standards other than the home country.
b. Company management might prefer mutual recognition, as it does not require a company to prepare any additional information and requires no additional expense or time commitments. However, companies in some countries might adopt IFRS voluntarily to increase their credibility with investors and increase the overall quality of their financial reporting.
c. Regulatory authorities might prefer reconciliation as it places the burden on companies yet provides adequate disclosure and investor protection.
d. Stock exchanges might prefer convergence as it is the only method that provides truly complete and identical information disclosure from companies outside the home market.
e. Professional associations will take positions according to their constituents – associations of stockbrokers might prefer convergence to the extent that it would make company information easier to understand, whereas associations of company executives might prefer reciprocity.
2. The following discussions are based on the respective organizations’ Web sites at the time of writing.
International Federation of Accountants (IFAC)
IFAC, an organization of national professional accountancy organizations, plays a critical role in the convergence of auditing standards and other international auditing initiatives. The organization has over 160 member organizations in 120 countries, representing more than 2.5 million accountants. Organized in 1977, IFAC’s goal is to develop the accountancy profession and converge its professional standards worldwide to enable accountants to provide services of consistently high quality in the public interest.
To achieve its objective, IFAC develops and promotes technical, professional and ethical standards for accountants, provides leadership on emerging issues, and serves as a voice for the world’s accountants on issues of public and professional concern. IFAC fosters the advancement of strong national professional accountancy organizations, and works closely with regional accountancy organizations and outside agencies to accomplish this.
The IFAC Council, comprised of one representative from each member body, provides overall leadership of IFAC. The council elects the IFAC Board, and is responsible setting policy and overseeing IFAC operations, the implementation of programs, and the work of IFAC’s standard setting groups and committees. The Public Interest Oversight Board (PIOB), an independent board, provides additional oversight. Day-to-day administration is provided by the IFAC chief executive located in New York, which is staffed by accounting professionals from around the world.
IFAC’s professional work is done through its standard setting boards and standing committees. IFAC standard setting boards are:
∙ International Accounting Education Standards Board
∙ International Auditing and Assurance Standards Board
∙ International Ethics Standards Board for Accountants
∙ International Public Sector Accounting Standards Board
IFAC standing committees are the following:
∙ Compliance Advisory Panel
∙ Developing Nations Committee
∙ Nominating Committee
∙ Professional Accountants in Business Committee
∙ Small and Medium Practices Committee
∙ Transnational Auditors Committee
IFAC issues standards in these key areas: auditing, assurance, and related services; education; ethics; and public sector accounting. IFAC’s International Auditing and Assurances Standards Board issues International Standards on Auditing (ISA), which are intended for international acceptance. ISAs deal with topics such as auditors’ responsibilities, risk assessment and evidence, and audit reporting.
IFAC has close ties with organizations such as the IASB and IOSCO, and its pronouncements are receiving growing recognition for their quality and relevance. Financial statements of companies around the world are increasingly being audited in conformity with International Standards on Auditing.
United Nations Intergovernmental Working Group of Experts on International Standards of Accounting and Reporting (ISAR)
ISAR was created in 1982 and is part of the United Nations’ Conference on Trade and Development (UNCTAD). ISAR is the only intergovernmental working group devoted to accounting and auditing at the corporate level. Its objective “is to promote the transparency, reliability and comparability of corporate accounting and reporting as well as to improve disclosures on corporate governance by enterprises in developing countries and countries with economies in transition. ISAR achieves this through an integrated process of research, intergovernmental consensus building, information dissemination and technical cooperation.”
In recent years, ISAR focused on important topics that other organizations were not yet ready to address, such as environmental accounting. It has also conducted technical assistance projects in a number of areas such as accounting reforms and retraining in the Russian Federation, Azerbaijan and Uzbekistan, and designing and developing a long-distance learning program in accountancy for French-speaking Africa. Topics discussed at recent ISAR conferences include practical implementation of IFRS, corporate responsibility reporting, and corporate governance disclosures.
Organization for Economic Cooperation and Development (OECD)
OECD is the international organization of 30 (mostly industrialized) market economy countries. It functions through its governing body, the OECD Council, and its extensive network of committees and working groups. Its publication Financial Market Trends, issued two times each year, assesses trends and prospects in the international and major domestic financial markets of the OECD area.
The OECD often publishes reports on the structure and regulation of securities markets, and has played a leading role in promoting improved corporate disclosure and governance around the world. With its membership consisting of larger, industrialized countries, the OECD is often a counterweight to other bodies (such as the United Nations and the International Confederation of Free Trade Unions) that have built-in tendencies to act contrary to the interests of its members.
3. As an example, consider the Financial Accounting Standards Board (FASB) in the United States. The FASB’s Web site presents detailed information on the FASB’s international activities, including an overview, convergence with IASB, cooperative efforts with other standards setters, and the FASB/IASB memorandum of understanding.
The FASB’s objective for participating in international activities is to increase the international comparability and the quality of standards used in the United States. This objective is consistent with the FASB’s obligation to its domestic constituents, who benefit from comparability of information across national borders. The FASB pursues that objective in cooperation with the International Accounting Standards Board (IASB) and national standard setters.
The FASB believes that the ideal outcome of cooperative international accounting standard-setting efforts would be the worldwide use of a single set of high-quality accounting standards for both domestic and cross-border financial reporting. At present, a single set of high-quality international accounting standards that is accepted in all capital markets does not exist. In the United States, for example, domestic firms that are registrants with the SEC must file financial reports using U.S. GAAP. Foreign firms filing with the SEC can use U.S. GAAP, their home country GAAP, or international standards – although if they use their home country GAAP or international standards, foreign issuers must provide a reconciliation to U.S. GAAP.
The FASB engages in a variety of activities in pursuit of the goals of high-quality international standards and increased convergence of the accounting standards used in different nations. Almost every FASB project is a matter of interest in some other country or with the IASB.
4. a. Comparison of standard-setting procedures
European Union
Accounting and auditing requirements are established under EU company law directives, which are legal instruments that member countries must implement. Thus, all accounting and auditing standards in EU directives become legally enforceable. The EU comprises several key organizations that need to be understood in order to understand how EU directives come into being. Briefly, the European Commission initiates EU policy and acts in the community’s general interest. Commissioners are completely independent and may not seek or take instructions from governments or interest groups. The Council of the European Commission is the EU’s decision-maker. Here, the member states legislate for the EU, deciding some matters by majority vote and others unanimously. The European Parliament represents the EU’s citizens. Its main functions are to enact legislation and to scrutinize and control the use of executive power. The Treaty of European Union of 1993 strengthened the European Parliament’s responsibilities. Only the Commission can propose new directives. Proposals typically undergo many drafts. Proposed directives are submitted to the Council of the European Commission, which first seeks opinions of the Economic and Social Committee and the European Parliament. Next, a working party set up by the Council discusses the proposal. Member countries typically are allowed several years to implement a new directive after its final adoption. (Note to instructors: The information contained in this paragraph is based on information on the EU’s Web site at the time of writing.)
IASB
The IASB follows due process in setting accounting standards. For each standard, the Board may publish a discussion paper that sets out the various possible requirements for the standard and the arguments for and against each one. Subsequently, the Board publishes an exposure draft for public comment, and then examines the arguments put forward in the comment process before deciding on the final form of the standard. An exposure draft and final standard can be issued only when nine (of 14) members of the board vote in favor of it.
IFAC
The standard setting boards of IFAC also follows a due process procedure. Meetings to discuss the development and approval of standards are open to the public and, where practicable, are broadcast over the Internet. Issues papers and draft standards are published on the IFAC Web site along with updated project summaries and meeting highlights. New projects are based on a review of national and international developments and comments from interested observers. An advisory group is consulted to determine priorities and activities. Task forces are usually assigned the responsibility for the development of new standards. These task forces conduct research and consult interested parties on the issues under consideration. One or more public forums or roundtables may be held before an exposure draft is issued. Re-exposure is sometimes necessary. Final standards are issued after considering comments to the exposure draft. (Note to instructors: The information contained in this paragraph is taken from IFAC’s Web site at the time of writing.)
a. At what types and sizes of enterprises are their standards primarily directed?
EU company law directives apply both to public and private companies in the EU, without respect to size.
IFRS are financial reporting standards for business whose applicability depends on the context. For example, if IFRS are adopted as national accounting standards in a particular country, their applicability depends on the type of entities that are subject to those national standards.
IFAC’s standards are directed toward the audits of both public and private companies.
In summary, all three sets of standards are meant to apply to most (if not all) enterprises, without regard to size or whether the enterprises are private or public.
b. Brief critique of statement
It is true that IFRS are particularly useful to companies that operate in more than one country, because IFRS are widely recognized and are acceptable in many different countries and stock exchanges. However, as stated in the text, IFRS also are used as the basis for national accounting standards in many countries, and these national standards typically apply to a wide range of companies, not just multinational companies.
5. Following is a sample essay on the 1995 European Commission adoption of a new approach to accounting harmonization. The essay is based on material in articles by Gerhard G. Mueller, "Harmonization: Efforts in the European Union," in Frederick D.S. Choi, ed., International Accounting and Finance Handbook, New York: John Wiley & Sons, 1997, page 11.28; and Peter Walton, “European Harmonization,” in Frederick D.S. Choi, ed., International Finance and Accounting Handbook, New York: John Wiley & Sons, 2003, page 17.7
Beginning in the early 1990s, the Commission examined a number of alternative harmonization strategies. These included, among others, substantive revisions of the existing accounting Directives, creation of a Europe-wide accounting standards-setting board, exempting certain European companies from all EU accounting requirements so that these companies might apply accounting standards of other jurisdictions, or re-enforce its earlier push for mutual recognition.
The reality of international pressures and the need of European multinationals to be listed on several stock exchanges finally made it clear that the creation of a strong European regional level of accounting regulation was simply adding an unnecessary third tier, sandwiched between national regulations and the international capital markets.
In the end, the European Commission adopted a new accounting harmonization strategy on November 14, 1995 and forwarded respective recommendations to the European Council and to the European Parliament. The essence of the recommendation is that the EU will support the IASC/IOSCO initiatives and work to bring EU accounting requirements in line with International Accounting Standards (IAS). The Commission decided, after many years of hesitation, to participate in IASC standard setting, although only as an observer.
In addition, the new harmonization strategy concentrated on consolidated financial statements. It had come to be realized that harmonization of individual company accounts is not necessarily very useful. This decision endorsed a break of the link between individual company accounts and consolidated accounts.
The new European Commission’s strategy for EU accounting harmonization is a major change from the EU accounting harmonization policies that had been in place over the preceding twenty-five years.
6. Note to Instructors: Exhibit 8-3 is current at the time of writing. It would be best for you to log on to the IASB Web site, www.iasb.org, and complete this exercise yourself before assigning it to students.
7. The following is taken from the IASB Web site at the time of writing.
8. To illustrate, the major differences between the GAAP of the United States and the revised IAS (as of December 2003) are:
∙ IAS 1 – Disclosure of “extraordinary items” is prohibited on the income statement.
∙ IAS 2 – Inventories must be stated at the lower of cost or net realizable value. LIFO is no longer allowed.
∙ IAS 8 – Retroactive restatement is required for all changes in accounting principles. They may not be included in current period income. (Note: U.S. GAAP has since changed. Now no major differences.)
∙ IAS 10 – No major differences introduced.
∙ IAS 16 – No major differences introduced.
∙ IAS 17 – No major differences introduced.
∙ IAS 21 – No major differences introduced.
∙ IAS 24 – No major differenced introduced.
∙ IAS 27 – Subsidiary is defined in terms of control.
∙ IAS 28 – No major differences introduced.
∙ IAS 31 – Proportional consolidation required for certain joint ventures.
∙ IAS 33 – No major differences introduced.
∙ IAS 40 – No major differences introduced.
9.
∙ IAS 1 – Under U.S. GAAP, events that are both unusual and infrequent are classified as extraordinary on the income statement. Prohibiting extraordinary gains and losses will have no effect on the balance sheet. The prohibition will affect the format of the income statement, but not net income. Under revised IAS 1, items that are classified as extraordinary would be shown in operating income. The current ratio, debt to equity ratio, and debt to asset ratio will be unaffected. Return on assets and return on equity ratios are potentially affected depending on the return measure an analyst uses. If it is “operating income” then both ratios are impacted, but if it is net income, then neither ratio is affected.
∙ IAS 2 – (a) Under U.S. GAAP, inventory is valued at the lower of cost or market, where market is normally replacement cost. Net realizable value is used when replacement cost is higher than net realizable value. On average, U.S. GAAP results in a larger write-down. Thus, U.S. GAAP results in a lower inventory amount and a lower income amount compared to revised IAS 2. Under U.S. GAAP, the current ratio is lower; debt to asset and debt to equity ratios are both lower; and return on assets and return on equity are both lower. (b) LIFO generally results in a lower inventory amount and lower profitability (assuming that inventory costs are increasing). Therefore, the effects on ratios are as described for lower of cost or net realizable value.
∙ IAS 8 – At the time that the 13 revised standards were published, U.S. GAAP required that the effects of most changes in GAAP are included in current period income. Revised IAS 8 requires retroactive restatement with an adjustment to opening retained earnings. This difference will have no effect on the current ratio. Year-end debt to equity and debt to asset ratios are unaffected. Both profitability ratios are affected since the effect of a change in GAAP is in income under U.S. GAAP. However, the effect is indeterminate since it can be positive or negative, depending on the change involved. Under current U.S. GAAP, there are no major differences with revised IAS 8.
∙ IAS 31 – Under U.S. GAAP, joint ventures are accounted for using the equity method. Using proportional consolidation instead affects the current ratio, and the debt to equity and debt to asset ratio. However, the effect depends on the composition of the joint venture’s balance sheet and so the effect is indeterminate. Profitability ratios are unaffected.
10. Note to Instructors: The following information is from the IASB Web site at the time of writing.
IAS 16: Property, Plant and Equipment
Both depreciated cost and fair value are allowed methods of valuations subsequent to acquisition. Neither is designated as the benchmark or allowed alternative method.
IAS 23: Borrowing CostsBenchmark: Treat borrowing costs as expenses.
Allowed alternative: Capitalize those borrowing costs directly
attributable to construction.
IAS 31: Interests in Joint Ventures
Proportional consolidation and the equity method are both allowed to account for jointly controlled entities. Neither is designated as the benchmark or allowed alternative method.
IAS 38: Intangible Assets
Historical cost (less any amortization and impairment losses) and revalued amount based on fair value (less any substantial amortization and impairment losses) are both allowed to account for intangible assets. Neither is designated as the benchmark or allowed alternative method.
It (almost) goes without saying that differences between IFRS benchmarks and allowed alternatives would have a significant impact on financial statement amounts. That is why the IASB moving away from allowed alternatives. IAS 16, 31, and 38 all had benchmark and allowed alternative treatments until their recent revisions.
11.
Return on equity:
Important measurement differences revealed by the restatement include intangible assets, pensions and other post-employment benefits, property plant and equipment, available-for-sale securities, and currency translations. The differences are not consistent between the two years. For example, the intangible assets difference decreases IFRS net income by 1,238 in 2005 but by roughly half that amount (590) in 2004. The available-for-sale securities difference increases IFRS net income in 2005, but decreases it in 2005. The currency translation difference has no effect on IFRS net income in 2005, but decreases it in 2004. There is somewhat more consistency between the restatement items in the two years for shareholders’ equity than for net income. They affect the reconciliation in the same direction in both years, but the amounts still vary. Return on equity is higher under IFRS than U.S. GAAP for both years, suggesting that it would be easier to maintain a minimum ROE under IFRS. Based on the above discussion, however, it is not clear that this conclusion would necessarily apply to future years.
12. a. (ii) Net realizable value of inventory is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. (IAS 2)
b. (ii and iii) The equity method and proportionate consolidation are both allowed for jointly controlled entities. Proportionate consolidation is used for jointly controlled assets and jointly controlled operations. (IAS 31)
c. (iv) None of these is an extraordinary item. (Note to instructors: The December 2003 revision to IAS 1 eliminated extraordinary items on the income statement.)
d. No. The effect of a change in an accounting estimate should be reflected (a) in the period of change, if the change affects that period only, or (b) in the period of the change and future periods, if the change affects both. (IAS 8)
e. False. The declaration of dividends on January 5 is an event after the balance sheet date. IAS 10 prohibits recognition of a liability for events that are indicative of conditions that arose after the balance sheet date. (IAS 10)
f. (i) and (iv) are not re-measured at fair value. In accordance with IAS 39, derivatives linked to investments in equity instruments that do not have a quoted market price and whose fair value cannot be reliably measured are not remeasured at fair value. Where the enterprise has the positive intent and ability to hold them to maturity, fixed-maturity instruments are also not remeasured at fair value. (IAS 39)
g. When an item of property, plant, and equipment is revalued, the entire class of property, plant, and equipment to which that asset belongs must be revalued. (IAS 16)
h. False. The interest cost may be capitalized, but the benchmark treatment is to charge borrowing costs to expense. (IAS 23)
Case 8-1
Petrochina Company Limited
1. The Summary of Principal Accounting Policies footnote of PetroChina Company Limited describes the accounting policies used in the preparation of the consolidated financial statements. A comparison of accounting policies described there with International Financial Reporting Standards summaries from the IASB and IAS Plus Web sites reveals how well the company’s accounting policies conform to IFRS. This comparison follows, based on information at the time of writing (January 2007).
a. Basis of consolidation. Subsidiaries are consolidated when more than half of the voting rights are owned or there is the power to govern the financial and operating policies. IAS 27 requires consolidation based on control, so PetroChina’s policy is consistent with it. The purchase method is used for business combinations and acquired assets and liabilities are recorded at fair value. Goodwill is the difference between the cost of the acquisition and the fair value of net assets acquired. Negative goodwill is recognized in income. These policies are consistent with IFRS 3. The same accounting policies are used throughout the consolidated group. This is consistent with IAS 27.
b. Investments in equity affiliates. The equity method is used for affiliates over which there is significant influence but not control. This is consistent with IAS 28.
c. Transactions with minority interests. The effects of these are recorded in equity. This is consistent with IAS 27 that requires minority interests be shown in equity.
d. Foreign currencies. The functional currency approach is used. In the case of transactions, monetary assets and liabilities are translated at the balance sheet date exchange rate and gains and losses from both transactions and translations are included in income. For foreign operations with a functional currency different than the presentation currency, income statement items are translated at the average exchange rate, balance sheet items are translated at the year-end exchange rate, and translation differences are included in shareholders’ equity. These policies are consistent with IAS 21.
e. Financial instruments. The first paragraph identifies the company’s financial instruments. The reader needs to look further in the accounting policy note to learn the accounting policy for each of these types of financial instruments. Derivatives are recognized at fair value and changes are recognized in income. This is consistent with IAS 39.
f. Investments. (Note that PetroChina only owns two classes of investments – loans and receivables, and available-for-sale securities.) Loans and receivables are initially valued at fair value and subsequently at cost. Available-for-sale securities are measured at fair value unless there is no quoted market price. These policies are consistent with IAS 39.
g. Property, plant and equipment. These assets are initially recorded at cost and subsequently carried at revalued amount (i.e., fair value). Depreciation is recorded over the useful lives of the assets to salvage value. Depreciation is based on revalued amounts. These policies are consistent with IAS 16. Interest to finance the construction of property, plant and equipment is capitalized. This is not the “benchmark treatment” but an “allowed alternative” under IAS 23.
h. Oil and gas properties. The successful efforts method is used to account for oil and gas exploration and production costs. IFRS 6 is effective 1-1-06. It requires companies to determine a policy specifying which expenditures are classified as “exploration and evaluation assets.” Thus, PetroChina’s policy seems to be consistent with IFRS 6, even though it wasn’t effective for the 2005 financial statements. PetroChina presumably would not capitalize any of these costs as assets.
i. Intangible assets. These are capitalized and amortized over their useful lives. They are not revalued. Internally generated intangible assets are not capitalized. Intangible assets are reviewed for impairment annually. These policies are consistent with IAS 38.
j. Leases. Leases are capitalized when the company assumes substantially all of the benefits and risks of ownership. Leases are treated as operating leases when the risks and benefits of ownership are retained by the lessor. This policy is consistent with IAS 17.
k. Related parties. IAS 24 requires the disclosure of related party transactions. This note only identifies PetroChina’s related parties. The reader would have to look elsewhere in the annual report to see if related party transactions are disclosed in accordance with IAS 24.
l. Inventories. Inventories are valued at the lower of cost or net realizable value. Net realizable value is the estimated selling price, less costs of completion and selling. The weighted average cost method is used. These policies are consistent with IAS 2.
m. Trade receivables. These are initially valued at fair value and subsequently at cost. They are written down when impaired. This treatment is consistent with IAS 39.
n. Cash and cash equivalents. This note only defines cash and cash equivalents. The summaries available online do not contain a definition. However, the complete IAS 7 offers a comparable definition.
o. Debts. Debts are initially recognized at fair value and subsequently at amortized cost. This is consistent with IAS 39.
p. Taxation. Deferred income tax is provided in full, using the liability method, for all temporary differences arising between the tax bases of assets and liabilities and their carrying values for financial reporting purposes. This treatment is consistent with IAS 12. Currently enacted tax rates are used to determine deferred income taxes. This is inconsistent with IAS 12. The tax rates that are expected to apply at reversal are supposed to be used.
q. Revenue recognition. Sales are recognized upon delivery of products or performance of services. This is consistent with IAS 18. (Note that PetroChina considered several EITFs in developing its revenue recognition policy. It was decided not to early adopt EITF 04-13.)
r. Provisions. These are recognized when there is a present legal or constructive obligation as a result of past events, it is probable that an outflow of resources will be required, and a reliable estimate of the amount can be made. This is consistent with IAS 37.
s. Research and development expenses. Research costs are expensed and development costs are capitalized when future economic benefits can be expected. This treatment is consistent with IAS 38.
t. Retirement benefit plans. PetroChina expenses contributions to retirement plans as paid. It has no material obligations to pay for other post-retirement benefits. Thus, the policy is consistent with IAS 19.
u. Share appreciation rights. These are measured at fair value and expensed over the vesting period. The summaries are not clear whether this policy is consistent with IFRS 2.
v. New accounting developments. This policy outlines PetroChina’s consideration of new standards and interpretations that are not yet effective. A disclosure such as this enhances the reader’s confidence that PetroChina is following IFRS.
w.
2. The above assessment has a moderate degree of reliability. First, it is based on a review of the accounting policy note, which provides highly summarized information. However, even close examination of the PetroChina’s complete annual report would yield incomplete information – a vast number of accounting treatment details is simply not disclosed. Only company employees and (to a lesser extent) their external auditors can assess compliance with IFRS, as they presumably have knowledge of the actual accounting policies and procedures used. Conformance with IFRS might be compromised if the company’s staff and/or external auditors are not closely familiar with IFRS.
3. Examination of the complete text of PetroChina’s annual report, and communication with PetroChina’s staff and auditors would provide useful further information. Examining the full IASB standard rather than just the summaries on the Web sites would also provide useful further information.
4. The auditor’s report states that PetroChina’s consolidated financial statements are in accordance with International Financial Reporting Standards. This information is useful, because it is based on an independent audit of the financial statements accepted in the United States and Hong Kong. The auditor is PricewaterhouseCoopers, one of the Big 4 audit firms, and it is signed in Hong Kong. These facts significantly increase the reliability of the assessment in question 1.
Case 8-2
Whither The Withering Standard Setters?
1. The boards of the IASB and FASB differ in several ways:
a. Size – The IASB has 14 board members (12 full-time and 2 part-time) while the FASB has 7 members (all full-time).
b. Membership requirements – The IASB board membership is based on a combination of technical expertise and diversity of international business and market experience. There are no geographic criteria for membership, but it is balanced to ensure that it is “not dominated by any particular constituency or geographical interest.” There must be a “mix of recent practical experience among auditors, preparers, users and academics.” FASB board members must have “knowledge of accounting, finance and business, and a concern for the public interest in matters of financial accounting and reporting.” The board has designated representatives from accounting firms, academia, corporations, and the investor community. Obviously, geographic diversity is not an issue with the FASB.
The boards are similar in that members are appointed for five-year terms, renewable once.
The two boards follow a similar due process in setting accounting standards. This is not surprising since the IASB is modeled after the FASB. Both boards determine their projects after getting input from various constituencies and their respective oversight bodies. Meetings are open to the public and agendas are publicized in advance. Technical issues are researched by working groups (IASB) or professional staff (FASB). Discussion papers are sometimes issued outlining the issues, and the pros and cons of each one. Exposure drafts are issued for the purpose of obtaining input from a broad array of constituents. Public meetings on exposure drafts are normally held. Standards are issued after considering comment letters, public roundtable discussions, and other information obtained during the exposure draft phase. Exposure drafts and final standards require a favorable vote of nine out of 14 members for the IASB, and four out of seven members for the IASB.
In determining its project agendas, the IASB considers whether it wants to partner with some national standard setting body. This body might be the FASB, but it could be another one such as the U.K. Accounting Standards Board. The FASB, in turn, may partner with the IASB or other national standard setter on a project. Convergence is an important consideration for both the IASB and FASB. The two boards meet twice a year and they align their agendas as much as possible.
2. So much attention is paid to IFRS and U.S. GAAP convergence because, to a large extent, national standards in many countries of the world have been based on IFRS or U.S. GAAP. Other national accounting standard setting bodies cannot and do not ignore those two substantial and advanced bodies of literature in developing their own national standards. Another major reason is that the U.S. SEC requires U.S.-listed non-U.S. companies to reconcile net income and shareholders’ equity from their reporting GAAP to U.S. GAAP. This requirement applies (at the time of writing) to companies following IFRS. As discussed in the chapter, there is a major push to eliminate this requirement as it relates to IFRS. If it were eliminated, a significant number of companies from around the world might choose to list their shares in the United States. These companies include the some 7,000 companies from the EU that have used IFRS since 2005.
The evidence is that IFRS and U.S. GAAP are converging toward each other. For example, the FASB followed the IASB lead in requiring the expensing of stock options at fair value. The FASB also followed the IASB lead in requiring “retrospective application” of voluntary changes in accounting policy. The IASB moved IFRS closer to U.S. GAAP regarding discontinued operations. Moreover, there are a number of joint projects between the IASB and FASB, such as the ones on business combinations and revenue recognition. (Note to instructors: Information on the joint projects is available on the IASB and FASB Web sites.)
3. U.S. accountants, analysts, and others involved in (U.S.) financial reporting need to know about IFRS for several reasons, including:
a. As discussed in question 2, IFRS influence the direction of U.S. GAAP. Today’s IFRS may be tomorrow’s U.S. GAAP and the implications of changing standards need to be understood.
b. More and more companies are reporting under IFRS. U.S. companies need to understand how their competitors reporting under IFRS are performing compared to themselves. Analysts are likely to assess companies using IFRS.
c. Deals in the merger and acquisition arena will be affected. U.S. companies need to understand the financial statements of potential targets using IFRS.
d. U.S. subsidiaries of EU-listed companies must report under IFRS. U.S. accountants are probably the ones preparing these IFRS financial statements.
e. Subsidiaries of U.S. companies operating in Europe and elsewhere may be required to prepare IFRS financial statements.
4. We doubt that the IASB and FASB will merge in the future. First of all, various points discussed in the chapter mean that it is unlikely that the IASB will disappear and the FASB will become the global standard setter. It also seems unlikely that the FASB will go away. It is difficult to believe that the United States will cede its authority over accounting standard setting to a multinational group. Even if the FASB felt that a merger was advantageous, would politicians or even the SEC allow international interests to supersede domestic ones? Another issue is principles- versus rules-based standards. Generally speaking, IFRS are principles-based while U.S. GAAP are rules-based. While it is true that IFRS are getting more rules-based and U.S. GAAP are (supposed to be) getting more principles-based, the litigiousness of the U.S. environment probably means that the United States will need additional implementation guidance even if IASB and FASB standards are converged. (Note to instructors: Refer to Case 4-1, “Standing on Principles.”) Financial resources are another consideration. Operating expenses for the IASC Foundation in 2005 were approximately €12 million (or approximately $15.6 million). Operating expenses of the Financial Accounting Foundation in 2005 were approximately $31 million. These numbers suggest that the FASB has a budget twice as large as the IASB. (Note to instructors: The annual reports of the two organizations are available on their Web sites.) Whether the IASB can match the resources of the FASB is unclear. Taken together, we argue that the IASB and FASB will remain separate accounting standard setting bodies in the future.
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