CHAPTER 4 INTERNATIONAL FINANCIAL REPORTING STANDARDS

Chapter Outline
I. The International Accounting Standards Board (IASB) had 30 International Accounting Standards (IAS) and 8 International Financial Reporting Standards (IFRS) in force in May 2008. A. In 2002, the IASB and U.S. Financial Accounting Standards Board (FASB) agreed to work together to reduce differences between IFRS and U.S. GAAP. There are several types of differences between IFRS and U.S. GAAP. A. Definition differences. Differences in definitions can occur even though concepts are similar. Definition differences can lead to differences in recognition and/or measurement. B. Recognition differences. Differences in recognition criteria and/or guidance related to (a) whether an item is recognized, (b) how it is recognized, and/or (c) when it is recognized (timing difference). C. Measurement differences. Differences in approach for determining the amount recognized resulting from either (a) a difference in the method required, or (b) a difference in the detailed guidance for applying a similar method. D. Alternatives. One set of standards allows a choice between two or more alternative methods; the other set of standards requires one specific method to be used. E. Lack of requirements or guidance. IFRS do not cover an issue addressed by U.S. GAAP, and vice versa. F. Presentation differences. Differences in the presentation of items in the financial statements. G. Disclosure differences. Differences in information presented in the notes to financial statements related to (a) whether a disclosure is required and/or (b) the manner in which a disclosure is required to be made. A variety of differences exist between IFRS and U.S. GAAP with respect to the recognition and measurement of assets. A. Inventory IFRS require inventory to be reported on the balance sheet at the lower of cost or net realizable value; U.S. GAAP requires the lower of cost or replacement cost, with net realizable value as a ceiling and net realizable value less a normal profit margin as the floor. U.S. GAAP allows the use of LIFO; IFRS do not. B. Property, plant and equipment subsequent to acquisition, IFRS allow fixed assets to be reported on the balance sheet using a cost model (historical cost less accumulated depreciation and impairment losses) or a revaluation model (fair value at the balance sheet date less accumulated depreciation and impairment losses); U.S. GAAP requires the use of the cost model. C. Development costs when certain criteria are met, IFRS require development costs to be capitalized as an asset and then amortized over their useful life; U.S. GAAP requires development costs to be expensed as incurred. An exception exists in U.S. GAAP for software development costs. D. Impairment of assets an asset is impaired under IFRS when its carrying amount exceeds its recoverable amount, which is the greater of net selling price and value in
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II.

III.

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use. Value in use is calculated as the present value of future cash flows expected from continued use of the asset and from its disposal. An asset is impaired under U.S. GAAP when its carrying amount exceeds the undiscounted future cash flows expected from the assets continued use and disposal. 1. Measurement of impairment loss the impairment loss under IFRS is the difference between carrying amount and recoverable amount; under U.S. GAAP, the impairment loss is the amount by which carrying amount exceeds fair value. Recoverable amount and fair value are likely to be different. 2. Reversal of impairment loss if subsequent to recognizing an impairment loss, the recoverable amount of an asset is determined to exceed its new carrying amount, IFRS require the original impairment loss to be reversed; U.S. GAAP does not allow the reversal of a previously recognized impairment loss. E. Borrowing costs the benchmark treatment in IFRS is to expense all borrowing costs when incurred, the allowed alternative is to capitalize borrowing costs to the extent they are attributable to the acquisition, construction, or production of a qualifying asset. The benchmark treatment is not allowed under U.S. GAAP; interest must be capitalized as part of a qualifying asset when certain criteria are met. F. Leases both IFRS and U.S. GAAP distinguish between operating and finance (capitalized) leases. U.S. GAAP provides bright line tests to determine when a lease must be capitalized; IFRS do not. IV. A number of IASB standards deal primarily with disclosure and presentation issues, and in some cases requirements differ from U.S. GAAP. A. IAS 1 requires presentation of a statement of cash flows. IAS 7 allows interest to be classified as operating, investing, or financing, whereas it always is classified as operating under U.S. GAAP. B. IAS 8 generally requires changes in accounting policies to be handled retrospectively; unlike under U.S. GAAP, the cumulative effect of a change is not included in income. C. IAS 14 requires disclosures for both business segments and geographical segments, with one being identified as the primary reporting format. The so-called management approach that requires the disclosure of operating segments used in U.S. GAAP is not followed. D. IAS 34 requires interim periods to be treated as discrete accounting periods, whereas U.S. GAAP treats interim periods as an integral part of the full year. E. IFRS 5 provides a more liberal definition of what qualifies as a discontinued operation than does U.S. GAAP.

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Answers to Questions 1. The types of differences that exist between IFRS and U.S. GAAP can be classified as: Definition differences Recognition differences Measurement differences Differences in allowed alternatives Differences in (lack of) guidance Presentation differences Disclosure differences 2. In applying the lower of cost and market rule for inventories, IAS 2 defines market as net realizable value (NRV) and U.S. GAAP defines market as replacement cost (with NRV as a ceiling and NRV less normal profit margin as a floor). 3. The two models allowed by IAS 16 are the cost model and the revaluation model. Under the revaluation model, property, plant, and equipment is reported on the balance sheet at a revalued amount, measured as fair value at the date of remeasurement, less accumulated depreciation and any accumulated impairment losses. 4. Under IAS 36, expenditures giving rise to a potential intangible are classified as either research or development expenditures. Research expenditures are expensed as incurred. Development expenditures are recognized as an intangible asset when six criteria are met. Under U.S. GAAP, research and development costs are expensed as incurred. The only exception is for software development costs, which are recognized as an asset when certain criteria have been met. 5. Under IAS 36, an impairment loss arises when an assets recoverable amount is less than its carrying value, where recoverable amount is the greater of net selling price and value in use. Value in use is determined as the expected future cash flows from use of the asset discounted to present value. The amount of the loss is the difference between carrying value and recoverable amount. Under U.S. GAAP, an impairment loss arises when the expected future cash flows (undiscounted) from the use of the asset are less than its carrying value. If impairment exists, the amount of the loss is equal to the difference between carrying value and fair value, which can be determined in different ways. 6. Goodwill must be tested for impairment annually. Goodwill that can be allocated to a specific cash-generating unit is tested for impairment using a bottom-up test. In this test, the carrying value of the cash-generating unit, including goodwill, is compared with the recoverable amount of the cash-generating unit. If the recoverable amount of a cashgenerating unit is less its carrying value, goodwill is deemed to be impaired and is written down. 7. IAS 23 (revised in 2007) requires borrowing costs to be capitalized to the extent that they are attributable to the acquisition, construction, or production of a qualifying asset; other borrowing costs are expensed immediately. Prior to the 2007 revision, IAS 23 allowed firms

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to choose between the current treatment or a treatment in which all borrowing costs are expensed immediately. 8. IAS 17 describes five situations that would normally lead to a lease being capitalized, but does not describe these as being absolute tests. The criteria implied in four of the situations are similar to the specific criteria in U.S. GAAP, but the IAS 17 criteria provide less bright line guidance. IAS 17 indicates that a lease would normally be capitalized when the lease term is for the major part of the leased assets life U.S. GAAP specifically defines major part as 75%. IAS 17 also indicates that a lease would normally be capitalized when the present value of minimum lease payments is equal to substantially all the fair value of the leased asset U.S. GAAP specifically defines substantially all as 90%. Determining whether a lease should be capitalized is an example of the principles-based approach followed in IFRS versus the rules-based approach of U.S. GAAP. 9. A difference in accounting for a sale-and-leaseback gain exists between IFRS and U.S. GAAP when the lease in the transaction is classified as an operating lease the gain is recognized immediately under IAS 17, but must be amortized over the life of the lease under U.S. GAAP. If the lease is classified as a financing lease, both IFRS and U.S. GAAP require the gain on sale-and-leaseback to be amortized over the life of the lease. 10. The criteria for the disclosure and recognition of a contingent liability (loss) are very similar in both IAS 37 and U.S. GAAP. The main difference is that IAS 37 defines probable in the context of recognizing a contingent liability as more likely than not. U.S. GAAP does not provide a definition for probable. IAS 37 allows recognition of a contingent asset (gain) when the gain is virtually certain, implying that it can be recognized prior to actual realization. U.S. GAAP does not allow recognition of contingent gains. The gain must be realized before it can be recognized. 11. IAS 19 requires past service cost related (a) to retirees and vested active employees to be expensed immediately and (b) to non-vested employees to be recognized on a straight-line basis over the remaining vesting period. In contrast, U.S. GAAP requires the past service cost related (a) to retirees be amortized over their remaining expected life and (b) to active employees be amortized over their remaining service period. 12. Neither the IASB nor the FASB is satisfied with its guidance regarding revenue recognition. Neither Board believes it has adequate literature that is both coherent and comprehensive. The IASB has a single revenue recognition standard that is not comprehensive, and U.S. GAAP contains over 200 pieces of authoritative literature developed on a piecemeal basis, which is not coherent.

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Solutions to Exercises and Problems

1. Monroe Company Inventory IFRS Historical cost Estimated selling price Costs to complete and sell Net realizable value Inventory loss 17,000 2,000 U.S. GAAP 20,00 Historical cost 0 Replacement cost Net realizable value 15,000 Normal profit margin 5,000 NRV - profit margin Market Inventory loss a. (1) IFRS: (2) U.S. GAAP: Year 1 Year 2 Year 1 Year 2 Inventory loss Cost of goods sold Inventory loss Cost of goods sold $5,000 $16,800 $6,000 $15,800 20,000 14,00 0 15,00 0 20% 11,60 0 14,000 6,00 0

b. Year 1: IFRS result in $1,000 larger income before tax, assets, and stockholders equity. Year 2: IFRS result in $1,000 smaller income before tax; assets and stockholders equity are the same at the end of Year 2 under both IFRS and U.S. GAAP. 2. Lincoln Company Research and Development Costs a. IFRS Research expense Deferred development costs (asset) Amortization expense deferred development costs U.S. GAAP Research and development expense Year 1 $6 million $4 million Year 2 $800,000 $10 million --

b. IFRS result in $4 million larger income before tax in Year 1 and $800,000 smaller income before tax in Years 2-6 compared to U.S. GAAP. Ignoring income taxes, total assets and total stockholders equity are larger under IFRS by the following amounts: Year 1 $4,000,000 Year 2 $3,200,000 Year 3 $2,400,000 Year 4 $1,600,000 Year 5 $800,000 Year 6 $0

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3. Jefferson Company Property, Plant and Equipment (measurement subsequent to acquisition) Cost, 1/2/Y1 Useful life Annual depreciation Book value, 12/31/Y2 IFRS Allowed Alternative Fair value, 1/2/Y3 Remaining useful life Annual depreciation a. Depreciation expense Years 1 and 2 Years 3, 4, and 5 $10,000,000 5 years $2,000,000 $6,000,000 $12,000,000 3 years $4,000,000 IFRS $2,000,000 $4,000,000 U.S. GAAP $2,000,000 $2,000,000

Income before tax is the same under IFRS and U.S. GAAP in Years 1 and 2. Income before tax is $2,000,000 smaller under IFRS in Years 3, 4, and 5. b. Equipment (book value) 1 IFRS Beginning $10 mn Revaluation Depreciation expense (2 mn) Ending $8 mn U.S. GAAP Beginning $10 mn Depreciation expense (2 mn) Ending $8 mn Stockholders equity 1 IFRS Beginning $0 Revaluation Depreciation expense($2 mn) Ending ($2 mn) U.S. GAAP Beginning $0 Depreciation expense($2 mn) Ending ($2 mn) 2 $8 mn (2 mn) $6 mn $8 mn (2 mn) $6 mn 2 ($2 mn) ($2 mn) ($4 mn) ($2 mn) ($2 mn) ($4 mn) End of Year 3 $6 mn 6 mn (4 mn) $8 mn $6 mn (2 mn) $4 mn End of Year 3 ($4 mn) $6 mn ($4 mn) ($2 mn) ($4 mn) ($2 mn) ($6 mn) 4 $8 mn (4 mn) $4 mn $4 mn (2 mn) $2 mn 4 ($2 mn) ($4 mn) ($6 mn) ($6 mn) ($2 mn) ($8 mn) 5 $4 mn (4 mn) $0 $2 mn (2 mn) $0 5 ($6 mn) ($4 mn) ($10 mn) ($8 mn) ($2 mn) ($10 mn)

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4. Madison Company Property, Plant and Equipment (impairment) IFRS Carrying amount 10,000,000 Net selling price 7,500,000 Discounted future cash flows 8,000,000 Value in use (larger amount) 8,000,000 Impairment loss 2,000,000 a. (1) IFRS: Year 1 U.S. GAAP Carrying amount Future cash flows No impairment

10,000,000 10,000,000 0

Depreciation expense Impairment loss

2,000,000 2,000,000 1,600,000 (8,000,000/5 years) 2,000,000 Year 3 Year 4

0 0

Years 2 - 6 Depreciation expense (2) U.S. GAAP: Years 1-6 b. Income before tax IFRS Depreciation expense Impairment loss Impact on income U.S. GAAP Depreciation expense Impact on income Diff. (IFRS-U.S. GAAP) Depreciation expense Year 1
(2,000,000)

Year 2
0

Year 5
0

Year 6
0

(2,000,000) (1,600,000) (1,600,000) (1,600,000) (1,600,000) (1,600,000) (4,000,000) (1,600,000) (1,600,000) (1,600,000) (1,600,000) (1,600,000)

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

(2,000,000) (2,000,000) (2,000,000) (2,000,000) (2,000,000) (2,000,000) (2,000,000) (2,000,000) (2,000,000) (2,000,000) (2,000,000) (2,000,000) (2,000,000) 400,000 400,000 400,000 400,000 400,000

Total Assets IFRS Year 1 Year 2 12,000,000 8,000,000 Carrying value (at 1/1) (2,000,000) (1,600,000) Depreciation expense (2,000,000) 0 Impairment loss 8,000,000 6,400,000 Carrying value (at 12/31) U.S. GAAP Year 1 Year 2 12,000,000 10,000,000 Carrying value (at 1/1) (2,000,000) (2,000,000) Depreciation expense 10,000,000 8,000,000 Carrying value (at 12/31) Diff. (IFRS-U.S.GAAP)
(2,000,000) (1,600,000)

Year 3
6,400,000 0 4,800,000

Year 4
4,800,000 0 3,200,000

Year 5
3,200,000 0 1,600,000

Year 6
1,600,000 0 0

(1,600,000) (1,600,000) (1,600,000) (1,600,000)

Year 3
8,000,000 6,000,000 (1,200,000)

Year 4
6,000,000 4,000,000 (800,000)

Year 5
4,000,000 2,000,000 (400,000)

Year 6
2,000,000 0 0

(2,000,000) (2,000,000) (2,000,000) (2,000,000)

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Total Stockholders Equity (ignoring income taxes) IFRS Year 1 Year 2 Year 3 Year 4 0 (4,000,000) (5,600,000) (7,200,000) Beginning balance Depreciation expense (2,000,000) (1,600,000) (1,600,000) (1,600,000) (2,000,000) 0 0 0 Impairment loss (4,000,000) (5,600,000) (7,200,000) (8,800,000) Ending balance U.S. GAAP Beginning balance Depreciation expense Ending balance
Diff. (IFRS-U.S.GAAP)

Year 5
(8,800,000) (1,600,000) 0 (10,400,000)

Year 6
(10,400,000) (1,600,000) 0 (12,000,000)

Year 1
0

Year 2

Year 3

Year 4

Year 5
(8,000,000) (2,000,000) (10,000,000) (400,000)

Year 6
(10,000,000) (2,000,000) (12,000,000) 0

(2,000,000) (4,000,000) (6,000,000)

(2,000,000) (2,000,000) (2,000,000) (2,000,000) (2,000,000) (4,000,000) (6,000,000) (8,000,000) (2,000,000) (1,600,000) (1,200,000) (800,000)

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5. Iptat International Revaluation of Fixed Assets a. Adjustment (a) relates to the depreciation of the revaluation amount on fixed assets. Adjustment (a) results in an addition to net income because the additional depreciation taken on the revaluation amount does not exist under U.S. GAAP. The addition to net income pertains to the current year only. The addition to net income in the current year plus the addition to net income in previous years is the cumulative effect on retained earnings, which is the shareholders equity account affected by adjustment (a). The addition to shareholders equity is greater than the addition to net income because of this cumulative effect. b. Adjustment (b) relates to the revaluation surplus (increase in shareholders equity) that is recorded when fixed assets are revalued. This increase does not exist under U.S. GAAP and shareholders equity must be reduced accordingly. In this case, the shareholders equity account affected is Revaluation Surplus. 6. Xanxi Petrochemical Company Deferred development costs and Gain on sale and leaseback Under IFRS, Xanxi apparently has capitalized some development costs as an asset (IAS 38), which would not be acceptable under U.S. GAAP. Adjustment (a) adds back the current years amortization expense on the deferred development costs that was deducted in determining IFRS net income. This adjustment results in a larger amount of U.S. GAAP net income. The addition to income flows through to retained earnings increasing shareholders equity. The addition to net income pertains to the current year only. The addition to net income in the current year plus the addition to net income in previous years is the cumulative effect on retained earnings. The addition to shareholders equity is greater than the addition to net income because of this cumulative effect. If the lease in a sale-leaseback transaction is classified as an operating lease, IAS 17 requires the gain on such a transaction to be reported in income immediately, whereas U.S. GAAP requires the gain to be amortized over the life of the lease. Adjustment (b) subtracts the gain on sale/leaseback in the current year that was recognized in full under IFRS. The amount of adjustment (b) is the difference between the entire gain recognized under IFRS and the portion of the gain that would be recognized under U.S. GAAP (including amortization of gains that might have been generated in earlier years). The same amount should be subtracted from retained earnings reducing shareholders equity. From the fact that adjustment (b) reduced shareholders equity by a larger amount than it reduces net income, we can infer that Xanxi had one or more sale/leaseback gains in previous years.

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7. Buch Corporation Determination of Impairment Loss and Subsequent Reversal Cost Useful life Residual value Annual depreciation charge Year 1 Carrying value (at 1/1) Depreciation expense Carrying value (at 12/31) Year 2 $100,000 (10,000) $90,000 $100,000 10 years $0 $10,000 Year 3 $90,000 (10,000) $80,000 $80,000 (10,000) $70,000

Test for impairment at December 31, Year 3: Carrying value Net selling price ($70,000 - $7,000) $63,000 Value in use $55,000 Recoverable amount (greater of the two) Impairment loss $70,000 63,000 $ 7,000

The impairment loss of $7,000 would be recognized in income on December 31, Year 3 with an offsetting reduction in the assets carrying value. As a result, the asset will be reported at on the December 31, Year 3 balance sheet at a carrying value of $63,000. This amount will be depreciated over the remaining useful life of 7 years on a straight-line basis. Carrying value (at 1/1) Depreciation expense Impairment loss Carrying value (at 12/31) Year 1 $100,000 (10,000) $90,000 Year 2 $90,000 (10,000) $80,000 Year 3 $80,000 (10,000) (7,000) $63,000 Year 4 $63,000 (9,000) $54,000 Year 5 $54,000 (9,000) $45,000

Review for reversal of impairment loss at December 31, Year 5: Carrying value $45,000 Net selling price ($50,000 - $7,000) $43,000 Value in use $53,000 Recoverable amount (greater of the two) 53,000 Impairment loss $ 0

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IAS 36 requires an impairment loss to be reversed if the recoverable amount of an asset is determined to exceed its new carrying amount, but only if there are changes in the estimates used to determine the original impairment loss or there is a change in the basis for determining the recoverable amount (from value in use to net selling price or vice versa). Because recoverable amount has changed from net selling price at the end of Year 3 to value in use at the end of Year 5, and the recoverable amount is greater than the carrying value at the end of Year 5, the impairment loss recognized in Year 3 should be reversed. However, the carrying value of the asset after reversal of the impairment loss should not exceed what it would have been if no impairment loss had been recognized. The carrying value of Machine Z at December 31, Year 5 would have been $50,000 if no impairment loss had been recognized in Year 3 ($100,000 original cost less $10,000 annual depreciation for five years). Thus, an increase in the carrying value of the asset of $5,000 should be recognized at December 31, Year 5 with a reversal of impairment loss in an equal amount. The assets carrying value on the December 31, Year 5 balance sheet will be $50,000 ($45,000 + $5,000). This amount will be depreciated over the remaining useful life of 5 years on a straight-line basis. Summary of amounts to be reported on the balance sheet and income statement in Years 1 5: Year 1 Year 2 Year 3 Year 4 Year 5 Carrying value (at 1/1) $100,000 $90,000 $80,000 $63,000 $54,000 Income Statement Depreciation expense (10,000) (10,000) (10,000) (9,000) (9,000) Impairment loss (7,000) Reversal of impairment loss 5,000 Carrying value (at 12/31) $90,000 $80,000 $63,000 $54,000 $50,000 Income statement effect (10,000) (10,000) (17,000) (9,000) (4,000)

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8. Holzer Company Capitalization of borrowing costs and Measurement of asset subsequent to acquisition using two alternative models IAS 16 Cost Model Carry asset on the balance sheet at cost less accumulated depreciation and any accumulated impairment losses. Capitalize borrowing costs borrowing costs attributable to the construction of qualifying assets. Annual interest ($900,000 x 10%) Interest to be capitalized in Year 1 ($500,000* x 10%) Interest expense in Year 1 $90,000 50,000 $40,000

* Expenditures of $1,000,000 were made evenly throughout the year, so the average accumulated expenditures during the year are $500,000 ($1,000,000 / 2). Cost of building: Construction costs Capitalized interest Total initial cost of building Annual depreciation (beginning in Year 2) ($1,050,000 / 40 years) Year 1 Income Statement Depreciation expense Balance Sheet Building (at 1/1) Depreciation Building (at 12/31) $0 Year 2 $26,250 Year 3 $26,250 Year 4 $26,250 $997,500 (26,250) $971,250 $1,000,000 50,000 $1,050,000 $26,250 Year 5 $26,250 $971,250 (26,250) $945,000

$0 $1,050,000 $1,023,750 (26,250) (26,250) $1,050,000 $1,023,750 $997,500

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IAS 16 Revaluation Model Carry asset on the balance sheet at revalued amount equal to fair value less any subsequent accumulated depreciation and any accumulated impairment losses. Capitalize borrowing costs attributable to the construction of qualifying assets. Annual interest ($900,000 x 10%) Interest to be capitalized in Year 1 ($500,000 x 10%) Interest expense in Year 1 Cost of building: Construction costs Capitalized interest Total initial cost of building Annual depreciation (beginning in Year 2) ($1,050,000 / 40 years) Year 1 Income Statement Depreciation expense Subtotal Loss on revaluation Reversal of revaluation loss Total expense (income) $0 $0 $0 Year 2 $26,250 $26,250 $26,250 Year 3 $26,250 $26,250 27,500 $43,750 Year 4 $25,5262 $25,526 $25,526 $970,000 (25,526) $944,474 $90,000 50,000 $40,000 $1,000,000 50,000 $1,050,000 $26,250 Year 5 $25,526 $25,526 (27,500) $(1,974) $944,474 (25,526) $918,948 27,5003 3,5523 $950,000

Balance Sheet Building (at 1/1) $0 $1,050,000 $1,023,750 Depreciation (26,250) (26,250) Building (at 12/31) $1,050,000 $1,023,750 $997,500 Loss on revaluation (27,500) 1 Reversal of revaluation loss Revaluation surplus Building (at 12/31) $1,050,000 $1,023,750 $970,000
1

$944,474

At December 31,Year 3, the fair value of the building is determined to be $970,000. The carrying value of the building is decreased by $27,500, with a loss on revaluation recognized in Year 3 net income. 2 Depreciation in Year 4 is $25,526 ($970,000 / 38 remaining years). 3 At December 31,Year 5, the fair value of the building is determined to be $950,000. The carrying value of the building is increased by $31,052. A reversal of revaluation loss of $27,500 is recognized in income and $3,552 ($31,052 27,500) is recorded as revaluation surplus in shareholders equity.

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9. Quantacc Company Reconciliation to U.S. GAAP Year 5 Net income under IFRS Adjustments: Reversal of depreciation on revaluation of fixed assets Reversal of amortization of deferred development costs Reversal of gain on sale and leaseback Amortization of gain on sale and leaseback Net income (loss) under U.S. GAAP December 31, Year 5 Stockholders equity under IFRS Adjustments: Reversal of revaluation of fixed assets Reversal of accumulated depreciation on revaluation of fixed assets Reversal of deferred development costs Reversal of accumulated amortization on deferred development costs Reversal of gain on sale and leaseback Accumulated amortization of gain on sale and leaseback Stockholders equity under U.S. GAAP $100,000 3,500 16,000 (150,000) 7,500 $ (23,000) $500,000 (35,000) 7,000 (80,000) 32,000 (150,000) 7,500 $ 281,500

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10.

Acceptable under
IFRS U.S. GAAP Both Neither

A company takes out a loan to finance the construction of a building that will be used by the company. The interest on the loan is capitalized as part of the cost of the building. Inventory is reported on the balance sheet using the last-in, first-out (LIFO) cost flow assumption. The gain on a sale and leaseback transaction classified as an operating lease is deferred and amortized over the lease term. A company writes a fixed asset down to its recoverable amount and recognizes an impairment loss in Year 1. In a subsequent year, the recoverable amount is determined to exceed the assets carrying value, and the previously recognized impairment loss is reversed. Past service costs related to retired employees that arise when a company makes an improvement to its pension plan are amortized over the remaining expected lives of the retirees. A company enters into an eight-year lease on equipment that is expected to have a useful life of ten years. The lease is accounted for as an operating lease. Dividends paid are classified as an operating cash outflow in the statement of cash flows. In preparing interim financial statements, interim periods are treated as discrete reporting periods rather than as an integral part of the full year. Research and development costs are capitalized when certain criteria are met.

X X

X1

X X

X2

This would be acceptable under IAS 17 if 80% of the life of the lease is not viewed as the major part of the lease. Neither IFRS nor U.S. GAAP allows capitalization of research costs.

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11. The answers to this exercise will depend upon the company and the three line items selected by the students to explain. If the number of students in class is small, each company can be assigned to a team of students, with responses to the requirements of the exercise presented in class.

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CASE 4-1 Jardine Matheson Group (part 2)

Choice among Alternatives Four areas in which IFRS allow a choice among alternatives and Jardines selection among the choices: Tangible fixed assets are stated at valuation, as are Investment properties as allowed by IAS 16 and IAS 40, respectively. The cost of Stocks and work in progress is determined by the first-in, first-out method as allowed by IAS 2. Borrowing costs related to major development projects are capitalized until the asset is substantially completed. All other borrowing costs are expensed as incurred. IAS 23 allows this treatment for borrowing costs. Actuarial gains and losses on defined benefit pension plans are recognized in full in the year in which they occur, outside profit and loss, as is allowed by IAS 19 (amended 2004). (Note: this topic is covered in the Appendix to the chapter.)

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CASE 4-2 Bessrawl Corporation

Reconciliation from U.S. GAAP to IFRS 2008 Income under U.S. GAAP Adjustments: Reversal of writedown of inventory to replacement cost Additional depreciation on revaluation of equipment Impairment loss on intangible asset (brand) Recognition of deferred development costs Reversal of amortization of deferred gain on sale and leaseback Difference in amortization of prior service cost Income under IFRS 10,000 (25,000) (5,000) 80,000 (30,000) (11,000) $1,019,000 2008 Stockholders equity under U.S. GAAP Adjustments: Reversal of writedown of inventory to replacement cost Original revaluation surplus on equipment Accumulated depreciation on revaluation of equipment Impairment loss on intangible assets (brand) Recognition of deferred development costs Recognition of gain on sale and leaseback in 2006 Accumulated amortization of deferred gain on sale and leaseback (20062008) Difference in cumulative amortization of prior service cost Stockholders equity under IFRS Explanation of Adjustments Inventory. Under U.S. GAAP, the company reports inventory on the balance sheet at the lower of cost or market, where market is defined as replacement cost ($180,000), with net realizable value ($190,000) as a ceiling and net realizable value less a normal profit ($152,00) as a floor. In this case, inventory was written down to replacement cost and reported on the December 31, 2008 balance sheet at $180,000. A $70,000 loss was included in 2008 income. In accordance with IAS 2, the company would report inventory on the balance sheet at the lower of cost ($250,000) and net realizable value ($190,000). Inventory would have been reported on the December 31, 2008 balance sheet at net realizable value of $190,000 and a loss on writedown of inventory of $60,000 would have been reflected in net income.
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$1,000,000

$8,000,000 10,000 600,000 (25,000) (5,000) 80,000 150,000 (90,000) (52,000) $8,668,000

IFRS income would be $10,000 larger than U.S. GAAP net income. IFRS retained earnings would be larger by the same amount. Equipment. Under U.S. GAAP, the company reports depreciation expense of $100,000 [($2,750,000 $250,000) / 25 years] in 2007 and in 2008. Under IAS 16s revaluation model, depreciation expense on equipment in 2007 was $100,000, resulting in a book value at the end of 2007 of $2,650,000. The equipment then would be revalued upward at the beginning of 2008 to its fair value of $3,250,000. The appropriate journal entry to recognize the revaluation would be: Dr. Equipment $600,000 Cr. Revaluation Surplus (a stockholders equity account) $600,000 In 2008, depreciation expense would be $125,000 [($3,250,000 - $250,000)/24 years]. The additional depreciation under IFRS causes IFRS-based income in 2008 to be $25,000 smaller than U.S. GAAP income. IFRS-based stockholders equity is $575,000 larger than U.S. GAAP stockholders equity. This is equal to the amount of the revaluation surplus ($600,000) less the additional depreciation in 2008 under IFRS ($25,000), which reduced retained earnings. Intangible Assets. Under U.S. GAAP, an asset is impaired when its carrying amount exceeds the undiscounted future cash flows expected to arise from continued use of the asset. The brand acquired in 2005 has a carrying amount of $40,000 and future expected cash flows are $42,000, so it is not impaired under U.S. GAAP. Under IAS 36, an asset is impaired when its carrying amount exceeds its recoverable amount, which is the greater of net selling price and value in use. The brands recoverable amount is $35,000; the greater of net selling price of $35,000 and value in use (present value of future cash flows) of $34,000. As a result, an impairment loss of $5,000 would be recognized under IFRS. IFRS income and retained earnings would be $5,000 less than U.S. GAAP income and retained earnings. Research and Development Costs. Under U.S. GAAP, research and development expense in the amount of $200,000 would be recognized in determining 2008 income. Under IAS 38, $120,000 (60% x $200,000) of research and development costs would be expensed in 2008, and $80,000 (40% x $200,000) of development costs would be capitalized as an intangible asset (deferred development costs). IFRS-based income in 2008 would be $80,000 larger than U.S. GAAP income. Because the new product has not yet been brought to market, there is no amortization of the deferred development costs under IFRS in 2008. Sale and Leaseback. Under U.S. GAAP, the gain on the sale and leaseback (operating lease) is recognized in income over the life of the lease. With a lease term of five years, $30,000 of the

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gain would be recognized in 2008. $30,000 also would have been recognized in 2006 and 2007, resulting in a cumulative amount of retained earnings at year-end 2008 of $90,000. Under IAS 13, the entire gain on the sale and leaseback of $150,000 would recognized in income in 2006. This resulted in an increase in retained earnings of that year. No gain would be recognized in 2008. IFRS income in 2008 would smaller than U.S. GAAP income, but stockholders equity at December 31, 2008 would be $60,000 larger than under U.S. GAAP. have been $150,000 in be $30,000 under IFRS

Pension Plan. Under U.S. GAAP, the prior service cost is amortized over the remaining service life of the employees. Expense recognized in 2008 is $4,000 [$60,000 / 15 years]. The cumulative expense (and reduction in retained earnings) recognized since the plan was changed in 2007 is $8,000 [$4,000 x 2 years]. Under IAS 19, the prior service cost attributable to the vested employees would have been expensed in 2007 $30,000 [50% x $60,000]. The prior service cost attributable to non-vested employees would be expensed over the two remaining years until vesting. Expense recognized in 2008 would be $15,000 [$30,000 / 2 years]. The cumulative expense (and reduction tin retained earnings) recognized since the plan was changed is $60,000 [$30,000 + ($15,000 x 2 years). IFRS income in 2008 would be $11,000 ($15,000 - $4,000) less than U.S. GAAP income, and stockholders equity at year-end 2008 under IFRS would be $52,000 ($60,000 - $8,000) less than under U.S. GAAP.

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