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Trabeck prepares for IFRS: An IFRS case study
J. of Acc. Ed. 31 (2013) 53–67
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Educational Case
Trabeck prepares for IFRS: An IFRS case study Martin Coe a,⇑, John Delaney b,1 a b
Department of Accounting and Finance, Western Illinois University, 3300 River Drive, Moline, IL 61265, United States Accounting Department, Augustana College, 639 38th Street, Rock Island, IL 61201, United States
a r t i c l e
i n f o
Article history: Available online 10 January 2013 Keywords: IFRS Teaching case
a b s t r a c t The growing acceptance of International Financial Reporting Standards (IFRSs) as a basis for US financial reporting represents a fundamental change for the US accounting profession. IFRS and US generally accepted accounting principles (GAAPs) both are based on principles; however, US GAAP largely uses rules to apply the principles. In contrast, IFRS relies heavily on the use of judgment in deciding how transactions should be recorded. This fictional case is designed to help students identify some fundamental differences between US GAAP and IFRS and apply this knowledge to general-purpose financial statements. Ó 2012 Elsevier Ltd. All rights reserved.
1. Introduction Doug is confused. His CPA, Barry, just informed him that there is a movement underway for organizations around the world to utilize a single set of global accounting standards. This movement is gathering momentum in the US and around the globe. In the US, this movement began to take hold in 2002, when the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued the Norwalk Agreement, in which they acknowledged their joint commitment to develop high-quality, compatible accounting standards that could be used for both domestic and cross-border financial reporting. In a process referred to as ‘‘convergence’’ the two
⇑ Corresponding author. Tel.: +1 309 762 9481x62304; fax: +1 309 764 7172. 1
E-mail addresses: [email protected] (M. Coe), [email protected] (J. Delaney). Tel.: +1 309 794 7732.
0748-5751/$ - see front matter Ó 2012 Elsevier Ltd. All rights reserved. http://dx.doi.org/10.1016/j.jaccedu.2012.12.002
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bodies have ever since been working together toward that end.2 Barry told Doug that this movement will likely impact how his company will record transactions and prepare financial statements in the future. Doug wondered how this could possibly impact his company. Doug is the owner of a manufacturing company in the Midwest called Trabeck. An engineer by trade, Doug formed Trabeck in 1978. Trabeck’s innovation has resulted in dozens of patents that have allowed Trabeck’s sales to grow to more than $20 million per year. While he is pleased with Trabeck’s growth, Doug feels that Trabeck has not yet achieved its full potential. More specifically, several recent patents provide an opportunity for Trabeck to enter new global markets. However, significant capital will be required to exploit this opportunity. Doug’s primary focus has historically been on marketing and production. In this vein, Doug utilizes a mix of operational reports to make day-to-day decisions. However, to analyze his company’s financial position and results of operations Doug relies heavily on the interim and annual financial statements his controller prepares. While Doug does not have a working knowledge of generally accepted accounting principles (US GAAPs), he is comfortable analyzing his company’s financial position and results of operations using financial statements prepared in accordance with US GAAP. Furthermore, Doug knows that his bankers also are able to use the company’s US GAAP-based financial statements to satisfy the banks’ requirements. Since Trabeck will require significant capital to achieve its full potential, Doug is considering selling Trabeck to a European company. When Doug was discussing with Barry his strategy to sell Trabeck to a European company, they initially focused on business valuation items. However, Barry indicated that a sale of the company might be impacted by International Financial Reporting Standards (IFRS). According to a report by PricewaterhouseCoopers (2011a), as of September 2011, more than 100 countries require or allow the use of IFRS for the preparation of financial statements. Accordingly, there is a possibility that if Trabeck is sold to a European company, that company would follow IFRS and would require Trabeck to convert its financial reporting to IFRS. Doug decided he needed to know more about IFRS and he also needed to understand how converting to IFRS might impact his company. 2. The IFRS project Doug met with his controller, Susan, to discuss IFRS. After summarizing his meeting with the CPA, Doug asked Susan if she could do some research to help him learn about IFRS and understand how converting to IFRS might impact Trabeck. Susan subsequently met with the CPA to identify sources for the research required for this task: 1. Information regarding convergence efforts from the Financial Accounting Standards Board (FASB), IASB, and SEC web sites. 2. IFRS standards, illustrative examples and implementation guidance from the IASB. 3. IFRS resources available from the AICPA’s web site. 4. IFRS resources available from some of the larger CPA firms. 5. Current Intermediate and Advanced Accounting textbooks that include IFRS coverage.
2 As of this writing, there is some evidence that the SEC may be retreating from its former stance regarding convergence. The Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for US Issuers Final SEC Staff Report that was issued on July 13, 2012 indicates that additional analysis is necessary before any SEC decision is made about incorporating IFRS into the US financial reporting system. In this vein, AICPA President and CEO Barry Melancon indicated that the United States must keep pushing for convergence of US GAAP and international standards. Melancon, addressing the AICPA governing Council on October 22, 2012, raised concerns that support is waning for convergence of international standards and US GAAP, with talk of comparability rather than convergence bubbling from the United States. The FASB and the IASB are responding to different stakeholders and are having some difficulties agreeing on a harmonized approach to certain projects, he said. For example, the FASB in July 2012 decided to take a step back from the so-called ‘‘three-bucket’’ impairment model the FASB and IASB boards had been developing for financial instruments and now the FASB is separately developing a ‘‘Current Expected Credit Loss’’ model. With convergence in question, SEC action on IFRS adoption is also uncertain because the SEC made the convergence progress by FASB and the IASB one of the milestones upon which the commission will base its IFRS decision.
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After completing the IFRS research, Susan gathered relevant information related to Trabeck’s 2012 financial statements to determine the impact IFRS would have on these statements. 3. US GAAP-based financial statements and other information Susan retrieved Trabeck’s 2012 US GAAP-based balance sheet (Fig. 1) and income statement (Fig. 2). As a result of the review of the statements, as well as Susan’s recollection of events that occurred in 2012, several items were identified where US GAAP and IFRS might differ. 1. Trabeck has two primary bank accounts. At December 31, 2012, one of these accounts had bank overdrafts that caused a negative balance of $100,000. The other bank account had a balance greater than $500,000. Trabeck recorded the $100,000 overdraft as a liability. In contrast, IFRS
Fig. 1. US GAAP-based balance sheet.
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Fig. 2. US GAAP-based income statement.
2.
3.
4.
5.
allows bank overdrafts to be offset against other cash accounts when overdrafts are payable on demand and fluctuate between positive and negative amounts as part of the normal cash-management program. Trabeck’s inventories are valued at the lower of cost, using the last-in, first-out (LIFO) method, or market. However, IFRS does not permit the use of LIFO. Accordingly, under IFRS, Trabeck’s inventories would be valued at the lower of cost, using the first-in, first-out (FIFO) or average cost method, or net realizable value. The impact of changing from LIFO to FIFO (excluding tax considerations) would cause the 2012 ending inventory to be $1200,000 higher and the 2012 cost of goods sold to be $1200,000 lower. According to US GAAP, market value for inventory is defined as replacement cost with a ceiling of net realizable value (NRV) and a floor of NRV less ‘‘normal profit margin.’’ However, under IFRS, inventory is valued at the lower of cost and NRV. IFRS also specifies that, if circumstances indicate, an inventory write-down is no longer appropriate, it must be reversed. Such reversals are not permitted under US GAAP. In 2011, Trabeck wrote-down the value of its inventory by $800,000. That inventory write-off should, under IFRS, be reversed in 2012. As required by US GAAP, Trabeck expenses research and development expenditures in the period incurred. However, under IFRS, development expenditures that meet specific criteria are capitalized as an intangible asset. Accordingly, $20,000 of 2012 development costs should be capitalized under IFRS. IFRS requires that each component of an item of property, plant and equipment be depreciated separately if its cost is significant in relation to the total cost of the item. US GAAP allows ‘‘component depreciation’’ but it is not often used in practice. Under IFRS, a $100,000 component would be depreciated separately at a faster rate than the asset of which the component is a part. This would cause 2012 depreciation expense to be $5000 higher.
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6. Under US GAAP, a company reports its property, plant, and equipment (PP&E) at cost less accumulated depreciation. IFRS also allows a company to report its property, plant and equipment at cost less accumulated depreciation or, alternatively, at its fair value. If a company chooses fair value, all of the assets within a class of property, plant and equipment must be revalued on a regular basis. US GAAP prohibits this type of revaluation. Under IFRS, the utilization of fair value for property, plant and equipment would increase property, plant and equipment at December 31, 2012 by $300,000 and increase the related accumulated depreciation by $100,000 (i.e. fair value is $200,000 greater than book value). 7. IFRS and US GAAP differ in the treatment related to accounting for the impairment value of property plant and equipment. One of these differences relates to the recoverability test. Under US GAAP, an impairment loss is required when an asset’s net book value exceeds the undiscounted sum of the asset’s estimated future cash flows. Under IFRS, an impairment loss is required when an asset’s carrying amount exceeds the higher of the asset’s value-in-use (present value of estimated future cash flows) and fair value less costs to sell. Under IFRS, there would be a $10,000 impairment loss related to property, plant and equipment in 2012. 8. Under IFRS, unlike US GAAP, convertible debt is divided into its liability and equity components. Trabeck has $103,000 of convertible debt that is currently recorded as long-term debt. The contractual arrangement specifies that the value of the debt portion is $98,000 and the value of the equity portion is $5000. 9. Lease accounting under US GAAP is driven by rules that determine if a lease should be capitalized. In contrast, IFRS utilizes principles to determine if a lease should be capitalized. A lease that is currently recorded as an operating lease would, under IFRS, be capitalized. The finance lease amount is $401,000. 10. In January 2012, Trabeck realized a gain on the sale and leaseback of an office building in the amount of $3000,000. The lease is accounted for as an operating lease and the term of the lease is 5 years. Under US GAAP, the gain on the sale and leaseback is recognized over the life of the lease. Under IFRS, the entire gain on an operating lease would be reported immediately. 11. Pension accounting is different under IFRS. Under IFRS, for defined benefit plans, prior service cost is expensed immediately to the extent it relates to benefits that have vested. Under US GAAP, prior service cost is included in other comprehensive income and amortized over the remaining service lives of employees. Vested prior service cost that has not been expensed as of December 31, 2012 is $100,000. 12. In considering the impact that IFRS might have related to Trabeck’s equity holdings, the controller noted that US GAAP requires companies to report information about reported segment profit or loss, including certain revenues and expenses included in the segment profit or loss, segment assets, and the basis of measurement. In addition to these items, IFRS also requires companies to disclose total liabilities of its reportable segments when this amount is regularly provided to the chief operating decision maker. Trabeck needs to disclose total liabilities related to its reportable segments in the amount of $8000,000.
4. Requirements Prepare a report to the owner that addresses the following requirements. 1. Determine if Trabeck can at this point adopt IFRS. 2. Use Trabeck’s 2012 US GAAP-based financial statements and other information to prepare Trabeck’s 2012 IFRS-based statement of financial position and statement of comprehensive income including relevant footnotes. Ignore the implications for income tax. 3. Reconcile the differences between Trabeck’s US GAAP-based and IFRS-based financial statements. 4. Summarize how converting from US GAAP to IFRS would impact Trabeck’s owners, creditors and other decision makers.
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5. Teaching note 5.1. Learning objectives While this case can be used by non-US readers to illustrate the impact IFRS is having on global accounting practices, the case is designed primarily for use in US undergraduate Advanced Accounting courses and graduate accounting programs. This case is most appropriate for students who have previously been exposed to IFRS and is not recommended as an introduction to IFRS unless the instructor intends to work through the case solutions with students. The learning objectives for this case include: 1. 2. 3. 4. 5.
Gain an understanding of some of the fundamental differences between US GAAP and IFRS. Prepare financial reports under both US GAAP and IFRS. Compare and contrast the differences between US GAAP-based and IFRS-based reports. Identify the areas where judgment played a role in the preparation of IFRS-based reports. Identify the areas where converting from US GAAP to IFRS might impact decisions made by decision-makers.
5.2. Evidence of efficacy This case was tested for efficacy in the classroom during the spring 2010 and fall 2010 semesters. The case was tested in the following settings:3 1. The residential campus of a large US public university in the Midwest. The students in this setting were primarily traditional students. 2. The nonresidential campus of the same public university in the Midwest. The students in this setting were primarily nontraditional students. The college and the department of accountancy of this public university are accredited by AACSB— International. While the two campuses serve different populations, the mission is the same and there is a common Department of Accountancy for both campuses. Accordingly, the underlying accounting curriculum is the same for both the residential and the nonresidential campuses. The case was tested for efficacy in the Advanced Accounting classes offered at these two campuses during the spring 2010 and fall 2010 semesters. The instructor for the advanced accounting class at the residential campus was a tenured professor and the instructor for the Advanced Accounting class at the nonresidential campus was a tenured associate professor. Both classes used the same textbook and had the same learning objectives. Students in the two Advanced Accounting classes had completed Intermediate Accounting with a grade of C or better. Prior to working on the case, students were generally exposed to IFRS concepts; however, students had not been required to apply IFRS. The case was administered and tested for efficacy in the four advanced accounting classes as follows: 1. Just prior to starting the case, students took a pretest to assess their understanding of the fundamental differences between US GAAP and IFRS. The pretest contained short-answer questions related to overall IFRS concepts and specific areas of IFRS application. The pretest was graded by the full professor (not the author). There were 10 questions. Each question was scored either as: correct, partially correct, or incorrect. If a student’s response to a question indicated that the student clearly understood the concept, the student received 2 points; if the student’s response indicated that the student partially understood the concept (addressed the question but lacked detail), the student received 1 point; and if the student’s response indicated that the student did not understand the concept, the student received 0 points.
3 In these settings, traditional students generally enter college after high school and attend college full-time and nontraditional students generally attend college part-time and tend to be older than traditional students.
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2. Students were assigned the case midpoint in the semester. The instruction for both classes included a 75-min lecture based on the IFRS/US GAAP differences contained in the case. Students were assigned the case two weeks before the lecture and they were asked to be prepared to discuss the case during the lecture period. In addition to the lecture, students were provided an IFRS handout (KPMG, 2012) that contained a side-by-side comparison of IFRS and US GAAP. 3. The case was due one week after the lecture. When the case was assigned, students were told the case would take approximately 8 h to complete. Students were also told how the case would impact their course points. 4. After completing the case, and prior to receiving their case back from the author, students took a posttest (the same test as the pretest). The posttest, which was graded independently from the pretest, was graded by the same full professor (not the author) who graded the pretest. The pretest and posttest results are summarized in Table 1. The pretest and posttest results were identified by student, so a paired-samples t-test was able to be conducted to compare pretest and posttest scores. There was a statistically significant difference between the pretest scores (M = 5.81, SD = 2.12) and the posttest scores (M = 14.36, SD = 3.30); t(57) = 18.3, p < 0.001. The results of the efficacy tests are depicted in Fig. 3. These results suggest that the case helped students gain an understanding of some of the fundamental differences between US GAAP and IFRS. 5.3. Recommended solution The following case solution includes: 1. Adjusting Journal Entries and Judgment Questions 2. Case Requirements–Solution 5.3.1. Adjusting journal entries and judgment questions
1.
Bank overdrafts – offset other cash accounts versus a liability
Other accrued expenses
100,000 Debit 100,000 Credit
Cash and equivalents
Source: IAS No.7 Judgment Question: Does the company’s normal cash management program include use of a bank overdraft where the balance fluctuates between positive and negative cash balances? 2.
LIFO not allowed
Inventory
1200,000 Debit 1200,000 Credit
COGS
Source: IAS No. 2 Judgment Question: Should FIFO or average costs be used to value inventory? 3.
Inventory write-off and definition of market
Inventory Inventory write-down expense
800,000 Debit 800,000 Credit
(continued on next page)
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Source: IAS No. 2 Judgment Question: Does a previous inventory write-down need to be reversed? 4.
R&D – capitalize development costs
Intangible asset R&D expense
20,000 Debit 20,000 Credit
Source: IAS No. 38 Judgment Question: Do development expenditures meet the capitalization criteria? 5.
Component capitalization
Depreciation expense Accumulated depreciation
5000 Debit 5000 Credit
Source: IAS No. 16 Judgment Question: Is a component significant and if so, does it have a different life than the asset it is a part of? 6.
Fair value option for PPE
PPE Accumulated depreciation
300,000 Debit 100,000 Credit 200,000 Credit
Revaluation surplus –Other Comprehensive Income (OCI) Source: IAS No. 16 Judgment Question: Should the fair value option be used? If so, how should fair value and the related life be estimated? 7.
PPE impairment loss
Impairment loss Accumulated depreciation
10,000 Debit 10,000 Credit
Source: IAS No. 36 Judgment Question: What are the estimated fair values? 8.
Convertible debt
Long-term debt Convertible debt Equity – conversion option
103,000 Debit 98,000 Credit 5000 Credit
Source: IAS No. 32 Judgment Question: What is the estimated fair value of a comparable debt instrument that does not have the conversion option? 9.
Finance leases
Leased equipment Lease payable Source: IAS No. 17
401,000 Debit 401,000 Credit
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Judgment Question: Does the lease in essence transfer the substantial risks and rewards of ownership of the asset to the lessee? 10.
Sale-leaseback
Deferred gain on sale-leaseback Gain on sale-leaseback
2400,000 Debit 2400,000 Credit
Source: IAS No. 17 Note: 600,000 would have been recognized in 2012, so the difference needs to be recorded. Judgment Question: Is the sales price at fair value? (If the sales price is above fair value, the difference is deferred and amortized over the period the asset is expected to be used.) 11.
Pension costs
Pension expense
100,000 Debit 100,000 Credit
OCI
Source: IAS No. 19 Judgment Question: Have pension benefits vested? 12.
Segment reporting
Additional footnote noting the liabilities related to its reportable segments are $8000,000. Source: IAS No. 8 Judgment Question: How should liabilities that relate to more than one segment be reported in the footnote?
Table 1 Pretest versus posttest results. Spring and fall 2010
Residential campus n = 36
Nonresidential campus n = 22
Average n = 58
Question
Pretest
Posttest
Pretest
Posttest
Pretest
Posttest
What is the fundamental difference between current US GAAP and IFRS? Who sets the IFRS standards? Can US companies follow IFRS today? What impact will IFRS have on US companies in the future? What is one difference between US GAAP and IFRS related to inventory? What is one difference between US GAAP and IFRS related to longterm assets? What is one difference between US GAAP and IFRS related to research and development costs? What is one difference between US GAAP and IFRS related to leases? What is one difference between US GAAP and IFRS related to pension costs? What is one difference between US GAAP and IFRS related to segment reporting?
0.61
1.86
0.86
1.91
0.71
1.88
1.25 1.33 1.17 0.89
1.89 1.03 1.28 1.89
1.45 0.82 1.32 0.82
1.82 1.64 1.50 1.91
1.33 1.14 1.22 0.86
1.86 1.26 1.36 1.90
0.19
1.28
0.09
1.00
0.16
1.17
0.44
1.67
0.05
1.50
0.29
1.60
0.03 0.08
1.17 1.19
0.09 0.00
1.09 1.00
0.05 0.05
1.14 1.12
0.00
1.11
0.00
1.00
0.00
1.07
Numbers range from 0 to 2, with higher numbers being better.
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Fig. 3. Efficacy results.
Table 2 Grading rubric. Meets expectations
Exceeds expectations
Trabeck could actually adopt IFRS at this point in time The IASB is the second designated standard setter (along with the FASB) in the AICPA code of ethics
Trabeck could actually adopt IFRS at this point in time The IASB is the second designated standard setter (along with the FASB) in the AICPA code of ethics US GAAP is the dominant set of standards in the US, so Trabeck would need a reason to follow IFRS instead of US GAAP One reason to follow IFRS is if a firm is owned or controlled by a foreign entity that uses IFRS. Since more than 100 countries either allow or require IFRS, it is reasonable to think that if a firm were owned or controlled by a foreign entity IFRS would need to be followed
5.3.2. Case requirements—solution 5.3.2.1. Requirement 1: Applicability of IFRS. Trabeck could actually adopt IFRS at this point in time. The IASB is the second designated standard setter (along with the FASB) in the AICPA code of ethics (AICPA, 2012). However, US GAAP is the dominant set of standards in the United States. Thus, Trabeck would need a reason to follow IFRS rather than US GAAP. One such reason would be if a firm were owned or controlled by a foreign entity that follows IFRS. Since more than one hundred countries allow or require IFRS (AICPA, 2009), it is reasonable to think that if a firm were owned or controlled by a foreign entity IFRS would need to be followed (Herz & Tweedie, 2009). Table 2 depicts a grading rubric for this requirement.
5.3.2.2. Requirement 2: IFRS-based statements. According to IFRS 1, an entity shall prepare and present an opening IFRS statement of financial position at the date of transition to IFRS. To comply with IAS 1, a complete set of financial statements comprises: a statement of financial position as at the end of the period, a statement of comprehensive income for the period (or it may elect to have two statements on financial performance where the determination of net profit or loss is reported in an income statement
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Fig. 4. IFRS-based statement of financial position.
and other comprehensive income is reported in the statement of comprehensive income), a statement of changes in equity for the period, a statement of cash flows for the period, notes, and a statement of financial position as at the beginning of the earliest comparative period when an entity applies an accounting policy retrospectively or makes a retrospective restatement of items in its financial statements, or when it reclassifies items in its financial statements. (An entity may use titles for the statements other than those identified except it must report a statement of comprehensive income.) For the purpose of this case, only the statement of financial position and the statement of comprehensive income are required. (The data necessary to prepare other required statements and comparative information are not included in the case.) In addition to consulting IAS 1, IFRS resources from PricewaterhouseCoopers (2011b) and KPMG (2011) were consulted to prepare the statement of financial position (Fig. 4) and the statement of comprehensive income (Fig. 5).
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Fig. 5. IFRS-based statement of comprehensive income.
Table 3 Financial statement impact. Account
Per US GAAP
Difference
Per IFRS
Cash and equivalents Inventories, net Property, plant and equipment, net Leased equipment Intangible assets, net Other accrued expenses Convertible debt Long-term debt Lease payable Deferred gain on sale-leaseback Equity conversion option Reserves Retained earnings Cost of sales Other expense (income), net Gain on sale-leaseback Impairment loss Current assets Non-current assets Total assets Current liabilities Non-current liabilities Total liabilities and equity Net profit Other comprehensive income Total comprehensive income
2500 1998 2901 0 3328 (768) 0 (6388) 0 (2400) 0 100 (8988) 12,868 (14) 0 0 8829 18,759 27,588 3393 12,303 27,588 (1248) 0 (1248)
(100) 2000 185 401 20 100 (98) 103 (401) 2400 (5) (300) (4305) (1200) (715) (2400) 10 1655 851 2506 (100) (2004) 2506 (4305) (300) (4605)
2400 3998 3086 401 3348 (668) (98) (6285) (401) 0 (5) (200) (13,293) 11,668 (729) (2400) 10 10,484 19,610 30,094 3293 10,299 30,094 (5553) (300) (5853)
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5.3.2.3. Requirement 3: Differences between Trabeck’s US GAAP-based and IFRS-based financial statements. The differences between Trabeck’s US GAAP-based and IFRS-based financial statements are summarized in Table 3. The differences relate to the following areas:
Bank overdrafts – offset other cash accounts versus a liability. LIFO not allowed. Inventory write-off and definition of net realizable value (NRV). R&D–capitalize development costs. Component capitalization. Fair value option for PPE. PPE impairment loss. Convertible debt. Finance leases. Sale-leaseback. Pension costs.
In addition, IFRS also requires companies to disclose total liabilities of its reportable segments when this is normally reported to the chief executive officer or chief operating officer. Trabeck’s total liabilities related to its reportable segments are $8000,000.
5.3.2.4. Requirement 4: Impact of IFRS on Trabeck’s decision makers. Converting from US GAAP to IFRS may have a significant impact on Trabeck’s owners, creditors, and other decision makers. From a financial statement analysis perspective, the following differences related to Trabeck’s 2012 financial statements are significant: Total assets increased $2506,000 (9.1%). Net profit increased $4305,000 (345%). Total Comprehensive income increased $4605,000 (369%). Table 4 Ratios. Category
Ratio
Formula
US GAAP
IFRS
Difference between US GAAP and IFRS
Liquidity ratios
Current ratio Quick or acid-test ratio
Current assets/current liabilities Cash, marketable securities, and receivables (net)/current liabilities
2.60 1.87
3.18 1.90
0.58 0.03
Activity ratios
Receivables turnover
Net sales/average trade receivables (net) Cost of goods sold/average inventory Net sales/average total assets
6.57
6.57
0.00
6.44 0.73
2.92 0.67
-3.52 -.06
Profit margin on sales Rate of return on assets Rate of return on common stock equity 10.49% Earnings per share
Net profit/net sales Net profit/average total assets
6.17% 4.52%
27.47% 18.45%
21.30% 13.93%
Net profit minus preferred dividends/average common 33.65% Net profit minus preferred Dividends/weighted shares outstanding
23.16% $0.21
$0.93
$0.72
Debt to total assets Times interest earned Book value per share
Total debt/total assets Profit before interest expense and taxes/interest expense Common stockholders’ equity/ outstanding shares
44.60% 5.9
34.22% 18.2
-10.37% 12.3
$1.98
$2.75
$0.77
Inventory turnover Asset turnover Profitability ratios
Stockholders’ equity
Coverage ratios
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Ratio analysis is commonly used to analyze financial statements. Trabeck’s ratio analysis is summarized in Table 4. The liquidity ratios are used to determine whether a company has the short-run ability to pay its maturing obligations. The most significant change for Trabeck comes from an increase in the current ratio under IFRS. This change is due primarily to increased inventories using FIFO instead of LIFO. Activity ratios are used to measure how effectively a company uses its assets. Most of the activity ratios for Trabeck did not have significant changes from US GAAP to IFRS, with the exception of the inventory turnover ratio. The decrease in the inventory turnover ratio was due to a combination of a decrease in cost of sales and an increase in inventory, primarily the result of the change in inventory valuation from LIFO to FIFO. Profitability ratios measure how successful a company was at generating profits over a given time period. The profitability ratios for Trabeck had significant changes. The primary difference between these ratios for Trabeck was the increase in net profit, which was due mainly to the gain on sale-leaseback recognized under IFRS (assuming the sales price is at fair value) as well as lower cost of sales under IFRS. All of these ratios for Trabeck look better using IFRS, making the company look more profitable. Coverage ratios measure the protection for long-term creditors and investors. For Trabeck, times interest earned saw the biggest change under IFRS due to the increase in profit. The other two ratios were affected by the decrease in liabilities and the increase in stockholders’ equity due to the deferred gain on sale-leaseback that was recognized as income under IFRS. Overall, almost all of the ratios under IFRS are better for Trabeck. The main reasons for most of the differences between the ratios in US GAAP and IFRS are the recognition of the deferred gain on saleleaseback as income under IFRS, and the conversion of inventory from LIFO to FIFO under IFRS. It is important to note that even though the financial statements changed, the underlying cash flow did not change. As convergence to IFRS continues, financial statement preparers will be faced with new challenges, including making certain judgments that may or may not have been required to make in the past. Some of these judgment questions are provided in the adjusting journal entries solution, and include: 1. Does the company’s normal cash management program include use of a bank overdraft facility where the balance fluctuates between positive and negative cash balances? 2. Should LIFO or average costs be used to value inventory? 3. Does a previous inventory write-down need to be reversed? 4. Do research and development expenditures meet the capitalization criteria? 5. Is a component asset significant and if so, does it have a different life than the asset of which it is a part of? 6. Should the fair-value option be used for property, plant and equipment? If so, how should fair value and the related life be estimated? 7. What are the estimated fair values of various assets? 8. Does the lease in essence transfer the risks and rewards of ownership of the asset to the lessee? 9. Is the sales price at or above fair value? 10. Have pension benefits vested? 11. How should liabilities that relate to more than one segment be reported in the footnote? As noted above, if IFRS is followed, Trabeck’s decision makers would be provided significantly different financial statements than if US GAAP is followed. In large part the differences are due to both rules (e.g. LIFO is not allowed under IFRS) and judgments (e.g. determination of fair value) made by the financial statement preparers intending to comply with the requirements of IFRS.
Acknowledgements The authors thank two anonymous reviewers, the associate editor who handled the review of our manuscript, and the editor-in-chief (David E. Stout) for their insightful comments and suggestions for improving this case.
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References AICPA (2009). IFRS primer for audit committees. New York, NY: AICPA. AICPA (2012). Council resolution designating bodies to promulgate technical standards. (Accessed 17.11.12). Herz, R., & Tweedie, D. (2009). IFRS-US GAAP convergence update. In A presentation at the AICPA/IASC conference on IFRS in North America, October 26, 2009. KPMG (2011). IFRS illustrative financial statements. UK: KPMG. KPMG (2012). IFRS compared to US GAAP: An overview. UK: KPMG. PricewaterhouseCoopers (2011a). IFRS adoption by country. New York, NY: PricewaterhouseCoopers LLP. PricewaterhouseCoopers (2011b). First-time IFRS annual financial statements: An illustration. New York, NY: PricewaterhouseCoopers LLP.
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J. of Acc. Ed. journal homepage: www.elsevier.com/locate/jaccedu
Educational Case
Trabeck prepares for IFRS: An IFRS case study Martin Coe a,⇑, John Delaney b,1 a b
Department of Accounting and Finance, Western Illinois University, 3300 River Drive, Moline, IL 61265, United States Accounting Department, Augustana College, 639 38th Street, Rock Island, IL 61201, United States
a r t i c l e
i n f o
Article history: Available online 10 January 2013 Keywords: IFRS Teaching case
a b s t r a c t The growing acceptance of International Financial Reporting Standards (IFRSs) as a basis for US financial reporting represents a fundamental change for the US accounting profession. IFRS and US generally accepted accounting principles (GAAPs) both are based on principles; however, US GAAP largely uses rules to apply the principles. In contrast, IFRS relies heavily on the use of judgment in deciding how transactions should be recorded. This fictional case is designed to help students identify some fundamental differences between US GAAP and IFRS and apply this knowledge to general-purpose financial statements. Ó 2012 Elsevier Ltd. All rights reserved.
1. Introduction Doug is confused. His CPA, Barry, just informed him that there is a movement underway for organizations around the world to utilize a single set of global accounting standards. This movement is gathering momentum in the US and around the globe. In the US, this movement began to take hold in 2002, when the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued the Norwalk Agreement, in which they acknowledged their joint commitment to develop high-quality, compatible accounting standards that could be used for both domestic and cross-border financial reporting. In a process referred to as ‘‘convergence’’ the two
⇑ Corresponding author. Tel.: +1 309 762 9481x62304; fax: +1 309 764 7172. 1
E-mail addresses: [email protected] (M. Coe), [email protected] (J. Delaney). Tel.: +1 309 794 7732.
0748-5751/$ - see front matter Ó 2012 Elsevier Ltd. All rights reserved. http://dx.doi.org/10.1016/j.jaccedu.2012.12.002
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bodies have ever since been working together toward that end.2 Barry told Doug that this movement will likely impact how his company will record transactions and prepare financial statements in the future. Doug wondered how this could possibly impact his company. Doug is the owner of a manufacturing company in the Midwest called Trabeck. An engineer by trade, Doug formed Trabeck in 1978. Trabeck’s innovation has resulted in dozens of patents that have allowed Trabeck’s sales to grow to more than $20 million per year. While he is pleased with Trabeck’s growth, Doug feels that Trabeck has not yet achieved its full potential. More specifically, several recent patents provide an opportunity for Trabeck to enter new global markets. However, significant capital will be required to exploit this opportunity. Doug’s primary focus has historically been on marketing and production. In this vein, Doug utilizes a mix of operational reports to make day-to-day decisions. However, to analyze his company’s financial position and results of operations Doug relies heavily on the interim and annual financial statements his controller prepares. While Doug does not have a working knowledge of generally accepted accounting principles (US GAAPs), he is comfortable analyzing his company’s financial position and results of operations using financial statements prepared in accordance with US GAAP. Furthermore, Doug knows that his bankers also are able to use the company’s US GAAP-based financial statements to satisfy the banks’ requirements. Since Trabeck will require significant capital to achieve its full potential, Doug is considering selling Trabeck to a European company. When Doug was discussing with Barry his strategy to sell Trabeck to a European company, they initially focused on business valuation items. However, Barry indicated that a sale of the company might be impacted by International Financial Reporting Standards (IFRS). According to a report by PricewaterhouseCoopers (2011a), as of September 2011, more than 100 countries require or allow the use of IFRS for the preparation of financial statements. Accordingly, there is a possibility that if Trabeck is sold to a European company, that company would follow IFRS and would require Trabeck to convert its financial reporting to IFRS. Doug decided he needed to know more about IFRS and he also needed to understand how converting to IFRS might impact his company. 2. The IFRS project Doug met with his controller, Susan, to discuss IFRS. After summarizing his meeting with the CPA, Doug asked Susan if she could do some research to help him learn about IFRS and understand how converting to IFRS might impact Trabeck. Susan subsequently met with the CPA to identify sources for the research required for this task: 1. Information regarding convergence efforts from the Financial Accounting Standards Board (FASB), IASB, and SEC web sites. 2. IFRS standards, illustrative examples and implementation guidance from the IASB. 3. IFRS resources available from the AICPA’s web site. 4. IFRS resources available from some of the larger CPA firms. 5. Current Intermediate and Advanced Accounting textbooks that include IFRS coverage.
2 As of this writing, there is some evidence that the SEC may be retreating from its former stance regarding convergence. The Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for US Issuers Final SEC Staff Report that was issued on July 13, 2012 indicates that additional analysis is necessary before any SEC decision is made about incorporating IFRS into the US financial reporting system. In this vein, AICPA President and CEO Barry Melancon indicated that the United States must keep pushing for convergence of US GAAP and international standards. Melancon, addressing the AICPA governing Council on October 22, 2012, raised concerns that support is waning for convergence of international standards and US GAAP, with talk of comparability rather than convergence bubbling from the United States. The FASB and the IASB are responding to different stakeholders and are having some difficulties agreeing on a harmonized approach to certain projects, he said. For example, the FASB in July 2012 decided to take a step back from the so-called ‘‘three-bucket’’ impairment model the FASB and IASB boards had been developing for financial instruments and now the FASB is separately developing a ‘‘Current Expected Credit Loss’’ model. With convergence in question, SEC action on IFRS adoption is also uncertain because the SEC made the convergence progress by FASB and the IASB one of the milestones upon which the commission will base its IFRS decision.
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After completing the IFRS research, Susan gathered relevant information related to Trabeck’s 2012 financial statements to determine the impact IFRS would have on these statements. 3. US GAAP-based financial statements and other information Susan retrieved Trabeck’s 2012 US GAAP-based balance sheet (Fig. 1) and income statement (Fig. 2). As a result of the review of the statements, as well as Susan’s recollection of events that occurred in 2012, several items were identified where US GAAP and IFRS might differ. 1. Trabeck has two primary bank accounts. At December 31, 2012, one of these accounts had bank overdrafts that caused a negative balance of $100,000. The other bank account had a balance greater than $500,000. Trabeck recorded the $100,000 overdraft as a liability. In contrast, IFRS
Fig. 1. US GAAP-based balance sheet.
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Fig. 2. US GAAP-based income statement.
2.
3.
4.
5.
allows bank overdrafts to be offset against other cash accounts when overdrafts are payable on demand and fluctuate between positive and negative amounts as part of the normal cash-management program. Trabeck’s inventories are valued at the lower of cost, using the last-in, first-out (LIFO) method, or market. However, IFRS does not permit the use of LIFO. Accordingly, under IFRS, Trabeck’s inventories would be valued at the lower of cost, using the first-in, first-out (FIFO) or average cost method, or net realizable value. The impact of changing from LIFO to FIFO (excluding tax considerations) would cause the 2012 ending inventory to be $1200,000 higher and the 2012 cost of goods sold to be $1200,000 lower. According to US GAAP, market value for inventory is defined as replacement cost with a ceiling of net realizable value (NRV) and a floor of NRV less ‘‘normal profit margin.’’ However, under IFRS, inventory is valued at the lower of cost and NRV. IFRS also specifies that, if circumstances indicate, an inventory write-down is no longer appropriate, it must be reversed. Such reversals are not permitted under US GAAP. In 2011, Trabeck wrote-down the value of its inventory by $800,000. That inventory write-off should, under IFRS, be reversed in 2012. As required by US GAAP, Trabeck expenses research and development expenditures in the period incurred. However, under IFRS, development expenditures that meet specific criteria are capitalized as an intangible asset. Accordingly, $20,000 of 2012 development costs should be capitalized under IFRS. IFRS requires that each component of an item of property, plant and equipment be depreciated separately if its cost is significant in relation to the total cost of the item. US GAAP allows ‘‘component depreciation’’ but it is not often used in practice. Under IFRS, a $100,000 component would be depreciated separately at a faster rate than the asset of which the component is a part. This would cause 2012 depreciation expense to be $5000 higher.
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6. Under US GAAP, a company reports its property, plant, and equipment (PP&E) at cost less accumulated depreciation. IFRS also allows a company to report its property, plant and equipment at cost less accumulated depreciation or, alternatively, at its fair value. If a company chooses fair value, all of the assets within a class of property, plant and equipment must be revalued on a regular basis. US GAAP prohibits this type of revaluation. Under IFRS, the utilization of fair value for property, plant and equipment would increase property, plant and equipment at December 31, 2012 by $300,000 and increase the related accumulated depreciation by $100,000 (i.e. fair value is $200,000 greater than book value). 7. IFRS and US GAAP differ in the treatment related to accounting for the impairment value of property plant and equipment. One of these differences relates to the recoverability test. Under US GAAP, an impairment loss is required when an asset’s net book value exceeds the undiscounted sum of the asset’s estimated future cash flows. Under IFRS, an impairment loss is required when an asset’s carrying amount exceeds the higher of the asset’s value-in-use (present value of estimated future cash flows) and fair value less costs to sell. Under IFRS, there would be a $10,000 impairment loss related to property, plant and equipment in 2012. 8. Under IFRS, unlike US GAAP, convertible debt is divided into its liability and equity components. Trabeck has $103,000 of convertible debt that is currently recorded as long-term debt. The contractual arrangement specifies that the value of the debt portion is $98,000 and the value of the equity portion is $5000. 9. Lease accounting under US GAAP is driven by rules that determine if a lease should be capitalized. In contrast, IFRS utilizes principles to determine if a lease should be capitalized. A lease that is currently recorded as an operating lease would, under IFRS, be capitalized. The finance lease amount is $401,000. 10. In January 2012, Trabeck realized a gain on the sale and leaseback of an office building in the amount of $3000,000. The lease is accounted for as an operating lease and the term of the lease is 5 years. Under US GAAP, the gain on the sale and leaseback is recognized over the life of the lease. Under IFRS, the entire gain on an operating lease would be reported immediately. 11. Pension accounting is different under IFRS. Under IFRS, for defined benefit plans, prior service cost is expensed immediately to the extent it relates to benefits that have vested. Under US GAAP, prior service cost is included in other comprehensive income and amortized over the remaining service lives of employees. Vested prior service cost that has not been expensed as of December 31, 2012 is $100,000. 12. In considering the impact that IFRS might have related to Trabeck’s equity holdings, the controller noted that US GAAP requires companies to report information about reported segment profit or loss, including certain revenues and expenses included in the segment profit or loss, segment assets, and the basis of measurement. In addition to these items, IFRS also requires companies to disclose total liabilities of its reportable segments when this amount is regularly provided to the chief operating decision maker. Trabeck needs to disclose total liabilities related to its reportable segments in the amount of $8000,000.
4. Requirements Prepare a report to the owner that addresses the following requirements. 1. Determine if Trabeck can at this point adopt IFRS. 2. Use Trabeck’s 2012 US GAAP-based financial statements and other information to prepare Trabeck’s 2012 IFRS-based statement of financial position and statement of comprehensive income including relevant footnotes. Ignore the implications for income tax. 3. Reconcile the differences between Trabeck’s US GAAP-based and IFRS-based financial statements. 4. Summarize how converting from US GAAP to IFRS would impact Trabeck’s owners, creditors and other decision makers.
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5. Teaching note 5.1. Learning objectives While this case can be used by non-US readers to illustrate the impact IFRS is having on global accounting practices, the case is designed primarily for use in US undergraduate Advanced Accounting courses and graduate accounting programs. This case is most appropriate for students who have previously been exposed to IFRS and is not recommended as an introduction to IFRS unless the instructor intends to work through the case solutions with students. The learning objectives for this case include: 1. 2. 3. 4. 5.
Gain an understanding of some of the fundamental differences between US GAAP and IFRS. Prepare financial reports under both US GAAP and IFRS. Compare and contrast the differences between US GAAP-based and IFRS-based reports. Identify the areas where judgment played a role in the preparation of IFRS-based reports. Identify the areas where converting from US GAAP to IFRS might impact decisions made by decision-makers.
5.2. Evidence of efficacy This case was tested for efficacy in the classroom during the spring 2010 and fall 2010 semesters. The case was tested in the following settings:3 1. The residential campus of a large US public university in the Midwest. The students in this setting were primarily traditional students. 2. The nonresidential campus of the same public university in the Midwest. The students in this setting were primarily nontraditional students. The college and the department of accountancy of this public university are accredited by AACSB— International. While the two campuses serve different populations, the mission is the same and there is a common Department of Accountancy for both campuses. Accordingly, the underlying accounting curriculum is the same for both the residential and the nonresidential campuses. The case was tested for efficacy in the Advanced Accounting classes offered at these two campuses during the spring 2010 and fall 2010 semesters. The instructor for the advanced accounting class at the residential campus was a tenured professor and the instructor for the Advanced Accounting class at the nonresidential campus was a tenured associate professor. Both classes used the same textbook and had the same learning objectives. Students in the two Advanced Accounting classes had completed Intermediate Accounting with a grade of C or better. Prior to working on the case, students were generally exposed to IFRS concepts; however, students had not been required to apply IFRS. The case was administered and tested for efficacy in the four advanced accounting classes as follows: 1. Just prior to starting the case, students took a pretest to assess their understanding of the fundamental differences between US GAAP and IFRS. The pretest contained short-answer questions related to overall IFRS concepts and specific areas of IFRS application. The pretest was graded by the full professor (not the author). There were 10 questions. Each question was scored either as: correct, partially correct, or incorrect. If a student’s response to a question indicated that the student clearly understood the concept, the student received 2 points; if the student’s response indicated that the student partially understood the concept (addressed the question but lacked detail), the student received 1 point; and if the student’s response indicated that the student did not understand the concept, the student received 0 points.
3 In these settings, traditional students generally enter college after high school and attend college full-time and nontraditional students generally attend college part-time and tend to be older than traditional students.
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2. Students were assigned the case midpoint in the semester. The instruction for both classes included a 75-min lecture based on the IFRS/US GAAP differences contained in the case. Students were assigned the case two weeks before the lecture and they were asked to be prepared to discuss the case during the lecture period. In addition to the lecture, students were provided an IFRS handout (KPMG, 2012) that contained a side-by-side comparison of IFRS and US GAAP. 3. The case was due one week after the lecture. When the case was assigned, students were told the case would take approximately 8 h to complete. Students were also told how the case would impact their course points. 4. After completing the case, and prior to receiving their case back from the author, students took a posttest (the same test as the pretest). The posttest, which was graded independently from the pretest, was graded by the same full professor (not the author) who graded the pretest. The pretest and posttest results are summarized in Table 1. The pretest and posttest results were identified by student, so a paired-samples t-test was able to be conducted to compare pretest and posttest scores. There was a statistically significant difference between the pretest scores (M = 5.81, SD = 2.12) and the posttest scores (M = 14.36, SD = 3.30); t(57) = 18.3, p < 0.001. The results of the efficacy tests are depicted in Fig. 3. These results suggest that the case helped students gain an understanding of some of the fundamental differences between US GAAP and IFRS. 5.3. Recommended solution The following case solution includes: 1. Adjusting Journal Entries and Judgment Questions 2. Case Requirements–Solution 5.3.1. Adjusting journal entries and judgment questions
1.
Bank overdrafts – offset other cash accounts versus a liability
Other accrued expenses
100,000 Debit 100,000 Credit
Cash and equivalents
Source: IAS No.7 Judgment Question: Does the company’s normal cash management program include use of a bank overdraft where the balance fluctuates between positive and negative cash balances? 2.
LIFO not allowed
Inventory
1200,000 Debit 1200,000 Credit
COGS
Source: IAS No. 2 Judgment Question: Should FIFO or average costs be used to value inventory? 3.
Inventory write-off and definition of market
Inventory Inventory write-down expense
800,000 Debit 800,000 Credit
(continued on next page)
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Source: IAS No. 2 Judgment Question: Does a previous inventory write-down need to be reversed? 4.
R&D – capitalize development costs
Intangible asset R&D expense
20,000 Debit 20,000 Credit
Source: IAS No. 38 Judgment Question: Do development expenditures meet the capitalization criteria? 5.
Component capitalization
Depreciation expense Accumulated depreciation
5000 Debit 5000 Credit
Source: IAS No. 16 Judgment Question: Is a component significant and if so, does it have a different life than the asset it is a part of? 6.
Fair value option for PPE
PPE Accumulated depreciation
300,000 Debit 100,000 Credit 200,000 Credit
Revaluation surplus –Other Comprehensive Income (OCI) Source: IAS No. 16 Judgment Question: Should the fair value option be used? If so, how should fair value and the related life be estimated? 7.
PPE impairment loss
Impairment loss Accumulated depreciation
10,000 Debit 10,000 Credit
Source: IAS No. 36 Judgment Question: What are the estimated fair values? 8.
Convertible debt
Long-term debt Convertible debt Equity – conversion option
103,000 Debit 98,000 Credit 5000 Credit
Source: IAS No. 32 Judgment Question: What is the estimated fair value of a comparable debt instrument that does not have the conversion option? 9.
Finance leases
Leased equipment Lease payable Source: IAS No. 17
401,000 Debit 401,000 Credit
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Judgment Question: Does the lease in essence transfer the substantial risks and rewards of ownership of the asset to the lessee? 10.
Sale-leaseback
Deferred gain on sale-leaseback Gain on sale-leaseback
2400,000 Debit 2400,000 Credit
Source: IAS No. 17 Note: 600,000 would have been recognized in 2012, so the difference needs to be recorded. Judgment Question: Is the sales price at fair value? (If the sales price is above fair value, the difference is deferred and amortized over the period the asset is expected to be used.) 11.
Pension costs
Pension expense
100,000 Debit 100,000 Credit
OCI
Source: IAS No. 19 Judgment Question: Have pension benefits vested? 12.
Segment reporting
Additional footnote noting the liabilities related to its reportable segments are $8000,000. Source: IAS No. 8 Judgment Question: How should liabilities that relate to more than one segment be reported in the footnote?
Table 1 Pretest versus posttest results. Spring and fall 2010
Residential campus n = 36
Nonresidential campus n = 22
Average n = 58
Question
Pretest
Posttest
Pretest
Posttest
Pretest
Posttest
What is the fundamental difference between current US GAAP and IFRS? Who sets the IFRS standards? Can US companies follow IFRS today? What impact will IFRS have on US companies in the future? What is one difference between US GAAP and IFRS related to inventory? What is one difference between US GAAP and IFRS related to longterm assets? What is one difference between US GAAP and IFRS related to research and development costs? What is one difference between US GAAP and IFRS related to leases? What is one difference between US GAAP and IFRS related to pension costs? What is one difference between US GAAP and IFRS related to segment reporting?
0.61
1.86
0.86
1.91
0.71
1.88
1.25 1.33 1.17 0.89
1.89 1.03 1.28 1.89
1.45 0.82 1.32 0.82
1.82 1.64 1.50 1.91
1.33 1.14 1.22 0.86
1.86 1.26 1.36 1.90
0.19
1.28
0.09
1.00
0.16
1.17
0.44
1.67
0.05
1.50
0.29
1.60
0.03 0.08
1.17 1.19
0.09 0.00
1.09 1.00
0.05 0.05
1.14 1.12
0.00
1.11
0.00
1.00
0.00
1.07
Numbers range from 0 to 2, with higher numbers being better.
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Fig. 3. Efficacy results.
Table 2 Grading rubric. Meets expectations
Exceeds expectations
Trabeck could actually adopt IFRS at this point in time The IASB is the second designated standard setter (along with the FASB) in the AICPA code of ethics
Trabeck could actually adopt IFRS at this point in time The IASB is the second designated standard setter (along with the FASB) in the AICPA code of ethics US GAAP is the dominant set of standards in the US, so Trabeck would need a reason to follow IFRS instead of US GAAP One reason to follow IFRS is if a firm is owned or controlled by a foreign entity that uses IFRS. Since more than 100 countries either allow or require IFRS, it is reasonable to think that if a firm were owned or controlled by a foreign entity IFRS would need to be followed
5.3.2. Case requirements—solution 5.3.2.1. Requirement 1: Applicability of IFRS. Trabeck could actually adopt IFRS at this point in time. The IASB is the second designated standard setter (along with the FASB) in the AICPA code of ethics (AICPA, 2012). However, US GAAP is the dominant set of standards in the United States. Thus, Trabeck would need a reason to follow IFRS rather than US GAAP. One such reason would be if a firm were owned or controlled by a foreign entity that follows IFRS. Since more than one hundred countries allow or require IFRS (AICPA, 2009), it is reasonable to think that if a firm were owned or controlled by a foreign entity IFRS would need to be followed (Herz & Tweedie, 2009). Table 2 depicts a grading rubric for this requirement.
5.3.2.2. Requirement 2: IFRS-based statements. According to IFRS 1, an entity shall prepare and present an opening IFRS statement of financial position at the date of transition to IFRS. To comply with IAS 1, a complete set of financial statements comprises: a statement of financial position as at the end of the period, a statement of comprehensive income for the period (or it may elect to have two statements on financial performance where the determination of net profit or loss is reported in an income statement
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Fig. 4. IFRS-based statement of financial position.
and other comprehensive income is reported in the statement of comprehensive income), a statement of changes in equity for the period, a statement of cash flows for the period, notes, and a statement of financial position as at the beginning of the earliest comparative period when an entity applies an accounting policy retrospectively or makes a retrospective restatement of items in its financial statements, or when it reclassifies items in its financial statements. (An entity may use titles for the statements other than those identified except it must report a statement of comprehensive income.) For the purpose of this case, only the statement of financial position and the statement of comprehensive income are required. (The data necessary to prepare other required statements and comparative information are not included in the case.) In addition to consulting IAS 1, IFRS resources from PricewaterhouseCoopers (2011b) and KPMG (2011) were consulted to prepare the statement of financial position (Fig. 4) and the statement of comprehensive income (Fig. 5).
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Fig. 5. IFRS-based statement of comprehensive income.
Table 3 Financial statement impact. Account
Per US GAAP
Difference
Per IFRS
Cash and equivalents Inventories, net Property, plant and equipment, net Leased equipment Intangible assets, net Other accrued expenses Convertible debt Long-term debt Lease payable Deferred gain on sale-leaseback Equity conversion option Reserves Retained earnings Cost of sales Other expense (income), net Gain on sale-leaseback Impairment loss Current assets Non-current assets Total assets Current liabilities Non-current liabilities Total liabilities and equity Net profit Other comprehensive income Total comprehensive income
2500 1998 2901 0 3328 (768) 0 (6388) 0 (2400) 0 100 (8988) 12,868 (14) 0 0 8829 18,759 27,588 3393 12,303 27,588 (1248) 0 (1248)
(100) 2000 185 401 20 100 (98) 103 (401) 2400 (5) (300) (4305) (1200) (715) (2400) 10 1655 851 2506 (100) (2004) 2506 (4305) (300) (4605)
2400 3998 3086 401 3348 (668) (98) (6285) (401) 0 (5) (200) (13,293) 11,668 (729) (2400) 10 10,484 19,610 30,094 3293 10,299 30,094 (5553) (300) (5853)
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5.3.2.3. Requirement 3: Differences between Trabeck’s US GAAP-based and IFRS-based financial statements. The differences between Trabeck’s US GAAP-based and IFRS-based financial statements are summarized in Table 3. The differences relate to the following areas:
Bank overdrafts – offset other cash accounts versus a liability. LIFO not allowed. Inventory write-off and definition of net realizable value (NRV). R&D–capitalize development costs. Component capitalization. Fair value option for PPE. PPE impairment loss. Convertible debt. Finance leases. Sale-leaseback. Pension costs.
In addition, IFRS also requires companies to disclose total liabilities of its reportable segments when this is normally reported to the chief executive officer or chief operating officer. Trabeck’s total liabilities related to its reportable segments are $8000,000.
5.3.2.4. Requirement 4: Impact of IFRS on Trabeck’s decision makers. Converting from US GAAP to IFRS may have a significant impact on Trabeck’s owners, creditors, and other decision makers. From a financial statement analysis perspective, the following differences related to Trabeck’s 2012 financial statements are significant: Total assets increased $2506,000 (9.1%). Net profit increased $4305,000 (345%). Total Comprehensive income increased $4605,000 (369%). Table 4 Ratios. Category
Ratio
Formula
US GAAP
IFRS
Difference between US GAAP and IFRS
Liquidity ratios
Current ratio Quick or acid-test ratio
Current assets/current liabilities Cash, marketable securities, and receivables (net)/current liabilities
2.60 1.87
3.18 1.90
0.58 0.03
Activity ratios
Receivables turnover
Net sales/average trade receivables (net) Cost of goods sold/average inventory Net sales/average total assets
6.57
6.57
0.00
6.44 0.73
2.92 0.67
-3.52 -.06
Profit margin on sales Rate of return on assets Rate of return on common stock equity 10.49% Earnings per share
Net profit/net sales Net profit/average total assets
6.17% 4.52%
27.47% 18.45%
21.30% 13.93%
Net profit minus preferred dividends/average common 33.65% Net profit minus preferred Dividends/weighted shares outstanding
23.16% $0.21
$0.93
$0.72
Debt to total assets Times interest earned Book value per share
Total debt/total assets Profit before interest expense and taxes/interest expense Common stockholders’ equity/ outstanding shares
44.60% 5.9
34.22% 18.2
-10.37% 12.3
$1.98
$2.75
$0.77
Inventory turnover Asset turnover Profitability ratios
Stockholders’ equity
Coverage ratios
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Ratio analysis is commonly used to analyze financial statements. Trabeck’s ratio analysis is summarized in Table 4. The liquidity ratios are used to determine whether a company has the short-run ability to pay its maturing obligations. The most significant change for Trabeck comes from an increase in the current ratio under IFRS. This change is due primarily to increased inventories using FIFO instead of LIFO. Activity ratios are used to measure how effectively a company uses its assets. Most of the activity ratios for Trabeck did not have significant changes from US GAAP to IFRS, with the exception of the inventory turnover ratio. The decrease in the inventory turnover ratio was due to a combination of a decrease in cost of sales and an increase in inventory, primarily the result of the change in inventory valuation from LIFO to FIFO. Profitability ratios measure how successful a company was at generating profits over a given time period. The profitability ratios for Trabeck had significant changes. The primary difference between these ratios for Trabeck was the increase in net profit, which was due mainly to the gain on sale-leaseback recognized under IFRS (assuming the sales price is at fair value) as well as lower cost of sales under IFRS. All of these ratios for Trabeck look better using IFRS, making the company look more profitable. Coverage ratios measure the protection for long-term creditors and investors. For Trabeck, times interest earned saw the biggest change under IFRS due to the increase in profit. The other two ratios were affected by the decrease in liabilities and the increase in stockholders’ equity due to the deferred gain on sale-leaseback that was recognized as income under IFRS. Overall, almost all of the ratios under IFRS are better for Trabeck. The main reasons for most of the differences between the ratios in US GAAP and IFRS are the recognition of the deferred gain on saleleaseback as income under IFRS, and the conversion of inventory from LIFO to FIFO under IFRS. It is important to note that even though the financial statements changed, the underlying cash flow did not change. As convergence to IFRS continues, financial statement preparers will be faced with new challenges, including making certain judgments that may or may not have been required to make in the past. Some of these judgment questions are provided in the adjusting journal entries solution, and include: 1. Does the company’s normal cash management program include use of a bank overdraft facility where the balance fluctuates between positive and negative cash balances? 2. Should LIFO or average costs be used to value inventory? 3. Does a previous inventory write-down need to be reversed? 4. Do research and development expenditures meet the capitalization criteria? 5. Is a component asset significant and if so, does it have a different life than the asset of which it is a part of? 6. Should the fair-value option be used for property, plant and equipment? If so, how should fair value and the related life be estimated? 7. What are the estimated fair values of various assets? 8. Does the lease in essence transfer the risks and rewards of ownership of the asset to the lessee? 9. Is the sales price at or above fair value? 10. Have pension benefits vested? 11. How should liabilities that relate to more than one segment be reported in the footnote? As noted above, if IFRS is followed, Trabeck’s decision makers would be provided significantly different financial statements than if US GAAP is followed. In large part the differences are due to both rules (e.g. LIFO is not allowed under IFRS) and judgments (e.g. determination of fair value) made by the financial statement preparers intending to comply with the requirements of IFRS.
Acknowledgements The authors thank two anonymous reviewers, the associate editor who handled the review of our manuscript, and the editor-in-chief (David E. Stout) for their insightful comments and suggestions for improving this case.
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References AICPA (2009). IFRS primer for audit committees. New York, NY: AICPA. AICPA (2012). Council resolution designating bodies to promulgate technical standards.