About This Chapter
Accounting regulations are not static. Although the FASB and the IASB issue standards, they are subject to subsequent amendments irrespective of the progress of the convergence project. Accounting standard setters are continuously monitoring company practices and issue revised or new standards where there are perceived deficiencies.
Sometimes there are new business practices to be regulated, or political and legal decisions made at the national level that require a new standard or amendments to an existing one. Not surprisingly, the process of convergence becomes entangled with these political and legal influences.
We make no judgments as to whether the convergence efforts successfully resolve these issues. As we stated above, standards change for various reasons and some of these may be country specific. What we illustrate in this chapter is the complexity of attempting to achieve convergence.
In addition to converging the requirements of a standard, there is also the application of that standard to be considered. The question arises as to whether the financial statements capture the full intention of the standard. Auditors in the EU have to ensure that financial statements comply with their understanding of the requirements of International Financial Reporting Standards (IFRS). In the United States auditors have to ensure that the financial statements comply with the regulations in that country as converged with IFRSs. As discussed in the previous chapter, there are questions on the completeness of convergence. It is possible that the EU and U.S. auditors, through their years of training and experience, have differing interpretations of the requirements. This chapter demonstrates that the complexity of the regulations may lead to differing interpretations.
In this chapter we look at some major issues that have confronted the standard setters in their search for convergence. The examples involve politics, business practices, and technical accounting considerations. In our discussions we concentrate on explaining the issues that confronted the standard setters, rather than a detailed analysis of the accounting requirements. The issues we discuss are:
- Revenue recognition
- Inventory valuation
- Stock-based payments
- Intangible assets
- Financial instruments
With each of these standards, we provide a brief history of the international standard to set the scene for the discussion on its requirements.
Legislation, Politics, and Convergence
Financial accounting is regulated not only by accounting standards, but also by other legislation that applies to companies and therefore impacts on the financial information they publicly disclose. Each country has its own government structure that regulates the operation of its organizations. In the United Kingdom the Financial Reporting Council (FRC) has the authority to determine the information, both financial and nonfinancial, that companies should disclose and this includes compliance with international accounting standards. The FRC is also responsible for ensuring that the Companies Act 2006, a significant and substantial document, is adhered to by all companies registered in the United Kingdom.
A significant piece of legislation passed in the United States was the Sarbanes–Oxley (SOX) Act of 2002. This was a regulatory response to the large financial frauds and accounting irregularities that had occurred in companies such as Enron, WorldCom, and Tyco.
- The chief executive officer (CEO) and chief financial officer (CFO) are responsible for signing off their company’s financial statements and indicating that the financial statements do not omit material information.
- The CEO and CFO must indicate that they are responsible for the company’s system of internal controls over financial reporting.
- The Public Accounting Oversight Board was established to oversee the audit of public companies.
- Listed companies must have a majority of independent directors and there must be regular meetings scheduled with managers of the company.
The SOX Act is possibly the most substantial legislation passed in the United States addressing financial accounting and reporting, and corporate governance for many decades. There have been criticisms that it places too large a burden on companies but, given the extent of the corporate misbehaviors that were taking place in the early 2000s, the government was compelled to take action.
Attempting to converge U.S. GAAP and IFRS, therefore, is not only about technical accounting. Indeed, it is sometimes less about technicalities and more about politics. Although the Securities and Exchange Commission (SEC) may be extremely powerful, it is still exposed to lobbying, arguments, persuasions, and criticisms. As the direct standard setter, the FASB has the same pressures, plus it is also answerable to the SEC.
The IASB, in some ways, is in an even more difficult position than the FASB as it is unable to enforce its standards. They must rely on the assumption that the countries adopting international accounting standards are in agreement with the regulations and will be diligent in ensuing that companies comply with the standards. There have been extensive discussions and debates over the issues surrounding enforcement and adoption of standards, but this is not the responsibility of the IASB. The IASB does, however, have an advantage over the FASB as it does not have a legal obligation to issue standards on any particular area of accounting.
Although technical accounting issues need to be addressed, both the FASB and the IASB must be receptive to the opinions of their constituents while trying to achieve convergence. Possibly, the best example of the two Boards working together was the joint revenue project. But even with this apparent success it has been argued that “History has shown from previous convergence efforts that even when the standards are identical, practice in the United States can differ from practice under IFRSs” (Holzmann and Hunter 2015, 1051).
It would also be fair to say that for the most part, standards do not lead to new business developments, but follow them. The FASB and the IASB attempt to identify developments at their early stages and introduce standards to regulate them. That they are not always successful in fully converging their efforts is illustrated in the following examples discussed in this chapter.
History of Standard
|January 1, 1984||IAS 18 Revenue recognition come into effect|
|January 1, 2018||Superseded by IFRS 15 Revenue from Contracts with Customers|
To calculate the profit or loss of a company for a financial period, we need to know the revenue from the transactions that were carried out by an organization in that period—that is, the sale of goods or services. This calculation can be far more difficult than individuals may realize. There are several factors that have an impact on the calculation of revenue and its effect on the income statement, which shows the profit or loss.
First, financial statements (apart from the cash flow statement) must be prepared on the accruals basis. This means that transactions and other events are recognized as they occur and not when cash or other equivalents, such as checks, are actually given or received. In other words, transactions are recorded when they are entered into, not at the time of the cash inflow or outflow. This rule applies in both accounting for revenue and the expenses generated in achieving it. The following straightforward example demonstrates the issues that can arise:
Example of Revenue Recognition
On March 1, an auto dealer buys a preowned Jaguar car for $30,000. He pays for the Jaguar immediately and fully in cash. The dealer subsequently discovers that the car, once some work has been done on it, can be considered a collector’s item. The work is completed by an associate for $10,000, which the dealer has to pay by the end of April. The dealer sells the car by the end of March for $60,000. The buyer pays a deposit of $15,000 by check and promises to pay the remaining balance in June.
Looking at the month of March, when applying the accruals basis of accounting, profit is calculated as follows:
|Cost of car||30,000|
There may be a major problem for the dealer as he has paid $30,000 for the car, but has only received $15,000 toward the sale. There is a cash deficit. There are also some uncertainties with the profit. Suppose the associate who did the repairs also worked on some other of the auto dealer’s vehicles at the same time, and these repairs were all included in the total bill for $10,000. How much of the $10,000 relates to the Jaguar?
Suppose that the buyer finds a problem with the car—will the dealer be expected to correct it free of charge? If the dealer goes out of business and disappears, how do we record the $10,000 of expenses? If the check for $15,000 is dishonored, how do we account for it and how does that impact on the total revenue?
- Customers may purchase several items over a period of time, but wish to pay for everything at one date, or in a series of installments.
- Costs can be incurred before the sale takes place, during the transaction, and sometime after. Payment can be immediate, delayed, or never made.
- Customers may require credit.
- The supplier may offer interest-free credit, but how does this affect the revenue and costs?
- The sale may cover two or more financial periods.
- If a service is offered, such as a maintenance contract, it could be for several years, although the customer pays the full amount in the first year. How is the payment recorded?
Both U.S. GAAP and IFRS had regulations on revenue recognition that were sometimes difficult to apply. There were also considerable differences between their respective approaches. In addition to the two approaches being different, it was acknowledged that with existing regulations there were opportunities for unscrupulous companies to massage their revenues. The companies could either accelerate the revenue into an earlier financial period or delay it into a later one.
Understandably, the topic of revenue recognition was an important regulation to address by the FASB and the IASB. It was an issue that required attention and appeared to offer an opportunity to develop a common standard for U.S. GAAP and IFRS that would:
- Remove inconsistencies and weaknesses in existing revenue requirements.
- Provide a more robust framework for addressing revenue issues.
- Improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets.
- Provide more useful information to users of financial statements through improved disclosure requirements.
- Simplify the preparation of financial statements by reducing the number of requirements to which an entity must refer.
The attempts to converge standards took many years. Finally, in 2014 the FASB and IASB each separately issued their final standards on revenue from contracts with customers. The standards were issued as ASU 2014-09 (codified in ASC 606) by the FASB and as IFRS 15, Revenue From Contracts With Customers, by the IASB. Both the FASB and the IASB requirements are effective in 2018.
IFRS 15 uses a five-step model and, in general, these are consistent and straightforward regardless of industry. The U.S. regulations identify whether a sale is realized or realizable and then whether it has been earned. The requirements depart from the international standard as there is a list of rules specific to the industry in which the business operates.
The research and comments on the impact of the new U.S. standard suggest that its effect will not be substantial and may be limited to certain industries. A survey of over 700 executives conducted in 2016 by PwC and Financial Executives Research Foundation (FERF)2 found that 64 percent of respondents did not expect the standard to have a material impact on the income statement and balance sheet, 20 percent were unsure, and 16 percent did expect a material impact. The argument has been made by Rutledge, Karim and Kim3 that the major impact will be on income tax expenses and deferred taxes.
Although there has been substantial convergence with revenue recognition, there remain some differences in the regulations. These may not appear major when comparing the wording of the two standards but could be significant when interpreted and applied to actual transactions.
One issue is the different definitions used in the two standards to define the word probable. The FASB definition is that “future event or events are likely to occur”. IAS 37 is the international standard defining probable and it considers that the term means that “the event is more likely than not to occur, i.e. the probability that the event will occur is greater that the probability that it will not.”
These are small linguistic differences but one study4 using students for the experiment gave them either FASB or IFRS definition of “probable” and asked them to evaluate five revenue recognition scenarios. Their findings showed that the differences in the definitions did not lead to differences in application of the requirements of the standards. Although this allays some concerns, it is difficult to predict whether opinions in the lecture theater are transferable to the business arena.
Understandably, the main preoccupation in the U.S. literature is concerned with the changes in the new U.S. standard compared to the old standards. It has been suggested that the new U.S. revenue recognition standard may decrease earnings quality because there is more scope for management judgment. If this is the case, there may be more differences in the application of the “converged” standards than were anticipated.
History of Standard
|October 1975||IAS 2 Inventories issued|
|December 1993||IAS 9 issued|
|December 18, 2003||IAS 2 issued|
|January 1, 2005||IAS 2 Revised comes into effect|
Closing inventory valuation is an extremely important subject as it is a key item in the calculation of profit and it informs the reader of the financial statement of the value of inventory at the company’s fiscal year-end. Inventory includes all of the costs incurred in purchasing merchandise and preparing it for sale. This includes raw materials, direct labor, and manufacturing overhead. Inventory values at the year-end can be substantial; we will demonstrate this fact through the example of General Electric (GE).
|December 31 (in millions, U.S. $)||2016||2015|
|Raw materials and work in progress||12,636||13,415|
|Less revaluations to last-in, first-out||383||207|
Source: GE Annual Report 2016, 156.
The cost for a significant portion of GE’s U.S. inventories is determined on a last-in, first-out (LIFO) basis: a method allowed in the United States but not under the international accounting standard. The cost of other GE inventories is determined on a first-in, first-out (FIFO) basis, which is a U.S. and international permitted method.
A merchandising company imports shoes at a cost of U.S. $10 each and sells them at U.S. $20 each. In January 2017, the number of shoes it purchased and sold is:
|Number imported: 100|
|Number sold: 90|
|Calculation of gross profit for January||$||$|
|Revenue (90 @ $20)||1,800|
|Cost of goods sold|
|Purchases (100 @ $10)||1,000|
|Deduct closing inventory (10 @ $10)||100||900|
Given the substantial dollar amounts, it is essential that we understand the impact of a change in valuation methods. A very simple example will demonstrate the calculation of gross profit and the critical importance of inventory valuation.
With this simple model, it is easy to calculate that a gross profit of U.S. $10 is made on each sneaker. If the company sells 90 of its products, the gross profit must be U.S. $900. The critical factor is the inventory or stock taking, which is conducted at the end of January. It is imperative to ensure that the closing inventory of 10 shoes is physically being held by the company. If the actual count of inventory is less than 10, this variance is an indication of an error, whether due to misappropriation of assets or disposals due to damage. If this is the case, then the closing inventory will be lower and the gross profit will therefore also be lower.
Having confirmed that 10 shoes are indeed in closing inventory, the next question is how they are to be valued. In the above example, valuation would be at the cost of U.S. $10. Problems will arise if the cost of shoes increases. Let us assume that the information for February is the same as that for January, except that the supplier has increased the cost of the shoes to U.S. $15.
- We can assume that we sold the last shoes that came in February first. Therefore, of the 100 shoes that came in February, we have 10 remaining at U.S. $15 and we still have the 10 from January at a cost of U.S. $10—total U.S. $250. This is known as the LIFO method.
- We can assume that in February, we first sold the 10 remaining shoes that had cost U.S. $10 each. The 20 shoes remaining therefore were all purchased in February at U.S. $15—total U.S. $300. This is known as the FIFO method.
The method that is chosen has a significant impact on gross profit. Table 4.1 shows the results for February using both methods.
Table 4.1 LIFO and FIFO comparison
|Less closing inventory||250||1,350||300||1,300|
FIFO, first-in, first-out; LIFO, last-in, first-out.
Under the LIFO method, the value of the closing inventory is lower and therefore the accounting calculation of the costs of goods sold is higher than that of the FIFO method. As the profit is lower, the company will pay less income tax. The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve. This reserve is essentially the amount by which an entity’s taxable income has been deferred by using the LIFO method. Of course, this is only true when the costs of purchases are increasing. If the purchase price declines the opposite results would occur.
For some companies, the different use of the inventory valuation method has little impact. There are also examples where separate parts of the business use alternative methods, such as the case with Walmart.
We value inventories at the lower of cost or market as determined primarily by the retail method of accounting, using the last-in, first-out (“LIFO”) method for substantially all of the Walmart U.S. segment’s inventories. The inventory at the Walmart International segment is valued primarily by the retail inventory method of accounting, using the first-in, first-out (“FIFO”) method. The retail method of accounting results in inventory being valued at the lower of cost or market since permanent markdowns are immediately recorded as a reduction of the retail value of inventory. The inventory at the Sam’s Club segment is valued using the LIFO method.
Source: Walmart Annual Report 2017, 33.
Not only does Walmart use both LIFO and FIFO, the weighted-average method is also used as it is permitted under both U.S. regulations and international standards. Walmart applies the retail inventory method of accounting, which is allowed in the United States and is in accordance with international standards.
Accounting for inventory in high-volume retail operations raises problems. It is difficult to determine the cost of each sale. The retail method, which is widely used, compiles the inventories at retail prices. In most retail entities, an observable pattern between cost and price exists. Retail prices can therefore be converted to cost through use of a formula.
The sales for the period are deducted from the retail value of the goods available for sale, to produce an estimated inventory at retail value. The ratio of cost to retail for all goods passing through a department or firm is then determined by dividing the total goods available for sale at cost by the total goods available at retail. The inventory valued at retail is converted to ending inventory at cost by applying the cost-to-retail ratio.
In the United States, the LIFO method has been an acceptable, popular accounting method since its inception in 1939 and is permitted for tax purposes. It is claimed that Congress believed that companies would not adopt it because it lowered profits, but the added effect of lowering taxes was too great an attraction for many companies.5
The tax advantages associated with LIFO have been documented by tax laws, research, literature, and Congress. The advantage is substantial in some industries and has led to the criticism of LIFO resulting in an unfair tax loophole for a few beneficial industries.6
Criticisms of LIFO have gathered strength and as part of the convergence project, it seemed that LIFO would be abolished so as to fall in line with the IFRS that prohibits LIFO as an acceptable method. The Obama administration proposed in its 2010 budget to repeal LIFO in the future, but there were signs that such a move would meet considerable opposition.7
Although there is resistance to the repeal of LIFO, there is evidence that some companies are voluntarily abandoning this method of valuing inventories. The number of public companies reporting LIFO reserves exceeded 1,000 from the late 1970s to the late 1980s. The tax advantage of LIFO is dependent on the presence of inflation, and the number of U.S. companies reporting a LIFO reserve decreased over the 5 years 2004–2008 as shown in Table 4.2.8
Table 4.2 Number of companies reporting LIFO reserves, 2004 to 2008
|Companies with inventory balances at the year-end||5,673||5,489||5,301||5,072||4,783|
|Companies with inventory balances and LIFO reserves at year-end||449||420||401||369||339|
|Percent of companies with inventory balance and LIFO reserve at year-end||7.91||7.65||7.56||7.28||7.09|
LIFO has been a method of valuing in the United States for nearly 100 years. The decision by the IASB to ban LIFO contributed to the calls within the United States to ban it. A recent article9 found that organizations in the oil and manufacturing industries have significant LIFO reserves whereas organizations in high-tech and health industries were less likely to adopt LIFO.
History of Standard
|January 1, 2005||IFRS 2 Share-based payments effective|
|January 1, 2009||Amendments|
|July 1, 2009||Amendments|
|January 1, 2010||Amendments|
|July 1, 2014||Amendments|
|January 1, 2018||Amendments|
The concept of share-based payments in IFRS 2 encompasses the issuance of shares, or rights to shares, in return for services and goods. This term covers several different types of transactions, but we will restrict our discussions to schemes that are designed for the benefit of employees, particularly directors (share options).
The price the company sets on the share (called the grant or strike price) is usually the market price of the share at the time the employee is given the options. Since those options cannot be exercised for some time, the hope of the lucky recipient is that the price of the shares will go up, so that selling them later at a higher market price will yield a profit. Definitions of some of the terms we use will be helpful.
Stock options (UK “Share options”): A benefit, given or sold by one party to another (in this case the employee), which gives the recipient the right, but not the obligation, to buy (call) or sell (put) a stock at an agreed-upon price within a certain period or on a specific date.
Strike price: The price at which the holder of a stock option may purchase the stock.
Vesting: When employees are given stock options, they usually do not gain control over the stock or options for a period of time. This period is known as the vesting period and is usually 3 to 5 years. During the vesting period, the employee cannot sell or transfer the stock or options.
Stock option expensing: The method of accounting for the value of stock options on the income statement.
Expiration date: The date by which you must exercise your options.
At the money stock options: The stock option’s strike price is identical to the prevailing market price.
In the money stock options: The stock option’s grant or strike price is lower than the prevailing market price.
An example of a stock option is as follows: The recipient receives options on 1,000 shares of company stock. The vesting period is spread over 5 years, with one-fifth of the stock vested each year. The recipient can buy 200 shares each year at the strike price, and if so wishes can sell the shares at the current market price.
There is considerable, and often heated, debate as to whether stock options should be permitted. There are those who argue that the issuance of options aligns executives’ interests with those of the company, increasing motivation and improving corporate performance. Others claim that it is merely a method of secretly siphoning off money to directors who are already handsomely rewarded.
One important aspect of the U.S. debate is stock optioning expensing—in other words, how companies should account for the options. In 1972, a new revision in U.S. GAAP meant that companies did not have to report executive incomes as an expense to their shareholders if the income resulted from an issuance of the money stock options. The result was that organizations reported higher profits and directors benefited without the full knowledge of shareholders.
There was an increasing growth in the use of stock options by companies and research indicated that in 2002, profit at technology firms in the S&P 500 would drop by 70 percent if they expensed options on the income statement. In utility organizations, the drop would only be 2 percent.10 The pressure was on for stock options to be expensed, but there were political hurdles preventing this regulation.
It was not until March 31, 2004, that the FASB issued its long-awaited Exposure Draft, Share-Based Payments. Congress became involved with the draft and a bill was put before Congress in 2004 to limit stock option expense reported in the statements to the top five officers.11
Subsequent research12 of the events in 2004 found that employee stock option expense under the bill before Congress would only be approximately 2 percent of what it would be under the FASB’s preferred method. The research also reports that political connections and business interests were influencing the debate in Congress.
In December 2004, the FASB published FASB Statement 123 (Revised 2004): Share-Based Payment. This required that the compensation cost relating to share-based payment transactions be recognized in financial statements. It took the Board 2 years to develop a revised standard that provided investors and other users of financial information with more complete and neutral financial information (FASB 2004).13 While Statement 123(R) is largely consistent with IFRS 2, some differences remain, as described in a Q&A document that FASB issued along with the new Statement.
IFRS 2 was originally issued by the IASB in February 2004 and first applied to annual periods beginning on or after January 1, 2005. The standard requires an entity to recognize share-based payment transactions (such as granted shares, share options, or share appreciation rights) in its financial statements, including transactions with employees or other parties that are to be settled in cash, other assets, or equity instruments of the entity. Specific requirements are included for equity-settled and cash-settled share-based payment transactions, as well as those transactions where the entity or supplier has a choice of cash or equity instruments.
The key provision of U.S. and international regulations is for public entities to recognize the fair value of the compensation cost for vested employees over their service period.
Critics could claim that the two Boards were unable to reach full convergence on this topic. However, given the many problems faced by the FASB, the reasonable response is that these accounting transactions were poorly regulated and a substantial degree of convergence has been achieved. Both U.S. GAAP and IFRS have issued standards over stock-based compensation.
The discussion above has been about accounting for stock options, from a technical accounting and convergence viewpoint. It is illuminating to look at business practices where the accounting regulations are not sufficiently clear. Stock options are a good example of a case where questionable (or even fraudulent) activities may be conducted by directors of a company.
With regard to stock options, two courses of action were taken that were of benefit to the directors receiving stock options. One of these was backdating, where option granting dates were retrospectively set to precede a rally in the underlying shares, locking in risk-free profits for recipients. The second is referred to as spring-loading, where grant dates are scheduled for just before a positive announcement or just after a negative one, anticipating a stock price rally and, therefore, resulting in higher profits for recipients.
The two practices above are not illegal, but must be properly disclosed in regulatory filings, taxed and reported on the accounting ledger. There is also a measure of control under the Sarbanes–Oxley Act that reduced the time that companies are required to report their options grants to the SEC from 30 days to 2 business days.
It is always difficult to state the extent of questionable behavior. One study by Persons14 took a sample of 111 fraudulent companies and 111 matched nonfraudulent companies. The results indicated a significantly positive association between director stock-option compensation and the likelihood of fraud. On the other hand, there is no association between the fraud likelihood and independent directors’ cash compensation and stock ownership.
The academic study conducted above does not reveal the financial impact of these questionable activities. In June 2007, in a report Swanton15 examining the involvement of general counsels (GC) stated that the SEC:
- Brought civil fraud charges against Nancy Heinen, former GC of Apple, for her involvement in backdating stock options.
- Filed a civil complaint against former Amkor Technology GC Kevin Heron for alleged insider trading. A federal grand jury previously indicted Heron on four counts of securities fraud for the same activities. Heron allegedly netted U.S. $290,000 from the illegal trades.
- D Marvell Technology Group announced the termination of Matthew Gloss, GC of its U.S. operating subsidiary.
- The company did not say why Gloss was terminated, but did say that it would take a U.S. $350,000 charge related to stock options backdating.
- D Amtel Corp. released the results of an internal investigation that found former GC Mike Ross and former CEO George Perlegos responsible for a stock options scandal at the semiconductor company. The company said Ross personally benefited from backdated options that were not approved by the Board.
Possibly the most publicized case is that of Greg Reyes in 2007, the former CEO of Brocade Communications Systems Inc. Bloomberg. In a broad government crackdown on options backdating, Reyes was the first chief executive convicted by a jury. He lost his bid to reverse his conviction for backdating employee stock-option grants and hiding the practice from auditors and investors.
He received an 18-month prison sentence and U.S. $15 million fine imposed after his second criminal trial. Brocade investors lost as much as U.S. $197.8 million in 2005 when they sold shares that had fallen in value after the practice was uncovered and the company restated financial results, prosecutors said in court filings.
History of Standard
|January 1, 1980||IAS 9 (1978) Accounting for Research and Development Activities issued
IAS 9 Accounting for Research and Development Activities effective
|January 1, 1995||IAS 9 (1993) Research and Development Costs effective|
|July 1, 1998||IAS 38 Intangible Assets
IAS 38 Intangible Assets effective
|March 31, 2004||Amendments|
|January 1, 2009||Amendments|
|July 1, 2009||Amendments|
|July 1, 2014||Amendments|
|January 1, 2016||Amendments|
Increasingly, companies have found that their most important assets for generating future benefits are not material assets such as buildings and machinery, but assets that have no physical substance. For an intangible asset to be recognized it must be (a) identifiable and (b) reliably measured. This means that the asset must be capable of being separated from the rest of the company and can be sold, licensed, rented, or exchanged either individually or together with a related item. The intangible asset can also be identifiable because it arises from contractual or legal rights, even if those rights are not separable from the business.
Recognizing and measuring the intangible asset will depend on how it has been identified. Some intangible assets will have been purchased by the company from another entity. The recognition is evident through the purchase and the measurement of the asset is by the price paid.
Some intangibles can be internally generated, in other words, the company has developed the intangible asset itself. For example, a food company may have developed a new slimming food that resulted in a patent, or a company may have developed a special kind of software for controlling its operations that led to increased efficiency.
The Problem of Goodwill
One intangible asset in particular where it has been problematic to agree with the correct accounting treatment is goodwill. This is a term that is difficult to define and somewhat easier to explain through an example. Consider the case of a very successful company that has built up a strong customer base, designed a range of quality products, and trained a good workforce. The company has gained an excellent reputation; this reputation, however valuable, will not appear anywhere on the financial statements of the company.
Imagine that a very large company acquires a smaller, but highly successful, company. Because the small company is so successful, the large company is willing to pay a high price for it. Let us assume that the price in this case is U.S. $5 million. The purchase is made and the large company calculates the fair value of the tangible assets, such as buildings and machinery, which it has acquired.
The large company calculates the fair value of the net identifiable assets, excluding goodwill, to be U.S. $4 million. As the purchase price was U.S. $5 million, the large company paid an extra U.S. $1 million for its acquisition. This excess represents all those aspects that are not tangible, but has made the smaller company successful, such as its reputation. In accounting, we assume that this payment of U.S. $1 million is for an intangible asset we term goodwill. This asset does not appear on the balance sheet of the smaller company as it was generated internally. However, as the large company has paid for goodwill, it will need to account for it. There are several options of doing so:
- Write off the cost of goodwill immediately to the income statement. This is not acceptable as U.S. $1 million has been paid for something; if that sum of money has gone out, we need to record what was received in exchange. Acquisitive companies had to convince their investors that they were purchasing something of value that would appear on the balance sheet.
- Record it on the balance sheet as an intangible asset and leave it there. Companies were mainly in favor of this method as the goodwill was an additional asset on their balance sheet and there were no costs to the income statement. The argument, mainly from standard setters, against this approach is that although the goodwill life may be indefinite, nothing is infinite. The goodwill cannot last forever. This leads us to the third option.
- The goodwill is placed on the balance sheet as an asset and written off to the income statement over several years in the same way as we do with tangible assets.
In most countries, after considerable experiments with the different methods, option 3 was selected. Not surprisingly, as it was national standard setters deciding for their own country, the periods of write-off time varied considerably, ranging from 5 years to 40 years.
Before 2001, the United States allowed companies to use one of two methods when making an acquisition: the pooling of interests or the purchase method. The first method combined the book value of assets and liabilities of the two companies to create the new balance sheet of the combined companies as if it had always been one. The acquisition price was not disclosed, so there was no goodwill. The second approach, purchase method, did give rise to goodwill and the regulations at that time required goodwill to be written off over 40 years.
In 2001, the FASB issued FAS 142, which, to the dismay of some, removed the pooling of interest option. At the same time, the method of writing off goodwill over 40 years was removed. Instead, it became necessary to review goodwill for impairment, either at the operating level, meaning a business segment, or at a lower organizational level.
Conceptually, there is considerable merit for a policy requiring the write-down of an asset when there has been a significant decline in value. A write-down can provide important information about the future cash flows that a company can generate from using the asset. However, in practice, this process is very subjective. Even if it appears certain that significant impairment of value has occurred, it is often difficult to measure the amount of the required write-down.
The procedure for assessment of impairment must be conducted annually. The computed fair value of a business segment, using the present value of future cash flows, is compared to the carrying value (book value of assets plus goodwill minus liabilities).
Where the book value of the unit exceeds its fair value, no further exercise needs to take place and valuation of goodwill remains unchanged. If, however, the fair value of the reporting unit is lesser than the book value, the goodwill is impaired and the amount of the impairment must be written off.
With the first step, the reporting unit’s fair value, including goodwill, is measured by using an appropriate valuation technique, such as a discounted cash flow method. Fair value is compared to the reporting unit’s carrying amount or book value of the goodwill. If the reporting unit’s fair value is greater than its carrying amount, the reporting unit’s goodwill is not considered to be impaired. If the reporting unit’s fair value is less than its carrying amount, then the second step is performed to determine if goodwill is impaired.
In step 2, for all classifications of property, plant, equipment, and intangible assets, the amount of impairment is measured as the excess of the book value of the asset over its fair value. However, unlike for most other assets, the fair value of goodwill cannot be measured directly (market value, present value of associated cash flows, and so on) and so must be implied from the fair value of the reporting unit that acquired the goodwill.
The implied fair value of goodwill is calculated in the same way that goodwill is determined in a business combination. That is, the implied fair value is a residual amount measured by subtracting the fair value of all identifiable net assets from the purchase price. The unit’s previously determined fair value is used as the purchase price.
In July 2012, the FASB issued guidance that gives companies the option to perform a qualitative impairment assessment for indefinite-lived intangible assets that may allow them to skip the annual fair-value calculation.
The present U.S. GAAP and international regulations are now very similar with some remaining differences. The international standard IAS 36—Impairment of Assets—has the following principles:
- Acquired goodwill should be recognized.
- Goodwill should be tested for impairment at least annually.
- Goodwill cannot be systematically amortized.
- Goodwill should not be revalued.
- Internally generated goodwill cannot be recognized.
There have been criticisms of the current regulations from users of financial statements who are uncertain about the reliability of the information. Preparers and users also express concern about the cost and complexity of the impairment testing.16
There is a considerable amount of work involved in conducting impairment testing for goodwill and the method is questionable as it relies heavily on judgment and estimates. The amounts to be written off can be significant if the company and the industry are experiencing poor economic conditions. For example, in 2012, General Motors Company wrote off goodwill impairment charges of U.S. $27,145 million. The company did not write off any goodwill in the years 2014 to 2016.
We started this section with a question and we will end with one—Is what Facebook bought worth U.S. $19 billion? Because Facebook paid that amount, accountants assume that is the value to appear on the balance sheet. Would other companies have paid that amount? We do not know but several commentators have queried the size of the payment.
If you are an investor in Facebook, we may be confident that they have complied with the regulations. However, you may think that Facebook has overpaid for the intangible assets that will appear on their balance sheet. After all, much of the declared value may represent little more than expectations for the future.
History of Standard
|January 1, 1999||IAS 17 Leases effective|
|January 1, 2005||Revised|
|January 1, 2009||Amended|
|January 1, 2019||IFRS 16 Leases effective|
Leasing has become an increasingly important activity in the business world and represents an essential source of funding for companies wishing to acquire or use noncurrent assets. In some taxation jurisdictions, it has been possible to structure agreements so that either, or both, the lessor or lessee enjoy significant taxation benefits.
Barebones could attempt to borrow U.S. $300,000 from the bank. The bank will want repayment of the loan plus interest. If we assume five annual repayments of U.S. $60,000 for the loan and U.S. $12,000 annually for interest:
- The balance sheet will show an asset under machinery of U.S. $300,000 and a liability to the bank of the same amount.
- On payment of each installment, the liability to the bank reduces by U.S. $60,000, and an interest charge goes to the income statement of U.S. $12,000.
- The end of each year brings an annual depreciation charge to the income statement of U.S. $60,000.
There are various methods that can be used to account for a lease. These methods can result in very different entries on the financial statements if there is no accounting standard in place to regulate practices.
Two of these methods can be demonstrated by taking the hypothetical example of Barebones Inc. Assume that the company wishes to buy some machinery with a useful life of 5 years costing U.S. $300,000, but has no cash. It therefore has to seek a method for funding the acquisition; there are two options for the company, assuming that no accounting standards exist.
With Option 1, Barebones will show a large loan on its balance sheet. It may not want to disclose on its financial statements that it has such a loan, as this may be assumed to be a financial weakness.
If you compare Option 2 to Option 1 you will see that the charge to the income statement is the same U.S. $72,000. The big difference is that nothing is shown on the balance sheet although Barebones owes the bank U.S. $300,000.
It is contended that companies may construct agreements to purposely classify leases as operating to avoid putting assets and liabilities on the balance sheet.17 This practice is made somewhat easier by U.S. GAAP having bright line rules to define the two types of leases.
- The present value at the beginning of the lease term of the payments not representing executory costs paid by the lessor equals or exceeds 90 percent of the fair value of the leased asset;
- The lease transfers ownership of the asset to the lessee by the end of the lease term;
- The lease contains a bargain purchase price;
- The lease is equal to 75 percent or more of the estimated economic life of the leased asset.
It does not require much ingenuity to draw up a contract where the percentages fall on the most advantageous side for the company and the information it wishes to disclose.
The original international standard (IAS 17—Accounting for Leases) is principles based. It avoids setting out quantitative thresholds, as is the case in the U.S. standard, but states that the classification of a lease depends on the substance of the transaction rather than the form. The standard describes situations that would normally lead to a lease being classified as a finance lease, including the following:
- The lease transfers ownership of the asset to the lessee by the end of the lease term;
- The lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than its fair value at the date the option becomes exercisable that, at the inception of the lease, it is reasonably certain that the option will be exercised;
- The lease term is for the major part of the economic life of the asset, even if the title is not transferred;
- At the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset; and
- The lease assets are of a specialized nature such that only the lessee can use them without major modifications being made. An example would be where certain equipment is required for certain manufacturing operations unique to the organization.
Under the existing regulations, it was claimed that companies using U.S. standards could structure agreements to avoid the quantitative thresholds and define the lease that best met their purposes.18 Criticisms on the ethicality of intentionally structuring lease contracts to avoid disclosing leased asset and liability amounts are voiced frequently. There is also the contention that the slippery slope of rule-based accounting for synthetic leases and special purpose entities led to the accounting scandals at Enron and other companies.19
Given the substantial differences between the U.S. and International Standards and the claimed abuse of the U.S. standard, it is not surprising that a project was added to the convergence agenda in 2006 to develop a new international accounting standard that addresses the deficiencies in existing regulations for accounting for leases.
The aim of the project was to agree to a single approach to lease accounting. The new standard would ensure the recognition of all assets and liabilities arising under lease contracts in the statement of financial position. The project was lengthy and the two Boards were unable to agree on a joint standard and, finally, issued their own versions.
The IASB’s approach covers virtually all leases, other than short term, as finance leases and they will appear as assets on the balance sheet. This includes intangible assets. The FASB’s standard only applies to property, plant, and equipment. Whether leases for such assets should appear on the balance sheet depends on a number of criteria that have some resemblance to the original U.S. regulations.
Although it is not presented as a rule, the new FASB lease accounting standard gives guidance as to what constitutes a lease that should appear on the balance sheet. The lease should cover a major part of an asset’s life. The standard suggests that one way to determine this is to use the 75 percent test of the original standard FAS 13.
It is impossible to say whether the two standards are sufficiently close to be considered “converged.” There are differences, but the main test will be how financial directors and auditors interpret and apply the requirements of the standards.
The classification of a lease depends on whether the lease meets certain criteria.
|January 1, 2005||IAS 32 Financial instruments: presentation|
|January 1, 2005||IAS 39 Financial instruments: recognition and measurement|
|January 1, 2007||IFRS 7 Financial instruments: disclosures|
|January 1, 2015||IFRS 9 Financial instruments: 2015|
The history of financial instruments has had so many changes and amendments that only the effective date of issued standards is given above. This obscures the complexity of the subject and the difficulties in accounting for these transactions.
Financial Instruments Explained
The definition of financial instruments states that there must be a contract and this gives rise to financial assets, financial liabilities, and equity, which appear on a balance sheet. The definition of a financial instrument is also two sided: The contract must always give rise to a financial asset of one party, with a corresponding financial liability or equity instrument of another party.
Financial markets are used by companies to raise finances for their business activities. External financial markets can be considered short term, less than a year, or long term. Short-term financial markets are often called money markets. Long-term financial markets are called capital markets, and include the equity market, the debt market, which includes borrowing from other firms, and the bank market. Multinational companies that used to raise equity capital solely from sources within their own country now look to other countries for potential shareholders; this is known as cross-border financing.
There are several types of risks associated with using financial markets. There is interest rate risk from making investments or taking out loans, or exchange rate risk through international trade. It is impossible to eliminate risk completely. However, companies can attempt to reduce it by hedging the risk.
An example of hedging is as follows: A company knows that it has to purchase supplies of materials in 3 months’ time. The materials, such as agricultural crops, may not be ready to be purchased right away, or the company may not wish to hold the materials until they are needed. There is a risk that the price of materials will increase before the end of the 3 months. The company can enter into an agreement now to purchase the goods in 3 months’ time, but at the current price. The company avoids the risk of the prices increasing in 3 months’ time when it requires the materials. It also loses the opportunity to make a gain if the price decreases in 3 months’ time.
Contracts are used for trading in derivatives. These are commonly traded among financial institutions, individual investors, fund managers, corporations, and private companies. The trades are conducted at either a physical location such as an Exchange or remotely in what is termed the over-the-counter market.
The four main types of derivatives are: forward contracts, future contracts, options, and swaps.
These contracts are the simplest form of derivatives. One of the parties in a forward contract agrees to buy the underlying asset on a future specified date for a certain specified price. The other party agrees to sell the asset on the agreed date for the agreed price. The price at which the parties agree to transact in the future is called the delivery price. No money changes hands at the time the parties enter into a forward contract. Once forward contracts are agreed upon, they can be traded between investors, typically on the over-the-counter market.
A futures contract is very similar to a forward contract. Futures contracts are traded on a variety of commodities, including live cattle, sugar, wool, lumber, copper, gold, and tin. They are also traded on a wide array of financial assets, including stock indexes, currencies, and treasury bonds.
There are two types of options. In contrast to forward and futures, options give the owner the right, but not the obligation, to transact. The owner, therefore, will only transact if it is profitable to do so. The price at which the parties transact in the future is called the strike price. When the transaction takes place, the owner of the option is said to exercise his option.
A swap is simply an agreement between two parties to exchange cash flows in the future. The agreement defines the dates when the cash flows are exchanged and the manner in which amounts are calculated. Swaps typically lead to cash flow exchanges on several future dates. There are interest rate swaps, where a floating-rate loan is exchanged for a fixed-rate loan by agreeing to pay a fixed payment in return for a variable payment. Similarly, currency swaps can be used to transform borrowings in one currency to borrowings in another currency, by agreeing to make a payment in one currency in return for a payment in another currency.
The global financial crisis of 2007 to 2008 caused considerable panic. Understandably, people wanted to know the cause of the crisis and financial instruments became the focus. The reasons offered for financial instruments being the culprit fell into two main camps. There were those who believed that the complex financial instruments had been used inappropriately. Others, particularly the banks, argued that it was not the financial instruments that were to blame but the way that they had to be accounted for, in other words, the accounting regulations.
The accounting standards were castigated because of the requirement for fair-value accounting. This required valuation of financial assets at their current market value. Thus, fair-value accounting forced companies to write-down financial asset values, destroying equity and weakening banks’ lending practices. The defenders of fair-value accounting argued that the method was not the cause of the crisis. They claimed that fair value only revealed the effects of poor decisions.
For the FASB and the IASB, the focus on accounting for financial instruments started in March 2006. The Boards declared their intentions to work together to improve and converge financial reporting standards by issuing a memorandum of understanding (MoU), A Roadmap for Convergence between IFRS and U.S. GAAP—2006–2008. As part of the MoU, the Boards worked jointly on a research project to reduce the complexity of the accounting for financial instruments.
Despite the many meetings and issue of documents, the Financial Instruments Project made very slow progress. The main differences in the convergence process have been extracted from a summary by Lin and Fink20 of several standards and is shown in Table 4.3.
Table 4.3 Major differences between U.S. GAAP and IFRS financial instruments—impairment
|Testing is required only when circumstances change||Testing is required at the end of each reporting period|
|Reversals are not allowed||Reversals are allowed|
|Undiscounted sum of future cash flows is used for measurement||Value-in-use and fair value less costs to sell are used for measurement|
Not only were the two Boards unable to agree on a joint standard, but the failure to do so confirmed that the convergence project was not proving completely successful. In 2012, the FASB and the IASB tried to resolve their differences, but finally decided to develop their own standards. The IASB continued its work in separate phases, whereas the FASB initially decided to issue one exposure draft for comment.
In 2014 the IASB published the complete version of IFRS 9 Financial Instruments which replaces most of the guidance in IAS 39. In 2016, the FASB issued Accounting Standards Update 2016-01, Financial Instruments—Overall: Recognition and Measurement of Financial Assets and Financial Liabilities. The FASB is continuing its deliberations on hedging.
Standard setting is subject to changes in business activities, political influences, and lobbying by those who support or are opposed to amendments to particular accounting regulations. The FASB and IASB convergence project is directed not only by technical accounting, but also by other influences and we discussed these in the first section of the chapter.
The topics discussed in this chapter demonstrate the complexities and influences on standard setting. They exemplify the successes of convergence but also highlight that convergence may not always be total and differences can remain. The research that has been conducted confirms that the convergence project has narrowed the differences or distance between U.S. GAAP and IFRS. There is also the suggestion that, in doing so, higher-quality standards have been produced, a notion we discussed in Chapter 3.
Although the requirements in the standards may have come closer together, insufficient experience has been gained to assess how the regulations are interpreted in practice. The intended result was that the financial statements of companies in different countries would be comparable, in other words transactions and events would be treated in the same way. Our review of some of the main standards indicates that there are differences between the IASB and the FASB requirements and there will be differences in interpretation.