Overview of International Financial Reporting Differences and Inflation EMBA Module 8 – PACE UNIVERSITY Copyright © 2009 by The McGraw-Hill Companies, All Rights Reserved. McGraw-Hill/Irwin

RCJM: Chapter 18 © Learning objectives 1.How globalization has relaxed cross-border barriers and prompted convergence of reporting standards across countries. 2.Why the International Accounting Standards Board (IASB) has become important. 3.What is IFRS? 4.How does IFRS differ from GAAP? 5.What is the impact of IFRS on technology companies? 6.U.S. Roadmap 7.Inflation Accounting

RCJM: Chapter 18 © Overview: Growth in cross-border securities transactions

RCJM: Chapter 18 © Overview: Why international accounting is important  U.S. companies do not dominate the global economy.  The growth in global investing has been fueled by: Relaxed security market regulatory rules - easier for foreign firms to meet listing requirements. Improvements in telecommunications and computer technology - investors access to information on a global scale. Investors understand that global investment strategy portfolios may be less risky than are those composed exclusively of domestic companies.

RCJM: Chapter 18 © What is IFRS?  As indicated within the title, these standards are aimed at a global practice.  IFRS stands for International Financial Reporting Standards.  The goal is to achieve a single set of high-quality, common accounting standards used around the world.  These standards are the result of a convergence of international viewpoints.

RCJM: Chapter 18 © International Financial Reporting: The IASC and the IASB International Accounting Standards Committee (IASC) Formed in Included professional accounting organizations in 10 countries – including the United States Establishes high quality, understandable and enforceable global accounting standards. Works to achieve convergence throughout the world. Includes more than 130 countries. Has issued 41 International Financial Reporting Standards (IFRS). International Accounting Standards Board (IASB)

RCJM: Chapter 18 © International Financial Reporting: U.S. GAAP vs. IFRS  Compared to U.S. GAAP, IASB standards allow firms more latitude.  IFRS often permit different accounting treatments for similar economic events.  IFRS frequently follow a more “broad brush” approach than does U.S. GAAP.  Existing differences between U.S. GAAP and IFRS will be narrowed in the future. Benchmark treatment Allowed treatment PreferredMay be used

RCJM: Chapter 18 © Is IFRS different than US GAAP?  There are differences between IFRS and US GAAP but more alike than different for most commonly encountered transactions.  IFRS is largely grounded in the same principles as US GAAP.  Differences standard setters have had the advantage of: Draw on the latest standard setters from around the world, Taking a fresh approach and avoid perceived problems that might exist in US GAAP, and Annual improvement process, the standards are reviewed to enhance their clarity and consistency.

RCJM: Chapter 18 © Is IFRS different than US GAAP?  IFRS standards are more broad and principles based with limited interpretive guidance - leave implementation of the principles embodied in the standards to preparers and auditors and its interpretive body.  US GAAP contains underlying principles as well but is more specific and rules based with far more comprehensive implementation guidance and industry interpretations: US GAAP is 25,000 pages and IFRS is 2,500 pages!  The following example is a simple illustration of principles- vs. rules-based concepts:

RCJM: Chapter 18 © Is IFRS different than US GAAP? Principles based:  Your parents tell you to do your best to get good grades and that if you do not, they will consider the substance of your reasons. Rules based:  Your parents tell you to get a 3.2 GPA or above and then provide 15 contingencies that might justify acceptance of lower grades.

RCJM: Chapter 18 © International Financial Reporting: Some difference between U.S. GAAP and IFRS U.S. GAAPIFRS Long-lived assets Historical cost minus depreciation and impairment loss Permits upward revaluation when replacement cost is above original cost Reversal of impairment losses ProhibitedPermitted Inventory valuation Allows LIFODoes not allow LIFO Research & development Expensed as incurredSeparate rules for “research” phase and “development” phase Capitalized interest Requires capitalization in certain instances Benchmark treatment is to expense all interest

RCJM: Chapter 18 © 2009 International Financial Reporting – Technology Companies  Differences in reporting using IFRS in technology companies.  Under GAAP – R&D costs are generally expensed when incurred – exemptions relate only to development of software for internal use and website development costs.  Under IFRS – The development activity results in an intangiable asset that gets capitalized and will get amortized based upon tests for impairment.  Bottom line – Capitalization rate for R&D for software and internet companies in Europe went from 0 to 61% for companies with R & D expenditures ranging from $30M to $2.1B. 12

RCJM: Chapter 18 © 2009 International Financial Reporting – Technology Companies Financial impact of using IFRS versus GAAP: - Different income statements and cash flows based on geography for R & D; - Results in transition year to IFRS affected; - Volatility from potential impairment of amounts capitalized, or reversal of that impairment; - Difference in taxes paid and tax credit received resulting from income tax credits from R&D expenditures, and - Companies will need to develop system capabilities and processes to reliably measure expenditures during development period to enable a proper analysis of costs for capitalization. 13

RCJM: Chapter 18 © International Financial Reporting: Monitoring compliance  Not only do financial reporting rules differ across countries, but also do the mechanisms for monitoring compliance with those rules.  Different countries have different structures for determining whether the stated principles are actually being followed. External auditor Securities commission Accounting court Competence Independence SEC can challenge financial reports Adequate staff and budget remains an issue Enterprise chartered in the Netherlands

RCJM: Chapter 18 © U.S. Roadmap  In 2008, the SEC unanimously approved releasing a proposed Roadmap - establishes a timeline and milestones for continuing US progress toward acceptance of IFRS for public companies.  The Roadmap sets forth several milestones and, if achieved, they could result in mandatory use of IFRS in financial statements filed with the SEC by US issuers beginning in 2014, with early adoption permitted.  The SEC will consider progress made toward achieving these milestones before its final decision in 2011 about whether to proceed with mandatory adoption of IFRS reporting standards.  The SEC dropped the reconciliation requirement, 20-F, for financial statements prepared using IFRS as of November 15, 2007.

RCJM: Chapter 18 © 2009 U.S. Roadmap  SEC next announcement was in February  SEC issued a work plan that included investor understanding and education regarding IFRS; examination of U.S. regulatory environment; impact of issuers; and human capital readiness.  December 2010, SEC Chairman Mary Schapiro dismissed speculation that IFRS decision be made by June 30, 2011 – but a decision made in  The SEC would allow a minimum of 4 years – first time reporters in 2015 and 2016 – implementation staggered thereafter. 16

RCJM: Chapter 18 © Where do we go from here?  The FASB and IASB remain committed to convergence: The goal is to achieve a single set of high-quality, common standards. The focus is on improved reporting, not convergence for the sake of convergence. In 2011, the SEC will reevaluate progress toward convergence. Significant resources are being devoted to this effort.  One thing is certain – there will be change. We are on the edge of an accounting change that will shape future of the entire profession.

RCJM: Chapter 18 © Inflation accounting  Inflation—a decline in the purchasing power of a country’s currency— complicates the analysis of international financial reports.  When inflation is a serious problem, historical cost accounting becomes less meaningful and inflation accounting is used.  Financial reporting standards in countries with high rates of inflation (e.g., Mexico) mandate some form of inflation accounting for both tax and financial statement reporting.  Two forms of inflation accounting are required by Mexican GAAP: Specific price-change adjustments General price-level adjustments Rate of price change for specific items like electronic components, coffee beans, or natural gas. Current cost accounting approach. General rate of inflation for the economy as a whole. General price-level accounting approach

RCJM: Chapter 18 © Inflation accounting: Current cost approach  Current cost refers to the market price that an individual firm would have to pay in order to replace the specific assets it owns.  Current cost accounting is designed to accomplish two things: 1. Reflect all nonmonetary assets (inventory, buildings, and equipment) at their current replacement cost as of the balance sheet date. 2. Differentiate between: (a) current cost income from continuing operations, and (b) increases or decreases in current cost amounts (holding gains or losses).

RCJM: Chapter 18 © Inflation accounting: General price-level accounting  The real amount of goods and services that can be acquired at any moment is what determines the purchasing power of a currency like the U.S. dollar.  General price-level accounting measures changes in purchasing power using a price index for a broad market basket of goods and services. Current cost accounting General price-level accounting Purchasing powers changes linked to special nonmonetary assets (e.g. computer chips inventory). Purchasing powers changes linked to general price index and broad market basket.