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Home / ... / Towards Convergence of IFRS to US GAAP Differences

by Sean Callaghan and Marie Treacy

For the past several years, momentum has been rapidly building towards a single set of high quality global accounting standards that could be consistently applied by companies and understood by investors around the world. However, while convergence efforts have been making important progress, what is seen in practice is that companies report significant differences in many areas of accounting between IFRS and US GAAP. In this article Sean Callaghan and Marie Treacy report on Ernst & Young’s survey of publicly available IFRS to US GAAP reconciliation information.

Ernst & Young has conducted a survey of publicly available IFRS to US GAAP reconciliation information filed by SEC foreign private issuers on fiscal years ended between 31 December 2005 and 31 March 2006, following the first-time adoption of IFRS across the globe. We believe these findings continue to be applicable for subsequent filings. The 130 companies included in the survey are some of the largest in the world markets with 42% of the companies surveyed being in the 2006 Financial Times Global 500. The research has generated a great deal of interest from SEC registrants and other companies who are using IFRS and/or US GAAP. We believe the findings are of significant value to preparers of IFRS and US GAAP companies’ reported results have been significantly impacted by differences between the two frameworks.

Where did the differences arise? The survey of reconciliations prepared by 130 companies identified almost 200 unique IFRS to US GAAP differences from a combined total of over 1,900 reconciling items. companies reported such a difference. Although the basic principles of purchase accounting are comparable, we see numerous differences arising in practice. 22% of the differences relate to purchase price measurement and allocation.

These include : - the date at which the fair value of consideration is measured, - recognition criteria for contingent consideration, - accounting for in-process research and development assets (particularly prevalent in the pharmaceutical and biotech sectors) and - differences in the recognition of restructuring provisions.

8% of the differences relate to measurement of, or accounting for, minority interests, including the acquisition of minority interests.

The recent joint combinations convergence project between the FASB and IASB has been re-considering the existing guidance under both frameworks and it is likely that fewer differences will arise on business combinations subsequent to the adoption date of the new standards.

As expected, a significant proportion (37%) of the differences in the business combinations category relate to the application of exemptions for first-time adoption of IFRS under IFRS 1 First-time Adoption of International Financial Reporting Standards. Under IFRS 1, a first-time adopter may elect not to apply IFRS 3 Business Combinations fully retrospectively to business combinations completed in prior years.

Financial Instruments

Differences relating to the recognition and measurement of financial instruments were reported by 70 companies. These included the presentation of debt issue costs and also the measurement of investments in unlisted companies. Differences in the definitions and requirements for accounting for financial instruments under IFRS and US GAAP can result in the same instrument being classified differently between debt and equity.

Some 38 companies in the survey reported differences relating to shareholders’ equity, principally relating to bonds with a conversion feature. In addition, many companies with preference shares also reported differing treatment, whether classifying them as a form of equity or as a liability.

Derivatives & Hedge Accounting

85 companies reported differences in the area of derivatives and hedge accounting. While many of the differences arose due to transition exemptions available under IFRS, 20% were due to hedge relationships not meeting the US GAAP designation and documentation requirements usually because companies elected not to designate and document their hedge relationships under US GAAP. A number of other differences were also reported in this area, including the treatment of embedded derivatives, partial term hedges and non-derivative hedging instruments.

Pensions and Post-Retirement Benefits The vast majority of companies report differences with respect to pension accounting, mainly due to the prevalent use of defined benefit (e.g. final salary) pension schemes, particularly by large multinationals. Historically, the accounting standards for defined benefit pension schemes and other post-employment retirement benefits have differed significantly between IFRS and US GAAP. Consequently, pensions accounting has been the subject of a convergence project. As part of the initial phase of that project, the FASB issued FAS 158 Employers’ Accounting for Defined Benefit Pension and Other Post-Retirement Plans in September 2006. The new standard should eliminate many of the balance sheet differences between IFRS and US GAAP reported in the survey. However, FAS 158 does not make changes to the amount of net periodic benefit cost included in net income, nor does it address a number of measurement issues associated with pension accounting. Therefore we believe that differences between IFRS and US GAAP relating to the recognition of actuarial gains and losses will continue to be reported by many companies, as will differences in connection with pension plan amendments and past service costs.

Share-based payment Over half of companies had differences relating to share-based payments although one third of these relate to IFRS transitional provisions: for example, companies are not generally required to apply IFRS 2 Share-Based Payment to equity instruments granted on or before 7 November 2002. Many of the other differences in this area arose from the different transition dates of the comparable fair value model of accounting for share-based payment in US GAAP, FAS 123 (R) Share-Based Payment or companies still following the intrinsic value method under APB 25 Accounting for Stock Issued to Employees at the time of the survey.

Other reported differences between the FASB and IASB has been re-considering the existing guidance under both frameworks and it is likely that fewer differences will arise on business combinations subsequent to the adoption date of the new standards. As expected, a significant proportion (37%) of the differences in the business combinations category relate to the application of exemptions for first-time adoption of IFRS under IFRS 1 First-time Adoption of International Financial Reporting Standards. Under IFRS 1, a first-time adopter may elect not to apply IFRS 3 Business Combinations fully retrospectively to business combinations completed in prior years.

Impairment Despite similar overall approaches to impairment by IFRS and US GAAP, differences often arise in practice. Almost half the companies reported differences in this are. The main ones identified were: - The reversal of previous impairment write-downs (generally prohibited under US GAAP, except for long-lived assets held for sale). - Evaluating long-lived assets (other than goodwill). US GAAP applies an initial undiscounted cash flow recoverability test to determine whether an impairment based on discounted cash flows is required. There is no undiscounted test under IFRS. - Goodwill being assessed for impairment at different levels (reporting units under US GAAP as opposed to cash generating units under IFRS).

Provisions

The area of provisions is another one where differing treatments under US GAAP and IFRS can be seen, with over half of the companies surveyed reporting differences. These often relate to: - restructuring costs and severance where the recognition criteria are different; and also - the discounting of provisions, which is much less frequent under US GAAP as the amount of the liability and the timing of payments must either be fixed or reliably determinable for provisions to be discounted.

Taxation

Differences relating to taxation were reported by 126 of the 130 companies despite the supposedly similar ‘full provision’ approaches to accounting for taxation under IFRS and US GAAP. This makes taxation the third most reported category of difference, after pensions and post¬retirement benefits and business combinations.

The reported differences reflect the many, often significant, methodology differences that exist in the computation of deferred tax between IFRS and US GAAP. However, the main reason for the number of reported differences relating to taxation is that they reflect the tax effects of other reported differences.

Many companies do not quantify the effect of taxation methodology differences separately from the deferred tax effect of other reconciliation items. It is therefore not possible to quantify the impact of methodology differences. However, we do see companies reconciling items because of differences in the specific IFRS and US GAAP guidance in several areas. For example:

- deferred tax arising on business combinations, - the tax treatment of share-based payments and - the classification of deferred tax amounts as either current or non¬current assets or liabilities.

The implementation of FIN 48 Accounting for Uncertainty in Income Taxes in US GAAP in 2007 will likely lead to additional differences in how companies account for tax contingencies compared to IFRS. FIN 48 introduces a new model for treating tax contingencies that differs to the treatment prescribed in IFRS.

So, what does allthis mean?

Recent announcements by the SEC have certainly moved IFRS and its differences to US GAAP more squarely into the spotlight. This has sparked increased speculation as to whether US GAAP may ultimately be replaced by IFRS.

The SEC is showing considerable interest in IFRS and has initiated a debate about whether US companies should be permitted to use IFRS rather than US GAAP.

The SEC is also examining the potential for removing the US GAAP reconciliation requirement for non-US companies registered with the SEC. In this regard, they have made consistency of application and presentation of IFRS financial information one of the key issues surrounding the potential elimination of the IFRS to US GAAP reconciliation requirement for foreign issuers. We are already seeing a vigorous and robust geographic and industry comparison in the SEC comment letter process.

Conclusion The recent convergence efforts by both the IASB and the FASB around business combinations, pensions and share-based payments will certainly help reduce the incidence of differences arising between IFRS and US GAAP in the future. It is clear, however, that a number of important and potentially significant differences will remain and that these will continue to cause complexity and confusion for preparers and readers of financial statements. Companies would be well advised to develop a heightened awareness of the IFRS and US GAAP standards and to closely monitor future developments in this area.

Sean Callaghan is a partner in Ernst & Young’s Capital Markets Group and Marie Treacy is a partner in Ernst & Young Dublin.

Accountancy Ireland December 2007 Vol.39 No.6

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