converting financial statements gaap ifrs jan2014 cpaj

8102019 Converting Financial Statements GAAP IFRS Jan2014 CPAJ

httpslidepdfcomreaderfullconverting-financial-statements-gaap-ifrs-jan2014-cpaj 110

IFRS has become the required or permitted accounting frame-work for financial reporting in many of the worldrsquos financialmarkets whether explicitly endorsed or integrated into nation-al regimes based on IFRS Even though IFRS is not current-

ly permitted by the SEC for US registrants US accountantsneed to know IFRSmdashand how it differs from US GAAPmdash

because they will encounter it in the financial statements of for-eign companies whose securities trade in the United States for-eign subsidiaries of US companies and US subsidiaries of foreign companies Although the IASB and FASB have reducedthe differences between these sets of standards over the pastdecade several remain

Converting Financial Statements fromUS GAAP to IFRS

A C C O U N T I N G amp A U D I T I N G

i n t e r n a t i o n a l a c c o u n t i n g

JANUARY 2014 THE CPA JOURNAL20

By Peter Harris Eva K Jermakowicz and Barry Jay Epstein

A Comprehensive Illustration



Coverage of IFRS in college accountingcurricula and professional-licensing exami-nations has expanded in the past decademaking newly minted practitioners at least

partially conversant with the remaining dif-ferences between GAAP and IFRSPractitioners who were educated and trained

before IFRS became widely employed how-ever might benefit from a comprehensiveillustration of the GAAP-to-IFRS conversion

processTo assist such CPAs the authors have

developed a comprehensive illustration of the process to be employed when convert-ing US GAAPndashbased financial statementsto conform with IFRS as these sets of standards exist today The goal is to intro-

duce the major differences between USGAAP and IFRS with their resultingdivergent effects on the financial statementsThe illustration presents a US GAAPndashpre-

pared statement of financial position and anincome statement then based on a set of specific facts affecting financial reporting bythe entity it details the conversion to IFRS-compliant financial statements The process

begins with the recording of IFRS compli-ance worksheet adjustments continueswith worksheet reconciliation from USGAAP to IFRS and concludes with the

preparation of IFRS-based statementsMost of the more significant and likelydifferences between the two frameworksare highlighted These matters pertain tothe capitalization of qualifying develop-ment costs allowable inventory costingmethods (ie use of the last-in first-out[LIFO] method is prohibited under IFRS) permissible use of the revaluationmodel for property plant and equipment(PPampE) use of component depreciationand the allowable reversal of impairmentlosses This example also addresses themore conservative approach of IFRSregarding the recognition of contingentlosses and the different finance (capital)lease requirements Finally this exampleillustrates the different requirements for

presenting compound financial instruments(eg convertible debt securities) given thatIFRS requires that the equity componentembedded in such securities be accountedfor and presented as equity

The presentation of the statement of financial position differs between the twoframeworks Under US GAAP thestatement begins with the most liquid assets

and liabilities followed by noncurrentand longer-term assets and liabilities andconcludes with shareholdersrsquo equitywhereas IFRS often (albeit not mandato-

rily) begins with the most illiquid accountsPresentation in the income statement alsovaries for example IFRS does not allowfor the characterization of gains or lossesas extraordinary

IFRS allows for greater flexibility on thecash flow statement for categorizing cer-tain items such as for interest and dividendincome as well as for interest expense The

present demonstration will only address

recognition and measurement issues affect-ing the statement of financial position andthe income statement because the cashflow display options under IFRS are prin-cipally elective alternatives not requireddifferences

Hypothetical Case StudyA hypothetical company JCL is a man-

ufacturer of prescription drugs Its mainheadquarters are in Newark New Jerseywhere the company has operated since1981 The company sells its products tothe retail market on a worldwide basis Itsfinancial statements presented in Exhibit 1

and Ex hib it 2 for the year endingDecember 31 2012 have been preparedusing US GAAP JCLrsquos managementwould like to preview the effects of usingIFRS on the statement of financial positionand income statement The company wouldlike to be able to report under IFRS by as

early as the next year as it is consideringa new stock issue to be offered in HongKong which requires IFRS complianceThe following paragraphs provide more

background information needed to under-stand the companyrsquos financial statementsand convert them to IFRS

During 2012 JCL incurred costs of $2000 to develop new prescription drugsrequiring high levels of technical knowl-edge The drugs under development hav-ing been heavily researched for severalyears reached technical and economic fea-sibility at the beginning of 2012 and theregulatory approval process has beenrecently completed The drugs will be test-ed in 2013 on a much larger patient pop-

ulation before making them available tocustomersJCL uses the LIFO method to value its

inventory The LIFO reserve (as used toadjust from first-in first-out [FIFO]) was$5000 at the beginning of the year and$7000 as of year-end

Management has determined that the fair value of PPampE as of December 312012 is $78571mdashan $8571 increaseabove book value These assets are on agoing-forward basis to be depreciated over a 10-year period using the straight-line

depreciation method There is no residualvalue Depreciation for 2012 was record-ed as $12000 for US GAAP financialreporting purposes

The patent is the only amortizable intan-gible asset it is expensed over a five-year

period using the straight-line method Thehalf-year convention is applied for all assets

placed in service during the year For theyear ended December 31 2012 amortiza-tion expense is $1200

In 2011 there was a goodwill impair-ment recognized in the amount of $2000thereby reducing the carrying value from$7000 to $5000 During 2012 the com-

pany tested for goodwill impairment andfound that the goodwillrsquos fair value hadactually increased to $6000

Investments consist of available-for-sale(AFS) securities with a fair value of $20000 at the end of the year The valueat the beginning of the year was $15000Exchange-rate currency gains accountedfor $2800 of the gain recognized duringthe year For simplicity assume that therewas no interest or dividend incomeearned on these investments during the

21JANUARY 2014 THE CPA JOURNAL

Significant differencespertain to the capitalization

of development costs

inventory costing methods

revaluation for PPampE and

component depreciation




year and any related income tax effectshave been disregarded Furthermore thisis the only item reflected in the share-holdersrsquo equityndashaccumulated comprehen-

sive income accountThe company suffered a loss of $4000due to a hurricane which is considered to

be both an unusual and infrequent occurrenceAccordingly under US GAAP it wasreported net of tax as an extraordinary item

There are long-term contingencies of $3000 stemming from civil lawsuitsconcerning customer personal injuriesarising from use of JCLrsquos products Legalcounsel considers the payout slightlyldquomore likely than notrdquo to occur In anunrelated case where the company is a

plaintiff counsel considers the recovery

of $10000 in a patent infringement caseto be probable Both cases are expectedto settle in a time frame of greater thanone year

JCL issued 50 convertible bonds onDecember 31 2012 at par value of $1000each in exchange for $50000 in proceedsThe bonds have a 10-year term and a couponrate of 6 to be paid semi-annually The

bonds are convertible at the option of theholder at any time until maturity at a rateof 100 shares per bond The prevailingmarket rate of similar bonds without the con-version option is 8 per year

JCL entered into a lease on January 12012 with the following terms JCL leasedspecialized machinery from Bell Corp that

will enable JCL to manufacture its phar-

maceuticals in a much more efficient man-ner This machinery was made specifical-ly for JCL to meet its unique productionneeds The lease term is for three years

with a minimum annual lease payment of $2500 payments are due on December 31of each year with the first payment due onDecember 31 2012 At the end of the leaseterm JCL has the option to buy theequipment for the then-prevailing marketvalue which will be established by an inde-

pendent third-party expert appraiser or tonegotiate a lease extension also at a mar-ket lease rate as determined by indepen-dent parties Furthermore983150 The lessee will pay all executory costs983150 The estimated useful life of the leased

asset is 50 months (41

frasl 6 years)

EXHIBIT 1Statement of Financial Position Prepared under US GAAP

JCL Inc Statement of Financial Position

as of December 31 2012

(Amounts in Thousands of Dollars)

ASSETS LIABILITIES AND SHAREHOLDERSrsquo EQUITY

Current Assets Current LiabilitiesCash 33000 Accounts payable 40000

Accounts receivable 47000 Accrued expenses 25000

Inventory (LIFO basis) 60000 Taxes payable 15000

Total Current Assets 140000 Total Current Liabilities 80000

Investments (Available for Sale) 20000 Noncurrent Liabilities

Bonds payable 6 convertible 50000

Property Plant and Equipment

Assets (at cost) 120000 Total Liabilities 130000

Less accumulated depreciation (50000) 70000

Shareholdersrsquo Equity

Intangible Assets Common stock ($1 par) 60000

Trade name 4000 Accumulated other 5000

comprehensive income

Patent (net of 3000 6000

accumulated amortization) Retained earnings 50000 115000

Goodwill 5000 15000

Total Assets 245000 Total Liabilities and 245000




JANUARY 2014 THE CPA JOURNAL 23

983150 The market value of the equipment atthe inception of the lease is $7500983150 The interest rate implicit in the lease isnot known by JCL

983150 The incremental borrowing rate of JCLis 8 the same rate it would currently payon straight (ie nonconvertible) debtissuances983150 The effective tax rate for JCL is 25

For the sake of simplicity with theexception of the inventory facts mentionedabove the income tax effects have beendisregarded in this case study

Based on the information above theauthors detail the following steps in theconversion of the financial statements fromUS GAAP to IFRS First all significant

accounts and balances affected by the tran-sition will be analyzed Then worksheetadjustments for these items will be pre-

pared to effect the conversion Finally theIFRS-based statements of financial posi-tion and income will be presented

Following this conversion the major dif-ferences in cash flow reporting betweenUS GAAP and IFRS will be briefly dis-cussed as will the likely impact on com-monly cited financial ratios

Significant Differences

The following sections analyze the sig-nificant differences between US GAAPand IFRSmdashthat is the financial statementitems requiring worksheet adjustment toconform to IFRSmdashin this case study

Capitalization of certain development

costs under IFRS IAS 38 Intangible

Assets requires the capitalization of devel-opment costs when technical and eco-nomic feasibility of a project can bedemonstrated in accordance with sixspecific criteria An intangible asset aris-ing from development (or from the devel-opment phase of an internal project) isrecognized if and only if an entity cansatisfy all of the following criteria1) the technical feasibility of completingthe development project 2) the reportingentityrsquos intention to complete the pro-

ject 3) the entityrsquos ability to use it or sell it 4) the probability that the projectwill generate future economic benefits5) the availability of adequate technicalfinancial and other resources to completethe project and 6) the ability to measurethe expenditure related to the intangibleasset during its development

The capitalization of development costsis not permitted under US GAAP(Accounting Standards Codification [ASC]985-20) with limited exceptions such as

for internal-use software website devel-opment developed technology acquired in business combinations and certain indus-try-specific situations Therefore two work-sheet adjustments are required to transitionto IFRS first to capitalize developmentcosts as an intangible asset on the state-ment of financial position and then toamortize this asset over a five-year peri-od (Using a half-year convention andthe straight-line method of amortizationrequires recognition of $200 of accumu-lated amortization at year-end) JCL

accordingly makes the following worksheetadjustments(1)Dr Development costs 2000

Cr Development expense(SGampA expenses) 2000

(2)Dr Amortization expense 200

Cr Accumulated amortizationmdash development costs 200

LIFO is not permitted under IFRS

Under the provisions of IAS 2 Inventoriesapart from specified classes of inventories

JCL has a choice between the FIFO or the weighted-average cost formulas For this illustration assume that JCL is switch-ing from LIFO to FIFO for its IFRS finan-cial reporting In this case the result will

be a $2000 decrease in 2012rsquos cost of goods sold by virtue of a greater invento-ry total under FIFO (measured by theincrease in the LIFO reserve from $5000to $7000) In addition there will be anoth-er increase in FIFO inventory to reflect theextra beginning-of-year reserve of $5000

bringing the total increase in inventory to$7000 Assuming for the moment thatJCL will continue to be a GAAP-report-ing entity in the United States and thusable to utilize LIFO for both financial andtax reporting purposes there will be anincrease in income tax expense of $500(25 of $2000) There will also be recog-nition of a deferred tax liability account for IFRS-basis reporting in the amount of $1750 (25 of $7000) The worksheetadjustments are as follows(3)Dr Inventory 2000

Cr Cost of Goods Sold 2000

(4)Dr Income Tax Expense 500

Cr Deferred Tax Payable 500(5)

Dr Inventory 5000Cr Deferred Tax Payable 1250Cr Retained Earnings 3750

Note that the increase to retained earn-ings represents the increased earningsattributable to prior years net of tax under the assumption that FIFO had been con-sistently applied ($5000 times [1 ndash 025])

Re va lu ati on mo del US GAAPrequires that PPampE assets be reported atcost less accumulated depreciation IFRS

permits an accounting policy alternative tothis cost model called the revaluation

model In accordance with IAS 16 Property Plant and Equipment after ini-tial recognition an item of PPampE whichhas a fair value that can be measured reli-ably may be carried at a revalued amountwhich is defined by its fair value at the dateof the revaluation less any subsequent




accumulated depreciation and subsequentaccumulated impairment losses If anitem is revalued the entire class of PPampEto which the asset belongs should be reval-

ued Revaluations should be made with suf-ficient regularity to ensure that the carry-ing amount is not materially different fromfair value at each reporting date

Using the revaluation model an increasein an assetrsquos carrying amount willincrease other comprehensive income andwill be accumulated in a revaluation sur-

plus account within equity (unless theincrease reverses a revaluation decrease

previously recognized in profit or loss) Adecrease is recognized in profit or lossexcept to the extent that it reverses a pre-

vious revaluation surplus on the same assetin which case it is recognized in other comprehensive income (OCI)

Under the revaluation model there aretwo available methods of accounting for accumulated depreciation983150 Restate the accumulated depreciation pro-

portionately with the change in the grosscarrying amount of the asset so that the net

carrying amount of the asset after revalua-tion equals its revalued amount IAS 16 statesthat this method is often used when an assetis revalued by applying an index to restate the

asset to its depreciated replacement cost983150 Eliminate the accumulated depreciationagainst the gross carrying amount of theasset and then restate the net amount to therevalued amount of the asset

Under either approach the adjusted net

carrying value of the asset after revalua-tion is the same as its revalued amountThe worksheet adjustments under twoapproaches are as follows983150 Under the first approach to recognizethe revaluation amounts for both PPampEand accumulated depreciation such that the

net value is increased by $8571 the fol-lowing computations are necessary for thegross amount $78571 divide $70000 times$120000 = $134693 for accumulateddepreciation $78571 divide $70000 times $50000= $56122 This results in an additionaldepreciation expense of $857 ($8571divided by the revised projected remaininglife of 10 years) which is already incorpo-

rated into the year-end revaluation adjust-ment The worksheet adjustment is as fol-lows(6a)

Dr PPampE 14693Cr Accumulated depreciation 6122Cr Revaluation surplusmdash Comprehensive income 8571

Under the second approach the work-sheet adjustments to eliminate accumulat-ed depreciation and revalue the carryingamount of PPampE are as follows(6b)Dr Accumulated depreciation 50000

Cr PPampE 50000Dr PPampE 8571

Cr Revaluation surplusmdashOCI 8571

Assume that JCL chooses to use the firstapproach for its IFRS-basis financialreporting Two other aspects of accountingfor long-lived assets under IFRS are alsoimportant to understand although not perti-nent to the present illustrative example

Component depreciation Under IFRSeach constituent part of an item of PPampEthat is material with respect to the total costof the asset must be depreciated separate-lymdasha process known as component depre-ciation Consequently if warranted by thefacts an asset may be considered to have

multiple parts (eg a roof and heating plantdistinct from the building itself) with each part depreciated over its appropriate esti-mated useful life For example consider anew truck purchased by a company for $55000 that has $10000 in tires ($2500

per tire) The truck ($45000) will have a10-year life but the tires ($10000) willhave a three-year life with no residualvalue In this example annual depreciationunder IFRS would be $7833 ([$45000 divide10)] + [$10000 divide 3]) Although thisapproach is permitted under US GAAPit is rarely used in practice and insteaddepreciation of $5500 ($55000 divide 10)would generally be recognized Thisdetail has been omitted from this casestudy inasmuch as there is insufficientinformation to make such judgments

Impairments When determining whether an item of PPampE is impaired an entityapplies IAS 36 Impairment of Assets toensure that such assets are not carried at morethan their recoverable amounts The recov-erable amount is the greater of the fair value less disposal costs or the value-in-use (the discounted net present value of

EXHIBIT 2

Statement of Income Prepared under US GAAP

JCL Inc Statement of Income

Year Ended December 31 2012


Sales 450000

Cost of Goods Sold 375000

Gross Profit 75000

SGampA Expenses 47000

Earnings before Interest and Taxes 28000

Interest Expense 4000

Income Before Tax 24000

Tax Expense (at 25 ) 6000

Income from Continuing Operations (before Extraordinary Item) 18000

Extraordinary Item Loss from Hurricane (Net of $1000 Income Tax) (3000)

Net Income 15000




expected future cash flows from the asset)An impairment loss is recognized in profitor loss if an assetrsquos carrying value is morethan its recoverable amount

In general an impairment loss can bereversed under IFRSmdashcontrary to USGAAP (ASC 360-10)mdashwhen the facts andcircumstances warrant doing so but thisaction is limited to an increase to whatthe carrying amount of the asset that wouldhave been net of depreciation if theimpairment had not been recognized for the asset in prior years This limitation on

the reversal of impairment losses does notapply if the asset is carried under the reval-uation model In those cases the fullimpairment reversal to fair value is

accounted for as a revaluation increaseThere is no prior impairment in this casestudy that needs to be reversed in the cur-rent period

Impairment of intangibles other than

goodwill Using US GAAP (ASC 350-30-35) intangibles other than goodwill (ie

patents) are tested whenever impairmentindicators exist Under IFRS (IAS 36)

the existence of impairment indicators must be assessed annually If appropriate aloss may be reversed up to the newlyestimated recoverable amount but it may

not exceed the initial carrying amount(adjusted for amortization) that would havealready been recognized This amount isrecorded in income Under US GAAPthe reversal of impairment losses is pro-hibited for all intangible assets In the tran-sition to IFRS JCLrsquos patent was testedfor possible impairment and no such evi-dence was detected

EXHIBIT 3

Statement of Financial Position IFRS Basis





Current Assets Current Liabilities

Cash 33000 Accounts payable 40000


Inventory (FIFO basis) 67000 Lease obligation 2143

Total Current Assets 147000 Taxes payable 15000Total Current Liabilities 85143

Investments (Available for Sale) 20000

Deferred income tax liability 1750

Property Plant and Equipment Noncurrent Liabilities

Assets (at cost) 134693 Lease obligation 2315

Less accumulated depreciation (56122) 78571 Bonds payable 6 convertible 43205 45520

Leased assets 6443 Total Liabilities 132413


Intangible Assets

Trade name 4000 Shareholdersrsquo EquityPatent (net of 3000 6000 Common stock ($1 par) 60000

accumulated amortization)

Development costs (net of 200 1800 Additional paid-in capitalmdash 6795

accumulated amortization) conversion feature

Goodwill 5000 16800 Accumulated other 2200


Revaluation surplus 8571

Retained earnings 56687 134253






Goodwill impairment Under USGAAP (ASC 350-20-35) impairment test-ing for goodwill is determined at the levelof a reporting unit (RU) Using IFRS (IAS

16) goodwill is tested for impairment atthe level of a cash-generating unit (CGU)or a group of CGUs which may differ from RU Under both US GAAP andIFRS a goodwill impairment loss oncerecognized cannot be reversed in a sub-sequent period

Financial instruments Under USGAAP the income or loss attributed tochanges in the fair value of AFS securi-ties (ASC 320-10) is part of comprehen-sive income in its entirety (except to theextent that the AFS security is designated

as being in a fair value hedge arrangementin which case changes in fair value are rec-ognized in income) Under IFRS howev-er a foreign currency exchange gain or losscomponent of the change experienced inthe fair value of financial instruments

attributable to the selection of a differentfunctional currency (as described by IAS21 The Effects of Changes in Foreign

Exchange Rates) is considered part of prof-

it or loss to be reported in the income state-ment Thus the worksheet adjustment for the transition to IFRS is as follows(7)Dr Accumulated OCI 2800

Cr Currency exchangerate gain 2800

No reporting of extraordinary items

under IFRS Unlike US GAAP which permits separate classifications of anextraordinary item on the income statementas a separate caption below the operatingincome (loss) section IAS 1 Presentation

of Financial Statements prohibits a sepa-rate presentation of extraordinary gains or losses in the statement of profit or loss andOCI (ie the statement of comprehensiveincome under US GAAP) Consequentlythis item must be included in the operat-

ing income (loss) section of the incomestatement IFRS however requires the sep-arate disclosure of any item that material-ly impacts the financial statements Unusual

and infrequent items that are material meetthis definition Such items may be report-ed as a separate component of continuingoperations and denoted as unusual nonre-curring or some similar term (but not

extraordinary)The gross amount of JCLrsquos hurricane

loss is $3000 net of tax ($4000 beforethe 25 tax rate) The worksheet reclassi-fication adjustment is as follows(8)Dr Hurricane lossmdashunusualoperating item 4000

Cr Extraordinary hurricane loss 3000Cr Tax expensemdashcurrent 1000The tax benefit would exist with an

ordinary loss as well but it is achievedthrough lower ldquoincome before taxrdquo

Loss contingencies Both US GAAPand IFRS require that loss contingencies

be recognized when a future economic out-flow is probable however this definitionof probable differs significantly betweenthe two frameworks US GAAP defines

probable as ldquolikelyrdquo (this has been gener-ally interpreted as greater than a 70

chance of occurring) Under IAS 37 Provisions Contingent Liabilities and

Contingent Assets probable is defined asldquomore likely than notrdquo (This has beendefined as a more than a 50 chance of occurring see Ernst amp Young AcademicResource Center ldquoCurrent Liabilities andContingenciesrdquo Lecture notes 2012 p 5)Consequently IFRS has a lower recogni-tion threshold for loss contingencies thanUS GAAP

In JCLrsquos case the loss is recorded onlyunder IFRS The worksheet adjustment isas follows(9)Dr Contingency loss 3000

Cr Contingency liability payable 3000 Neither US GAAP nor IAS 37 recog-

nizes contingent gains until the date whenrecovery is virtually certain As such nocontingency gain was realized in the cur-rent illustrative case for the US GAAPfinancial statements in addition none isrecognized for IFRS reporting purposes

Compound financial instruments Fromthe issuerrsquos perspective a convertible bondtypically consists of a liability component

EXHIBIT 4Statement of Comprehensive Income IFRS Basis




Sales 450000


Gross Profit 77352

Contingency Loss 3000

Unusual LossmdashHurricane Damages 4000

Currency (Gains) (2800)

Other SGampA Expenses 45200

49400Earnings before Interest and Taxes 27952



Tax Expense (5500)

Net Income 17937

Other Comprehensive Income

Revaluation Surplus 8571

Gain on Financial Instruments 2200

Total Comprehensive Income 28708




(a contractual obligation to deliver cashor other financial asset) and an equityinstrument (the holderrsquos option [ie a calloption] to convert the bond into a fixed

number of common shares within a spec-ified period of time) The principle of substance over legal form is applied tocompound financial instruments under IAS32 Financial Instruments PresentationThus the component parts are accountedfor and presented separately according totheir substance based on the definitions of liability and equity (referred to as ldquosplitaccountingrdquo) The split is made when theinstruments are issued and is not revisedfor subsequent changes in share pricesmarket interest rates or other factors that

might affect the likelihood that the con-version option will be exercisedWhen splitting the initial carrying

amount of a compound financial instru-ment into its equity and liability compo-nents the equity component is the residu-al amount that is it is equal to the fair value of the instrument as a whole less thefair value of the liability componentTherefore the issuer of a bond convert-ible into common shares first measures theliability component at the fair value of asimilar liability that does not have an equi-

ty component and the carrying amount of an equity instrument is then calculated asthe difference between the fair value of afinancial instrument as a whole and the fair value of the liability

JCL issued bonds carrying a 6 couponand a conversion feature at par Based onan expert appraisal of JCLrsquos creditworthi-ness at the date the bonds were firstissued and market rates of interest pre-vailing at that date for similarly riskyissuers it is determined that these bondswould have commanded a 8 yield absentthe conversion feature If bonds carryinga 6 coupon were priced to yield 8the JCL bonds would have brought pro-ceeds of only $43205 To comply withIFRS therefore JCL must restate the lia-

bility for bonds payable to reflect their intrinsic value without the conversion fea-ture and allocate the additional proceedsto an equity account The discount on the

bonds will be amortized per the usualeffective yield method over their term

If the bonds are paid off at maturity theamount originally allocated to the conver-sion feature will remain in paid-in capital in

the equity section of the statement of finan-cial position If the bond conversion featureis exercised the carrying value of the

bonds at the date of exercise (ie taking into

account the amortized portion of the dis-count) will be moved to paid-in-capital alsoThe worksheet adjustment is as follows(10)Dr Bonds payablemdashdiscount 6795

Cr Equitymdashconversion feature 6795 Note that this bond discount of $6795

will be accreted as additional interestexpense over the life of the bonds If the

bondholder does not exercise the optionthe bonds will be redeemed for cash atfull-face (par) value If the conversionfeature is not exercised the amount allo-

cated to paid-in-capital will remain as anadditional paid-in capital account associ-ated with the forfeited conversion privilege

Le as es In accordance with USGAAP (ASC 840-10) if the lessee meetsany of the four tests indicated below thetransaction must be accounted for as a cap-

ital lease If none of the conditions aresatisfied it will be classified as an operat-ing lease983150 Test 1mdash Lease term is equal to or greater than 75 of the economic life of the assetGiven the facts of this case 36 months divide50 months = 72 therefore the 75threshold is not met983150 Test 2mdash Transfer of title to lessee Notmet in this case983150 Test 3mdash Bargain purchase option Notmet in this case the transfer option is atmarket value not bargain value983150

Test 4mdash Present value of the minimumlease payments is equal or greater than90 of the assetrsquos fair market value using

EXHIBIT 5Differences in Cash Flows

Account US GAAP IFRS

Differences Between US GAAP and IFRS Cash Flow Presentations

Interest income CFO CFO or CFI

Interest expense (CFO) (CFO) or (CFF)

Dividend income CFO CFO or CFI

Cash dividends paid (CFF) (CFO) or (CFF)

No Changes in Cash Flows but Reclassifications for Cash Flow Presentations

Development costs Expense (CFO) When capitalized (CFI)

Lease payments If operating (CFO) If financing (CFF)

for principal

Option embedded liabilities Issuance of debt (CFF) Issuance of debt and

option for conversion

(CFF)

No Effect on Cash Flows

Revaluation of assets

Asset impairment losses

Reversal of impairment losses

Added depreciation and amortization from revalued assets

Reduced depreciation and amortization from impaired assets

Contingent losses accrued but unpaid

Unrealized gains and losses on marketable securities

Split accounting reclassification from liability to equity for compound instruments issued

Notes CFO = cash flows from operations CFI = cash flows from investing

CFF = cash flows from financing Cash payments noted by parentheses




the lesseersquos incremental borrowing rate asthe discount factor or the implicit rate of the lease if it is lower and is known tothe lessee In this case the minimum

lease payments are $2500 discounted asan ordinary annuity over 3 years at the 8interest rate (the implicit rate is notknown by the lessee so its incremental bor-rowing rate discussed previously is used)which yields a value of $6443 This isslightly lower (859) than 90 of theassetrsquos $7500 value Thus Test 4 is alsonot met

The facts support the conclusion that thisis an operating lease (ie an offndashbalancesheet transaction) and lease paymentsshould be accounted for as rent which

given the nature of the equipment will probably be included in manufacturingcosts and thus in the cost of sales and ininventory depending upon the extent towhich the final sale of the goods pro-duced has occurred For the sake of sim-

plicity it is assumed that the gross rentalexpense amounting to $2500 was includ-ed in cost of goods sold in the US GAAPfinancial statements with no allocation toinventory and for the sake of consisten-cy the non-interest (ie depreciation) por-tion of periodic lease expense will also be

fully assigned to the cost of goods sold inthe IFRS financial statementsUnder IAS 17 Leases more general cri-

teria based on the substance of the lease areused to determine whether a lease is a capi-talfinance lease If the lessee assumes thesubstantial economic benefits and the risksassociated with the leased asset then the

transaction is treated as a capitalfinance leaseSpecifically because this machine is spe-cialized for JCLrsquos use it is likely that JCLwill elect to either purchase the asset or

extend the lease when the three-year term iscompleted In addition because many of thetests under GAAP are nearly met there arestrong indications that a capitalfinance clas-sification is warranted rather than an oper-ating lease classification Presumably JCLwould be able to circumvent the capital leaserules under US GAAP by making arguableand favorable assumptions and estimatessuch as the 50-month useful life of the leasedassetsmdashbut the more ldquoprinciples-basedrdquo IFRSrequirement would seemingly preclude thisresult

If classified as a capitalfinance leasethe lease is amortized as shown in the side- bar Amortization Table

The worksheet adjustments to reclassi-fy this as a financing lease under IFRSare as follows(11)Dr Leased asset 6443

Cr Minimum lease obligation 6443(12)Dr Depreciation expense 2148

Cr Accumulated depreciation 2148(13)

Dr Interest expense 515Dr Minimum lease obligation 1985Cr Rent expensemanufacturing costs 2500

The balance of the minimum leaseobligation at the year-end is $4458 ($6443less $1985) of this total obligation $2143is current and $2315 is long term

IFRS BasisGiven the above adjustments JCLrsquos

IFRS-compliant statement of financial posi-tion as of December 31 2012 and the

income statement for the year then endedare show in Exhibit 3 and Exhibit 4 Notethat this case study employs the com-

bined statement of income and compre-hensive income approach with a functionalclassification of expenses Alternativelyseparate statements of income and of com-

prehensive income could be providedand expenses could be classified by their nature rather than function

Impact on Cash FlowsThe different treatments noted above in

the discussion of the statements of finan-cial position and the income statements willnecessarily lead to differing statements of cash flows With regard to the cash flowthere are several differences between USGAAP and IFRS Exhibit 5 presents thefollowing differences983150 Classification of cash flows (only)

between IFRS and US GAAP983150 Items connoting no change in cashflows but reclassifications resulting fromIFRSndashUS GAAP accounting differ-ences983150

IFRSndashUS GAAP differences that haveno effect on cash flows or presentation and983150 Cash flow changes created byIFRSndashUS GAAP differences

Effect of Tax ObligationsThe final category of differential

treatment under US GAAP and IFRS pertains to those situations where the dis- parity in accounting has consequentialeffects most typically in the form of higher or lower tax obligations This isillustrated by the disallowance of theLIFO inventory costing method under IFRS which has corresponding implica-tions for tax payments due currently Inthe general case of rising prices an enti-tyrsquos gross profits will be higher under IFRS (versus using LIFO under USGAAP) resulting in higher cash tax pay-ments If FIFO is used the added tax pay-ment will equal the difference in theLIFO reserve created during the year (meaning a higher pre-tax income)multiplied by the tax rate In the case of JCL the added cash tax payment will

be $500 ($2000 times 25)

AMORTIZATION TABLE

Minimum Lease

Obligation Balance

Date Payment Interest (8) Principal (Present Value)

Jan 1 2012 $6443

Dec 31 2012 $2500 $515 $1985 4458

Dec 31 2013 2500 357 2143 2315

Dec 31 2014 2500 185 2315 0

Totals $7500 $817 $6443




Effects on Financial RatiosAny changes made to the statement

of financial position and income state-ment will inevitably affect some of the

ratios commonly used by analystslenders and even management Thedirection of the changes will depend onmany factors some of which are very sit-uation-specific The following changeswould be experienced by JCL when con-verting to IFRS (effects that wouldcommonly be perceived to be improve-ments are shown in bold)

US

Ratio GAAP IFRS

Current ratio 175 173Debt ratio 53 497

Debt to equity 113 99

Times interest earned 70 619Inventory turnover 625 556Return on assets 612 673

Gross profit 1667 1720

Net profit margin 333 399

Asset turnover 1838 1688Leverage ratio 213 199

Return on equity 1304 1336

Although the effects are modest it isimportant to appreciate the fact that somemandatory changes when adopting IFRS willhave impacts on the financial ratios that

many third parties (ie investors and lenders)rely upon to make credit or investing deci-sions Some of the expected impacts flowdirectly and intuitively from the differentrequirements imposed by IFRS

For example under IFRS inventory andearnings will be greater than under USGAAP if LIFO is employed by thereporting entity In addition because of IFRS rules pertaining to the capitalizationof development expenses assets andearnings will tend to be enhanced at leastin the years when those costs are beingincurred (which then must be amortized infuture years lowering earnings holdingother factors constant)

If a reporting entity avails itself of theoption to revalue long-lived assets this willalso enhance the statement of financial

position and accordingly improve certainfinancial ratios Nevertheless financialstatement users are alert to these effects

particularly in the case of items such asrevaluations that have no current or futuresalutary effects on cash flows

Some critics might say that given thesomewhat greater accounting flexibility it

provides IFRS presents more prospects for earnings management and income volatil-ity This possibility is constrained if notfully eliminated by the need for consistent

application of chosen accounting princi- ples which is as much an imperative under IFRS as it is under US GAAP

LimitationsThe above case study ignores the fact

that entities adopting IFRS must follow therequirements set out in IFRS 1 In accor-dance with IFRS 1 entities initiallyadopting IFRS must present at least oneyear of comparative information disclos-ing all applicable exemptions explanationsof the transition IAS 36 disclosures for

impairments identified during the transi-tion and historical summaries under pre-vious GAAP In principle IFRS 1 stipu-lates that an entity should apply the currentversion of IFRS for all periods presentedin its first set of IFRS financial statementsas well as in its opening IFRS statementof financial position (at the beginning of the earliest period presented) without con-sidering superseded or amended versions

Thus IFRS 1 requires retrospectiveapplication of the standards effective asof the reporting date of an entityrsquos first

IFRS-compliant financial statements ButIFRS 1 prohibits retrospective applicationof some aspects of other standards(ldquomandatory exceptionsrdquo) and permits

elective exemptions from some require-ments of other standards (ldquooptional exemp-tionsrdquo) An entity will thus have choices

between different options of accounting policies within IFRS 1 as well as withinother standards that must be resolved when

preparing its first IFRS financial statements

ConclusionConsequent to the SEC report issued in

July 2012 it seems unlikely that full-scaleadoption of IFRS in the United Stateswill occur in the foreseeable future (seeWork Plan for the Consideration of

Incorporating International Financial

Reporting Standards into the Financial

Reporting System for US Issuers andthe IASBrsquos response in IFRS Foundation

Staff Analysis of the SEC Final Staff

ReportmdashWork Plan for the consideration

of incorporating IFRS into the financial

reporting system for US issuers October 2012) Nevertheless IFRS comprehen-

sion is critical for US preparers andusers of financial information as most non-US countries as well as many foreign-domiciled subsidiaries of US entities

require its use In todayrsquos ever continuingexpanding global economy it is highlylikely that CPAs will undertake engage-ments that require IFRS knowledgeEqually important is the need for futureCPAs to obtain a solid understanding of IFRS during their education The abovecase study is intended to help further these goals

Peter Harris CPA CFA is a professor at

the New York Institute of Technology New

York NY Eva K Jermakowicz PhDCPA is a professor and head of the

department of accounting at Tennessee

State University Nashville Tenn Barry

Jay Epstein PhD CPACFF is a prin-

cipal at Cendrowski Corporate Advisors

LLC Chicago Ill



Coverage of IFRS in college accountingcurricula and professional-licensing exami-nations has expanded in the past decademaking newly minted practitioners at least

partially conversant with the remaining dif-ferences between GAAP and IFRSPractitioners who were educated and trained

before IFRS became widely employed how-ever might benefit from a comprehensiveillustration of the GAAP-to-IFRS conversion

processTo assist such CPAs the authors have

developed a comprehensive illustration of the process to be employed when convert-ing US GAAPndashbased financial statementsto conform with IFRS as these sets of standards exist today The goal is to intro-

duce the major differences between USGAAP and IFRS with their resultingdivergent effects on the financial statementsThe illustration presents a US GAAPndashpre-

pared statement of financial position and anincome statement then based on a set of specific facts affecting financial reporting bythe entity it details the conversion to IFRS-compliant financial statements The process

begins with the recording of IFRS compli-ance worksheet adjustments continueswith worksheet reconciliation from USGAAP to IFRS and concludes with the

preparation of IFRS-based statementsMost of the more significant and likelydifferences between the two frameworksare highlighted These matters pertain tothe capitalization of qualifying develop-ment costs allowable inventory costingmethods (ie use of the last-in first-out[LIFO] method is prohibited under IFRS) permissible use of the revaluationmodel for property plant and equipment(PPampE) use of component depreciationand the allowable reversal of impairmentlosses This example also addresses themore conservative approach of IFRSregarding the recognition of contingentlosses and the different finance (capital)lease requirements Finally this exampleillustrates the different requirements for

presenting compound financial instruments(eg convertible debt securities) given thatIFRS requires that the equity componentembedded in such securities be accountedfor and presented as equity

The presentation of the statement of financial position differs between the twoframeworks Under US GAAP thestatement begins with the most liquid assets

and liabilities followed by noncurrentand longer-term assets and liabilities andconcludes with shareholdersrsquo equitywhereas IFRS often (albeit not mandato-

rily) begins with the most illiquid accountsPresentation in the income statement alsovaries for example IFRS does not allowfor the characterization of gains or lossesas extraordinary

IFRS allows for greater flexibility on thecash flow statement for categorizing cer-tain items such as for interest and dividendincome as well as for interest expense The

present demonstration will only address

recognition and measurement issues affect-ing the statement of financial position andthe income statement because the cashflow display options under IFRS are prin-cipally elective alternatives not requireddifferences

Hypothetical Case StudyA hypothetical company JCL is a man-

ufacturer of prescription drugs Its mainheadquarters are in Newark New Jerseywhere the company has operated since1981 The company sells its products tothe retail market on a worldwide basis Itsfinancial statements presented in Exhibit 1

and Ex hib it 2 for the year endingDecember 31 2012 have been preparedusing US GAAP JCLrsquos managementwould like to preview the effects of usingIFRS on the statement of financial positionand income statement The company wouldlike to be able to report under IFRS by as

early as the next year as it is consideringa new stock issue to be offered in HongKong which requires IFRS complianceThe following paragraphs provide more

background information needed to under-stand the companyrsquos financial statementsand convert them to IFRS

During 2012 JCL incurred costs of $2000 to develop new prescription drugsrequiring high levels of technical knowl-edge The drugs under development hav-ing been heavily researched for severalyears reached technical and economic fea-sibility at the beginning of 2012 and theregulatory approval process has beenrecently completed The drugs will be test-ed in 2013 on a much larger patient pop-

ulation before making them available tocustomersJCL uses the LIFO method to value its

inventory The LIFO reserve (as used toadjust from first-in first-out [FIFO]) was$5000 at the beginning of the year and$7000 as of year-end

Management has determined that the fair value of PPampE as of December 312012 is $78571mdashan $8571 increaseabove book value These assets are on agoing-forward basis to be depreciated over a 10-year period using the straight-line

depreciation method There is no residualvalue Depreciation for 2012 was record-ed as $12000 for US GAAP financialreporting purposes

The patent is the only amortizable intan-gible asset it is expensed over a five-year

period using the straight-line method Thehalf-year convention is applied for all assets

placed in service during the year For theyear ended December 31 2012 amortiza-tion expense is $1200

In 2011 there was a goodwill impair-ment recognized in the amount of $2000thereby reducing the carrying value from$7000 to $5000 During 2012 the com-

pany tested for goodwill impairment andfound that the goodwillrsquos fair value hadactually increased to $6000

Investments consist of available-for-sale(AFS) securities with a fair value of $20000 at the end of the year The valueat the beginning of the year was $15000Exchange-rate currency gains accountedfor $2800 of the gain recognized duringthe year For simplicity assume that therewas no interest or dividend incomeearned on these investments during the

21JANUARY 2014 THE CPA JOURNAL

Significant differencespertain to the capitalization

of development costs

inventory costing methods

revaluation for PPampE and

component depreciation


















frasl 6 years)





















Goodwill 5000 15000
































































EXHIBIT 2





Sales 450000


Gross Profit 75000








Net Income 15000













EXHIBIT 3


















Intangible Assets












































Sales 450000


Gross Profit 77352








Tax Expense (5500)

Net Income 17937





































for principal



(CFF)









































be $500 ($2000 times 25)

AMORTIZATION TABLE

Minimum Lease

Obligation Balance


Jan 1 2012 $6443

Dec 31 2012 $2500 $515 $1985 4458

Dec 31 2013 2500 357 2143 2315

Dec 31 2014 2500 185 2315 0

Totals $7500 $817 $6443







US

Ratio GAAP IFRS











































LLC Chicago Ill


















frasl 6 years)





















Goodwill 5000 15000
































































EXHIBIT 2





Sales 450000


Gross Profit 75000








Net Income 15000













EXHIBIT 3


















Intangible Assets












































Sales 450000


Gross Profit 77352








Tax Expense (5500)

Net Income 17937





































for principal



(CFF)









































be $500 ($2000 times 25)

AMORTIZATION TABLE

Minimum Lease

Obligation Balance


Jan 1 2012 $6443

Dec 31 2012 $2500 $515 $1985 4458

Dec 31 2013 2500 357 2143 2315

Dec 31 2014 2500 185 2315 0

Totals $7500 $817 $6443







US

Ratio GAAP IFRS











































LLC Chicago Ill






























































EXHIBIT 2





Sales 450000


Gross Profit 75000








Net Income 15000













EXHIBIT 3


















Intangible Assets












































Sales 450000


Gross Profit 77352








Tax Expense (5500)

Net Income 17937





































for principal



(CFF)









































be $500 ($2000 times 25)

AMORTIZATION TABLE

Minimum Lease

Obligation Balance


Jan 1 2012 $6443

Dec 31 2012 $2500 $515 $1985 4458

Dec 31 2013 2500 357 2143 2315

Dec 31 2014 2500 185 2315 0

Totals $7500 $817 $6443







US

Ratio GAAP IFRS











































LLC Chicago Ill













EXHIBIT 3


















Intangible Assets












































Sales 450000


Gross Profit 77352








Tax Expense (5500)

Net Income 17937





































for principal



(CFF)









































be $500 ($2000 times 25)

AMORTIZATION TABLE

Minimum Lease

Obligation Balance


Jan 1 2012 $6443

Dec 31 2012 $2500 $515 $1985 4458

Dec 31 2013 2500 357 2143 2315

Dec 31 2014 2500 185 2315 0

Totals $7500 $817 $6443







US

Ratio GAAP IFRS











































LLC Chicago Ill


































Sales 450000


Gross Profit 77352








Tax Expense (5500)

Net Income 17937





































for principal



(CFF)









































be $500 ($2000 times 25)

AMORTIZATION TABLE

Minimum Lease

Obligation Balance


Jan 1 2012 $6443

Dec 31 2012 $2500 $515 $1985 4458

Dec 31 2013 2500 357 2143 2315

Dec 31 2014 2500 185 2315 0

Totals $7500 $817 $6443







US

Ratio GAAP IFRS











































LLC Chicago Ill

































for principal



(CFF)









































be $500 ($2000 times 25)

AMORTIZATION TABLE

Minimum Lease

Obligation Balance


Jan 1 2012 $6443

Dec 31 2012 $2500 $515 $1985 4458

Dec 31 2013 2500 357 2143 2315

Dec 31 2014 2500 185 2315 0

Totals $7500 $817 $6443







US

Ratio GAAP IFRS











































LLC Chicago Ill






























be $500 ($2000 times 25)

AMORTIZATION TABLE

Minimum Lease

Obligation Balance


Jan 1 2012 $6443

Dec 31 2012 $2500 $515 $1985 4458

Dec 31 2013 2500 357 2143 2315

Dec 31 2014 2500 185 2315 0

Totals $7500 $817 $6443







US

Ratio GAAP IFRS











































LLC Chicago Ill







US

Ratio GAAP IFRS











































LLC Chicago Ill

converting financial statements gaap ifrs jan2014 cpaj

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