The increasing use of International Financial Reporting Standards is a consideration for U.S. organizations accustomed to relying upon U.S. Generally Accepted Accounting Principles for evaluating and executing merger and acquisition activities.
The emergence of IFRS reflects efforts for converging U.S. and international accounting standards to make global commerce more efficient. IFRS is used now throughout much of the world. Some U.S.-based companies are already preparing financial statements based on IFRS. Within the next five years, use of IFRS may become standard for publicly-traded corporations within the United States.
Companies considering a merger or acquisition now need to be aware of how IFRS influences due diligence and a transaction itself. Attaining that necessary awareness begins with understanding the history and general principles of IFRS and how it differs from GAAP.
Background
Adoption of IFRS as a global reporting standard is being driven by a decade-long effort by the Financial Accounting Standards Board in the United States, and the International Accounting Standards Board to converge U.S. and international financial reporting standards.
The IASB announced in 2001 that it would adopt a body of accounting standards, previously known as International Accounting Standards, under the IFRS designation. New standards would also carry that designation.
In 2002, the FASB and IASB issued a memorandum of understanding, the Norwalk Agreement, which established a joint commitment to develop accounting standards for U.S. and cross-border financial reporting. The U.S. Securities and Exchange Commission subsequently announced support for the Norwalk Agreement.
Adoption of IFRS grew. In 2005, The European Union began requiring companies in its member states to prepare statements under IFRS for securities listed on EU-regulated stock exchanges.
A 2008 IFRS report issued by the American Institute of Certified Public Accountants stated that more than 12,000 companies in almost 100 countries were using IFRS. Fewer than 40 countries now prohibit the use of IFRS. Many Canadian companies now face a 2011 requirement to prepare financial statements based on IFRS.
Recent announcements indicate that IFRS is being strongly considered as the future accounting standard in the United States as well. On February 24, 2010, the SEC issued a release stating its support for IFRS and GAAP convergence, and the adoption of global accounting standards. In December 2010, the SEC reiterated that support, and said that the earliest year for adoption by U.S. publicly-traded companies would be 2015.
While the exact date when IFRS may become a requirement in the United States remains uncertain, recent events illustrate its growing use throughout the world.
Fundamental Differences
GAAP is more of a rules-based standard while IFRS is based more on principles. The FASB offers far more detail, far more guidance for applying GAAP than what is offered by the IASB for IFRS.
IFRS does not provide the levels of industry-specific guidance found in GAAP. Applications of some IFRS standards vary from one country to another, so evaluating financial statements from companies sited in other countries requires recognition of such differences.
Overall, IFRS places greater emphasis than GAAP on applying professional judgment when assessing a transaction. There are specific differences between GAAP and IFRS, too, in how due diligence considerations are approached.
Potential buyers mulling an acquisition or merger need to understand crucial differences between GAAP and IFRS in revenue recognition, business combinations and other relevant concerns.
In many situations, revenue may be recognized earlier under IFRS than it is under GAAP. A single IFRS standard, IAS 18, provides guidance for revenue recognition, while GAAP offers specific direction for various industries and types of products or services, such as software and real estate entities and related transactions.
IFRS sets differing revenue recognition criteria for renderings of services in various contractual relationships. Under GAAP, revenue in certain instances is amortized over a defined service period, while IFRS offers the possibility for greater up-front revenue recognition when performance has occurred.
GAAP requires deferring revenue recognition on part of a multi-element contract, if a refund would be triggered by failure to deliver remaining elements. With IFRS, revenue is generally recognized on a delivered element, even if a refund were triggered by a failure to deliver the remaining elements.
For long-term construction contracts, GAAP allows the “percentage of completion” approach if certain criteria are met. Use of completed contract method is also required under some circumstances. If the percentage of completion cannot be reliably estimated, IFRS requires use of cost-recovery method, or a revenue-cost approach. The completed contract method is not allowed under IFRS.
Additionally, under GAAP inventory write-downs establish a new cost basis, which cannot be reversed. However, IFRS allows write-downs to be reversed up to the original impairment amount when it is determined the reason for the impairment no longer exists.
Such differences between GAAP and IFRS may add complexity to analyzing the earnings of the company targeted for a merger or acquisition transaction.
Business Combination Considerations
The FASB’s Accounting Standards Codification 805 and the IASB’s IFRS 3R regarding business combinations represents one of the first major joint projects between the IASB and FASB. However, despite this move toward convergence differences between GAAP and IFRS make an analysis of prospective acquisition targets challenging.
Both ASC 805 and IFRS 3R require using the acquisition method to account for all business combinations. Under that method, the underlying transaction is measured at fair value. However, because of existing requirements under both GAAP and IFRS, other differences may occur. For example, under IFRS 3R there is no specific guidance on how to determine fair value, which could potentially lead to significant differences between the fair values determined for the acquired assets as of the acquisition date.
For GAAP, a noncontrolling interest is measured at fair value. That fair value includes the noncontrolling interest’s share of goodwill. IFRS measures a noncontrolling interest at either fair value including goodwill, or the proportionate fair value share of the acquiree’s identifiable net assets, excluding goodwill.
GAAP and IFRS differ in how they measure assets and liabilities arising from contingencies, too. For initial recognition, GAAP distinguishes between contractual and noncontractual contingencies. IFRS initially recognizes a contingent liability at the acquisition date if a present obligation arises from past events and its fair value can be reliably measured. However, IFRS does not provide specific guidance on the definition of “present obligation,” which again creates another example of the increasing use of judgment under IFRS.
Impairment
GAAP and IFRS provide similar definitions of indicators used to assess the impairment of long-lived assets. Both require that goodwill be reviewed at least annually, and more frequently in the presence of impairment indicators. Both also require that an impaired asset be written down, with an impairment loss recognized.
GAAP and IFRS differ, though, in testing for impairment of long-lived assets, calculating the impairment loss for a long-lived asset, allocating goodwill, and calculating the goodwill impairment loss. For example, one of the significant differences between GAAP and IFRS is that impairment of long-lived assets not being held for sale can be reversed in total, which would potentially create significant fluctuations in net income and asset values on the balance sheet. However, goodwill impairment cannot be reversed under IFRS.
Other Considerations
GAAP and IFRS offer differences in their treatments of leases, joint ventures and intangible assets.
For leases, GAAP requires testing to determine whether or not the fair value of land merits separate classification in a lease of land and building. IFRS requires that separate classification unless the amount that would be recognized for the land is deemed immaterial. GAAP and IFRS also differ in their recognition of gains or losses in the sales of operating or capital leasebacks.
For consolidations GAAP focuses on controlling financial interest, while IFRS focuses on the concept of the power to control. That power to control exists if the parent entity owns more than 50 percent of the voting rights.
The equity method is generally used in GAAP to account for joint ventures, whereas IAS 31 allows the use of either the proportionate consolidation method or the equity method for accounting for joint ventures within IFRS.
GAAP calculations for determining the impairment loss on intangible assets with an indefinite life are based on how much the carrying value of an asset exceeds its fair value. IFRS bases that measurement on how much an asset’s carrying value exceeds its recoverable amount.
While globally-recognized accounting standards hold appeal, comments expressed at a July 2011 SEC roundtable involving business representatives and accountants indicate that considerable concern remains in the United States regarding the adoption of IFRS by U.S. public companies.
Some concerns focus on the general magnitude of such a requirement, while other comments addressed differing needs between companies whose operations are limited to the United States, versus entities with global business concerns.
The SEC plans to announce this year whether or when IFRS would become a reporting requirement. Roundtable participants urged that the SEC not rush toward that decision.
The exact status of IFRS adoption in the United States presents uncertainties, but the continued convergence of accounting standards makes IFRS awareness an increasingly important consideration for entities involved in cross-border merger and acquisition activities.
Brian A. Reed, CPA, CVA is the director of Transaction Advisory Services at Weaver, ranked the largest independent certified public accounting firm in the Southwest with offices throughout Texas. He can be reached at 972.448.6936 or brian.reed@weaverllp.com
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