Reading Financial Reports for Dummies (46 page)

Though IFRS wouldn’t fix all the problems seen in 2007 and 2008 as financial institutions fessed up to their reporting shenanigans, a global standard would make it harder to hide problems across country borders. As U.S. investors become aware that they no longer have to massage the numbers to compare the results of U.S. companies to companies based outside the U.S., they’ll push for IFRS so they can compare apples to apples.

262
Part V: The Many Ways Companies Answer to Others

Companies that use IFRS tend to have longer annual reports than companies that use GAAP, and the reports are more transparent. While a U.S. report based on GAAP may be 60 to 70 pages, a report using IFRS may be closer to 110 pages. That may seem even more overwhelming to you, but you’ll have more information with which to make your decisions.

Capital markets

Capital markets would benefit from IFRS, because if all companies operate under one set of accounting standards, investors can more easily access multiple foreign markets as they build their investment portfolios. This will stimulate investment and enable capital flows across borders.

Companies

Companies stand to gain the most from this rule change because it will simplify the financial reporting requirements if they operate in more than one country. Allowing U.S. companies who operate globally to use IFRS will:

✓

Standardize and improve accounting and financial policies.

Companies will no longer have to maintain two or more sets of books to prepare financial statements based on varying rules.

✓

Lead to more efficient use of resources.
Companies will be able to more easily centralize their accounting processes and simplify the training required for their employees if only one set of standards for reporting is required to meet governmental regulations.

✓

Improve controls.
IFRS give companies more control over statutory reporting, which reduces the risks related to penalties and compliance problems to meet the regulations of each country in which the company operates.

✓

Facilitate better cash management.
By having more consistent rules across borders, companies will be able to manage their cash more efficiently.

Exploring Key Differences

between GAAP and IFRS

Major reports have been written about the key differences between the GAAP

and the IFRS. I don’t have the space to do a comprehensive breakdown of the differences, but I do give you a quick peek at some of the key differences in this section.

Chapter 20: Creating a Global Financial Reporting Standard
263

If you want a full comparison, you can download an excellent report from PricewaterhouseCoopers (a major global accounting firm) at www.pwc.com/

us/ifrs/ifrs_us_gaap_comparison.html.

Accounting framework

A significant difference between IFRS and GAAP is that IFRS permit the revaluation of intangible assets, property, plant and equipment, and investment property. GAAP prohibit revaluations except for certain categories of financial instruments that are carried at fair value.

Many analysts believe that assets are undervalued on the balance sheets of major U.S. corporations that compile their reports based on GAAP, especially when it comes to the value of property and plants. Corporate headquarters and factories that were built 20 to 30 years ago are valued on the balance sheets at cost. These assets likely have appreciated greatly even though the buildings have been depreciated to near zero on the balance sheets.

If U.S. corporations do decide to switch to IFRS, you may see a dramatic increase in the value of assets held by some companies as they revalue their property and plants.

Financial statements

The key financial statements required by both IFRS and GAAP are similar, but the ways in which the numbers are calculated sometimes differ. Also, IFRS

only require two years of data for the income statements, changes in equity, and cash flow statements, while GAAP require three years of data for SEC

registrants.

I discuss some key differences in the following sections, but if your company is considering a switch to IFRS, or if you’re an investor who really wants to understand how the differences may impact the compilation of the numbers for the financial statements, I highly recommend that you download the report from PricewaterhouseCoopers mentioned earlier in the chapter.

Balance sheet

GAAP require assets, liabilities, and equity to be presented in decreasing order of liquidity. The balance sheet is generally presented with total assets equaling total liabilities and shareholders’ equity. For more details on how the balance sheet is presented, review Chapter 6.

264
Part V: The Many Ways Companies Answer to Others

IFRS don’t require any specific format, but entities are expected to present current and noncurrent assets and current and noncurrent liabilities as separate classifications on their balance sheets, except when liquidity presentation provides more relevant and reliable information.

I did review several balance sheets of European companies and didn’t find any significant differences in the way the balance sheet was presented. The basic format of the GAAP balance sheet seems to be pretty well accepted globally. In Chapter 6, I include a financial position format, which is sometimes used by companies not based in the U.S.

Income statement

IFRS don’t prescribe a standard format, but GAAP do require the use of a single-step or multi-step format, as shown in Chapter 7. IFRS prohibit the use of the category “extraordinary items,” but GAAP allow an extraordinary line item on the income statement.

Extraordinary items are defined as being both infrequent and unusual. For example, when goodwill is shown as a negative item, it’s listed as an extraordinary item on the income statement. In 2007 and 2008, as financial institutions put goodwill in this category from acquisitions gone bad because of the mortgage mess, they usually put it down as an extraordinary item. By separating these items from operating income results, a company can make its net income look better.

Writing down goodwill doesn’t involve the use of cash. Cash is used when a company buys another company for more than the value of its assets. If this happened many years ago, it doesn’t impact the current year’s operating results.

Statement of Recognised Income and Expense (SoRIE)

The SoRIE is unique to IFRS, but the information is commonly shown at the bottom of the income statement by companies filing reports under the rules of GAAP, or it’s presented on a separate document called the
statement of
changes in shareholder’s equity.
In either case, the information presents the total income and accumulated income over time.

Note:
Notice that
recognised
is spelled with an “s” instead of a “z.” I use the common British spelling because this statement isn’t used by U.S. corporations but instead is used primarily by companies in Europe that use a British spelling.

Statement of changes in shareholders’ equity

This statement is similar in both the IFRS and the GAAP, unless a non-U.S. company files a SoRIE. This statement isn’t required as a separate document under GAAP rules. A company can choose to present the information about changes in shareholders’ equity as part of the notes to the financial statements.

Chapter 20: Creating a Global Financial Reporting Standard
265

Cash flow statement

In both the IFRS and the GAAP, this statement is presented with similar head-ings. IFRS give limited guidance on what information must be included on the statement.

GAAP give more specific guidance for which categories must be included in each section of the statement. Statements can be prepared using the direct or indirect method under either IFRS or GAAP. I discuss the differences between the direct and indirect methods in Chapter 8.

Revenue recognition

Both IFRS and GAAP require the recognition of revenue when an item’s ownership is transferred to the buyer of the goods, but GAAP give much more detailed guidance for specific types of transactions. In Chapter 23, I detail the games that some companies play with revenue recognition, even under the more detailed GAAP rules. I certainly hope that as the international financial regulators converge the requirements of the two systems, they improve the rules related to the recognition of revenue.

Assets

One key difference between IFRS and GAAP is that assets can be revalued under IFRS, as discussed earlier in the “Accounting framework” section.

Another key difference is that only research is expensed as a cost of doing business under IFRS, but both research and development are expensed under the GAAP rules. Under IFRS, development costs are capitalized and amortized (or written off) over several years.

This policy can have a major impact on a company’s bottom line. For example, suppose a company determines that of the $5 million it spent on bringing a new product to market, $1 million was for research and $4 million was for development of the product after research was concluded. Under the GAAP

rules, the $5 million would be expensed in each year of the development based on when the expenses are recognized (I talk about expense recognition in Chapters 7 and 16). Those expenses would decrease net income significantly.

A company operating under the requirements of the IFRS would report this same scenario differently. It would only need to expense the $1 million spent on research as it was spent, but it could capitalize the $4 million and write it off more slowly as an amortization. Depending on the life span given the value of the development, it could be written off over 10 to 15 years or more and reduce the impact of development on the bottom line.

266
Part V: The Many Ways Companies Answer to Others

If you’re trying to determine which company makes the better investment, you must look carefully at this key difference in research and development. After all global firms use IFRS to file their financial statements, this difference will no longer be a factor when comparing U.S. companies to companies based outside the U.S.

Inventory

Another key difference between IFRS and GAAP is the way inventory is valued. All companies that file reports under IFRS must use FIFO or weighted-average inventory valuation methods (I discuss inventory valuation methods in Chapter 15). Those filing under GAAP rules can also use LIFO.

FIFO stands for “first in, first out.” This type of inventory valuation assumes that the first item in the door is the first item sold. Because prices of goods are usually increasing, the item with the lowest cost likely sells first. LIFO

stands for “last in, first out.” When this inventory valuation method is used, the last item bought will be the first item sold. In this case, the most expensive item is likely sold, while the older, cheaper items remain on the shelf.

LIFO can increase the cost of goods sold and decrease net income, making it look like a company made less money and therefore reducing the company’s taxes. FIFO results in a lower cost of goods sold and higher net income.

When comparing companies using two different inventory valuation methods, determining the actual costs of doing business can be difficult. If all companies were required to use either FIFO or the weighted-average inventory valuation methods, comparing apples to apples would be easier. When the two systems are merged in the future, the IFRS requirements on inventory valuation will hopefully be adopted. In fact, the LIFO option may be discontinued under GAAP rules.

Related-party transactions-disclosures

In related-party transactions — transactions between, say, a corporation and one of its affiliates — companies filing under IFRS regulations must disclose the compensation of key management personnel in the financial statements.

GAAP don’t require such disclosure.

Hopefully, the IFRS rules will be adopted when the systems converge.

Shareholders need to know the compensation of management personnel, and this information should be made very visible in the financial statements. U.S.

investors will definitely benefit from fuller disclosure in this area.

Chapter 20: Creating a Global Financial Reporting Standard
267

Discontinued operations

Under IFRS, if operations are discontinued, the operations and cash flows must be clearly distinguished for financial reporting and must represent a separate line of business or geographical area of operations, including if a subsidiary is acquired exclusively for the purpose of being sold. That happens often when a company buys another for a specific purpose and isn’t interested in continuing every area of the bought company’s operations.

Under GAAP, the lines are more blurred for discontinued operations. A segment, operating segment, reporting unit, subsidiary, or asset group can be shown as separate losses for discontinued operations.

Some analysts believe that companies filing under GAAP use this loophole to hide significant problems. I talk more about how discontinued operations are used to clear out deadwood on a balance sheet in Chapter 23. U.S. investors will benefit if the clear IFRS lines are drawn for U.S. companies, and fewer problems will be swept under the rug.

Impairment charges

Sometimes an asset loses value. For example, a computer manufacturer may have inventory of older models that can no longer be sold at full price because newer, more advanced models are now available. Their values become
impaired
and must be written down.

Under GAAP, when an impairment charge is recorded in inventory, the company can’t reverse the impairment charge if assets subsequently increase in value. Under IFRS, however, the company is allowed to reverse the impairment charge if assets subsequently go back up in value.

This can impact both the income statement and the balance sheet, as assets whose values have been impaired are adjusted in later years. Investors need to watch the ups and downs of assets, which can impact the profit or loss of a company without a change in operations.