Accounting for business combinations and the convergence of international financial reporting standards with U.S. generally accepted accounting principles: a case study.
James, Marianne L.
INTRODUCTION
Financial accounting and reporting in the U.S. is changing rapidly.
During the past six months, the Financial Accounting Standards Board,
the primary accounting standard setter in the U.S., issued twelve (12)
new standards and launched its on-line "Accounting Standards
Codification," which organizes existing GAAP into 90 topics (FASB,
2009). At the same time, a significantly more dramatic change is on the
horizon for accounting professionals, company executives, and financial
statement users.
Consistent with the SEC's 2008 proposal entitled,
"Roadmap for the Potential Use of Financial Statements Prepared in
Accordance With International Financial Reporting Standards by U.S.
Issuers," (Roadmap) in approximately five years, public companies
likely will have to utilize IFRS, instead of U.S. GAAP (SEC, 2008). In
fact, some large global U.S.-based entities are permitted to early-adopt
IFRS starting in 2009. The SEC expects to reach a final decision
regarding the mandatory adoption of IFRS in 2011 (SEC, 2008).
If the U.S. indeed adopts IFRS as the required standard for
financial accounting and reporting, the U.S. will join the more than 100
nations worldwide that currently permit or mandate the use of IFRS. For
example, starting with the 2005 reporting period, all European public
companies listed on any European stock exchange must prepare IFRS-based
financial statements. Other nations, such as Canada, are planning to
adopt IFRS in the near future.
Currently, U.S. GAAP and IFRS are not identical. However, since
signing their Memorandum of Understanding, commonly referred to as the
"Norwalk Agreement," in 2002, FASB and the IASB have been
working together to develop a set of high-quality globally acceptable
financial accounting standards and to bring about convergence of U.S.
GAAP and IFRS. Since the Norwalk Agreement was signed, many new and
revised standards issued by FASB and the IASB have served the purpose of
eliminating existing differences. However, while many differences have
been eliminated, others persist.
Accounting for and reporting by global entities is quite complex.
U.S., as well as international accounting rules require that a parent
company consolidates its subsidiaries' financial statements with
the parent company's financial statements. Recent standards issued
by the IASB and FASB have eliminated many differences between U.S. GAAP
and IFRS in accounting for business combinations and financial reporting
for consolidated entities. However, some significant differences
continue to exist.
KLUGEN CORPORATION
Irma Kuhn, CPA, CMA holds the position of Chief Financial Officer
(CFO) of Klugen Corporation, a global telecommunications company. Klugen
is a consolidated entity headquartered in the U.S. with four
majority-owned European subsidiaries. The company has expanded primarily
by acquiring majority interest in European companies and holds between
51% and 70% of the outstanding voting stock of its subsidiaries. Three
of these subsidiaries were acquired in stages and consolidated once the
company achieved majority ownership.
Consistent with current accounting rules, Klugen consolidates all
four of its subsidiaries. In addition, Klugen also holds financial
interests in several unconsolidated entities and accounts for those as
investments.
Klugen's European subsidiaries currently prepare their
financial statements consistent with International Financial Reporting
Standards (IFRS), which are promulgated by the International Accounting
Standards Board (IASB). Klugen, the parent company, issues consolidated
financial statements, which include the results of its majority-owned
subsidiaries in conformity with U.S. GAAP. Preparation of Klugen's
consolidated financial statements requires that Irma and her staff
convert the subsidiaries' IFRS-based financial statements into U.S.
GAAP prior to consolidating the numbers. This process is quite complex
and requires many of the accounting departments' resources.
Irma is well aware of efforts between the FASB and the IASB to
bring about convergence between U.S. GAAP and IFRS. She expects that
consistent with the SEC's "Roadmap," (SEC, 2008) within
the next five years, U.S. public companies likely will have to apply
IFRS, rather than U.S. GAAP. Irma welcomes this development and believes
that in the long-run, use of IFRS by the parent company as well as its
subsidiaries will preserve and strengthen the company's global
financial competitiveness. In addition, she believes that it will
simplify the accounting and consolidation process significantly and, in
the long-run, reduce financial reporting costs. She is aware, however,
that in the short-run many challenges, such as conversion of the
accounting and IT systems and extensive staff training will increase
costs. Knowing that the SEC's Roadmap proposes a phased-in adoption
by public companies between 2014 and 2016, Irma plans to recommend
adoption of IFRS at the earliest permitted time.
As the person who ultimately is responsible for financial
reporting, Irma is very knowledgeable about current and proposed changes
in U.S. GAAP as well as IFRS. She knows that the IASB and FASB have
issued new and revised standards applicable to business combinations
that affect the company's consolidated financial statements. After
in depths analysis of the new and revised standards, she determined that
many of the past differences between U.S. GAAP and IFRS where eliminated
when the FASB issues FAS 141 R "Business Combinations" and FAS
160 "Noncontrolling interest in consolidated financial
statements" (FASB, 2007) and the IASB revised IFRS 3 "Business
Combinations" and IAS 27 "Consolidated and Separate Financial
Statements" (IASB, 2008). She also realizes that some significant
differences still persist. Klugen Corporation has properly adopted FAS
141R and FAS 160 (now codified in sections 805 and 810 of FASB's
2009 Standards Codification) for the 2009 fiscal period and its
forthcoming annual report will reflect those changes.
Irma regularly conducts in-house seminars to instruct her
accounting staff regarding new developments in financial reporting. In
fact, her seminars meet the Continuing Professional Education (CPE)
sponsor requirements set forth by the National Association of State
Boards of Accountancy (NASBA) and the Quality Assurance Service (QAS),
which is required by State Boards of Accountancy and other licencing
organizations for the renewal of CPA, CMA and other professional
certifications.
Irma's CPE seminars entitled "Financial Reporting
Updates" are always well received by her staff. During the past six
months, Irma already has held several seminars to inform her staff
regarding IFRS. Those who attended all her seminars are already familiar
with the SEC's Roadmap that proposes adoption of IFRS starting in
2014, and also know about some of the most significant differences
between U.S. GAAP and IFRS.
Since in about five (5) months, Klugen Corporation will issue its
consolidated financial statements, which will, for the first time,
incorporate FAS 160 and FAS 141R, Irma decides to schedule a seminar on
"Business Combinations--Consolidated Financial Statements" for
October 15, 2009. The following is a brief agenda for Irma's
Seminar:
Business Combinations--Consolidated Financial Statements--Financial
Reporting Update
October 15, 2009--Agenda
1. Review of fundamental concepts of business combinations and
consolidated financial statements
2. Changes to U.S. GAAP (FAS 141R and FAS 160)
3. Significant continuing differences between U.S. GAAP and IFRS
4. Developments with potential impact on future fiscal periods
5. Questions
The seminar will be highly beneficial for staff members who are
currently involved or planning to become involved in critical aspects of
financial reporting and also for those who want to develop their
knowledge of IFRS. During the seminar, Irma distributes several
handouts, including the company's prior year income statement and
balance sheet for reference.
The Seminar
Agenda Item 1 Fundamental Concepts of Business
Combinations--Consolidated
Financial Statements
During the first part of the seminar, Irma reviews several
fundamental concepts relating to accounting for business combinations.
She emphasizes that these concepts are common to both U.S. GAAP and
IFRS.
Fundamental Concepts common to both U.S. GAAP and IFRS
* The parent company issues consolidated financial statements that
include the results for all subsidiaries that the company controls.
* Control is usually assumed when the parent holds a controlling
financial interest (generally, more than 50% ownership of the
outstanding voting common stock.
* Consolidated financial statements include 100% of the
subsidiaries' assets, liabilities, revenue, expense, gains, and
losses, even if the subsidiary is only partially owned.
* Subsidiaries' previously unrecognized assets are identified
at time of business combination and are recognized in the consolidated
financial statements.
* Goodwill is recognized on the consolidated balance sheet if the
acquisition cost exceeds the fair value of the subsidiaries'
identifiable net assets.
* Goodwill is not amortized, but periodically tested for
impairment.
* Non-controlling interest (formerly called minority interest) is
recognized on the consolidated balance sheet.
Agenda Item 2 Changes in U.S. GAAP
Irma discusses the most important changes in accounting and
financial reporting for consolidated entities consistent with FAS 141R
and FAS 160. She prepares a handout for the seminar participants,
consisting of a comparative table that contrast the new rules (effective
for the 2009 financial statements) with the prior rules.
Agenda Item 3 Significant Continuing Differences Between U.S. GAAP
and IFRS
Irma highlights continuing significant differences between U.S.
GAAP and IFRS. This information is particularly important for those
staff members who are involved in the consolidation process and those
who wish to prepare for the future adoption of IFRS. The following table
represents a handout based on Irma's PowerPoint presentation:
Agenda Item 4 Developments with Potential Impact on Future Fiscal
Periods
Irma briefly mentions other developments in the consolidation area.
She mentions that in June 2009, FASB issued FAS 166, "Accounting
for Transfers of Financial Assets," and FAS 167, "Amendments
to FASB Interpretation No. 46R" (FASB, 2009). FAS 166 eliminates
the concept of qualifying special purpose entities (SPE); FAS 167 deals
with the consolidation aspects of this elimination. Specifically,
companies with formerly classified qualifying SPEs must now assess these
entities for possible consolidation.
FAS 167 focuses on control and the primary beneficiary of the SPE
in determining whether a company, such as Klugen Corp., must consolidate
its SPE. A primary beneficiary is (1) able to direct activities of the
SPE and is required to absorb significant gains and losses. A company is
assumed to have control if (1) it has the power to direct activities,
(2) has the most significant impact on the entity's performance,
and (3) is required to absorb losses, and benefit from gains (FAS 167,
par. 14A-G). Irma reminds her staff that currently Klugen Corporation
does not have investments in qualifying SPE's; thus, the new
standards will not affect the company.
Irma also mentions that in December 2008, the IASB issued Exposure
Draft 10 (ED 10) "Consolidated Financial Statements," (IASB,
2008), which proposes a single definition of control that is very
similar to the FAS 167 definition. Once this exposure draft is
finalized, convergence between U.S. GAAP and IFRS likely will be further
enhanced. Irma promises to keep her staff informed about developments in
that area.
Agenda Item 5 Questions
At the end of the seminar, many questions arise from the staff and
some from the CEO, who attended the second half of the seminar. Irma
answers as many questions as possible and promises to prepare a short
question/answer briefing sheet for all those who were present at the
seminar. During the seminar she summarizes the following questions as
shown in the Assignments section.
ASSIGNMENTS
Answer the questions specifically assigned by your instructor.
U.S. GAAP Questions
1. How will adoption of the new accounting standards (FAS 141R and
FAS 160) affect Klugen Corporation's financial statements in the
forthcoming reporting period?
2. Utilizing the 2008 numbers, prepare (1) a partial income
statement starting at income from operations and (2) the equity section
of the balance sheet consistent with the requirements of FAS 141R and
FAS 160 (FASB Accounting Standards Codification sections 805 and 810).
3. How will adoption of FAS 141R and FAS 160 affect Klugen
Corporation's financial statements in the long-run?
4. What key financial ratios will be affected by the adoption of
FAS 141R and FAS 160? What will be the likely effect?
5. What additional estimates have to be made consistent with the
new accounting standards?
6. Could any of the recent and forthcoming changes affect the
company's acquisition strategies and potentially its growth?
7. What were FASB's primary reasons for issuing FAS 141R and
FAS 160? (Research question)
8. What are qualifying SPEs? Do they exist under IFRS? What is the
effect of FAS 166 eliminating the concept of qualifying SPEs on the
convergence of accounting standards?
9. FASB and IASB recently issued an updated Memorandum of
Understanding. Retrieve the updated memorandum and identify several
issues that the two standard setting boards are jointly focusing on to
facilitate convergence. (Research Question)
IFRS Questions
1. From the consolidation perspective, what would be the likely
overall effect of adopting IFRS on the company's financial
statements?
2. What potential effect would arise if Klugen were to select the
option under IFRS 3 to value non-controlling interest at the
proportionate share of its subsidiaries' net identifiable assets?
3. Do you believe that an impairment of goodwill would be more
likely under IFRS or under U.S. GAAP? Why, or why not?
4. What challenges would arise for the accounting staff if the
company adopts IFRS? Do you believe that he company is making progress
toward meeting some of these challenges?
5. What opportunities would arise for the accounting staff if the
company adopts IFRS?
6. What other (non-staff related) factors should Klugen Corporation
consider prior to adopting IFRS? Differentiate between advantages and
disadvantages.
7. Two of Klugen's non-consolidated entities regularly grant
stock options to its employees. How could this affect Klugen's
accounting for these entities under IFRS?
8. As indicated in the case, Irma previously highlighted some other
significant differences between IFRS and U.S. GAAP. Research the issue
and find three (3) differences other than those related to business
combinations. You may want to consider accounting for inventory,
extraordinary items, property, plant and equipment, and research and
development.
9. Assume that the SEC provides a choice in the timing of the
adoption of IFRS. What ethical issues could arise for the CFO in
deciding whether to adopt IFRS at the earliest possible, or at a later
required date? (Research question)
10. Review comment letters received by the SEC regarding its
Roadmap. List two concerns mentioned by those offering comments.
(Research question)
REFERENCES
Committee on Accounting Procedures (1959). Accounting Research
Bulletin No. 51. Consolidated Financial Statements. Original
Pronouncement. Financial Accounting Standards Board: Stamford: CT.
Financial Accounting Standards Board (2009). FASB Accounting
Standards Codification. Http://www.fasb.org.
Financial Accounting Standards Board (2009). FASB Statement No.
167. Amendments to FASB Interpretation 46R. Retrieved on July 7, 2009,
from http://www.fasb.org.
Financial Accounting Standards Board (2009). FASB Statement No.
166. Accounting for the Transfer of Financial Assets--an amendment of
FASB Statement No. 140. Retrieved on July 7, 2009, from
http://www.fasb.org.
Financial Accounting Standards Board (2007). FASB Statement No.
160. Non-Controlling Interest in Consolidated Financial Statement.
Retrieved on January 5, 2008, from http://www.fasb.org.
Financial Accounting Standards Board (2007). FASB Statement No.
141R. Business Combinations. Retrieved on January 5, 2008, from
http://www.fasb.org.
Financial Accounting Standards Board (2002). Memorandum of
Understanding. The Norwalk Agreement. September 18. Retrieved on June
18, 2008, from fasb.org/newsmemoradum.pdf.
International Accounting Standards Board (2008). ED 10 Consolidated
Financial Statements. December 2008. Retrieved on March 30, 2009, from
http://www.iasb.org.
International Accounting Standards Board (2008). International
Financial Reporting Standard No. 3. Business Combinations. London,
England: IASB.
International Accounting Standards Board (2008). International
Accounting Standard No. 27. Consolidated and Separate Financial
Statements. London, England: IASB.
Securities and Exchange Commission (2008). Roadmap for the
Potential Use of Financial Statements Prepared in Accordance With
International Financial Reporting Standards by U.S. Issuers. Release
No.: 33-8982, File No. S7-27-08. Retrieved on November 19, from
http://www.sec.gov.
AUTHOR'S NOTE
This is a fictitious case. Any similarities with real companies,
individuals, and situations are solely coincidental.
Marianne L. James, California State University, Los Angeles
Table 1
Klugen Corporation
Consolidated Statement of Income
for the year ended December 31, 2008
Numbers are in million (except share amounts)
Operating Revenues
Business service $15,500
Residential service 10,200
Wireless service 18,000 $ 43,700
Operating Expenses
Cost of services (excludes depreciation & $ 15,200
amortization)
Selling, general, administrative expenses 11,100
Depreciation and amortization 7,150 $ 33,450
Operating Income $ 10,250
Other Income (Expense)
Interest expense (820)
Minority interest (1,010)
Investment income 405 (1,425)
Income Before Income Taxes $ 8,825
Income Tax 3,250
Net Income 5,575
Basic Earnings Per Share $2.08
Diluted Earnings Per Share $1.92
The accompanying notes are an integral part of the consolidated
financial statements
Table 2
Klugen Corporation
Consolidated Balance Sheet
December 31, 2008
(Numbers are in millions)
Assets
Current Assets
Cash and cash equivalents $ 519
Accounts receivables (net of allowances of $310) 4,200
Prepaid expenses 400
Other current assets 520
Total Current Assets $ 5,639
Non-Current Assets
Property, plant & equipment (net) 25,600
Goodwill 18,500
Licenses 12,900
Customer relationships (net) 3,100
Investments in non-consolidated entities 1,000
Dividends receivables 300
Other assets 1,200
Total Non-Current Assets $62,600
Total Assets $68,239
Liabilities and Stockholders' Equity
Current Liabilities
Accounts payable and accrued liabilities 5,200
Advanced billings and deposits 920
Accrued taxes 420
Total Current Liabilities $ 6,540
Non-Current Liabilities
Long-term debt 25,500
Post-retirement benefits 2,300
Deferred taxes 3,200
Total Non-Current Liabilities $31,000
Total Liabilities $37,540
Minority Interest 5,000
Stockholders' Equity
Common stock ($1 par, 100,000,000 authorized, 60
60,000,000 issued)
Additional paid in capital 13,095
Retained earnings 14,588
Accumulated other comprehensive income (2,044)
Total Stockholders' Equity 25,699
Total Liabilities and Stockholders' Equity $68,239
The accompanying notes are an integral part of the consolidated
financial statements.
Table 3
Recent Changes to U.S. GAAP-effective 2009--FAS 141R and FAS 160
Issue Effective 2009 Pre-2009 Financial
Financial Statements Statements
Subsidiaries' assets All assets and Assets and
and liabilities liabilities are liabilities were
revalued to fair revalued based on the
market value at parent's ownership
acquisition date percentage
(100% revaluation).
Negative goodwill Recognized as gain Recognized as a
for year of proportionate
acquisition. reduction of long-
term assets.
Balance sheet NCI is classified as NCI is recognized as
classification of equity. liability, equity, or
non-controlling between liabilities
interest (NCI) and equity.
Income statement Presented as a NCI was presented as
presentation of NCI's separate deduction part of "Other
share of income from consolidated income, expenses,
income to derive gains, and losses."
income to controlling
stockholders.
NCI valuation Is carried at fair Carried at book value
market value of of subsidiaries' net
subsidiaries' net assets, multiplied by
assets, multiplied by NCI percentage.
NCI percentage.
Cost of business Direct costs are Direct costs were
combinations expensed during year capitalized as part
of acquisition of acquisition cost.
Inprocess research Are capitalized at Could be expensed at
and development (R&D) time of acquisition. time of acquisition.
Acquisition in stages Previously acquired Measurement was based
equity interest is on values at time of
remeasured when individual equity
acquiring company acquisition
achieves control;
gain or loss is
recognized in the
income statement.
Terminology Minority interest is The commonly used
now referred to as term was "minority
"non-controlling interest."
interest."
Table 4
Summary of Current Differences Between U.S. GAAP and IFRS
Issue U.S. GAAP IFRS
Definition of control Defined as Focuses on "power to
"controlling govern financial and
financial interest" operating policies"
(ARB 51).
Usually interpreted (IFRS 3, par. 19);
as majority voting The goal is that
interest. activities generate
"benefits" for
controlling entity.
Shares considered for Only existing voting May include
determining control rights are exercisable shares.
considered.
Calculation of non- NCI interest is Choice between (1)
controlling interest measured at fair fair value and (2)
(NCI) value of total net proportionate share
assets and includes of fair value of
share of goodwill. identifiable net
assets.
Calculation of Goodwill (if it If second option is
goodwill at time of exists) also includes chosen, goodwill is
acquisition share attributed to only attributed to
NCI. controlling interest
(parent).
Contingencies-- Contractual Recognition of
initial measurement contingent assets or contingent liability:
liabilities are Contingent liability
valued at fair market is recognized even if
value. it is does not meet
Non-contractual the 'probable' test
contingent assets and if the present
liabilities that meet obligation arises
the 'more likely than from a past event and
not' test are is reliably measured.
accounted for
consistent with SFAC
6.
Non-contractual
assets and
liabilities: If they
do not meet 'more
likely than not test'
are accounted for
consistent with FAS
5.
Goodwill impairment Two-step approach: One-step approach
test (1) compare book Compare book value to
value of reporting larger of cash
unit to fair market generating unit's (a)
value of reporting fair value less
unit; (2) if book selling cost and (b)
value is larger, value in use [value
impairment is equal in use = PV of
to book value less expected future cash
implied fair value of flows].
goodwill.
