Accounting for global entities and the effect of the convergence Of U.S. generally accepted accounting principles to international financial reporting standards.

James, Marianne L.

CASE DESCRIPTION

The primary subject matter of this case concerns strategic decisions that global entities, their executives, and accountants face in light of the almost certain convergence of U.S. Generally Accepted Accounting Principles (GAAP) to International Financial Reporting Standards (IFRS). Secondary, the effect of convergence to IFRS on the financial statements of U.S. based global entities, on financial statement users, and the accounting profession is explored. This case has a difficulty level of three to four and can be taught in about 45 minutes. Approximately two hours of outside preparation is necessary to fully address the issues and concepts. This case can be utilized in Intermediate Accounting as part of the coverage of pending changes in U.S. financial accounting and reporting, in an International Accounting course, or in a graduate accounting course focusing more extensively on underlying conceptual issues and the research components of this case. The case has analytical, critical thinking, conceptual, and research components. Utilizing this case can enhance students' oral and written communication skills.

CASE SYNOPSIS

In December 2007, the Securities and Exchange Commission (SEC) issued a rule entitled, "Acceptance From Foreign Private Issuers of Financial Statements Prepared in Accordance With International Financial Reporting Standards Without Reconciliation to U.S. GAAP" (SEC, 2007). This new rule eliminates the typically costly reconciliation of financial statements prepared using International Financial Reporting Standards (IFRS) to U.S. GAAP that previously was required of non-U.S. companies reporting to the SEC. This rule is likely to significantly affect foreign entities, U.S. multinational entities, financial statement users, and the accounting profession.

The SEC's decision is part of a broader movement in the U.S. toward the acceptance of IFRS and is supported by the Financial Accounting Standards Board (FASB). The SEC also is considering allowing U.S. companies to choose between U.S. GAAP and IFRS when reporting to the SEC and may require that all U.S. public companies utilize IFRS by the year 2016 (SEC, 2008).

While no final decisions have been reached, it is virtually certain that the U.S. will be moving away from the traditional U.S. GAAP and toward a convergence with IFRS, which already are required or permitted in more than 100 nations. U.S. and global entities, the accounting profession, accounting majors, and financial statement users must prepare for this change. Educators play a key role in this process.

The primary focus of this case concerns the U.S. convergence to IFRS and explores the effects of IFRS on global entities' financial statements, financial statement users, and the strategic decisions accounting professionals and entities may face.

This case can be taught at the same time that expected changes in U.S. financial reporting are discussed in Intermediate Accounting or in a more advanced accounting course focusing primarily on underlying concepts and the case's research components. The case has critical thinking, analytical, conceptual, communication, and research components.

* This is an illustrative case. Any similarities with real companies, individuals, and situations are solely coincidental.

INTRODUCTION

For several decades, global organizations, such as the European Union, the International Organization of Securities Commissions (IOSCO), and the International Accounting Standards Committee (IASC), headquartered in London, England, supported international efforts to harmonize financial accounting standards and reporting. For example, the IASCO consistently recommended the "adoption of a set of high-quality accounting standards for cross-border listing" (Doupnik & Perera, 2007, 78). Consistent with the IASCO's goal, during the 1990s the IASC focused on developing a set of international standards that would be accepted for cross-border listing (Doupnik & Perera, 2007) and issued 41 International Accounting Standards (IASs).

In 2001, the IASC reorganized and the International Accounting Standards Board (IASB) was created. Harmonization efforts shifted toward globalization. In 2002, the Financial Accounting Standards Board (FASB) and the IASB signed what is commonly referred to as the Norwalk Agreement. In this agreement the two major standard setting organizations concurred to work together to develop a high-quality single set of accounting standards that would be utilized internationally for "domestic and cross border financial reporting." (FASB, 2002).

To achieve their high priority goal, the FASB and IASB agreed to eliminate existing differences between U.S. GAAP and International Accounting Standards, and to coordinate their efforts on future standard setting projects (FASB, 2002). The FASB and the IASB work closely together toward that goal. For example, each new standard issued by FASB during the past six years refers to the IASB standards and the compatibility of the U.S. standards with the IASB standards. Currently, the standards issued by the IASB and its predecessor, the IASC, consist of 41 IASs and eight IFRS. These standards now are collectively referred to as IFRSs.

As a result of the joint efforts by FASB and the IASB, IFRS and U.S. GAAP are compatible in many areas. However, some significant differences still exist. For example, the LIFO (Last-in-first-out) inventory cost flow assumption is widely used in the U.S., but is specifically prohibited under IFRS. Other differences also exist and have to be reconciled if a global set of standards is to emerge.

The Sarbanes-Oxley Act of 2002 (SOX), an Act of Congress that was issued to improve financial reporting and protect investors, requires that the SEC conduct a study regarding the adoption of a principles-based set of accounting standards (U.S. Congress, 2002, HR 3763, 108, 2d). IFRSs generally are considered principles-based standards, while U.S. GAAP is considered more rule-based. SOX specifies that the U.S. standard setters should consider "the extent to which international convergence on high quality accounting standards is necessary ..." (U.S. Congress, 2002, 108, 1Av).

U.S. GAAP has influenced accounting standards in many countries. A decade ago, some still expected that U.S. GAAP will eventually become globally accepted, but this no longer is likely (Herz, 2008). Instead, during the past few years, a distinctive global shift toward use of IFRS emerged. In fact, in January 2003, the European Parliament declared that starting in 2005, all companies listed on European stock exchanges are required to file financial statements consistent with IFRS (Deloitte, 2003). This rule was implemented in 2005 by the approximately 7,000 European public companies listed on European stock exchanges.

Many nations have adopted IFRS for financial reporting purposes. Today, more than 100 nations either require or permit the use of IFRS for financial reporting (KPMG, 2008). It is very likely that IFRS will soon become globally accepted. Robert Herz, Chairman of FASB, supports convergence to IFRS. In a recent interview with the Journal of Accountancy, Mr. Herz estimated that within the next five years, convergence to some form of IFRS will occur (Herz, 2008). In addition, the SEC, which requires that U.S. as well as non-US companies that raise capital on U.S. financial markets must file their financial statements with the SEC, also supports convergence to IFRS.

During 2007, the SEC issued a proposal to allow non-U.S. companies to choose between U.S. GAAP and IFRS when reporting to the SEC. In December, the SEC issued a final rule allowing this choice and effectively eliminating the often costly reconciliation to U.S. GAAP (SEC, 2007). This rule has affected foreign issuers quite significantly. According to a SEC representative, approximately 100 non-U.S. SEC registrants that routinely prepare IFRS-based statements in their home country now file IFRS-based financial statements with the SEC as well. Only one company that prepares IFRS-based financial statements still chooses to reconcile to U.S. GAAP (Erhardt, 2008).

The SEC currently also is considering allowing U.S. public companies to choose between IFRS and US. GAAP when filing their financial statements with the SEC. However, choice between two sets of financial reporting standards is not the ultimate goal (SEC, 2007). A single set of high quality globally accepted financial accounting standards tends to better serve the financial users and likely lead to the greatest comparability between companies.

In fact, on November 14, 2008, the SEC issued a proposal entitled, "Roadmap for the Potential Use of Financial Statements Prepared in Accordance With International Financial Reporting Standards by U.S. Issuers," which would require that U.S. public companies start utilizing IFRS for fiscal periods ending after December 15, 2014, 2015, or 2016, depending on the filing status of the entity (SEC, 2008). In addition, the SEC may permit early adoption of IFRS by certain very large corporations for fiscal periods ending after December 15, 2009 (SEC, 2008).

Professional organizations, such as the American Institute of Certified Public Accountants (AICPA) also support convergence efforts. For example, on May 15, 2008, the AICPA launched a website "AICPA.IFRS.com" to help inform and educate accounting professionals about the expected change (AICPA, 2008).

Standard setters, accounting educators, public accounting firms, global entities, and many U.S. entities are preparing for the expected convergence to IFRS. Public accounting firms and especially the "Big 4" are spending tremendous resources to prepare their professionals for the coming change.

Current accounting students--the future accounting professionals--must become knowledgeable about IFRS and the effect on companies' financial statements, consider strategic decisions entities may face on the path toward convergence, and must prepare for the pending convergence. This case addresses many of the issues that arise during this process.

Elisa Hartwald is the Chief Financial Officer (CFO) of Wichtel Corporation, a multinational company, whose parent company is headquartered in the U.S. The company is a consolidated entity currently consisting of the parent and seven majority owned vertically integrated entities. All of its subsidiaries are located in Western Europe. The U.S. parent company purchases and imports parts from its subsidiaries as well as from unaffiliated entities. The European subsidiaries are listed on European stock exchanges and prepare financial statements consistent with IFRS.

During the past, Wichtel has raised capital selling stocks and bonds only in the U.S. Because of the cost of compliance with SEC regulations, the company's European subsidiaries also have raised capital exclusively in their home countries. Wichtel Corporation's board of directors recently voted on a new expansion project that would allow it to gain global market share. The company currently is exploring the possibility of raising additional capital either in the U.S. or on European markets.

Elisa, who is a Certified Public Accountant, has closely followed developments toward global harmonization of financial accounting and reporting. She is very familiar with the differences between U.S. GAAP and IFRS and the difficulties and challenges of consolidating entities utilizing different GAAP. She also is aware of the trend toward convergence of U.S. GAAP to IFRSs. Elisa already has prepared a brief summary focusing on current differences between U.S. GAAP and IFRS that are pertinent to Wichtel Corporation. This summary is shown in table 1.

Elisa is in charge of preparing consolidated financial statements for the parent company and its European subsidiaries. Under U.S. GAAP and also IFRS, companies must consolidate entities that they control. In completing this process, Elisa must translate and reconcile the IFRS-based statements of Wichtel's European subsidiaries into U.S. GAAP. Then she combines the financial statements applying U.S. rules of consolidation. This is a complicated process.

Wichtel Corporation's most recent consolidated income statement and balance sheet are presented below:

The Chief Executive Officer (CEO), James Miellers, asks Elisa to consider their company's position regarding the SEC proposal to permit U.S. companies to utilize IFRS. James also asks Elisa to consider the company's strategic plans to raise additional capital in light of the expected changes in financial reporting rules and to consider their implementation strategies if the SEC requires (or permits) use of IFRS for all public companies. She decides to consider the issues and the likely effect of IFRS on the company's financial statements, discuss them with the CEO, and also to draft a comment letter to the SEC.

ASSIGNMENTS

Answer the questions that were assigned by your instructor. Provide concise answers.

Company-Specific and General Questions:

1. Consider Wichtel Corporation's most current financial statements presented in this case (see Tables 2 and 3). What would be the likely effect of adopting IFRS on Wichtel Corporation's financial statements? How would use of IFRS affect the company's key financial ratios?

2. How could use of IFRS affect Wichtel Corporation's cost of capital? How could this affect Wichtel Corporation's strategies regarding future sources of capital?

3. What are the advantages for Wichtel to continue preparing financial statements utilizing U.S.

GAAP?

4. What would be the advantages of preparing financial statements utilizing IFRS?

5. What would be the likely effect on financial statement users if the SEC allows U.S. companies to choose between U. S. GAAP and IFRS for preparing their financial statements? What do you recommend that Wichtel Corporation should choose in that situation?

6. What would be the likely effect on financial statement users if the SEC requires that all U.S. public companies utilize IFRS for preparing their financial statements?

7. Draft a concise letter addressed to the SEC to express your opinion regarding the issue of whether U.S. companies should be (a) permitted or (b) required to prepare financial statements consistent with IFRS. Support your position and focus on advantages and disadvantages. Also indicate whether you would support early adoption of IFRS, if permitted, and whether you agree with the SEC's proposal to phase-in adoption over several years. Address the letter to Florence E. Harmon, Securities and Exchange Commission, 100 F Street, NE, Washington, D.C. 20549-1090.

8. Indicate any additional issues that the company may want to consider.

9. The SEC is considering requiring that all public companies use IFRS by the year 2016. How will this affect the accounting profession?

Researchable Questions:

1. Research and briefly describe the perceptions of the corporate or the financial community regarding allowing U.S. companies to choose between U.S. GAAP and IFRS.

2. What are some of the most important critical issues that must be addressed prior to convergence of U.S. GAAP to IFRS?

3. Research current developments regarding convergence to IFRS.

4. Convergence to IFRS has not yet occurred. Research and briefly describe major joint projects between the FASB and IASB.

5. Research the convergence issue from the perspective of non-public entities.

REFERENCES

American Accounting Association Annual Meeting. (2008, August 3-8). Anaheim, CA.

American Institute of Certified Public Accountants. (2008). IFRS Resources. Available at http://www.AICPA.IFRS.org.

Deloitte Touche Tomatsu. (2003). IAS PLUS. IFRSs in Europe--Events in 2003. Retrieved on August 1, 2008, from http://www.iasplus.com/restruct/euro2003.htm.

Doupnik T & H. Perera (2007). International Accounting. New York, NY: McGraw-Hill Companies.

Erhardt, J. A., SEC Representative. (2008, August) Challenges of Regulators and Practitioners If IFRS is Adopted for Domestic Issuers. Presented to the American Accounting Association Annual Meeting, Anaheim, California.

Financial Accounting Standards Board (2002). Memorandum of Understanding. The Norwalk Agreement. September 18. Retrieved on June 18, 2008, from fasb.org/newsmemoradum.pdf.

Herz R. (2008, February). Change Agent. Journal of Accountancy. Retrieved on April 2, 2008, from http://www.aicpa.org/pubs/jofa/feb2008/robert_herz_interview.htm.

KPMG. IFRS: The Emergence of World Wide Accounting Standards. (2008, February). Retrieved on August 11, 2008, from www.us.kpmg.com.

Securities and Exchange Commission. (2008, November). 17 CFR Parts 210, 229, 230, 240, 244 and 249, Release Nos. 33-8982; 34-58960; File No. S7-27-08. Roadmap for the Potential Use of Financial Statements Prepared in Accordance With International Financial Reporting Standards by U.S. Issuers. Retrieved on November 16, 2008, from http://sec.gov/rules/proposed/2008/33-8982.pdf.

Securities and Exchange Commission. (2008, August). SEC Proposes Roadmap Toward Global Accounting Standards to Help Investors Compare Financial Information More Easily. For Immediate Release. 2008-184. Retrieved on August 28, 2008, from http://sec.gov/news/press/2008/2008-184.htm.

Securities and Exchange Commission. (2007, December). 17 CFR Parts 210, 230, 239 and 249. Acceptance From Foreign Private Issuers of Financial Statements Prepared in Accordance With International Financial Reporting Standards Without Reconciliation to U.S. GAAP. Retrieved on January 27, 2008, from http://www.sec.gov/rules/final/2007/33-8879.pdf.

Securities and Exchange Commission (2007, August). Concept Release On Allowing U.S. Issuers To Prepare Financial Statements In Accordance With International Financial Reporting Standards (Corrected). Release No. 33-8831. Retrieved on August 1, 2008, from http://www.sec.gov/rules/concept.shtml.

Securities and Exchange Commission. (2007) International Financial Reporting Standards 'Roadmap' Retrieved on March 3, 2008 from http://www.sec.gov.

U.S. Congress. (2002). One Hundred Seventh Congress of the United States of America at the second Session. Sarbanes-Oxley Act of2002. H.R. 3763.

Marianne L. James, California State University, Los Angeles

Table 1: Differences between U.S. GAAP and IFRS

    Accounting Issue                       U.S. GAAP

Inventory: Cost Flow       LIFO, FIFO and weighted average
Assumptions                methods are permitted.
Inventory: Valuation -     Market is defined as replacement cost
Lower-of-cost-or-market    constrained by net realizable value
Rule                       (ceiling) and net realizable value minus
                           normal profit (floor) Inventory value
                           write-downs cannot be reversed.
Property, Plant and        Land is carried at cost. Plant and
Equipment                  equipment are carried at cost less
                           accumulated depreciation. Revaluation
                           to market value is not permitted.
Intangible Assets          Depreciable assets with a finite life are
                           amortized and carried at cost less
                           accumulated amortization. Revaluation
                           to market value is not permitted.
Research and Development   All research and development costs
Costs                      must be expenses as incurred.
Discontinued Operations    A component of a business that can be
                           separately held for sale is classified as
                           discontinued operations.
Extraordinary Items        Items that are both unusual and
                           infrequent are shown as extraordinary
                           items, apart from income from
                           continuing operations.
Convertible Bonds          Convertible bonds are solely classified
                           as liabilities.
Terminology                Undistributed cumulative income is
                           referred to as "Retained Earnings."

    Accounting Issue                         IFRS

Inventory: Cost Flow       FIFO and weighted average methods
Assumptions                are permitted; LIFO is expressly
                           prohibited.
Inventory: Valuation -     Market is defined as net realizable
Lower-of-cost-or-market    value (selling price less selling cost).
Rule                       In addition, inventory write-downs
                           can be reversed.
Property, Plant and        Allows choice between market value
Equipment                  and cost less accumulated
                           depreciation.
Intangible Assets          Allows choice between market value
                           and cost less accumulated
                           amortization.
Research and Development   Research costs must be expensed as
Costs                      incurred, but development costs can
                           be capitalized as intangible assets if
                           they meet certain criteria.
Discontinued Operations    Only major product lines or divisions
                           are classified as discontinued
                           operations.
Extraordinary Items        The category "extraordinary items" is
                           not permitted under IFRS. Gains or
                           losses arising from such transactions
                           are shown as part of other income or
                           losses.
Convertible Bonds          Convertible bonds are classified as
                           liabilities and equity (i.e., value is
                           assigned to the conversion feature
                           and classified as equity).
Terminology                Undistributed cumulative income is
                           referred to as "Reserves."

Table 2: Wichtel Corporation and Subsidiaries Consolidated
Income Statement for the year ended December 31, 2007
(Numbers are in Millions)

Sales Revenue                                                   $21,700
Less: Cost of Goods Sold                                         10,200
Gross Margin                                                    $11,500
Less: Operating Expenses
Depreciation and amortization expense                             1,585
Research and development expense                                    380
Rent expense                                                        220
Wages and salaries expense                                        1,200
Bad debt expense                                                    300
Pension cost                                                        200
Utilities                                                           100
Other accrued expenses                                              289
Operating expenses                                               $4,274
Operating Income                                                 $7,226
Other income, losses and expenses
Interest revenue                                                    220
Interest expense                                                    250
Loss contingency                                                    200
Income from continuing operations (before taxes, non-control)    $6,996
Income tax expense                                                2,597
Non-controlling interest income                                     139

Table 2: Wichtel Corporation and Subsidiaries Consolidated
Income Statement for the year ended December 31, 2007
(Numbers are in Millions)

Income from continuing operations                $4,260
Loss from discontinued operations (net of tax)      400
Extraordinary loss (net of tax)                     607
Net Income                                       $3,253
Basic earnings per common share                   $5.94
Diluted earnings per share                        $5.11

Table 3: Wichtel Corporation and Subsidiaries Consolidated
Balance Sheet December 31, 2007
(Numbers are in Millions)

Assets
Current Assets
Cash and Equivalents                                           $1,220
Investments                                                     2,150
Interest receivables                                              105
Accounts receivable, net                                        3,000
Inventories (LIFO inventory method)                             5,000
Prepaid insurance                                                 120
Total Current Assets                                          $11,595
Non-current Assets
Investments DEH joint venture                                   1,635
Property, Plants, Equipment (net of accum. depr. Of 10,000)    13,609
Intangible Assets
Goodwill                                                        2,675
Patents                                                         1,775
Other Assets
Deferred tax benefit                                            1,500
Total Non-Current Assets                                      $21,194
Total Assets                                                  $32,789

Liabilities and Stockholders' Equity
Current Liabilities
Accounts Payables                                               2,220
Interest Payable                                                  329
Accrued wages payable                                             150
Deferred tax liabilities                                          200
Total Current Liabilities                                       2,899
Non-current Liabilities
Notes payable                                                     483
Bonds payable (5%, convertible)                                 5,000
Total Non-current Liabilities                                   5,483
Total Liabilities                                              $8,382
Stockholders' Equity
Common stock                                                   16,830
Retained earnings                                               5,940
Accumulated other comprehensive income - avail. f.                105
sale securities
Non-controlling interest                                        1,532
Total Stockholders' Equity                                    $24,407
Total Liabilities and Stockholders' Equity                    $32,789