IFRS Simplified:
A fast and easy to understand overview of the new International Financial Reporting Standards
by
Mike Morley, CPA
Smashwords Edition
Published by Nixon-Carre Ltd. on Smashwords
Copyright © 2011 by Mike Morley
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Copyright © 2011 by Mike Morley
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Table of Contents
Chapter 2 - The Four Key Principles
Chapter 3 - The Balance Sheet or Statement of Financial Position
Chapter 4 - The Income Statement or Statement of Results of Operations
Chapter 5 - The Cash Flow Statement
Chapter 7 - First-time adoption (IFRS 1)
Chapter 8 - International Accounting Standards (IAS) Summaries
Chapter 10 - Staying Up to Date
Introduction
Like it or not, the accounting rules in North America are changing!
Researching the new International Financial Reporting Standards for my clients was a painful task. Continually searching through long, difficult to read technical manuals it became obvious to me that there was a need for an easy-to-understand, concise introduction to IFRS.
I have tried to translate the technical accounting language into plain English so that everyone can understand the new accounting rules that will soon apply to “publicly accountable enterprises” in North America.
“IFRS Simplified” provides a jump start for accountants and finance executives who want to quickly and easily get up to date on IFRS.
However, since International Financial Reporting Standards are rules that are constantly being reviewed and updated to meet the changing needs of investors, if you have a specific question as to whether the Standard that you are using is current check with your auditor, or visit the websites listed in Chapter 10: Staying up to date.
Mike Morley, CPA
www.mikemorley.com
Chapter 1: GAAP vs. IFRS
GAAP has worked great up to now, why change things?
Although North American publicly traded companies are presently preparing their financial statements according to Generally Accepted Accounting Principles (GAAP), this is quickly changing. Canada is moving to IFRS based statements effective January 1, 2011, and the chairman of the SEC announced a roadmap to achieve IFRS compliance in the USA by 2014.
Even companies that are not legally required to comply with IFRS will feel strong pressure to adapt to the new worldwide standards. This is especially true of private companies wanting to merge with large public firms and companies that are suppliers to international IFRS compliant firms.
GAAP has been with us for many years and is not being abandoned. GAAP will continue to be used for some time after the official switch to IFRS.
So what’s the difference between GAAP and IFRS?
GAAP is rules based while IFRS is principles based. What this means is that IFRS provides more flexible guidelines for choosing what to include in (and what to leave out of) the financial statements while GAAP imposes more rigid rules. IFRS requires more judgment decisions on the part of the accountants, but provides more flexibility to explain unique situations.
Another important difference between GAAP and IFRS is that GAAP measures assets at historical cost (the original purchase price of the asset), while IFRS can measure assets in terms of their potential future benefits for the company. For example, a painting originally purchased for $1000 to decorate the lobby of a building, but which is now appraised at more than $100,000 would, under GAAP, continue to be recorded at its original $1000 cost, while, under IFRS, the value of the asset would be increased to reflect its fair market value, thus making the increase in the value of the company visible to the investor.
Investors have been demanding this changeover in order to be able to more easily compare international investing opportunities.
Who needs to comply?
“Publicly Accountable Enterprises” in the 25 countries of the European Union as well as Australia, New Zealand, South Africa, Russia, China, and many other countries are already required to produce IFRS financial statements. “Publicly Accountable Enterprises” in the USA and Canada will require IFRS compliance shortly.
“Publicly Accountable Enterprises” are companies that hold assets in a fiduciary capacity. In other words, they are companies that hold public money “in trust”, such as banks, insurance companies, and companies whose shares are traded on a public stock exchange, such as the London Stock Exchange, the New York Stock Exchange, and the NASDAQ.
The Benefits of IFRS
Standardization
The push to change from GAAP to IFRS has primarily come from large international companies wanting to have a universal method of producing financial statements. IFRS financial statements are faster and less expensive for these companies to produce because the accounting staff of a multi-national company will not have to be familiar with all the variations of GAAP in the different countries in which the company operates. Another advantage is that IFRS makes it easier for companies to develop a common system for internal management accounting reports.
Investor confidence
IFRS promotes investor confidence by requiring better explanatory notes to the financial statements. Since IFRS requires more judgment decisions in choosing how to record the value of liabilities, assets, and equity, explanations describing how those judgments were made are also required. In other words, the notes need to explain why the choices were made.
Substance over form
The principle of “substance over form” means that clarity is the primary consideration. Investors must feel confident that the financial statements are providing them with a true and fair presentation of the company’s financial condition.
Facilitating the free flow of capital
IFRS makes financial statements easier to compare. Since investors tend to put their money into companies and investments that they understand, having clear IFRS financial statements available makes decision making easier.
IFRS makes it easier for companies to be listed on foreign stock exchanges. The ability to get listed on foreign stock exchanges gives companies access to additional investors. Most foreign stock exchanges either require or accept IFRS financial statements.
IFRS vs. SOX
The implementation of IFRS does not affect Sarbanes-Oxley (SOX).
Sarbanes-Oxley is the law that makes executives of publicly traded US companies personally and criminally responsible for their company’s financial statements and disclosures. In other words, SOX is about making executives accountable for the reliability of the financial statements while IFRS is about the rules for preparing the financial statements.
Until recently, SOX demanded that audited financial statements prepared using US GAAP must be filed with the SEC. However, the SEC recently announced that it is now accepting IFRS based audited statements in addition to US GAAP statements.
Deadlines
The deadline for comparative IFRS financial statements for “Publicly Accountable Enterprises” in the USA is January 1, 2014 and January 1, 2011 in Canada. To meet these requirements the company will have to have IFRS systems in place one year in advance in order to produce the required two years of comparative figures in the financial statements.
IFRS 1 requires that the first year adopters of IFRS must start with a comparative balance sheet that converts it from GAAP to IFRS. It also requires a reconciliation statement that explains the differences between the GAAP financial statements and the IFRS financial statements.
IFRS are continually being revised and updated. The International Accounting Standards Board (IASB), which is the body responsible for establishing world wide accounting standards, issues proposals for changes and regular updates. Keeping up with these changes can be a challenge.
Summary
- GAAP is rules based while IFRS is principles based. IFRS introduces a new way of thinking about financial statements by introducing guidelines rather than strict rules in choosing accounting policies. Judgment decisions will have to be made every day about how to account for financial transactions, deciding on the value of assets, and how to report revenue.
- GAAP measures assets at historical cost while IFRS can measure assets in terms of their potential future benefits.
- “Publicly Accountable Enterprises” must comply. These are companies that “hold assets in a fiduciary capacity”, in other words, companies that hold public money “in trust”.
- The deadline for comparative IFRS financial statements for “Publicly Accountable Enterprises” in the USA is January 1, 2014 and January 1, 2011 in Canada.
Chapter 2: The Four Key Principles
Four key principles, clarity, relevance, reliability, and comparability, are the foundation of IFRS. They provide the necessary guidelines for accountants who must make many more judgment decisions under principles based IFRS than they ever did under rules based GAAP.
1) Clarity
The principle of clarity simply means that the financial statements must be easy to read and easy to understand.
Making financial statements understandable to accountants is not a problem. However, not everyone who reads the financial statements is a trained accountant. In fact, most readers are not fluent in accounting jargon. The real challenge is in making the financial statements, especially the notes to the statements, easy for all readers to understand.
To achieve clarity, accountants should choose simplicity over complexity. The true financial position of the company should be clear to anyone.
2) Relevance
IFRS says that an item is relevant if the information about that item has the potential to influence the decisions of lenders, investors, and other users of the financial statements.
The IFRS principle of relevance corresponds to the GAAP principle of materiality. Although in the past, many accountants and audit firms used a specific dollar amount as a minimum guideline to determine if something was material, now more and more accountants are following a standard very close to IFRS which means that they examine the nature of the item as well as the dollar value.
Under the GAAP materiality principle any information which could influence the decisions of lenders, investors, and other users of the statements, should be included at least in the notes, if not in the body of the financial statements.
The IFRS requirement that only relevant information be included means that the accountant must also decide the level of detail. Given that IFRS also demands clarity, the notes to the financial statements must be capable of being understood by the users of the financial statements and add value to the financial statements by adding clarity, and not simply add confusion.
Accountants must be skilled communicators providing relevant, clear, concise notes to the financial statements.
Accountants must be prepared to meet the challenge of defending their decisions concerning relevance to management and the auditor. This is an issue that worries many accountants.
3) Reliability
The principle of reliability refers to the extent to which information presented in the financial statements can be counted on to be true.
True and fair
Reliable information means that the financial statements are a reflection of the company’s economic reality. In other words, are they a true and fair presentation of the company’s operating results and its financial condition? But what is “true and fair”? In an IFRS context, “true” means that the information is objective and represented in an unbiased manner and “fair” means that common sense prevails because IFRS encourages balancing the level of spending on preparing the statements with the level of value delivered to the readers of the statements. For example, if you have sufficient information, IFRS lets you assign a percentage increase in the aggregate value of a large group of similar assets without the added expense of calculating and verifying the increase for each asset in the group.
Free of material errors
In order for information to be reliable, it must be free of material errors. So just what is material? Material items are those that have the potential to change the opinion of the readers of the financial statements. Materiality is more than just a minimum dollar level. $1000 might be material in one company but not in another, but if the $1000 item involves fraud then it is material to all companies, therefore the nature of the item, not just its dollar value determines materiality. Material information must not be withheld from lenders and creditors. If there is any doubt about whether an item is material or not, the information should be provided. Full disclosure is always the wiser choice.
Neutral
Reliable information must also be neutral. It must be free from bias. Although it is impossible because of human nature to completely eliminate all bias, accountants must continually endeavor to be independent. The notes to the financial statements should be carefully written in a manner that conveys the facts without expressing any personal views or emotions.
Complete
Reliable information must also be complete. One of the goals of IFRS is to inspire confidence that all pertinent information is included.
Substance over form
Decisions about whether information about individual transactions should be reported must be based on the intention of presenting a true and fair picture of the company’s results and financial condition. IFRS is very clear that reflecting the company’s economic reality in its financial statements is a matter of substance over form.
Prudence
International Financial Reporting Standards requires that accountants who prepare financial statements must exercise judgment in dealing with the inevitable uncertainties of valuation and materiality. They are expected to use a degree of caution in making these judgments. Accountants must be prudent in their approach by considering all the facts and information, both objective and subjective, to produce financial statements that meet the reliability requirement of IFRS.
4) Comparability
The principle of comparability refers to the ability to compare financial statements from year-to-year, company-to-company, and industry-to-industry.
IFRS requires that financial statements focus primarily on the needs of the users of the financial statements rather than the desires of those producing the statements. Comparability is one feature that definitely benefits the end user. Being able to easily compare financial statements is such a desirable factor that it is the driving force behind developing universal standards that enhance comparability. One of the International Accounting Standards Board’s objectives is to remove as many choices of accounting methods as possible first within IFRS, then between IFRS and GAAP (both USA and Canadian GAAP), in order to produce a single set of international standards that vary as little as possible from company to company, and from country to country.
However, some accountants have argued that the emphasis on uniformity of accounting methods to achieve comparability will not produce the most faithful financial statements because it takes away any allowance for differences among individual companies. This group is quickly becoming a minority. Comparability has clearly been recognized as a priority by the accounting profession and demanded by investors.
Trading off
IFRS encourages “trading off” between principles. For example, if information about a particular item is not as reliable as the accountant would like, he or she should add clarity by providing helpful information in expanded notes to the statement. In other words, reduced reliability is exchanged for clarity. This can be applied to any of the four basic principles of IFRS. “Substance over form” demands that a “true and fair” financial statement be presented by the company.
As you can see, being principles based rather than rules based, IFRS allows substantial discretion in deciding what information will be included and how it will be presented or disclosed, the final decision rests with the accountant. This is the aspect of IFRS that makes many accountants uncomfortable, preferring the sense of security that came with being able to follow the old GAAP rules.
Summary
- International Financial Reporting Standards are governed by four key principles: clarity, relevance, reliability, and comparability.
- The principle of “clarity” simply means that the financial statements must be easy to read and easy to understand.
- An item is “relevant” if the information about that item has the potential to influence the decisions of users of the financial statements.
- “Reliability” refers to the extent to which information presented in the financial statements can be counted on to be true.
- “Comparability” refers to the ability to compare financial statements from year-to-year, company-to-company, and industry-to-industry.
- IFRS allows substantial discretion in deciding what information will be included and how it will be presented or disclosed, the final decision rests with the accountant.
Chapter 3: The Balance Sheet or Statement of Financial Position
The balance sheet is the company’s list of things it has (assets), money it owes (liabilities), and what the difference is (equity). Under IFRS the balance sheet is called the statement of financial position. The balance sheet is the foundation for the other parts of the financial statements such as the income statement and the cash flow statement. It is the “score” at the end of the accounting reporting period. It compares the current score with the score at the end of the last accounting period. That it why is it is called a comparative statement of financial position. Some companies present three years for comparison even though they are not required to do so under IFRS.
Items are separated into current items (assets and liabilities which are expected to be used up or paid in the next year) and non-current items (assets which will take more than a year to be used up or liabilities that will be paid over a period longer than a year). Within each category they are listed in order of liquidity, which means the ease with which the asset can be sold and converted to cash.
1. Current Assets
Cash and cash equivalents
Cash is classified as a financial asset. It includes cash on hand and demand deposits with banks and other financial institutions which management intends to spend for current purposes (within a year).
Cash which is restricted and not available for use within one year should be included in noncurrent assets, not current assets. An example of this would be a bank loan that requires that a minimum amount of cash (often called a “compensating balance”) remain on hand at all times in the company’s bank account. The minimum deposit amount is not available for the company to spend. Not only is this a form of collateral for the loan, it increases the effective yield on the loan. IFRS requires a separate disclosure with regard to this cash which is not available for immediate use.
Cash equivalents, also classified as financial assets, include short-term, easy-to-sell investments that can be sold for a predictable amount of cash. To be included in this category, cash equivalents must be free of any significant risk of changes in value. Examples of these are treasury bills and money market funds. In the past, this category would have included commercial paper, but the latest subprime mortgage “credit crunch” proves that some commercial paper can be extremely volatile. Therefore, subprime mortgage commercial paper should be classified as a financial instrument with significant impairment, rather than a cash equivalent.
Inventory
For most companies inventory is one of the largest assets. From an accounting point of view inventory is important because it affects both the income statement and the balance sheet.
Inventory includes items available for sale in the ordinary course of business, as well as materials and supplies used in the manufacturing process or in the rendering of services.
Valuation
Under IFRS inventory must be valued at the lower of cost or net realizable value. Net realizable value is the usual selling price less the estimated selling costs and the costs of making the product available for sale.
FIFO (first-in-first-out) and “weighted average” are the only two acceptable costing methods under IFRS. LIFO used under US GAAP is not acceptable.
Write-downs
Any write-downs of inventory are recorded as an expense in the accounting period in which they occur. If these write-downs or losses, in whole or in part, later reverse themselves, they must be recorded as a reduction of the expense in the accounting period in which the reversal occurs.
Exclusions
IFRS requires that research costs and development costs not be included in inventory costs. R & D costs are expensed in the accounting period in which they occur. Exclusions include administrative and selling expenses, wasted materials, and storage costs.
Accounts receivable
Trade receivables
Accounts receivable include trade receivables for goods and services provided to customers in the normal course of business. As with GAAP, under IFRS, accounts receivable must be reported at net realizable value (an estimate of how much cash will be collected).
How you treat unearned interest and finance charges is optional under GAAP, but they must be deducted under IFRS. In addition, if material, an amount for estimated returns, allowances, and other discounts should be deducted.
Other receivables
Other receivables should be listed in a separate category. Examples of other receivables include notes receivable, and amounts due from related parties, such as officers of the company and associated companies. Under IFRS, these receivables are usually shown separately in their own receivables category, which helps highlight non-trade receivables such as loans to officers.
Pledging accounts receivable
As with GAAP, if accounts receivable are pledged as collateral, no accounting entry is needed, but adequate disclosure in the notes is required.
Assigning accounts receivable
If accounts receivable are assigned to a third party, the assigning company receives a reduced advance payment in return for handing over the rights to collect the customer accounts. Because the accounts receivable are still the assets of the assignor, they continue to be shown in the assigning company’s balance sheet along with the appropriate disclosure.
Accounts receivable can be sold outright to a factor without recourse (the factor cannot turn to the selling company for compensation if the accounts receivable become uncollectible) or with recourse (the factor can ask the company to reimburse any bad debt losses). If the risks and rewards associated with the accounts receivable are substantially transferred from the company to the factor, then the asset moves off the company’s balance sheet to that of the factor. Otherwise, the company keeps the accounts receivable on its balance sheet and discloses whether they are factored with or without recourse.
Financial Instruments
Under IFRS, a financial instrument is a contract to create a financial asset for one company and a financial liability or equity item for another company. Until the contract is signed neither company should record the financial instrument on its books. The company that records financial liability cannot remove this debt from its books until it has met all the conditions to discharge its debt, or if the instrument expires or is canceled.
Stocks, bonds, and derivatives such as options, forwards, and swaps, are examples of financial instruments. Physical assets, such as inventory, plant and equipment, and intangible assets, such as patents and goodwill, are not considered to be financial instruments.
Unlike GAAP, a commodity future to deliver physical assets, such as pork futures, is also not considered a financial instrument, because the fair value of these physical, non-financial assets cannot be measured reliably until the delivery date.
Classification
Financial assets are classified into 4 groups: 1) Financial assets at fair value (such as cash), 2) Loans and receivables (such as accounts receivable and payable), 3) Held-to-maturity investments which management does not intend to sell (such as certificates of deposit), and 4) Available-for-sale financial assets which management intends to sell (such as stock market shares of public companies).