A

& A U D I
international accounting

C C O U N T I N G

T I N G

Converting Financial Statements from

U.S. GAAP to IFRS
A Comprehensive Illustration
By Peter Harris, Eva K. Jermakowicz, and Barry Jay Epstein

FRS has become the required or permitted accounting framework for financial reporting in many of the worlds financial
markets, whether explicitly endorsed or integrated into national regimes based on IFRS. Even though IFRS is not currently permitted by the SEC for U.S. registrants, U.S. accountants
need to know IFRSand how it differs from U.S. GAAP

because they will encounter it in the financial statements of foreign companies whose securities trade in the United States, foreign subsidiaries of U.S. companies, and U.S. subsidiaries of
foreign companies. Although the IASB and FASB have reduced
the differences between these sets of standards over the past
decade, several remain.

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JANUARY 2014 / THE CPA JOURNAL

Coverage of IFRS in college accounting

curricula and professional-licensing examinations has expanded in the past decade,
making newly minted practitioners at least
partially conversant with the remaining differences between GAAP and IFRS.
Practitioners who were educated and trained
before IFRS became widely employed, however, might benefit from a comprehensive
illustration of the GAAP-to-IFRS conversion
process.
To assist such CPAs, the authors have
developed a comprehensive illustration of
the process to be employed when converting U.S. GAAPbased financial statements
to conform with IFRS, as these sets of
standards exist today. The goal is to introduce the major differences between U.S.
GAAP and IFRS, with their resulting
divergent effects on the financial statements.
The illustration presents a U.S. GAAPprepared statement of financial position and an
income statement; then, based on a set of
specific facts affecting financial reporting by
the entity, it details the conversion to IFRScompliant financial statements. The process
begins with the recording of IFRS compliance worksheet adjustments, continues
with worksheet reconciliation from U.S.
GAAP to IFRS, and concludes with the
preparation of IFRS-based statements.
Most of the more significant and likely
differences between the two frameworks
are highlighted. These matters pertain to
the capitalization of qualifying development costs; allowable inventory costing
methods (i.e., use of the last-in, first-out
[LIFO] method is prohibited under
IFRS); permissible use of the revaluation
model for property, plant, and equipment
(PP&E); use of component depreciation;
and the allowable reversal of impairment
losses. This example also addresses the
more conservative approach of IFRS
regarding the recognition of contingent
losses and the different finance (capital)
lease requirements. Finally, this example
illustrates the different requirements for
presenting compound financial instruments
(e.g., convertible debt securities), given that
IFRS requires that the equity component
embedded in such securities be accounted
for and presented as equity.
The presentation of the statement of
financial position differs between the two
frameworks. Under U.S. GAAP, the
statement begins with the most liquid assets
JANUARY 2014 / THE CPA JOURNAL

and liabilities, followed by noncurrent

and longer-term assets and liabilities, and
concludes with shareholders equity,
whereas IFRS often (albeit not mandatorily) begins with the most illiquid accounts.
Presentation in the income statement also
varies; for example, IFRS does not allow
for the characterization of gains or losses
as extraordinary.
IFRS allows for greater flexibility on the
cash flow statement for categorizing certain items, such as for interest and dividend
income, as well as for interest expense. The
present demonstration will only address

Significant differences
pertain to the capitalization
of development costs,
inventory costing methods,
revaluation for PP&E, and
component depreciation.
recognition and measurement issues affecting the statement of financial position and
the income statement, because the cash
flow display options under IFRS are principally elective alternatives, not required
differences.

Hypothetical Case Study

A hypothetical company, JCL, is a manufacturer of prescription drugs. Its main

headquarters are in Newark, New Jersey,
where the company has operated since
1981. The company sells its products to
the retail market on a worldwide basis. Its
financial statements, presented in Exhibit 1
and Exhibit 2 for the year ending
December 31, 2012, have been prepared
using U.S. GAAP. JCLs management
would like to preview the effects of using
IFRS on the statement of financial position
and income statement. The company would
like to be able to report under IFRS by as

early as the next year, as it is considering

a new stock issue to be offered in Hong
Kong, which requires IFRS compliance.
The following paragraphs provide more
background information needed to understand the companys financial statements
and convert them to IFRS.
During 2012, JCL incurred costs of
$2,000 to develop new prescription drugs
requiring high levels of technical knowledge. The drugs under development, having been heavily researched for several
years, reached technical and economic feasibility at the beginning of 2012, and the
regulatory approval process has been
recently completed. The drugs will be tested in 2013 on a much larger patient population before making them available to
customers.
JCL uses the LIFO method to value its
inventory. The LIFO reserve (as used to
adjust from first-in, first-out [FIFO]) was
$5,000 at the beginning of the year and
$7,000 as of year-end.
Management has determined that the fair
value of PP&E, as of December 31,
2012, is $78,571an $8,571 increase
above book value. These assets are, on a
going-forward basis, to be depreciated over
a 10-year period using the straight-line
depreciation method. There is no residual
value. Depreciation for 2012 was recorded as $12,000 for U.S. GAAP financial
reporting purposes.
The patent is the only amortizable intangible asset; it is expensed over a five-year
period using the straight-line method. The
half-year convention is applied for all assets
placed in service during the year. For the
year ended December 31, 2012, amortization expense is $1,200.
In 2011, there was a goodwill impairment recognized in the amount of $2,000,
thereby reducing the carrying value from
$7,000 to $5,000. During 2012, the company tested for goodwill impairment and
found that the goodwills fair value had
actually increased to $6,000.
Investments consist of available-for-sale
(AFS) securities with a fair value of
$20,000 at the end of the year. The value
at the beginning of the year was $15,000.
Exchange-rate currency gains accounted
for $2,800 of the gain recognized during
the year. For simplicity, assume that there
was no interest or dividend income
earned on these investments during the

21

year, and any related income tax effects

have been disregarded. Furthermore, this
is the only item reflected in the shareholders equityaccumulated comprehensive income account.
The company suffered a loss of $4,000
due to a hurricane, which is considered to
be both an unusual and infrequent occurrence.
Accordingly, under U.S. GAAP, it was
reported net of tax as an extraordinary item.
There are long-term contingencies of
$3,000 stemming from civil lawsuits,
concerning customer personal injuries
arising from use of JCLs products. Legal
counsel considers the payout slightly
more likely than not to occur. In an
unrelated case where the company is a
plaintiff, counsel considers the recovery

of $10,000 in a patent infringement case

to be probable. Both cases are expected
to settle in a time frame of greater than
one year.
JCL issued 50 convertible bonds on
December 31, 2012, at par value of $1,000
each, in exchange for $50,000 in proceeds.
The bonds have a 10-year term and a coupon
rate of 6%, to be paid semi-annually. The
bonds are convertible at the option of the
holder, at any time until maturity, at a rate
of 100 shares per bond. The prevailing
market rate of similar bonds without the conversion option is 8% per year.
JCL entered into a lease on January 1,
2012, with the following terms: JCL leased
specialized machinery from Bell Corp. that
will enable JCL to manufacture its phar-

maceuticals in a much more efficient manner. This machinery was made specifically for JCL to meet its unique production
needs. The lease term is for three years,
with a minimum annual lease payment of
$2,500; payments are due on December 31
of each year, with the first payment due on
December 31, 2012. At the end of the lease
term, JCL has the option to buy the
equipment for the then-prevailing market
value, which will be established by an independent third-party expert appraiser, or to
negotiate a lease extension, also at a market lease rate as determined by independent parties. Furthermore:
n The lessee will pay all executory costs.
n The estimated useful life of the leased
asset is 50 months (416 years).

EXHIBIT 1
Statement of Financial Position Prepared under U.S. GAAP

JCL Inc.: Statement of Financial Position

as of December 31, 2012
(Amounts in Thousands of Dollars)
ASSETS
Current Assets
Cash
Accounts receivable
Inventory (LIFO basis)
Total Current Assets

33,000
47,000
60,000
140,000

Investments (Available for Sale)

Property, Plant, and Equipment
Assets (at cost)
Less: accumulated depreciation
Intangible Assets
Trade name
Patent (net of 3,000
accumulated amortization)
Goodwill
Total Assets

22

20,000

120,000
(50,000)

LIABILITIES AND SHAREHOLDERS EQUITY

Current Liabilities
Accounts payable
40,000
Accrued expenses
25,000
Taxes payable
15,000
Total Current Liabilities
80,000
Noncurrent Liabilities
Bonds payable 6%, convertible

50,000

Total Liabilities

130,000

70,000

4,000

Shareholders Equity
Common stock ($1 par)
Accumulated other
comprehensive income

60,000
5,000

Retained earnings

50,000

6,000
5,000

115,000

15,000
245,000

Total Liabilities and

Shareholders Equity

245,000

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The market value of the equipment at

the inception of the lease is $7,500.
n The interest rate implicit in the lease is
not known by JCL.
n The incremental borrowing rate of JCL
is 8%, the same rate it would currently pay
on straight (i.e., nonconvertible) debt
issuances.
n The effective tax rate for JCL is 25%.
For the sake of simplicity, with the
exception of the inventory facts mentioned
above, the income tax effects have been
disregarded in this case study.
Based on the information above, the
authors detail the following steps in the
conversion of the financial statements from
U.S. GAAP to IFRS. First, all significant
accounts and balances affected by the transition will be analyzed. Then, worksheet
adjustments for these items will be prepared to effect the conversion. Finally, the
IFRS-based statements of financial position and income will be presented.
Following this conversion, the major differences in cash flow reporting between
U.S. GAAP and IFRS will be briefly discussed, as will the likely impact on commonly cited financial ratios.
n

Significant Differences

The following sections analyze the significant differences between U.S. GAAP
and IFRSthat is, the financial statement
items requiring worksheet adjustment to
conform to IFRSin this case study.
Capitalization of certain development
costs under IFRS. IAS 38, Intangible
Assets, requires the capitalization of development costs when technical and economic feasibility of a project can be
demonstrated in accordance with six
specific criteria. An intangible asset arising from development (or from the development phase of an internal project) is
recognized if, and only if, an entity can
satisfy all of the following criteria:
1) the technical feasibility of completing
the development project; 2) the reporting
entitys intention to complete the project; 3) the entitys ability to use it or
sell it; 4) the probability that the project
will generate future economic benefits;
5) the availability of adequate technical,
financial, and other resources to complete
the project; and 6) the ability to measure
the expenditure related to the intangible
asset during its development.

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The capitalization of development costs

is not permitted under U.S. GAAP
(Accounting Standards Codification [ASC]
985-20), with limited exceptions, such as
for internal-use software, website development, developed technology acquired in
business combinations, and certain industry-specific situations. Therefore, two worksheet adjustments are required to transition
to IFRS: first, to capitalize development
costs as an intangible asset on the statement of financial position, and then to
amortize this asset over a five-year period. (Using a half-year convention, and
the straight-line method of amortization,
requires recognition of $200 of accumulated amortization at year-end.) JCL
accordingly makes the following worksheet
adjustments:
(1)
Dr. Development costs
2,000
Cr. Development expense
(SG&A expenses)
2,000
(2)
Dr. Amortization expense
200
Cr. Accumulated amortization
development costs
200
LIFO is not permitted under IFRS.
Under the provisions of IAS 2, Inventories,
apart from specified classes of inventories,
JCL has a choice between the FIFO or
the weighted-average cost formulas. For
this illustration, assume that JCL is switching from LIFO to FIFO for its IFRS financial reporting. In this case, the result will
be a $2,000 decrease in 2012s cost of
goods sold by virtue of a greater inventory total under FIFO (measured by the
increase in the LIFO reserve, from $5,000
to $7,000). In addition, there will be another increase in FIFO inventory to reflect the
extra beginning-of-year reserve of $5,000,
bringing the total increase in inventory to
$7,000. Assuming, for the moment, that
JCL will continue to be a GAAP-reporting entity in the United States, and thus
able to utilize LIFO for both financial and
tax reporting purposes, there will be an
increase in income tax expense of $500
(25% of $2,000). There will also be recognition of a deferred tax liability account for
IFRS-basis reporting in the amount of
$1,750 (25% of $7,000). The worksheet
adjustments are as follows:
(3)
Dr. Inventory
2,000
Cr. Cost of Goods Sold
2,000

(4)
Dr. Income Tax Expense
500
Cr. Deferred Tax Payable
500
(5)
Dr. Inventory
5,000
Cr. Deferred Tax Payable
1,250
Cr. Retained Earnings
3,750
Note that the increase to retained earnings represents the increased earnings
attributable to prior years, net of tax, under
the assumption that FIFO had been consistently applied ($5,000 [1 0.25]).
Revaluation model. U.S. GAAP
requires that PP&E assets be reported at
cost less accumulated depreciation. IFRS
permits an accounting policy alternative to
this cost model, called the revaluation
model. In accordance with IAS 16,
Property, Plant and Equipment, after initial recognition, an item of PP&E which
has a fair value that can be measured reliably may be carried at a revalued amount,
which is defined by its fair value at the date
of the revaluation, less any subsequent

23

accumulated depreciation and subsequent

accumulated impairment losses. If an
item is revalued, the entire class of PP&E
to which the asset belongs should be revalued. Revaluations should be made with sufficient regularity to ensure that the carrying amount is not materially different from
fair value at each reporting date.
Using the revaluation model, an increase
in an assets carrying amount will
increase other comprehensive income and
will be accumulated in a revaluation surplus account within equity (unless the
increase reverses a revaluation decrease
previously recognized in profit or loss). A
decrease is recognized in profit or loss,
except to the extent that it reverses a previous revaluation surplus on the same asset,
in which case it is recognized in other comprehensive income (OCI).
Under the revaluation model, there are
two available methods of accounting for
accumulated depreciation:
n Restate the accumulated depreciation proportionately with the change in the gross
carrying amount of the asset, so that the net

carrying amount of the asset after revaluation equals its revalued amount. IAS 16 states
that this method is often used when an asset
is revalued by applying an index to restate the
asset to its depreciated replacement cost.
n Eliminate the accumulated depreciation
against the gross carrying amount of the
asset and then restate the net amount to the
revalued amount of the asset.
Under either approach, the adjusted net
carrying value of the asset after revaluation is the same as its revalued amount.
The worksheet adjustments under two
approaches are as follows:
n Under the first approach, to recognize
the revaluation amounts for both PP&E
and accumulated depreciation such that the
net value is increased by $8,571, the following computations are necessary: for the
gross amount, $78,571 $70,000
$120,000 = $134,693; for accumulated
depreciation, $78,571 $70,000 $50,000
= $56,122. This results in an additional
depreciation expense of $857 ($8,571
divided by the revised projected remaining
life of 10 years), which is already incorpo-

EXHIBIT 2
Statement of Income, Prepared under U.S. GAAP

JCL Inc.: Statement of Income

Year Ended December 31, 2012
(Amounts in Thousands of Dollars)
Sales

450,000

Cost of Goods Sold

375,000

Gross Profit

75,000

SG&A Expenses

47,000

Earnings before Interest and Taxes

28,000

Interest Expense
Income Before Tax
Tax Expense (at 25 %)

24

4,000
24,000
6,000

Income from Continuing Operations (before Extraordinary Item)

18,000

Extraordinary Item: Loss from Hurricane (Net of $1,000 Income Tax)

(3,000)

Net Income

15,000

rated into the year-end revaluation adjustment. The worksheet adjustment is as follows:
(6a)
Dr. PP&E
14,693
Cr. Accumulated depreciation 6,122
Cr. Revaluation surplus
Comprehensive income
8,571
Under the second approach, the worksheet adjustments to eliminate accumulated depreciation and revalue the carrying
amount of PP&E are as follows:
(6b)
Dr. Accumulated depreciation 50,000
Cr. PP&E
50,000
Dr. PP&E
8,571
Cr. Revaluation surplusOCI 8,571
Assume that JCL chooses to use the first
approach for its IFRS-basis financial
reporting. Two other aspects of accounting
for long-lived assets under IFRS are also
important to understand, although not pertinent to the present illustrative example.
Component depreciation. Under IFRS,
each constituent part of an item of PP&E
that is material with respect to the total cost
of the asset must be depreciated separatelya process known as component depreciation. Consequently, if warranted by the
facts, an asset may be considered to have
multiple parts (e.g., a roof and heating plant
distinct from the building itself), with each
part depreciated over its appropriate estimated useful life. For example, consider a
new truck purchased by a company for
$55,000 that has $10,000 in tires ($2,500
per tire). The truck ($45,000) will have a
10-year life, but the tires ($10,000) will
have a three-year life, with no residual
value. In this example, annual depreciation
under IFRS would be $7,833 ([$45,000
10)] + [$10,000 3]). Although this
approach is permitted under U.S. GAAP,
it is rarely used in practice, and instead
depreciation of $5,500 ($55,000 10)
would generally be recognized. This
detail has been omitted from this case
study, inasmuch as there is insufficient
information to make such judgments.
Impairments. When determining whether
an item of PP&E is impaired, an entity
applies IAS 36, Impairment of Assets, to
ensure that such assets are not carried at more
than their recoverable amounts. The recoverable amount is the greater of the fair
value less disposal costs, or the value-inuse (the discounted net present value of
JANUARY 2014 / THE CPA JOURNAL

expected future cash flows from the asset).

An impairment loss is recognized in profit
or loss if an assets carrying value is more
than its recoverable amount.
In general, an impairment loss can be
reversed under IFRScontrary to U.S.
GAAP (ASC 360-10)when the facts and
circumstances warrant doing so, but this
action is limited to an increase to what
the carrying amount of the asset that would
have been, net of depreciation, if the
impairment had not been recognized for
the asset in prior years. This limitation on

the reversal of impairment losses does not

apply if the asset is carried under the revaluation model. In those cases, the full
impairment reversal to fair value is
accounted for as a revaluation increase.
There is no prior impairment in this case
study that needs to be reversed in the current period.
Impairment of intangibles other than
goodwill. Using U.S. GAAP (ASC 35030-35), intangibles other than goodwill (i.e.,
patents) are tested whenever impairment
indicators exist. Under IFRS (IAS 36),

the existence of impairment indicators must

be assessed annually. If appropriate, a
loss may be reversed up to the newly
estimated recoverable amount, but it may
not exceed the initial carrying amount
(adjusted for amortization) that would have
already been recognized. This amount is
recorded in income. Under U.S. GAAP,
the reversal of impairment losses is prohibited for all intangible assets. In the transition to IFRS, JCLs patent was tested
for possible impairment, and no such evidence was detected.

EXHIBIT 3
Statement of Financial Position, IFRS Basis

JCL Inc.: Statement of Financial Position

as of December 31, 2012
(Amounts in Thousands of Dollars)
ASSETS
Current Assets
Cash
Accounts receivable
Inventory (FIFO basis)
Total Current Assets

33,000
47,000
67,000
147,000

LIABILITIES AND SHAREHOLDERS EQUITY

Current Liabilities
Accounts payable
40,000
Accrued expenses
28,000
Lease obligation
2,143
Taxes payable
15,000
Total Current Liabilities

Investments (Available for Sale)

Property, Plant, and Equipment
Assets (at cost)
Less: accumulated depreciation
Leased assets
Less: accumulated depreciation

Intangible Assets
Trade name
Patent (net of 3,000
accumulated amortization)
Development costs (net of 200
accumulated amortization)
Goodwill

Total Assets

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85,143

20,000

134,693
(56,122)
6,443
(2,148)

78,571

Deferred income tax liability

Noncurrent Liabilities
Lease obligation
Bonds payable 6%, convertible
Total Liabilities

2,315
43,205

45,520
132,413

4,295

4,000
6,000

Shareholders Equity
Common stock ($1 par)

1,800

Additional paid-in capital

conversion feature
Accumulated other
comprehensive income
Revaluation surplus
Retained earnings
Total Liabilities and
Shareholders Equity

5,000

1,750

16,800

266,666

60,000
6,795
2,200
8,571
56,687

134,253
266,666

25

Goodwill impairment. Under U.S.

GAAP (ASC 350-20-35), impairment testing for goodwill is determined at the level
of a reporting unit (RU). Using IFRS (IAS
16), goodwill is tested for impairment at
the level of a cash-generating unit (CGU)
or a group of CGUs, which may differ
from RU. Under both U.S. GAAP and
IFRS, a goodwill impairment loss, once
recognized, cannot be reversed in a subsequent period.
Financial instruments. Under U.S.
GAAP, the income or loss attributed to
changes in the fair value of AFS securities (ASC 320-10) is part of comprehensive income in its entirety (except to the
extent that the AFS security is designated
as being in a fair value hedge arrangement,
in which case changes in fair value are recognized in income). Under IFRS, however, a foreign currency exchange gain or loss
component of the change experienced in
the fair value of financial instruments

attributable to the selection of a different

functional currency (as described by IAS
21, The Effects of Changes in Foreign
Exchange Rates) is considered part of profit or loss to be reported in the income statement. Thus, the worksheet adjustment for
the transition to IFRS is as follows:
(7)
Dr. Accumulated OCI
2,800
Cr. Currency exchange
rate gain
2,800
No reporting of extraordinary items
under IFRS. Unlike U.S. GAAP, which
permits separate classifications of an
extraordinary item on the income statement
as a separate caption below the operating
income (loss) section, IAS 1, Presentation
of Financial Statements, prohibits a separate presentation of extraordinary gains or
losses in the statement of profit or loss and
OCI (i.e., the statement of comprehensive
income under U.S. GAAP). Consequently,
this item must be included in the operat-

EXHIBIT 4
Statement of Comprehensive Income, IFRS Basis

JCL Inc.: Statement of Income

Year Ended December 31, 2012
(Amounts in Thousands of Dollars)
Sales
Cost of Goods Sold
Gross Profit
Contingency Loss
Unusual LossHurricane Damages
Currency (Gains)
Other SG&A Expenses
Earnings before Interest and Taxes
Interest Expense
Income Before Tax
Tax Expense
Net Income
Other Comprehensive Income:
Revaluation Surplus
Gain on Financial Instruments
Total Comprehensive Income

26

450,000
372,648
77,352
3,000
4,000
(2,800)
45,200
49,400
27,952
4,515
23,437
(5,500)
17,937
8,571
2,200
28,708

ing income (loss) section of the income

statement. IFRS, however, requires the separate disclosure of any item that materially impacts the financial statements. Unusual
and infrequent items that are material meet
this definition. Such items may be reported as a separate component of continuing
operations and denoted as unusual, nonrecurring, or some similar term (but not
extraordinary).
The gross amount of JCLs hurricane
loss is $3,000, net of tax ($4,000 before
the 25% tax rate). The worksheet reclassification adjustment is as follows:
(8)
Dr. Hurricane lossunusual
operating item
4,000
Cr. Extraordinary hurricane loss 3,000
Cr. Tax expensecurrent*
1,000
*The tax benefit would exist with an
ordinary loss as well, but it is achieved
through lower income before tax.
Loss contingencies. Both U.S. GAAP
and IFRS require that loss contingencies
be recognized when a future economic outflow is probable; however, this definition
of probable differs significantly between
the two frameworks. U.S. GAAP defines
probable as likely (this has been generally interpreted as greater than a 70%
chance of occurring). Under IAS 37,
Provisions, Contingent Liabilities, and
Contingent Assets, probable is defined as
more likely than not. (This has been
defined as a more than a 50% chance of
occurring; see Ernst & Young Academic
Resource Center: Current Liabilities and
Contingencies, Lecture notes, 2012, p. 5.)
Consequently, IFRS has a lower recognition threshold for loss contingencies than
U.S. GAAP.
In JCLs case, the loss is recorded only
under IFRS. The worksheet adjustment is
as follows:
(9)
Dr. Contingency loss
3,000
Cr. Contingency liability payable 3,000
Neither U.S. GAAP nor IAS 37 recognizes contingent gains until the date when
recovery is virtually certain. As such, no
contingency gain was realized in the current illustrative case for the U.S. GAAP
financial statements; in addition, none is
recognized for IFRS reporting purposes.
Compound financial instruments. From
the issuers perspective, a convertible bond
typically consists of a liability component
JANUARY 2014 / THE CPA JOURNAL

(a contractual obligation to deliver cash

or other financial asset) and an equity
instrument (the holders option [i.e., a call
option] to convert the bond into a fixed
number of common shares within a specified period of time). The principle of
substance over legal form is applied to
compound financial instruments under IAS
32, Financial Instruments: Presentation.
Thus, the component parts are accounted
for and presented separately according to
their substance, based on the definitions of
liability and equity (referred to as split
accounting). The split is made when the
instruments are issued, and is not revised
for subsequent changes in share prices,
market interest rates, or other factors that
might affect the likelihood that the conversion option will be exercised.
When splitting the initial carrying
amount of a compound financial instrument into its equity and liability components, the equity component is the residual amount; that is, it is equal to the fair
value of the instrument as a whole, less the
fair value of the liability component.
Therefore, the issuer of a bond convertible into common shares first measures the
liability component at the fair value of a
similar liability that does not have an equity component, and the carrying amount of
an equity instrument is then calculated as
the difference between the fair value of a
financial instrument as a whole and the fair
value of the liability.
JCL issued bonds carrying a 6% coupon
and a conversion feature at par. Based on
an expert appraisal of JCLs creditworthiness at the date the bonds were first
issued and market rates of interest prevailing at that date for similarly risky
issuers, it is determined that these bonds
would have commanded a 8% yield absent
the conversion feature. If bonds carrying
a 6% coupon were priced to yield 8%,
the JCL bonds would have brought proceeds of only $43,205. To comply with
IFRS, therefore, JCL must restate the liability for bonds payable to reflect their
intrinsic value, without the conversion feature, and allocate the additional proceeds
to an equity account. The discount on the
bonds will be amortized, per the usual
effective yield method, over their term.
If the bonds are paid off at maturity, the
amount originally allocated to the conversion feature will remain in paid-in capital in
JANUARY 2014 / THE CPA JOURNAL

the equity section of the statement of financial position. If the bond conversion feature
is exercised, the carrying value of the
bonds at the date of exercise (i.e., taking into
account the amortized portion of the discount) will be moved to paid-in-capital, also.
The worksheet adjustment is as follows:
(10)
Dr. Bonds payablediscount 6,795
Cr. Equityconversion feature 6,795
Note that this bond discount of $6,795
will be accreted as additional interest
expense over the life of the bonds. If the
bondholder does not exercise the option,
the bonds will be redeemed for cash, at
full-face (par) value. If the conversion
feature is not exercised, the amount allocated to paid-in-capital will remain as an
additional paid-in capital account associated with the forfeited conversion privilege.

Leases. In accordance with U.S.

GAAP (ASC 840-10), if the lessee meets
any of the four tests indicated below, the
transaction must be accounted for as a capital lease. If none of the conditions are
satisfied, it will be classified as an operating lease.
n Test 1Lease term is equal to or greater
than 75% of the economic life of the asset.
Given the facts of this case, 36 months
50 months = 72%; therefore, the 75%
threshold is not met.
n Test 2Transfer of title to lessee. Not
met in this case.
n Test 3Bargain purchase option. Not
met; in this case, the transfer option is at
market value, not bargain value.
n Test 4Present value of the minimum
lease payments is equal or greater than
90% of the assets fair market value, using

EXHIBIT 5
Differences in Cash Flows

Account

U.S. GAAP

IFRS

Differences Between U.S. GAAP and IFRS Cash Flow Presentations

Interest income
Interest expense
Dividend income
Cash dividends paid

CFO
(CFO)
CFO
(CFF)

CFO or CFI
(CFO) or (CFF)
CFO or CFI
(CFO) or (CFF)

No Changes in Cash Flows, but Reclassifications for Cash Flow Presentations

Development costs
Lease payments

Expense (CFO)
If operating (CFO)

Option embedded liabilities

Issuance of debt (CFF)

When capitalized (CFI)

If financing, (CFF)
for principal
Issuance of debt and
option for conversion
(CFF)

No Effect on Cash Flows

Revaluation of assets
Asset impairment losses
Reversal of impairment losses
Added depreciation and amortization from revalued assets
Reduced depreciation and amortization from impaired assets
Contingent losses accrued but unpaid
Unrealized gains and losses on marketable securities
Split accounting reclassification from liability to equity for compound instruments issued
Notes: CFO = cash flows from operations; CFI = cash flows from investing;
CFF = cash flows from financing. Cash payments noted by parentheses.

27

the lessees incremental borrowing rate as

the discount factor or the implicit rate of
the lease, if it is lower and is known to
the lessee. In this case, the minimum
lease payments are $2,500, discounted as
an ordinary annuity over 3 years at the 8%
interest rate (the implicit rate is not
known by the lessee, so its incremental borrowing rate, discussed previously, is used),
which yields a value of $6,443. This is
slightly lower (85.9%), than 90% of the
assets $7,500 value. Thus, Test 4 is also
not met.
The facts support the conclusion that this
is an operating lease (i.e., an offbalance
sheet transaction), and lease payments
should be accounted for as rent which,
given the nature of the equipment, will
probably be included in manufacturing
costs, and thus in the cost of sales and in
inventory, depending upon the extent to
which the final sale of the goods produced has occurred. For the sake of simplicity, it is assumed that the gross rental
expense, amounting to $2,500, was included in cost of goods sold in the U.S. GAAP
financial statements, with no allocation to
inventory, and for the sake of consistency, the non-interest (i.e., depreciation) portion of periodic lease expense will also be
fully assigned to the cost of goods sold in
the IFRS financial statements.
Under IAS 17, Leases, more general criteria based on the substance of the lease are
used to determine whether a lease is a capital/finance lease. If the lessee assumes the
substantial economic benefits and the risks
associated with the leased asset, then the

transaction is treated as a capital/finance lease.

Specifically, because this machine is specialized for JCLs use, it is likely that JCL
will elect to either purchase the asset or
extend the lease when the three-year term is
completed. In addition, because many of the
tests under GAAP are nearly met, there are
strong indications that a capital/finance classification is warranted, rather than an operating lease classification. Presumably, JCL
would be able to circumvent the capital lease
rules under U.S. GAAP by making arguable
and favorable assumptions and estimates,
such as the 50-month useful life of the leased
assetsbut the more principles-based IFRS
requirement would seemingly preclude this
result.
If classified as a capital/finance lease,
the lease is amortized as shown in the sidebar, Amortization Table.
The worksheet adjustments to reclassify this as a financing lease under IFRS
are as follows:
(11)
Dr. Leased asset
6,443
Cr. Minimum lease obligation 6,443
(12)
Dr. Depreciation expense 2,148
Cr. Accumulated depreciation 2,148
(13)
Dr. Interest expense
515
Dr. Minimum lease obligation 1,985
Cr. Rent expense/
manufacturing costs
2,500
The balance of the minimum lease
obligation at the year-end is $4,458 ($6,443
less $1,985); of this total obligation, $2,143
is current and $2,315 is long term.

AMORTIZATION TABLE

Date
Jan. 1, 2012
Dec. 31, 2012
Dec. 31, 2013
Dec. 31, 2014
Totals

28

Payment

Interest (8%)

Principal

$2,500
2,500
2,500
$7,500

$515
357
185
$817

$1,985
2,143
2,315
$6,443

Minimum Lease
Obligation Balance
(Present Value)
$6,443
4,458
2,315
0

IFRS Basis

Given the above adjustments, JCLs

IFRS-compliant statement of financial position as of December 31, 2012, and the
income statement for the year then ended
are show in Exhibit 3 and Exhibit 4. Note
that this case study employs the combined statement of income and comprehensive income approach, with a functional
classification of expenses. Alternatively,
separate statements of income and of comprehensive income could be provided,
and expenses could be classified by their
nature rather than function.

Impact on Cash Flows

The different treatments noted above in

the discussion of the statements of financial position and the income statements will
necessarily lead to differing statements of
cash flows. With regard to the cash flow,
there are several differences between U.S.
GAAP and IFRS. Exhibit 5 presents the
following differences:
n Classification of cash flows (only)
between IFRS and U.S. GAAP;
n Items connoting no change in cash
flows, but reclassifications resulting from
IFRSU.S. GAAP accounting differences;
n IFRSU.S. GAAP differences that have
no effect on cash flows or presentation; and
n Cash flow changes created by
IFRSU.S. GAAP differences.

Effect of Tax Obligations

The final category of differential

treatment under U.S. GAAP and IFRS
pertains to those situations where the disparity in accounting has consequential
effects, most typically in the form of
higher or lower tax obligations. This is
illustrated by the disallowance of the
LIFO inventory costing method under
IFRS, which has corresponding implications for tax payments due currently. In
the general case of rising prices, an entitys gross profits will be higher under
IFRS (versus using LIFO under U.S.
GAAP), resulting in higher cash tax payments. If FIFO is used, the added tax payment will equal the difference in the
LIFO reserve created during the year
(meaning a higher pre-tax income),
multiplied by the tax rate. In the case of
JCL, the added cash tax payment will
be $500 ($2,000 .25).
JANUARY 2014 / THE CPA JOURNAL

Effects on Financial Ratios

Any changes made to the statement

of financial position and income statement will inevitably affect some of the
ratios commonly used by analysts,
lenders, and even management. The
direction of the changes will depend on
many factors, some of which are very situation-specific. The following changes
would be experienced by JCL when converting to IFRS (effects that would
commonly be perceived to be improvements are shown in bold):
U.S.
Ratio
GAAP
IFRS
Current ratio
1.75
1.73
Debt ratio
.53
.497
Debt to equity
1.13
.99
Times interest earned
7.0
6.19
Inventory turnover
6.25
5.56
Return on assets
6.12%
6.73%
Gross profit
16.67% 17.20%
Net profit margin
3.33%
3.99%
Asset turnover
1.838
1.688
Leverage ratio
2.13
1.99
Return on equity
13.04% 13.36%
Although the effects are modest, it is
important to appreciate the fact that some
mandatory changes when adopting IFRS will
have impacts on the financial ratios that
many third parties (i.e., investors and lenders)
rely upon to make credit or investing decisions. Some of the expected impacts flow
directly, and intuitively, from the different
requirements imposed by IFRS.
For example, under IFRS, inventory and
earnings will be greater than under U.S.
GAAP if LIFO is employed by the
reporting entity. In addition, because of
IFRS rules pertaining to the capitalization
of development expenses, assets and
earnings will tend to be enhanced, at least
in the years when those costs are being
incurred (which then must be amortized in
future years, lowering earnings, holding
other factors constant).
If a reporting entity avails itself of the
option to revalue long-lived assets, this will
also enhance the statement of financial
position, and accordingly improve certain
financial ratios. Nevertheless, financial
statement users are alert to these effects,
particularly in the case of items, such as
revaluations, that have no current or future
salutary effects on cash flows.
Some critics might say that, given the
somewhat greater accounting flexibility it

JANUARY 2014 / THE CPA JOURNAL

provides, IFRS presents more prospects for

earnings management and income volatility. This possibility is constrained, if not
fully eliminated, by the need for consistent
application of chosen accounting principles, which is as much an imperative under
IFRS as it is under U.S. GAAP.

Limitations

The above case study ignores the fact

that entities adopting IFRS must follow the
requirements set out in IFRS 1. In accordance with IFRS 1, entities initially
adopting IFRS must present at least one
year of comparative information, disclosing all applicable exemptions, explanations
of the transition, IAS 36 disclosures for
impairments identified during the transition, and historical summaries under previous GAAP. In principle, IFRS 1 stipulates that an entity should apply the current
version of IFRS for all periods presented
in its first set of IFRS financial statements,
as well as in its opening IFRS statement
of financial position (at the beginning of
the earliest period presented), without considering superseded or amended versions.
Thus, IFRS 1 requires retrospective
application of the standards effective as
of the reporting date of an entitys first
IFRS-compliant financial statements. But
IFRS 1 prohibits retrospective application
of some aspects of other standards
(mandatory exceptions), and permits
elective exemptions from some requirements of other standards (optional exemptions). An entity will thus have choices
between different options of accounting
policies within IFRS 1, as well as within
other standards, that must be resolved when
preparing its first IFRS financial statements.

sion is critical for U.S. preparers and

users of financial information, as most nonU.S. countries, as well as many foreigndomiciled subsidiaries of U.S. entities,
require its use. In todays ever continuing
expanding global economy, it is highly
likely that CPAs will undertake engagements that require IFRS knowledge.
Equally important is the need for future
CPAs to obtain a solid understanding of
IFRS during their education. The above
case study is intended to help further
these goals.
q
Peter Harris, CPA, CFA, is a professor at
the New York Institute of Technology, New
York, N.Y. Eva K. Jermakowicz, PhD,
CPA, is a professor and head of the
department of accounting at Tennessee
State University, Nashville, Tenn. Barry
Jay Epstein, PhD, CPA/CFF, is a principal at Cendrowski Corporate Advisors
LLC, Chicago, Ill.

Conclusion

Consequent to the SEC report issued in

July 2012, it seems unlikely that full-scale
adoption of IFRS in the United States
will occur in the foreseeable future (see
Work Plan for the Consideration of
Incorporating International Financial
Reporting Standards into the Financial
Reporting System for U.S. Issuers, and
the IASBs response in IFRS Foundation
Staff Analysis of the SEC Final Staff
ReportWork Plan for the consideration
of incorporating IFRS into the financial
reporting system for U.S. issuers, October
2012). Nevertheless, IFRS comprehen-

29