International Financial Reporting Standards Essay
In the United States, the Financial Accounting Standards Board (FASB) has been the organization that establishes standards that govern the preparation of financial statements, known as the United States Generally Accepted Accounting Principals (US GAAP). Many countries have established their own national accounting standards as well; however, as international business and trade increases, so does the need for a common set of accounting standards.In response to this need, the International Accounting Standards Board (IASB) was established with the purpose of developing a set of international accounting standards to increase the comparability of financial reporting globally.
These standards are known as the International Financial Reporting Standards (IFRS). Although US GAAP and IFRS are comparable in some aspects, there are also some contrasting aspects.Under IFRS, the International Accounting Standard 2 (IAS 2) governs the accounting treatment for inventories. IAS 2 “provides guidance on the determination of the cost and subsequent recognition of expense (including write-down of inventory to its net realizable value).
The Standard also provides guidance on the cost flow assumptions (“cost formulas”) that are to be used in assigning costs to inventories” (Mirza, Orrell and Holt). In addition, IAS 2 provides guidance on write-down reversals.IAS 2 applies to all inventories except work in process under construction contracts and work in process directly related to service contracts, which are governed by IAS 11, Construction Contracts; financial instruments, which are covered by IAS 32, Financial Instruments: Presentation; and biological assets related to agricultural activity and agricultural produce at the point of harvest, which are covered by IAS 41, Agriculture. According to IAS 2, the measure of the value of inventories is the lower of cost or net realizable value.Net realizable value “is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale” (iasb.
org website). On the other hand, US GAAP measures the value of inventories at lower of cost price or current market value; however, in rare instances, fair value in excess of cost is allowed. Also, US GAAP does not have special rules regarding biological inventory, unlike IFRS.IAS 2 does not apply to the measurement of inventories that are “held by producers of agriculture and forest products, agricultural produce after harvest, and minerals and minerals products, to the extent that they are measured at net realizable value in accordance with best practices within those industries” (Mirza, Orrell and Holt). When the above mentioned inventories are measured at their net realizable value, any changes in value are then recognized in the profit or loss in the period in which the change occurred.
Also, IAS 2 does not apply to the measurement of inventories that are “held by commodity brokers-traders who measure their inventories at fair value less cost to sell” (Mirza, Orrell and Holt). Again, any changes in value are recognized as profit or loss in the period of change. When it comes to accounting for inventories, the main concern is the amount of cost to be recognized as an asset.A company determines inventory cost under IFRS according to IAS 2; the cost is comprised of all costs of purchase, costs of conversion, and other costs that are “incurred in bringing the inventories to their present location and condition” (Mirza, Orrell and Holt). The cost of inventories under US GAAP is expressed vaguely, stating cost is “the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location” (Epstein, Nach and Bragg).The language, concerning inventory costs, used in the Wiley IFRS Guide is more explicit than the language used in the Wiley GAAP Guide.
Furthermore, the Wiley GAAP Guide states that “this definition allows for a wide interpretation of the costs to be included in inventory” (Epstein, Nach and Bragg). According to IFRS, the costs of purchase include the purchase price of the inventory, the costs of import duties, transportation costs, and any handling costs that are directly related to the acquisition of the inventories.Amounts that are deducted for costs of purchase include trade discounts and rebates that pertain to the inventories. The costs of conversion are any and all costs that are directly attributable to the units of production. This includes the costs of raw material, direct labor, fixed overhead, and variable costs. Other costs include those that are incurred in bringing the inventories to a present location and condition, transportation costs and designing costs for a specific inventory.
Costs that are excluded when determining the cost of inventory include any abnormal amounts of wasted labor, materials, or other production costs, storage costs (except when storage is an essential step in the production process), selling costs, and administrative costs that are not directly attributable to inventories. Once the cost of inventory is determined, a company must select a cost flow method or formula. The allowable cost methods for IFRS are FIFO (first-in, first-out) and weighted-average cost. US GAAP allows FIFO and weighted-average cost methods, as well as LIFO (last-in, first-out).Additionally, both IFRS and US GAAP allow the specific identification cost method when inventories are easily distinguishable.
This would be more common with customized or unique inventories. Both IFRS and US GAAP suggest that when inventories are similar in nature and use, the cost method used should be consistent; however, when inventories are not similar in nature and use, different cost methods are acceptable. When inventories are damaged, become obsolete, or have a decline in selling price, there is a need to write-down the value of the inventories. Writing-down is allowable by IFRS and US GAAP, but is required under IFRS.
According to IAS 2, inventories should not be carried in excess of amounts that are likely to be realized at the sale point or time of use. At year end, inventories are written-down to net realizable value. This is done on an item-by-item basis; it is recommended, under IAS 2, that it is not appropriate to write-down inventories on a classification basis or based on a geographical segment or industry. Unlike US GAAP, IFRS permits and requires a reversal of write-downs when appropriate. Net realizable value is estimated through reliable evidence of realizable amounts of inventories.
Once a write-down is made, the net realizable values of the inventories are assessed in each consecutive period. If there is an increase the net realizable value, an earlier write-down reversal is required by IAS 2 in order to make the new carrying amount equal to the lower of cost or the revised net realizable value. The amount of any write-down of inventory is recognized as a period expense; however, the amount of any reversal of a write-down of inventory must be a reduction to any amount written off in the period in which it was reversed.Disclosures of inventories in the financial statements are required by IFRS and US GAAP; however, there are differences. The major difference is the statement of write-down reversals.
Since US GAAP does not permit reversals of earlier write-downs, there is no requirement to disclose this information in US GAAP presented financial statements. IFRS presented financial statement disclosures regarding write-down reversals include a statement of the circumstances that required a reversal of an earlier write-down and the amount of any write-down reversal.In addition, IFRS equires disclosure of the carrying amount of any inventories that are carried at fair value less costs to sell; this is not a US GAAP required disclosure. US GAAP requires some unique disclosures as well.
A company presenting financial statements according to US GAAP must disclose of inventory accounting principals that are peculiar to a particular industry, product financing arrangements, accrued net losses on firm purchase commitments, amount of revenue and costs associated with inventory exchanges recognized at fair value, and of course liquidation of LIFO inventories and effects on income.Currently, the main issue concerning US companies converging to IFRS is the LIFO cost method. Under US GAAP, companies are allowed to use the LIFO cost method for tax purposes, as long as the company uses the LIFO cost method for financial reporting purposes. Of course, using the LIFO cost method for tax purposes is beneficial because it portrays a lower net income than if the company were to use the FIFO or the weighted average cost methods.
Since IFRS does not allow the LIFO cost method, companies would not be permitted to use the LIFO method for US tax purposes.It seems that the quickest way for the US to agree upon this issue is if there was new tax legislation that continued to allow the use of LIFO, regardless of the cost method used for financial reporting. One reason that US companies want to avoid converging with IFRS is the instant tax impact that would occur in the first year, if the company was currently using LIFO. Switching from LIFO to FIFO or even to weighted-average cost methods, creates an increase in net income, which results in a higher income tax.No company wants an increase in income tax, but if US companies want to remain competitive in an international market, they need to consider benefits instead of just the detriment.
Converting to IFRS has pros and cons. If a company decides to convert to IFRS, the goal of raising capital abroad may be more attainable due to foreign investors being able to compare financial statements that have common accounting standards. The investor will have more confidence in making an investing decision. In turn, this may lead to an overall greater increase in foreign direct investment.
Also, companies that have foreign subsidiaries or that are foreign subsidiaries that already present financial statements under IFRS will be able to present the entire company in one common presentation. In contrast, converting to IFRS may not lessen complications because other regulators and authorities may still require presented financial statements under US GAAP. Some companies have no present incentive to convert to IFRS; however, there are no certainties that incentives will not exist in the future. Overall, IFRS and US GAAP have more commonalities than dissimilarities.
One major difference is the allowance of LIFO under US GAAP but the disallowance of LIFO under IFRS. Another major difference is the reversal of inventory write-downs that are required by IFRS, but not permitted by US GAAP. The difference also has an impact on net income and can be viewed negatively, although it doesn’t seem to have as much attention in the media. Because convergence is inevitable, companies should begin to educate themselves and possibly begin the process in order to understand the full impact. Based on the impact, companies can establish a strategy that will allow the company to remain profitable.