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Chapter Four

International FinancialReporting StandardsLearning Objectives

After reading this chapter, you should be able to

• Describe the requirements of International Financial Reporting Standards (IFRSs)on the recognition and measurement of assets.

• Explain the differences between IFRSs and U.S. generally accepted accountingprinciples (GAAP) on recognition and measurement issues.

• Describe the requirements of IFRSs related to the disclosure of financial information.

• Explain the difference between IFRSs and U.S. GAAP on disclosure issues.

• Use numerical examples to highlight the differences between IFRSs and U.S. GAAP.

INTRODUCTION

As noted in Chapter 3, International Financial Reporting Standards (IFRSs) havebeen adopted as generally accepted accounting principles (GAAP) for listed com-panies in a number of countries around the world and are accepted for cross-listing purposes by most major stock exchanges.1 Increasingly, accountants arebeing called on to prepare and audit, and users are finding it necessary to read andanalyze, IFRS-based financial statements. This chapter describes and demon-strates the requirements of selected IASB standards, particularly those relating tothe recognition and measurement of assets, through numerical examples. IFRSsthat deal exclusively with disclosure issues also are briefly summarized. Theappendix to this chapter includes IFRSs related to the measurement and recogni-tion of liabilities, revenues, financial instruments, and other issues.

The International Accounting Standards Committee (IASC) issued a total of 41International Accounting Standards (IASs) during the period 1973–2001. Ten ofthese standards have been superseded or withdrawn. Most of the 31 remainingstandards have been revised one or more times.2 Since 2001, the IASB has issued

1 The term International Financial Reporting Standards (IFRSs) describes the body of authoritativepronouncements issued or adopted by the IASB. IFRSs consist of International Accounting Standardsissued by the IASC (and adopted by the IASB), International Financial Reporting Standards issued by theIASB, and interpretations developed by IFRIC or the former SIC.2 In December 2003, 13 IASs were revised as part of the IASB’s Improvements to International AccountingStandards (London: IASB, 2003); and IAS 36, Impairment of Assets, and IAS 38, Intangible Assets, wererevised in March 2004 in conjunction with the issuance of IFRS 3, Business Combinations.

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six International Financial Reporting Standards (IFRSs). Exhibit 3.2 in Chapter 3provides a list of IASs and IFRSs issued by the IASB as of March 2005.

In September 2002, the IASB and the U.S. Financial Accounting StandardsBoard (FASB) agreed to work together to reduce differences between IFRSs andU.S. GAAP. The goal of this so-called Norwalk Agreement is to make the two setsof existing standards compatible as soon as possible and to coordinate future pro-jects to ensure that, once achieved, compatibility is maintained. In this chapter, indescribing the guidance provided by IFRSs, we make comparisons with U.S.GAAP to indicate the differences and similarities between the two sets of stan-dards.3 In this way we can begin to appreciate the impact a choice between the twosets of standards has on financial statements.

TYPES OF DIFFERENCES BETWEEN IFRSs AND U.S. GAAP

The FASB has identified numerous differences between IFRSs and U.S. GAAP.4

The types of differences that exist can be classified as follows:

• Definition differences. Differences in definitions exist even though conceptsare similar. Definition differences can lead to recognition or measurementdifferences.

• Recognition differences. Differences in recognition criteria and/or guidance arerelated to (1) whether an item is recognized or not, (2) how it is recognized,and/or (3) when it is recognized (timing difference).

• Measurement differences. Differences in approach for determining the amount rec-ognized result from either (1) a difference in the method required or (2) a differ-ence in the detailed guidance for applying a similar method.

• Alternatives. One set of standards allows a choice between two or more alterna-tive methods; the other set of standards requires one specific method to be used.

• Lack of requirements or guidance. IFRSs may not cover an issue addressed by U.S.GAAP, and vice versa.

• Presentation differences. Differences exist in the presentation of items in the fi-nancial statements.

• Disclosure differences. Differences in information presented in the notes to finan-cial statements are related to (1) whether a disclosure is required or not, and(2) the manner in which disclosures are required to be made.

In many cases, IFRSs are more flexible than U.S. GAAP. Several IASs allowfirms to choose between a “benchmark treatment” and an “allowed alternativetreatment” in accounting for a particular item. Also, IFRSs generally have lessbright-line guidance than U.S. GAAP; therefore, more judgment is required in ap-plying IFRSs. IFRSs are said to constitute a principles-based accounting system(broad principles with limited detailed rules), whereas U.S. GAAP is a rules-basedsystem.5 However, in some cases, IFRSs are more detailed than U.S. GAAP.

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3 It is worth noting that both IFRSs and U.S. GAAP are moving targets, constantly changing. This chapterdescribes IFRSs and makes comparisons with U.S. GAAP as of March 2005.4 Financial Accounting Standards Board, The IASC-U.S. Comparison Project, 2nd ed. (Norwalk, CT: FASB,1999).5 In response to several accounting scandals, including those at Enron and Worldcom, the Sarbanes-OxleyAct passed by the U.S. Congress in 2002 requires the FASB to investigate the desirability of U.S. GAAPshifting to a principles-based approach.

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RECOGNITION AND MEASUREMENT STANDARDSIAS 2, InventoriesIAS 2, Inventories, is an example of an International Accounting Standard that pro-vides more extensive guidance than U.S. GAAP, especially with regard to invento-ries of service providers and disclosures related to inventories. The cost of inventoryincludes all costs of purchase, costs of conversion, and an allocation of productionoverhead (variable and fixed). IAS 2 specifically allows capitalization of interestfor those inventories that “require a substantial period of time to bring them to asaleable condition.”

IAS 2 does not allow as much choice with regard to cost flow assumption asdoes U.S. GAAP. First in, first out (FIFO) and weighted-average cost are acceptabletreatments under IAS 2, but last in, first out (LIFO) is not. The standard costmethod and retail method also are acceptable provided that they approximate costas defined in IAS 2.

Lower of Cost or Net Realizable ValueIAS 2 requires inventory to be reported on the balance sheet at the lower of cost ornet realizable value. Net realizable value is defined as “estimated selling price in theordinary course of business less the estimated costs of completion and the esti-mated costs necessary to make the sale.” This rule may be applied item by item orto pools of items. Write-downs to net realizable value must be reversed when theselling price increases.

U.S. GAAP requires inventory to be reported at the lower of cost or replacementcost with a ceiling (net realizable value) and a floor (net realizable value less normalprofit margin). The two sets of standards will provide similar results only when re-placement cost is greater than net realizable value. Under U.S. GAAP, write-downsto market may not be reversed if replacement costs should subsequently increase.

Example: Application of Lower of Cost or Net Realizable Value RuleAssume that Distributor Company Inc. has the following inventory item on handat December 31, Year 1:

International Financial Reporting Standards 119

Historical cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000.00Replacement cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800.00Estimated selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 880.00Estimated costs to complete and sell . . . . . . . . . . . . . . . . . . . . 50.00Net realizable value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 830.00Normal profit margin—15% . . . . . . . . . . . . . . . . . . . . . . . . . . 124.50Net realizable value less normal profit margin . . . . . . . . . . . . . $ 705.50

IFRSs Net realizable value is $830, which is lower than historical cost. Inventorymust be written down by $170 ($1,000 − $830).

The journal entry at December 31, Year 1, is:

Inventory loss $170

Inventory $170

To record the write-down on inventory due to decline in net realizable value.

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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U.S. GAAP Market is replacement cost of $800 (falls between $705.50 and $830),which is lower than historical cost. Inventory must be written down by $200($1,000 − $800).

The journal entry at December 31, Year 1, is:

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Inventory loss $200

Inventory $200

To record the write-down on inventory due to decline in market value.

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Inventory $100

Recovery of inventory loss (increase in income) $100

To record a recovery of inventory loss taken in the previous period.

. . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Assume that at the end of the first quarter in Year 2, replacement cost has in-creased to $900, the estimated selling price has increased to $980, and the esti-mated cost to complete and sell remains at $50. The item now has a net realizablevalue of $930.

IFRSs The net realizable value is $930, which is $100 greater than carrying value(and $70 less than historical cost. $100 of the write-down that was made atDecember 31, Year 1, is reversed through the following journal entry:

U.S. GAAP The new cost for the item is $800, which is less than the currentreplacement cost of $900. No adjustments are necessary.

In effect, under IFRSs, the historical cost of $1,000 is used in applying the lowerof cost or net realizable value rule over the entire period the inventory is held. Incontrast, under U.S. GAAP, the inventory write-down at the end of Year 1 estab-lishes a new cost used in subsequent periods in applying the lower of cost ormarket rule.

Over the period of time that inventory is held by a firm, the two sets of stan-dards result in the same amount of expenses (cost of goods sold plus any inven-tory loss). However, the amount of expense recognized in any given accountingperiod can differ between the two rules as can the amount at which inventory ismeasured on the balance sheet.

IAS 16, Property, Plant, and EquipmentIAS 16, Property, Plant, and Equipment, provides guidance for the following aspectsof accounting for fixed assets:

1. Recognition of initial costs of property, plant, and equipment.2. Recognition of subsequent costs.3. Measurement at initial recognition.4. Measurement after initial recognition.5. Depreciation.6. Derecognition (retirements and disposals).

Impairment of assets, including property, plant, and equipment, is covered by IAS 36,Impairment of Assets. Accounting for impairments is discussed later in this chapter.

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RecognitionRelying on the definition of an asset provided in the IASB’s Framework for thePreparation and Presentation of Financial Standards, both initial costs and subsequentcosts related to property, plant, and equipment should be recognized as an assetwhen (1) it is probable that future economic benefits will flow to the enterprise and(2) the cost can be measured reliably. Replacement of part of an asset should becapitalized if (1) and (2) are met, and the carrying amount of the replaced partshould be derecognized (removed from the accounts).

Depreciation and DerecognitionDepreciation is based on estimated useful lives, taking residual value into account.The depreciation method should reflect the pattern in which the asset’s futureeconomic benefits are expected to be consumed. The carrying value of an item ofproperty, plant, and equipment should be derecognized when it is retired or oth-erwise disposed of. Gains and loss on retirement and disposal of fixed assetsshould be recognized in income.

Measurement at Initial RecognitionProperty, plant, and equipment should be initially measured at cost, which in-cludes (1) purchase price, including import duties and taxes; (2) all costs directlyattributable in bringing the asset to the location and condition necessary for it toperform as intended; and (3) an estimate of the costs of dismantling and removingthe asset and restoring the site on which it is located.

An item of property, plant, and equipment acquired in exchange for a nonmon-etary asset or combination of monetary and nonmonetary assets should be initiallymeasured at fair value unless the exchange transaction lacks commercial sub-stance. Fair value is defined as the “amount for which an asset could be exchangedbetween knowledgeable, willing parties in an arm’s length transaction.”6 If the fairvalue of an asset acquired in a nonmonetary exchange cannot be determined, itscost is measured as the carrying value of the asset given up.

Measurement Subsequent to Initial RecognitionA substantive area of difference between IFRSs and U.S. GAAP relates to the mea-surement of property, plant, and equipment subsequent to initial recognition. IAS 16allows two treatments for reporting fixed assets on balance sheets subsequent totheir acquisition: the cost model (the benchmark treatment) and the revaluationmodel (the allowed alternative treatment).

Under the cost model, an item of property, plant, and equipment is carried onthe balance sheet at cost less accumulated depreciation and any accumulated im-pairment losses. This is consistent with U.S. GAAP.

Under the revaluation model, an item of property, plant, and equipment is car-ried at a revalued amount, measured as fair value at the date of revaluation, lessany subsequent accumulated depreciation and any accumulated impairmentlosses. If an enterprise chooses to follow this measurement model, revaluationsmust be made often enough that the carrying amount of assets does not differ ma-terially from the assets’ fair value. When revaluations are made, an entire class ofproperty, plant, and equipment must be revalued. Revaluation increases are cred-ited directly to equity as a revaluation surplus; revaluation decreases are recorded


6 IAS 16, paragraph 6.

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as an expense. The revaluation surplus may be transferred to retained earnings ondisposal of the asset. Revalued assets may be presented either (1) at a grossamount less a separately reported accumulated depreciation (both revalued) or(2) at a net amount. Allowing firms the option to revalue fixed assets is one of themost substantial differences between IFRSs and U.S. GAAP. Guidelines for apply-ing this option are presented in more detail in the following paragraphs.

Determination of Fair Value The basis of revaluation is the fair value of the assetat the date of revaluation. The definition in IAS 16 indicates that fair value is theamount at which an asset could be exchanged between knowledgeable, willingparties in an arm’s-length transaction. The fair value of land and buildings is usu-ally determined through appraisals conducted by professionally qualified valuers.The fair value of plant and equipment is also usually determined through appraisal.In the case of a specialized asset that is not normally sold, fair value may need tobe estimated using, for example, a depreciated replacement cost approach.

Frequency of Revaluation IAS 16 requires that revalued amounts should not dif-fer materially from fair values at the balance sheet date. The effect of this rule isthat, once an enterprise has opted for the fair value model, it has an obligation tokeep the valuations up to date. Although the IASB avoids mandating annual reval-uations, these will be necessary in some circumstances in order to comply with thestandard. In other cases, annual changes in fair value will be insignificant andrevaluation may be necessary only every several years.

Selection of Assets to Be Revalued IAS 16 requires that all assets of the sameclass be revalued at the same time. Selectivity within a class is not permitted, butselection of a class is. Following are examples of classes of assets described in thestandard:

• Land• Land and buildings• Machinery• Ships• Aircraft• Motor vehicles• Furniture and fixtures• Office equipment

Detailed disclosures are required for each class of property, plant, and equip-ment (whether revalued or not). Thus, if a company divides its assets into manyclasses to minimize the effect of the rule about revaluing a whole class of assets, itwill incur the burden of being required to make additional disclosures for each ofthose classes.

Accumulated Depreciation Two alternative treatments are described in IAS 16for the treatment of accumulated depreciation when an item of property, plant,and equipment is revalued:

1. Restate the accumulated depreciation proportionately with the change in thegross carrying amount of the asset, so that the carrying amount of the assetafter revaluation equals its revalued amount. The Standard comments thatthis method is often used where an asset is revalued by means of an indexand is the appropriate method for those companies using current costaccounting.

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2. Eliminate the accumulated depreciation against the gross carrying amount ofthe asset and restate the net amount to the revalued amount of the asset.

Example: Treatment of Accumulated Depreciation upon RevaluationAssume that Kiely Company Inc. has buildings that cost $1,000,000, have accumu-lated depreciation of $600,000, and a carrying amount of $400,000 on December 31,Year 1. On that date, Kiely Company determines that the market value for thesebuildings is $750,000. Kiely Company wishes to carry buildings on the December 31,Year 1, balance sheet at a revalued amount. Under treatment 1, Kiely Companywould restate both the buildings account and accumulated depreciation on build-ings such that the ratio of net carrying amount to gross carrying amount is 40 per-cent ($400,000/$1,000,000) and the net carrying amount is $750,000. To accomplishthis, the following journal entry would be made at December 31, Year 1:


Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $875,000

Accumulated depreciation—buildings . . . . . . . . . . . . . . . . . . . . . . . . . $525,000

Revaluation surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350,000

To revalue buildings and related accumulated depreciation

Accumulated depreciation—buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600,000

Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600,000

To eliminate accumulated depreciation on buildings to be revalued.

Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $350,000

Revaluation surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $350,000

To revalue buildings.

Under treatment 2, accumulated depreciation of $600,000 is first eliminatedagainst the buildings account and then the buildings account is increased by$350,000 to result in a net carrying amount of $750,000. The necessary journalentries are as follows:

As a result of making these two entries, the buildings account has a net carryingamount of $750,000 ($1,000,000 − 600,000 + 350,000). Under both treatments, bothassets and equity are increased by a net amount of $350,000.

Treatment of Revaluation Surpluses and Deficits On the first revaluation afterinitial recording, the treatment of increases and decreases in carrying amount as aresult of revaluation is very straightforward:

• Increases are credited directly to a revaluation surplus in equity.• Decreases are charged to the income statement as an expense.

Original Cost Revaluation Total %

Gross carrying amount $1,000,000 + $875,000 = $1,875,000 100%Accumulated depreciation 600,000 + 525,000 = 1,125,000 60Net carrying amount $ 400,000 + 350,000 = $ 750,000 40%

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At subsequent revaluations, the following rules apply:

• To the extent that there is a previous revaluation surplus with respect to anasset, a decrease first should be charged against it and any excess of deficit overthat previous surplus should be expensed.

• To the extent that a previous revaluation resulted in a charge to expense, a sub-sequent upward revaluation first should be recognized as income to the extentof the previous expense and any excess should be credited to equity.

Example: Treatment of Revaluation SurplusAssume that Kiely Company Inc. has elected to measure property, plant, andequipment at revalued amounts. Costs and fair values for Kiely Company’s threeclasses of property, plant, and equipment at December 31, Year 1 and Year 2, are asfollows:

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Land Buildings Machinery

Cost . . . . . . . . . . . . . . . . . . . . . . . . . $100,000 $500,000 $200,000Fair value at 12/31/Y1 . . . . . . . . . . . 120,000 450,000 210,000Fair value at 12/31/Y2 . . . . . . . . . . . 150,000 460,000 185,000

The following journal entries are made at December 31, Year 1, to adjust the car-rying amount of the three classes of property, plant, and equipment to fair value:

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000

Revaluation surplus—land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000

Loss on revaluation—buildings (expense) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50,000

Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50,000

Machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000

Revaluation surplus—machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $30,000

Revaluation surplus—land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $30,000

Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000

Recovery of loss on revaluation—buildings (income) . . . . . . . . . . . . . . . $10,000

Revaluation surplus—machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000

Loss on revaluation—machinery (expense) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

Machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $25,000

At December 31, Year 2, the following journal entries are made:

IAS 16 indicates that the revaluation surplus in equity may be transferred toretained earnings when the surplus is realized. The surplus may be considered

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to be realized either through use of the asset or upon its sale or disposal.Accordingly,

• The revaluation surplus in equity may be transferred to retained earnings as alump sum at the time the asset is sold or scrapped, or

• Each period, an amount equal to the difference between depreciation on therevalued amount and depreciation on the historical cost of the asset may betransferred to retained earnings.

A third possibility apparently allowed by IAS 16 would be to do nothing with therevaluation surplus. However, this would result in revaluation surpluses beingreported in equity related to assets no longer owned by the firm.

With shares traded on the New York Stock Exchange, China Eastern AirlinesCorporation (CEA) is required to reconcile IFRS-based income and shareholders’equity to a U.S. GAAP basis. Exhibit 4.1 presents CEA’s reconciliation to U.S.GAAP, along with the note describing significant differences between IFRSs andU.S. GAAP with respect to revaluation of property, plant, and equipment. In 2003,CEA’s reversal of the depreciation taken on revalued property, plant, and equip-ment caused U.S. GAAP income to be $7.72 million larger than IFRS income. Thisamount represents 6.7 percent of IFRS income.

IAS 40, Investment PropertyIAS 40, Investment Property, prescribes the accounting treatment for investmentproperty, that is, land and/or buildings held to earn rentals, capital appreciation, orboth. The principles related to accounting for plant, property, and equipment gen-erally apply to investment property, including the option to use either a cost modelor a fair value model in measuring investment property subsequent to originalacquisition. The fair value model for investment property differs from the revalua-tion method for property, plant, and equipment in that changes in fair value arerecognized as gains or loss in current income and not as a revaluation surplus.

IAS 38, Intangible AssetsIAS 38, Intangible Assets, provides accounting rules for purchased intangible assets,intangible assets acquired in a business combination, and internally generatedintangible assets. (Goodwill is covered by IFRS 3, Business Combinations.)

IAS 38 defines an intangible asset as an identifiable, nonmonetary asset withoutphysical substance held for use in the production of goods or services, for rental toothers, or for administrative purposes. As an asset, it is a resource controlled by theenterprise as a result of past events from which future economic benefits are expectedto arise. If a potential intangible asset does not meet this definition (i.e., it is iden-tifiable, controlled, and future benefits are probable) or cannot be measured reliably,it should be expensed immediately, unless it is obtained in a business combination,in which case it should be included in goodwill.

Purchased IntangiblesPurchased intangibles are initially measured at cost, and their useful life is as-sessed as finite or indefinite. The cost of intangible assets with a finite useful life isamortized on a systematic basis over the useful life. The residual value is assumedto be zero unless (1) a third party has agreed to purchase the asset at the end of itsuseful life or (2) there is an active market for the asset from which a residual valuecan be estimated.


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126 Chapter Four

EXHIBIT 4.1

CHINA EASTERN AIRLINES CORPORATION LIMITEDForm 20-F

2003 Revaluation of Property, Plant, and Equipment

Notes to the Consolidated Financial Statements

Excerpt from Note 40. Significant Differences between IFRS and U.S. GAAP

Differences between IFRS and U.S. GAAP which have significant effects on the consolidated profits/(loss) attributable to shareholdersand consolidated owners’ equity of the Group are summarized as follows:

Consolidated profit/(loss) attributable to shareholders

(Amounts in thousands except per share data)

Year Ended December 31

20032001 2002 2003 US$

Note RMB RMB RMB (note 2a)

As stated under IFRS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541,713 83,369 (949,816) (114,758)

U.S. GAAP adjustments:Reversal of difference in depreciation charges arisingfrom revaluation of fixed assets . . . . . . . . . . . . . . . . . . (a) 94,140 20,370 63,895 7,720

Reversal of revaluation deficit of fixed assets . . . . . . . . . (a) — 171,753 — —

Gain/(loss) on disposal of aircraft and related assets . . . . (b) 5,791 (26,046) (10,083) (1,218)

Others . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (c) (11,295) 23,767 6,860 829

Deferred tax effect on U.S. GAAP adjustments . . . . . . . (d) (155,877) (28,477) (9,101) (1,100)

As stated under U.S. GAAP . . . . . . . . . . . . . . . . . . . . . . . . 474,472 247,736 (892,245) (108,527)

Basic and fully diluted earnings/(loss) per share under

U.S. GAAP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . RMB0.097 RMB0.051 (RMB0.185) (US$0.022)

Basic and fully diluted earnings/(loss) per American

Depository Share (“ADS”) under U.S. GAAP . . . . . . . . . . RMB9.75 RMB5.09 (RMB18.46) (US$2.23)

Consolidated owners’ equity

(Amounts in thousands)

December 31

20032002 2003 US$

Note RMB RMB (note 2a)

As stated under IFRS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,379,103 6,382,151 771,099

U.S. GAAP adjustments:

Reversal of net revaluation surplus of fixed assets . . . . . . . . . . . . . . . . . . . . . . . . (a) (908,873) (908,873) (109,811)

Reversal of difference in depreciation charges and accumulated depreciation

and loss on disposals arising from the revaluation of fixed assets . . . . . . . . . . . (a),(b) 637,423 691,235 83,516

Others . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (c) 29,111 35,971 4,346

Deferred tax effect on U.S. GAAP adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . (d) 20,844 9,225 1,115

As stated under U.S. GAAP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,157,608 6,209,709 750,264

Notes:

(a) Revaluation of fixed assets

Under IFRS, fixed assets of the Group are initially recorded at cost and are subsequently restated at revalued amounts lessaccumulated depreciation. Fixed assets of the Group were revalued as of June 30, 1996, as part of the restructuring of the Groupfor the purpose of listing. In addition, as of December 31, 2002, a revaluation of the Group’s aircraft and engines was carried outand difference between the valuation and carrying amount was recognized. Under U.S. GAAP, the revaluation surplus or deficitand the related difference in depreciation are reversed since fixed assets are required to be stated at cost.

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An intangible asset is deemed to have an indefinite life when there is no fore-seeable limit to the period over which it is expected to generate cash flows for theentity. If the useful life of an intangible asset is indefinite, no amortization shouldbe taken until the life is determined to be definite.

The distinction made in IAS 38 between intangibles with a finite life and thosewith an indefinite life and corresponding accounting treatment is consistent withU.S. GAAP. A departure from U.S. GAAP is that IAS 38 allows intangible assets tobe carried on the balance sheet at cost less accumulated amortization (benchmark)or fair value (allowed alternative). However, the fair value method is applicable onlyfor intangibles with an active secondary market—which is rare.

Intangibles Acquired in a Business CombinationUnder both IAS 38 and U.S. GAAP, intangibles such as patents, trademarks, andcustomer lists acquired in a business combination should be recognized as assetsapart from goodwill at their fair value. The acquiring company should recognizethese intangibles as assets even if they were not recognized as assets by the ac-quiree, so long as their fair value can be measured reliably. If fair value cannot bemeasured reliably, the intangible is not recognized as a separate asset but is in-cluded in goodwill.

A special situation arises with respect to development costs that have beenincurred by the acquiree prior to the business combination. Under U.S. GAAP,in-process research and development costs acquired in a business combinationmust be written off immediately. In accordance with IAS 38, in-process develop-ment costs that meet certain criteria (described in more detail in the followingsubsections) must be capitalized as an intangible asset unless their fair valuecannot be measured reliably, in which case they are included in goodwill. Ineither case, the development costs are capitalized under IFRSs but expensedunder U.S. GAAP.

Internally Generated IntangiblesA major difference between IFRSs and U.S. GAAP lies in the treatment of inter-nally generated intangibles. To determine whether an internally generated intan-gible should be recognized as an asset, IAS 38 requires the expenditures giving riseto the potential intangible to be classified as either research or developmentexpenditures. If the two cannot be distinguished, all expenditures should be classi-fied as research expenditures. Research expenditures must be expensed as incurred.Development expenditures, in contrast, must be recognized as an intangible assetwhen an enterprise can demonstrate all of the following:

1. The technical feasibility of completing the intangible asset so that it will beavailable for use or sale.

2. Its intention to complete the intangible asset and use or sell it.3. Its ability to use or sell the intangible asset.4. How the intangible asset will generate probable future economic benefits.

Among other things, the enterprise should demonstrate the existence of a mar-ket for the output of the intangible asset or the existence of the intangible assetitself or, if it is to be used internally, the usefulness of the intangible asset.

5. The availability of adequate technical financial, and other resources to completethe development and to use or sell the intangible asset.

6. Its ability to reliably measure the expenditure attributable to the intangible assetduring its development.


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Items that might qualify as assets under IAS 38 include the following:

• Computer software costs• Patents, copyrights• Motion picture films• Mortgage servicing rights• Fishing licenses• Franchises• Customer or supplier relationships• Customer loyalty• Market share• Marketing rights• Import quotas

IAS 38 specifically excludes the following from being recognized as internallygenerated intangible assets:

• Brands• Mastheads• Publishing titles• Customer lists• Advertising costs• Training costs• Business relocation costs

The recognition of development costs in general as an asset is a major differencefrom U.S. GAAP, which allows such recognition only with respect to computersoftware development costs. Internally generated goodwill may not be capitalizedunder IFRSs or U.S. GAAP.

Considerable management judgment is required in determining whether de-velopment costs should be capitalized. Managers must determine the point atwhich research ends and development begins. IAS 38 provides the following ex-amples of activities generally included in research:

• Activities aimed at obtaining new knowledge.• The search for application of research findings or other knowledge.• The search for alternatives for materials, devices, products, processes, systems,

or services.• The formulation, design, evaluation, and selection of possible alternatives

for new or improved materials, devices, products, processes, systems, orservices.

Development activities typically include the following:

• The design, construction, and testing of preproduction prototypes and models.• The design of tools, jigs, molds, and dies involving new technology.• The design, construction, and operation of a pilot plant that is not of a scale eco-

nomically feasible for commercial production.• The design, construction, and testing of a chosen alternative for new or

improved materials, devices, products, processes, systems, or services.

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IAS 38 also provides a list of activities that are neither research nor develop-ment, including the following:

• Engineering follow-through in an early phase of commercial production.• Quality control during commercial production, including routine testing of

products.• Troubleshooting in connection with breakdowns during commercial production.• Routine efforts to refine, enrich, or otherwise improve upon the qualities of an

existing product.• Adaptation of an existing capability to a particular requirement or customer’s

need as part of a continuing commercial activity.• Seasonal or other periodic design changes to existing products.• Routine design of tools, jigs, molds, and dies.• Activities, including design and construction engineering, related to the con-

struction, relocation, rearrangement, or start-up of facilities or equipment otherthan facilities or equipment used solely for a particular research and develop-ment project.

Once the research and development phases of a project have been deter-mined, management must assess whether all six criteria (listed earlier) for de-velopment cost capitalization have been met. Judgments of future circumstancesoften will be necessary and may be highly subjective. The ultimate decision candepend on the degree of optimism or pessimism of the persons making thejudgment.

Development costs consist of (1) all costs directly attributable to developmentactivities and (2) those costs that can be reasonably allocated to such activities,including:

• Personnel costs.• Materials and services costs.• Depreciation of plant, property, and equipment.• Amortization of patents and licenses.• Overhead costs, other than general administrative costs.

In other words, development costs are similar to costs incurred in producing in-ventory. Because the costs of some, but not all, development projects will be de-ferred as assets, it is necessary to accumulate costs for each development project asif it were a separate work in progress.

Borrowing costs could be included in research and development costs if theallowed alternative treatment (capitalization) in IAS 23, Borrowing Costs, isadopted. Under that treatment, borrowing costs should be included as part ofthe cost of development activities to the extent that the costs of those activitiesconstitute a “qualifying asset.” IAS 23 is discussed in more detail later in thischapter.

Deferred (capitalized) development costs are accounted for using the samerules as any other intangible. They must be amortized over a period not to exceed20 years, using a method that best reflects the pattern in which the asset’s eco-nomic benefits are consumed. Declining-balance, units-of-production, andstraight-line methods are among the acceptable methods. Amortization beginswhen the intangible asset is available for sale or use.


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Example: Accounting for Deferred Development CostsAssume that Szabo Company Inc. incurred costs to develop a specific product fora customer in Year 1, amounting to $300,000. Of that amount, $250,000 was in-curred up to the point at which the technical feasibility of the product could bedemonstrated. In Year 2, Szabo Company incurred an additional $300,000 in costsin the development of the product. The product was available for sale on January 2,Year 3, with the first shipment to the customer occurring in mid-February, Year 3.Sales of the product are expected to continue for four years, at which time it isexpected that a replacement product will need to be developed. The total numberof units expected to be produced over the product’s four-year economic life is2,000,000. The number of units produced in Year 3 is 800,000. Residual value iszero.

In Year 1, $250,000 of development costs is expensed and $50,000 is recognizedas an asset. The journal entry is as follows:

130 Chapter Four

Development expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $250,000

Deferred development costs (intangible asset) . . . . . . . . . . . . . . . . . . . . . . . . 50,000

Cash, payables, etc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300,000

To record development expense and deferred development costs.

Deferred development costs (asset) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300,000

Cash, payables, etc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300,000

To record deferred development costs.

Carrying amount of deferred development cost . . . . . . . . . . . . . . . . . . . . . . . $350,000

Units produced in Year 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000

Total number of units to be produced over economic life . . . . . . . . . . 2,000,000

% of total units produced in Year 3 . . . . . . . . . . . . . . . . . . . . . . . . . 40%

Amortization expense in Year 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $140,000

Amortization expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $140,000

Deferred development costs (asset) . . . . . . . . . . . . . . . . . . . . . . . . . . . $140,000

To record annual amortization expense.

In Year 2, $300,000 of development costs is recognized as an asset:

Amortization of deferred development costs begins on January 2, Year 3, when theproduct becomes available for sale. Szabo Company determines that the units-of-production method best reflects the pattern in which the asset’s economic benefitsare consumed. Amortization expense for Year 3 is calculated as follows:

The journal entry to record amortization of deferred development costs atDecember 31, Year 3, is as follows:

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If Szabo Company were unable to estimate with reasonable certainty the numberof units to be produced, it would be appropriate to amortize the deferred devel-opment costs on a straight-line basis over the four-year expected life. In that case,the journal entry to record amortization in Year 3 is as follows:


Amortization expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $87,500

Deferred development costs (asset) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $87,500

To record annual amortization expense.

Impairment of Development CostsIAS 36, Impairment of Assets, must be applied to determine whether deferred de-velopment costs have been impaired and recognition of an impairment loss is ap-propriate. We discuss IAS 36 in the next section of this chapter.

Finnish cellular telephone manufacturer Nokia Corporation is a Europeanmultinational that has used IFRSs for several years. Exhibit 4.2 presents the recon-ciliation of net income from IFRSs to U.S. GAAP provided by Nokia in its Form 20-Ffiled with the U.S. Securities and Exchange Commission (SEC), and the note de-scribing the U.S. GAAP adjustment related to development costs. Adjusting forthe capitalization of development costs under IFRSs that would not be allowedunder U.S. GAAP resulted in U.S. GAAP net income being €66 million less thanIFRS income in 2002. However, in 2003 and 2004, U.S. GAAP net income was €322million and €42 million greater than IFRS income, respectively. The larger incomeunder U.S. GAAP in these years most likely is attributable to the amount of amor-tization expense related to deferred development costs under IFRSs exceeding thedevelopment costs expensed immediately under U.S. GAAP.

IAS 36, Impairment of AssetsIAS 36, Impairment of Assets, requires impairment testing and recognition of im-pairment losses for property, plant, and equipment; intangible assets; goodwill;and investments in subsidiaries, associates, and joint ventures. It does not apply toinventory, construction in progress, deferred tax assets, employee benefit assets, orfinancial assets such as accounts and notes receivable. U.S. GAAP also requires im-pairment testing of assets. However, several important differences exist betweenthe two sets of standards.

Definition of ImpairmentUnder IAS 36, an asset is impaired when its carrying amount (book value) exceedsits recoverable amount.

• Recoverable amount is the greater of net selling price and value in use.• Net selling price is the price of an asset in an active market less disposal costs.• Value in use is determined as the present value of future net cash flows expected

to arise from continued use of the asset over its remaining useful life and upondisposal. In calculating value in use, projections of future cash flows should bebased on approved budgets and should cover a maximum of five years (unlessa longer period can be justified). The discount rate used to determine presentvalue should reflect current market assessments of the time value of money andthe risks specific to the asset under review.

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132 Chapter Four

Under U.S. GAAP, impairment exists when an asset’s carrying amount exceedsthe future cash flows (undiscounted) expected to arise from its continued use anddisposal. Net selling price is not involved in the test, and future cash flows are notdiscounted to their present value. When value in use is the recoverable amountunder IAS 36, an impairment is more likely to arise under IFRSs (discounted cashflows) than under U.S. GAAP (undiscounted cash flows).

Measurement of Impairment LossThe measurement of impairment loss under IAS 36 is straightforward. It is theamount by which carrying value exceeds recoverable amount and it is recognized in

NOKIAForm 20-F

2004 Development Costs

Notes to the Consolidated Financial Statements

Excerpt from Note 37. Differences between International Financial Reporting Standards andU.S. Generally Accepted Accounting Principles

The Group’s consolidated financial statements are prepared in accordance with International FinancialReporting Standards, which differ in certain respects from accounting principles generally accepted in theUnited States (U.S. GAAP). The principal differences between IFRS and U.S. GAAP are presented belowtogether with explanations of certain adjustments that affect consolidated net income and totalshareholders’ equity as of and for the years ended December 31:

2004 2003 2002EURm EURm EURm

Reconciliation of net income:

Net income reported under IFRS . . . . . . . . . . . . . . . . . . . . . . 3,207 3,592 3,381

U.S GAAP adjustments:

Pension expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — (12) (5)

Development costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 322 (66)

Provision for social security cost on stock options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (8) (21) (90)

Stock compensation expense . . . . . . . . . . . . . . . . . . . . . . . (21) (9) (35)

Cash flow hedges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89 9 6

Net investment in foreign companies . . . . . . . . . . . . . . . . . — — 48

Amortization of identifiable intangible assets acquired . . . . (11) (22) (22)

Impairment of identifiable intangible assets acquired . . . . . (47) — —

Amortization of goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . 106 162 206

Impairment of goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . — 151 104

Deferred tax effect of U.S. GAAP adjustments . . . . . . . . . . (14) (75) 76

Net income under U.S. GAAP . . . . . . . . . . . . . . . . . . . . . . . . 3,343 4,097 3,603

Development costs

Development costs have been capitalized under IFRS after the product involved has reached a certaindegree of technical feasibility. Capitalization ceases and depreciation begins when the product becomesavailable to customers. The depreciation period of these capitalized assets is between two and five years.

Under U.S. GAAP, software development costs would similarly be capitalized after the product hasreached a certain degree of technical feasibility. However, certain non-software related development costscapitalized under IFRS would not be capitalizable under U.S. GAAP and therefore would have beenexpensed under U.S. GAAP.

EXHIBIT 4.2

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income. In the case of property, plant, and equipment carried at a revalued amount,the impairment loss is first taken against revaluation surplus and then to income.

The comparison of carrying value and undiscounted future cash flows underU.S. GAAP is done to determine whether an asset is impaired. The impairmentloss is then measured as the amount by which carrying value exceeds fair value.Fair value may be determined by reference to quoted market prices in active mar-kets, estimates based on the values of similar assets, or estimates based on theresults of valuation techniques. It is unlikely that fair value (U.S. GAAP) andrecoverable amount (IFRSs) for an asset will be the same, resulting in differencesin the amount of impairment loss recognized between the two sets of standards.

Example: Determination and Measurement of Impairment LossAt December 31, Year 1, Toca Company has specialized equipment with thefollowing characteristics:

Carrying value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50,000Selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000Costs of disposal . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000Expected future cash flows . . . . . . . . . . . . . . . . . . . 55,000Present value of expected future cash flows . . . . . . . 46,000

IFRSs In applying IAS 36, the asset’s recoverable amount would be determinedas follows:

Net selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . $40,000 − 1,000 = $39,000Value in use . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $46,000

Recoverable amount (greater of the two) $46,000

The determination and measurement of impairment loss would be:


Carrying value . . . . . . . . . . . . . . . . . . . . . . . . . . $50,000Recoverable amount . . . . . . . . . . . . . . . . . . . . . 46,000Impairment loss . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,000

The following journal entry would be made to reflect the impairment of this asset:

Impairment loss $4,000

Equipment $4,000

To recognize an impairment loss on equipment.

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

U.S. GAAP Under U.S. GAAP, an impairment test would be carried out as follows:

Carrying value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50,000Expected future cash flows (undiscounted) . . . . . . . . 55,000

Because expected future cash flows exceed the asset’s carrying value, no impair-ment is deemed to exist. The asset would be reported on the December 31, Year 1,balance sheet at $50,000.

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Reversal of Impairment LossesAt each balance sheet date, a review should be undertaken to determine if impair-ment losses have reversed. (Indicators of impairment reversal are provided inIAS 36.) If subsequent to recognizing an impairment loss, the recoverable amountof an asset is determined to exceed its new carrying amount, the impairment lossshould be reversed. However, the loss should be reversed only if there are changesin the estimates used to determine the original impairment loss or there is a changein the basis for determining the recoverable amount (from value in use to net sell-ing price or vice versa). The carrying value of the asset is increased but not toexceed what it would have been if no impairment loss had been recognized. Thereversal of an impairment loss should be recognized in income immediately. U.S.GAAP does not allow the reversal of a previously recognized impairment loss.

The shares of Lihir Gold Limited, a mining company based in Papua NewGuinea, are traded on the NASDAQ national market in the United States. LihirGold uses IFRSs in preparing its financial statements. The reconciliation of netincome to U.S. GAAP and procedures followed by Lihir Gold in complying withIAS 36’s impairment rules are summarized in Exhibit 4.3. The company explainsthat impairment losses were recorded in 1999 and 2000 under IAS 36, but only theloss in 2000 would have been recognized under U.S. GAAP. In 2002 and 2003, pre-vious impairment losses were determined to have been overstated and a reversalwas recognized under IAS 36. The reversal of impairment loss would not have beenacceptable under U.S. GAAP. As a result, IFRS income was reduced by $31.1 millionin 2003 ($37.9 million in 2002) to reconcile to U.S. GAAP.

Impairment of GoodwillThe recoverable amount of goodwill must be determined annually regardless ofwhether impairment indicators are present. The recoverable amount is deter-mined for the cash-generating unit (e.g., an acquired business) to which the good-will belongs by first applying a bottom-up test. In this test, goodwill is allocated tothe individual cash-generating unit under review, if possible, and impairment ofthat cash-generating unit is then determined by comparing (1) the carrying amountplus allocated goodwill and (2) the recoverable amount.

If goodwill cannot be allocated on a reasonable and consistent basis to the cash-generating unit under review, then both a bottom-up test and a top-down testshould be applied. Under the top-down test, goodwill is allocated to the smallestgroup of cash-generating units to which it can be allocated on a reasonable andconsistent basis, and impairment of the group of cash-generating units is then de-termined by comparing (1) the carrying amount of the group plus allocated good-will and (2) the recoverable amount. U.S. GAAP requires only a bottom-up testand only for that goodwill associated with those assets that are being reviewed forimpairment.

Example: Application of the Bottom-Up and Top-Down Tests for GoodwillIn Year 1, Lebron Company acquired another company that operates a chain ofthree restaurants, paying $300,000 for goodwill. By the end of Year 4, it is clear thatthe restaurants are not generating the profit and cash flows expected at the date ofpurchase. Therefore, Lebron Company is required to test for impairment.

Each restaurant is a cash-generating unit, but Lebron cannot allocate the good-will on a reasonable and consistent basis to individual restaurants. Both a bottom-up test and a top-down test must be applied.

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Bottom-Up Test A bottom-up test is applied to each restaurant by estimating therecoverable amount of the assets of each restaurant and comparing with the carryingvalue of those assets. An impairment loss is recognized for the amount by which arestaurant’s carrying value exceeds its recoverable amount. The loss is allocated tothe impaired restaurant’s assets on a pro rata basis according to the relative carry-ing value of the assets. The bottom-up test checks for impairment of the assets ofthe individual restaurants but provides no information about the impairment of

LIHIR GOLD LIMITEDForm 20-F

2003 Impairment of Assets

Notes to the Financial Statements

Excerpt from Note 30: Reconciliation to US GAAP

The basis of preparation of these financial statements is set out in Note 1. These accounting policies varyin certain important respects from the accounting principles generally accepted in the United States (“USGAAP”). The material differences affecting the profit and loss account and shareholders’ equity betweengenerally accepted accounting principles followed by the Company and those generally accepted in theUS are summarised below.

As Restated

2003 2002 2001US$’000 US$’000 US$’000

Net income/(loss) in accordance with IAS GAAP . . . . . . . . . . 34,778 53,247 59,176

Adjusted as follows:

Rehabilitation, restoration and environmental provision (i) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — (374) (420)

Mine properties—capitalized interest (ii) . . . . . . . . . . . . . . — — —

Depreciation of mine properties (iii) . . . . . . . . . . . . . . . . . . 353 — —

Impairment charge/(reversal) under IAS GAAP (v) . . . . . . . (31,061) (37,893) —

Deferred tax benefit under IAS GAAP (vi) . . . . . . . . . . . . . — 16,426 (16,426)

Deferred mining costs under IAS GAAP (vii) . . . . . . . . . . . . (7,163) (3,675) —

Deferred mining costs under US GAAP (vii) . . . . . . . . . . . . 3,067 10,894 —

Net income/(loss) under US GAAP before cumulative effect of change in accounting policy . . . . . . . . . . . . . . . (26) 38,625 42,330

Cumulative effect of change in accounting policy (i) . . . . . 400 — —

Net income/(loss) under US GAAP after cumulative effect of change in accounting policy . . . . . . . . . . . . . . . . . 374 38,625 42,330

v) Impairment: Under IAS 36, the impairment test for determining the recoverable amount of non-current assets is the higher of net selling price and value in use. At 31 December 1999 and again at 31 December 2000, the Company determined that an impairment charge was necessary as thediscounted cash flows were less than the carrying value of the asset. Under US GAAP, the mineproperty assets were evaluated for impairment on an undiscounted basis and, because the sum ofexpected (undiscounted) future cash flows exceeded the asset’s carrying amount, no impairment losswas recognised in 1999. During 2000 the undiscounted value of expected future cash flows were lessthan the asset’s carrying values, which resulted in an impairment provision calculated on the same basisas for IFRS. In 2003, having revised critical assumptions, including life of mine, remaining reserves, along term gold price assumption of $US340 (2002: $US305) and a pre-tax real discount rate of 7%(2002: 7%), the directors resolved to partially reverse previously recognised impairments, to the valueof $US31.1 million (2002: $US37.9 million). US GAAP does not allow the reversal of impairmentprovisions previously recognised.

EXHIBIT 4.3

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the goodwill that was purchased in the acquisition of the chain of restaurants. As-sume the following carrying values and recoverable amounts for the three restau-rants acquired:

Cash-Generating Unit Carrying Recoverable Impairment(restaurant location) Value Amount Loss

Anaheim . . . . . . . . . . . . . . . . . $1,000,000 $ 970,000 $30,000Buena Park . . . . . . . . . . . . . . . 1,000,000 1,050,000 0Cerritos . . . . . . . . . . . . . . . . . . 1,000,000 1,020,000 0

An impairment loss of $30,000 is recognized, and the assets of the Anaheim restau-rant are written down by the same amount. The carrying value of Anaheim’s netassets is now $970,000.Top-Down Test Lebron determines that the smallest cash-generating unit towhich goodwill can be allocated is the entire chain of restaurants. Therefore,Lebron estimates the recoverable amount of the chain of restaurants and comparesthis with the carrying value of the assets of all the restaurants plus goodwill.Goodwill is considered to be impaired to the extent that the carrying value of theassets plus goodwill exceeds the restaurant chain’s recoverable amount.

136 Chapter Four

Cash-Generating Unit Carrying(restaurant location) Value

Anaheim . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 970,000Buena Park . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000Cerritos . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,970,000Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,270,000

Lebron estimates the recoverable amount of the chain of restaurants to be$3,000,000. Lebron compares this amount with the total carrying value of$3,270,000 to determine that goodwill is impaired. A loss on the impairment ofgoodwill of $270,000 must be recognized.

IAS 23, Borrowing CostsIAS 23, Borrowing Costs, provides two methods of accounting for borrowing costs:

1. Benchmark treatment: Expense all borrowing costs in the period incurred.2. Allowed alternative treatment: Capitalize borrowing costs to the extent they are at-

tributable to the acquisition, construction, or production of a qualifying asset;other borrowing costs are expensed in the period incurred.

Adoption of the benchmark treatment would not be acceptable under U.S.GAAP. The allowed alternative is similar to U.S. GAAP, but some definitional andimplementation differences exist. The IASB requires those enterprises adopting acapitalization policy to apply that treatment consistently to all qualifying assets;picking and choosing between assets is not allowed.

IAS 23 defines borrowing costs as interest and other costs incurred by an enter-prise in connection with the borrowing of funds. This definition is broader inscope than the definition of interest cost under U.S. GAAP. Borrowing costs in

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accordance with IAS 23 specifically include foreign exchange gains and losses onforeign currency borrowings to the extent they are regarded as an adjustment tointerest costs.

An asset that qualifies for borrowing cost capitalization is one that necessarilytakes a substantial period to get ready for its intended use or sale. Both IAS 23 andU.S. GAAP exclude inventories that are routinely manufactured or produced inlarge quantities on a repetitive basis over a short period. However, IAS 23 specifi-cally includes inventories that require a substantial period to bring them to a mar-ketable condition.

The amount to be capitalized is the amount of interest cost that could have beenavoided if the expenditure on the qualifying asset had not been made. This isdetermined by multiplying the weighted-average accumulated expenditures byan appropriate interest rate. The appropriate interest rate is determined similarlyunder both IAS 23 and U.S. GAAP, being a weighted-average interest rate on bor-rowings outstanding. If a specific new borrowing can be associated with a quali-fying asset, the actual interest rate is used to the extent the weighted-averageaccumulated expenditures are less than the amount of the specific borrowing.

The capitalization of borrowing costs begins when expenditures for the assetare incurred and ceases when substantially all the activities necessary to preparethe asset for sale or use are completed. Similar rules exist under U.S. GAAP.

IAS 17, LeasesIAS 17, Leases, distinguishes between finance (capitalized) leases and operatingleases. IAS 17 provides guidance for classifying leases as finance or operating, andthen describes the accounting procedures that should be used by lessees andlessors in accounting for each type of lease. IAS 17 also provides rules for sale-leaseback transactions. IAS 17 and U.S. GAAP are conceptually similar, but IAS 17provides less specific guidance than U.S. GAAP.

Lease ClassificationAs a case in point, IAS 17 indicates that a lease should be classified and accountedfor as a finance lease when it transfers substantially all the risks and rewards ofownership to the lessee. The standard then provides five situations that wouldnormally lead to a lease being capitalized:

1. The lease transfers ownership of the asset to the lessee by the end of the leaseterm.

2. The lessee has the option to purchase the asset at a price less than fair marketvalue.

3. The lease term is for the major part of the leased asset’s economic life.4. The present value of minimum lease payments at the inception of the lease is

equal to substantially all the fair value of the leased asset.5. The leased asset is of a specialized nature such that only the lessee can use it.

In contrast, U.S. GAAP stipulates that if any one of four very specific criteria ismet, a lease must be capitalized. These criteria are similar to 1–4 above; in fact, thefirst two are exactly the same as (1) and (2). In the U.S. GAAP version of criterion(3), major part is specifically defined as 75 percent, and in criterion (4), substantiallyall is defined as 90 percent. Depending on the manner in which a financial state-ment preparer defines these terms, application of IAS 17 and U.S. GAAP might ormight not lead to similar classification of leases.


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Finance LeasesIAS 17 requires leases classified as finance leases to be recognized by the lessee asassets and liabilities at an amount equal to the fair value of the leased propertyor, if lower, at the present value of the future minimum lease payments. Leasepayments are apportioned between interest expense and a reduction in the leaseobligation using an effective interest method to amortize the lease obligation, andthe leased asset is depreciated in a manner consistent with assets owned by thelessee.

The lessor should treat the same lease as a finance sale. The leased asset is re-placed by the “net investment” in the lease, which is equal to the present value offuture minimum lease payments (including any unguaranteed residual value).Any profit on the “sale” is recognized at the inception of the lease, and interest isrecognized over the life of the lease using an effective interest method. Under U.S.GAAP, the net investment in the lease is determined simply as the lessor’s cost orcarrying amount for the leased asset.

Operating LeasesAny lease not classified as a finance lease is an operating lease. With an operatinglease, lease payments are recognized by the lessee as an expense and by the lessoras income. The asset remains on the books of the lessor and is accounted for simi-larly to any other asset owned by the lessor.

Sale-Leaseback TransactionA sale-leaseback transaction involves the sale of an asset by the initial owner of theasset and the leasing of the same asset back to the initial owner. If the lease is clas-sified as a finance lease, IAS 17 requires the initial owner to defer any gain on thesale and amortize it to income over the lease term. U.S. GAAP rules are generallysimilar. If the fair value of property at time of sale-leaseback is less than undepre-ciated cost, IAS 17 allows recognition of a loss only if the loss is due to an impair-ment in the value of the asset sold. U.S. GAAP requires immediate recognition ofthe loss regardless of its source.

If the lease in a sale-leaseback transaction is classified as an operating lease, U.S.GAAP again requires the seller to amortize any gain over the lease term. IAS 17, incontrast, requires immediate recognition of the gain in income.

The difference in accounting treatment for gains on sale-leaseback transactionsbetween IAS 17 and U.S. GAAP is described by Swisscom AG in Exhibit 4.4. In itsreconciliation to U.S. GAAP, Swisscom made an adjustment for this accountingdifference that resulted in an increase in income, as stated under U.S. GAAP, of24 million Swiss francs.

Other DifferencesOther differences between IAS 17 and U.S. GAAP with respect to finance leases in-clude the following:

• The lessee’s discount rate for determining present value of the future paymentsand interest expense. The implicit rate in the lease is generally used under IAS 17;the lessee’s incremental borrowing rate is generally used under U.S. GAAP.

• Initial direct costs of the lessee in connection with negotiating the lease. Thesecosts are capitalized as part of the cost of the asset under IAS 17; U.S. GAAP issilent with respect to this issue, but common practice is to defer and amortizethe costs over the lease term.

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Continued

EXHIBIT 4.4

SWISSCOM AGForm 20-F

2003 Sale and Leaseback Transactions

Notes to Consolidated Financial Statements

Excerpt from Note 42. Differences between International Financial Reporting Standards and U.S. Generally AcceptedAccounting Principles

The consolidated financial statements of Swisscom have been prepared in accordance with International Financial ReportingStandards (IFRS), which differ in certain respects from generally accepted accounting principles in the United States (U.S. GAAP).Application of U.S. GAAP would have affected the balance sheet as of December 31, 2001, 2002 and 2003 and net income for each of the years in the three-year period ended December 31, 2003 to the extent described below. A description of the materialdifferences between IFRS and U.S. GAAP as they relate to Swisscom are discussed in further detail below

Reconciliation of net income from IFRS to U.S. GAAP

The following schedule illustrates the significant adjustments to reconcile net income in accordance with IFRS to the amountsdetermined in accordance with U.S. GAAP for each of the three years ended December 31.

CHF in millions 2001 2002 2003

Net income according to IFRS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,964 824 1,569

U.S. GAAP adjustments:

a) Capitalization of interest cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (31) (1) (1)

b) Retirement benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 (17) (12)

c) Stock based compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (8) 9 6

d) Termination benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 (20) 11

e) Write-down of long-lived assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (30) — —

f) Capitalization of software . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (124) — —

g) Impairment of investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 00 00

h) Cross-border tax leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 (13) 15

i) Debitel purchase accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (142) (82) (86)

j) Application of SAB 101 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 9 31

k) Site restoration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 14 (13)

l) Telephone poles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 4 —

m) Goodwill amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — 304 213

m) Goodwill impairment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,130 (283) 280

n) Dilution gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (72) — —

o) Derivative accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 (21) —

p) Sale and leaseback transaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (286) 30 24

q) Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114 29 21

Net income before cumulative effect of accounting change according to U.S. GAAP . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,702 786 2,058

k) l) m) Cumulative effect of accounting change, net of tax . . . . . . . . . . — (1,649) 38

Net income (loss) according to U.S. GAAP . . . . . . . . . . . . . . . . . . . . . 5,702 (863) 2,096

In March 2001 Swisscom entered into two master agreements for the sale of real estate. The first relates to the sale of 30 commercialand office properties for CHF 1,272 million to a consortium led by Credit Suisse Asset Management. The second concerns the sale of166 commercial and office properties for CHF 1,313 million to PSP Real Estate AG and WTF Holding (Switzerland) Ltd. At the sametime Swisscom entered into agreements to lease back part of the sold property space. The gain on the sale of the properties aftertransaction costs of CHF 105 million and including the reversal of environmental provisions (see Note 28), was CHF 807 millionunder IFRS.

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Other Recognition and Measurement StandardsThe appendix to this chapter summarizes several IFRSs pertaining to the recogni-tion and measurement of liabilities, revenue, and financial instruments. IAS 21,Foreign Currency Translation, which provides guidance for dealing with foreigncurrency transactions and the translation of foreign currency financial statements,is covered in detail in Chapters 6 and 7. IFRSs related to business combinations(IFRS 3), consolidated financial statements (IAS 27), investments in associates(IAS 28), investments in joint ventures (IAS 31), and financial reporting in hyper-inflationary economies (IAS 29) are covered in Chapter 8, Additional FinancialReporting Issues.

DISCLOSURE AND PRESENTATION STANDARDS

Several IFRSs deal primarily with disclosure and presentation issues. This sectionsummarizes those standards. While briefly introduced here, IAS 14, SegmentReporting, is discussed in greater detail in Chapter 8.

IAS 7, Cash Flow Statements

• IAS 1 requires presentation of a cash flow statement in a set of IAS-based finan-cial statements. IAS 7 requires cash flows to be classified into operating, invest-ing, and financial activities. Operating cash flows may be presented using eitherthe direct or indirect methods. Investing and financing activities that do notgive rise to cash flows should be disclosed separately. There are no substantivedifferences between IAS 7 and U.S. GAAP, although classification of some itemsmight differ between the two sets of standards. For example, IAS 7 allows divi-dends paid to be classified as either an operating or a financing cash flow,whereas U.S. GAAP classifies dividends paid as a financing activity. Interest re-ceived and paid may be classified as an operating, investing, or financing activ-ity under IAS 7, but must be classified as an operating activity under U.S.GAAP.

IAS 8, Accounting Policies, Changes in Accounting Estimates, and Errors

• IAS 8 provides guidance on selecting and changing accounting policies, andprescribes the accounting treatment and disclosures related to changes in ac-counting polices. It also prescribes accounting for changes in accounting esti-mates and corrections of errors.

• Changes in accounting estimates are handled prospectively.

140 Chapter Four

A number of the leaseback agreements are accounted for as finance leases under IFRS and the gain on the sale of these properties ofCHF 239 million is deferred and released to income over the individual lease terms. See Note 28. The accounting is similar under U.S.GAAP. The remaining gain of CHF 568 million represents the gain on the sale of buildings which were either sold outright or whichunder IFRS qualify as operating leases. Under IFRS, the gain on a leaseback accounted for as an operating lease is recognizedimmediately. Under U.S. GAAP, the gain is deferred and amortized over the lease term. If the lease back was minor, the gain wasimmediately recognized. In addition, certain of the agreements did not qualify as sale and leaseback accounting because ofcontinuing involvement. These transactions are accounted for under the finance method and the sales proceeds would be reported asa financing obligation and the properties would remain on the balance sheet and would be depreciated as in the past. The leasepayments would be split into an interest part and an amortization of the obligation.

EXHIBIT 4.4 (Continued )

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• Material prior-period errors should be corrected retrospectively through the re-statement of comparative amounts for the prior period(s) in which the error(s)occurred.

• A change in accounting policy is allowed only if required by an IASB standardor interpretation, or if the change results in reliable and more relevant informa-tion being provided in the financial statements. A change in accounting policyrequired by an IASB standard or interpretation should be accounted for in ac-cordance with the transitional provisions in that standard or interpretation, ifprovided. Otherwise, changes in accounting policies should be handled retro-spectively, by adjusting comparative amounts as if the new accounting policyhad always been applied.

• The amount of a correction of a prior-period error and the cumulative effect ofa change in accounting policy may not be included in income; comparative in-formation for prior periods is presented as if the error had never occurred andthe new accounting method had always been applied.

IAS 10, Events After the Balance Sheet Date

• Financial statements should be adjusted for certain events (adjusting events)that occur after the balance sheet date. Adjusting events are those that provideevidence of conditions that existed, but were unknown, at the balance sheetdate. U.S. GAAP requirements are very similar.

IAS 14, Segment Reporting

• Disclosures are required for both business segments and geographical seg-ments, one of which is identified as the primary reporting format and the otheras secondary. Disclosures required for the primary segments include segmentrevenues, profit, assets, liabilities, capital expenditures, depreciation expense,and noncash expenses. Segment revenues, assets, and capital expendituresshould be disclosed for the secondary type of segment. U.S. GAAP requires op-erating segments to be determined using a management approach that mightresult in a different segmentation from what is required by IAS 14. WhereasIAS 14 allows geographical segments to be an individual country or groups ofcountries, U.S. GAAP requires disclosures to be made by individual countries.7

IAS 24, Related Party Disclosures

• Transactions between related parties must be disclosed in the notes to financialstatements. Parties are related if one party has the ability to control or exert sig-nificant influence over the other party. Related parties can include parent com-panies, subsidiaries, equity method associates, individual owners, and keymanagement personnel. Similar rules exist in U.S. GAAP.

IAS 33, Earnings per Share

• Basic and diluted earnings per share must be reported on the face of the incomestatement. IAS 33 provides guidance for calculating earnings per share. U.S.GAAP provides more detailed guidance with respect to the calculation ofdiluted earnings per share. Application of this guidance would appear to beconsistent with IAS 33.


7 In January 2005, as part of its short-term convergence project with the FASB, the IASB announced itsdecision to adopt the management approach of FASB Statement 131, Disclosures about Segments of anEnterprise and Related Information. A revision of IAS 14 had not been completed at the time this bookwent to press.

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IAS 34, Interim Financial Reporting

• IAS 34 does not mandate which companies should prepare interim statements,how frequently, or how soon after the end of an interim period. The standarddefines the minimum content to be included in interim statements and identi-fies the accounting principles that should be applied. With certain exceptions,IAS 34 requires interim periods to be treated as discrete reporting periods. Thisdiffers from the position in U.S. GAAP, which treats interim periods as an inte-gral part of the full year.

IFRS 5, Non-current Assets Held for Sale and Discontinued Operations

• Noncurrent assets held for sale must be reported separately on the balancesheet at the lower of (1) carrying value or (2) fair value less costs to sell. Assetsheld for sale are not depreciated. Similar rules exist in U.S. GAAP.

• A discontinued operation is a component of an entity that represents a majorline of business or geographical area of operations, or is a subsidiary acquiredexclusively with a view to resell, that either has been disposed of or has beenclassified as held for sale. The after-tax profit or loss and after-tax gain or loss ondisposal (or from measurement to fair value less costs to sell) must be reportedas a single amount on the face of the income statement. Detail of the revenues,expenses, gain or loss on disposal, and income taxes comprising this singleamount must be disclosed in the notes or on the face of the income statement. Ifpresented on the face of the income statement, it must be presented in a sectionidentified as discontinued operations. The definition of the type of operationthat can be classified as discontinued is somewhat narrower than under U.S.GAAP. In addition, U.S. GAAP requires both pretax and after-tax profit or lossto be reported on the income statement. Otherwise the two sets of standards aresubstantially similar.

Summary 1. Differences exist between IFRSs and U.S. GAAP with respect to recognition,measurement, presentation, disclosure, and choice among alternatives. In 2002,the IASB and FASB agreed to work together to converge their two sets of stan-dards as soon as possible.

2. In many cases, IFRSs are more flexible than U.S. GAAP. Several IFRSs allowfirms to choose between a benchmark treatment and an allowed alternative inaccounting for a particular item. Also, IFRSs generally have less bright-lineguidance than U.S. GAAP; therefore, more judgment is required in applyingindividual IFRSs. However, in some cases, IFRSs are more detailed than U.S.GAAP.

3. A small number of foreign firms required to file Form 20-F with the U.S. Securi-ties and Exchange Commission use IFRSs as their primary set of accountingprinciples. The reconciliation of IFRS income and shareholders’ equity to a U.S.GAAP basis included in Form 20-F provides considerable insight into the dif-ferences that exist in practice between IFRSs and U.S. GAAP.

4. Some of the more important recognition and measurement differences betweenIFRSs and U.S. GAAP relate to the following issues: inventory valuation; reval-uation of property, plant, and equipment; capitalization of development costs;measurement of impairment losses; and expensing of all borrowing costs.

5. IAS 2 requires inventory to be reported on the balance sheet at the lower of costand net realizable value. Write-downs to realizable value must be reversed

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when the selling price increases. IAS 2 no longer allows the use of last in, firstout (LIFO) in determining the cost of inventory.

6. IAS 16 allows property, plant, and equipment to be carried at cost less accumu-lated depreciation and impairment losses or at a revalued amount less any sub-sequent accumulated depreciation and impairment losses. Specific guidance isprovided for those firms that choose the revaluation option.

7. IAS 38 requires development costs to be capitalized as an intangible asset whensix specific criteria are met. Development costs can include personnel costs;materials and services; depreciation of property, plant, and equipment; amorti-zation of patents and licenses; and overhead costs, other than general adminis-trative costs. Deferred development costs are amortized over their useful life,not to exceed 20 years.

8. IAS 36 requires impairment testing of property, plant, and equipment; intangi-bles, including goodwill; and long-term investments. An asset is impairedwhen its carrying value exceeds its recoverable amount, which is the greater ofnet selling price and value in use. An impairment loss is the amount by whichcarrying value exceeds recoverable amount. If subsequent to recognizing an im-pairment loss, the recoverable amount of an asset exceeds its new carryingvalue, the impairment loss must be reversed.

9. IAS 23 provides two methods of accounting for borrowing costs: (1) Expenseall borrowing costs in the period incurred, or (2) capitalize borrowing costs tothe extent they are attributable to the acquisition of a qualifying asset, whileexpensing other borrowing costs immediately.

Other Recognition and Measurement StandardsThis appendix summarizes selected International Financial Reporting Standards(IFRSs) related to the recognition and measurement of liabilities (IAS 37, IAS 19,IFRS 2, and IAS 12); revenues (IAS 18); and financial instruments (IAS 32 and IAS 39).

IAS 37, Provisions, Contingent Liabilities and Contingent AssetsIAS 37, Provisions, Contingent Liabilities and Contingent Assets, attempts to providea consistent framework and approach for accounting for liabilities (and assets) forwhich the timing, amount, or existence is uncertain. IAS 37 also contains specificrules related to onerous contracts and restructuring costs. By way of examples inappendixes, guidance is also provided with regard to issues such as environmen-tal costs and nuclear decommissioning costs.

Contingent Liabilities and ProvisionsIAS 37 distinguishes between a contingent liability, which is not recognized on thebalance sheet, and a provision, which is. A provision is defined as a “liability of un-certain timing or amount.” A provision should be recognized when

1. The entity has a present obligation as a result of a past event;2. it is probable (more likely than not) that an outflow of resources embodying eco-

nomic events will be required to settle the obligation.3. a reliable estimate of the obligation can be made.

Appendix to Chapter 4


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Contingent liabilities are defined as

• Possible obligations that arise from past events and whose existence will be con-firmed by the occurrence or nonoccurrence of a future event, or

• A present obligation that is not recognized because (1) it is not probable that anoutflow of resources will be required to settle the obligation or (2) the amountof the obligation cannot be measured with sufficient reliability.

Contingent liabilities are disclosed unless the possibility of an outflow of resourcesembodying the economic future benefits is remote.

The rules for recognition of a provision and disclosure of a contingent liabilityare generally similar to the U.S. GAAP rules related to contingent liabilities. UnderU.S. GAAP, a contingent liability is neither recognized nor disclosed if the likeli-hood of an outflow of resources is remote; it is disclosed if such an outflow is pos-sible but not probable; and it is recognized on the balance sheet when an outflowof resources is probable. The main difference is that U.S. GAAP requires accrualwhen it is probable that a loss has occurred, with no guidance as to how the wordprobable should be interpreted. In defining a provision, IAS 37 specifically definesprobable as “more likely than not.”

IAS 37 requires the recognition of a provision for the present obligation relatedto an “onerous contract,” that is, a contract in which the unavoidable costs of meet-ing the obligation of the contract exceed the economic benefits expected to be re-ceived from it. However, recognition of a provision for expected future operatinglosses is not allowed.

IAS 37 provides guidance for measuring a provision as the best estimate of theexpenditure required to settle the present obligation at the balance sheet date. Thebest estimate is the expected value when a range of estimates exist; the midpointwithin a range if all estimates are equally likely. Provisions must be discounted topresent value. Subsequent reduction of provisions can be made only for the ex-penditures for which the provision was established, and provisions should be re-versed to the extent they are no longer required for particular expenditures. UnderU.S. GAAP, contingent liabilities should be recognized as the low end of the rangeof possible amounts when a range of estimates exist; in some cases, the amount isnot discounted to present value.

With respect to disclosure of contingent liabilities, IAS 37 allows an enterprise“in extremely rare cases” to omit disclosures that “can be expected to prejudiceseriously the position of the enterprise in a dispute with other parties.” No suchexemption exists under U.S. GAAP.

Contingent AssetsA contingent asset is a probable asset that arises from past events and whose ex-istence will be confirmed only by the occurrence or nonoccurrence of a futureevent. Contingent assets should not be recognized, but should be disclosedwhen the inflow of economic benefits is probable. If the realization of incomefrom a contingency is determined to be virtually certain, then the related benefitis considered to meet the definition of an asset and recognition is appropriate.IAS 37 allows earlier recognition of a contingent asset (and related gain) thandoes U.S. GAAP, which generally requires the asset to be realized before it can berecognized.

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Summary of IAS 37, Recognition and Disclosure Guidelines

Contingent Element Likelihood of Realization Accounting Treatment

Contingent liability Probable (more likely than not)— Reliably measurable Recognize provision— Not reliably measurable DisclosureNot probable DisclosureRemote No disclosure

Contingent asset Virtually certain Recognize assetProbable DisclosureNot probable No disclosure

Appendix C to IAS 37 provides many illustrations of the application of the stan-dard’s recognition principles. Example 6 illustrates just how restrictive the conceptof “present obligation” is intended to be in determining whether a provisionshould be recognized. In the example, there is a legislative requirement to installsmoke filters by a particular date. The firm does not comply by the deadline. At thebalance sheet date subsequent to the missed deadline, there is no present obliga-tion related to the cost of installing smoke filters because no obligating event (i.e.,installation) has occurred. Therefore, no provision would be recognized. However,if it is more likely than not (probable) that a penalty will be paid for missing thedeadline, the best estimate of that penalty should be recognized as a provision be-cause an obligating event (i.e., noncompliance) has occurred.

RestructuringA difference exists between IAS 37 and U.S. GAAP with respect to when a provi-sion should be recognized related to a restructuring plan. IAS 37 indicates that theprovision should be recognized only when (1) a detailed formal plan exists, and(2) the plan’s main features have been announced to those affected by it or imple-mentation of the plan has begun.

U.S. GAAP does not allow recognition of a restructuring provision until a lia-bility has been incurred. The existence of a restructuring plan and its announce-ment does not necessarily create a liability. Thus, the recognition of a restructuringprovision may occur at a later date under U.S. GAAP.

IAS 19, Employee BenefitsIAS 19, Employee Benefits, is a comprehensive standard covering the followingtypes of employee benefits:

1. Short-term employee benefits (such as compensated absences and bonuses).2. Postemployment benefits (pensions, medical benefits, and other postemploy-

ment benefits).3. Other long-term employee benefits.4. Termination benefits (such as severance pay and early retirement benefits).

Pension PlansBoth IAS 19 and U.S. GAAP distinguish between defined contribution and definedbenefit pension plans. The definition of a defined contribution plan differs be-tween the two sets of standards and could lead to differences in classification(and therefore accounting) of pension plans. In addition to a potential difference in


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classification of pension plans, IAS 19 and U.S. GAAP differ on a number of issueswith respect to the accounting for defined benefit plans. Each of these issues isdiscussed in the following paragraphs.

Past Service CostPast service cost arises when an employer improves the benefits to be paid em-ployees in conjunction with a defined benefit plan. IAS 19 provides the followingrules related to past service cost:

• Past service cost related to retirees and vested active employees is expensed im-mediately.

• Past service cost related to nonvested employees is recognized on a straight-linebasis over the remaining vesting period.

In comparison, U.S. GAAP requires that the past service cost related to retirees beamortized over their remaining expected life, and the past service cost to activeemployees be amortized over their remaining service period.

Example: Recognition of Past Service CostAssume that on January 1, Year 7, Eagle Company Inc. amends its defined benefitpension plan to increase the amount of benefits to be paid. The benefits vest afterfive years of service. At the date of the plan amendment, the increase in the presentvalue of the defined benefit obligation attributable to vested and nonvested em-ployees is as follows:

146 Chapter Four

Employees with more than five years of service at 1/1/Y7 . . . . . . $10,000Employees with less than five years of service at 1/1/Y7 . . . . . . . . 8,000

Total present value of additional benefits . . . . . . . . . . . . . . . . . $18,000

On average, the nonvested employees have two years of service at 1/1/Y7.IFRSs Eagle Company recognizes the past service cost attributable to vested em-ployees in Year 7 and the past service cost attributable to nonvested employees isamortized on a straight-line basis over Years 7, 8 and 9 (average three years untilvesting). The total amount of past service cost recognized as a component of pen-sion expense in Year 7 is computed as follows:

Past service cost (vested employees) . . . . . . . . . . . . . . . . . . . . . . . $10,000Past service cost (nonvested employees) $8,000/3 years . . . . . . . . 2,667

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,667

The unrecognized past service cost of $5,333 is subtracted from the present valueof the defined benefit obligation in determining the amount of asset or liability tobe recognized on the balance sheet.U.S. GAAP Under U.S. GAAP, because all of the employees affected by the planamendment are active employees, the past service cost of $18,000 would be amor-tized to expense over the remaining service life of those employees. Assuming anaverage remaining service life of 12 years, $1,500 of past service cost would berecognized as a component of pension expense in Year 7.

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Minimum LiabilityU.S. GAAP requires recognition of at least the unfunded accumulated pensionbenefit obligation as a minimum liability on the balance sheet. There is no mini-mum liability recognition requirement in IAS 19.

Anticipation of Changes in Future BenefitsIAS 19 permits anticipation of future changes in the law in measuring the em-ployer’s pension benefit obligation. This is especially relevant in those situationswhere the level of pension benefits provided by the employer is linked to the levelof retirement benefit that will be provided by national and local governments. U.S.GAAP does not permit anticipation of future changes in the law.

Amortization of Actuarial Gains and LossesBoth IAS 19 and U.S. GAAP allow a similar “corridor” approach to smooth the im-pact that actuarial gains and losses have on net income. IAS 19 also permits anysystematic method of amortization that results in faster recognition of gains andlosses (including immediate recognition) provided the same basis is applied togains and losses and is applied consistently period to period. If a company choosesto recognize actuarial gains and losses in the period in which they occur, it may doso by including them either in net income or in a separate component of share-holders’ equity. Bypassing income to accumulate actuarial gains and losses inequity is not acceptable under U.S. GAAP.

Curtailments and SettlementsA pension plan curtailment arises when there is a material reduction in thenumber of employees covered by a plan (such as when a plant is closed as part ofa restructuring) or when the future service by current employees will no longerqualify for pension benefits or will qualify only for reduced benefits. A pensionplan settlement involves lump-sum cash payments to employees in exchange fortheir rights to received defined pension benefits. Gains and losses usually arise inconjunction with plan curtailments and settlements. IAS 19 treats these gains andlosses similarly; both are recognized in income in the period in which the entityis demonstrably committed and a curtailment or settlement has been announced.U.S. GAAP treats gains and losses on plan curtailments and settlements differ-ently, with losses generally recognized earlier than gains. A curtailment gain can-not be recognized until the related employees terminate or the plan has beenadopted.

Balance Sheet Recognition and LimitationThe amount recognized on the balance sheet related to a defined benefit plan canbe either an asset or a liability and is equal to the present value of the defined ben-efit obligation plus (minus) unrecognized actuarial gains (losses) minus any un-recognized past service cost (related to nonvested benefits) minus the fair value ofplan assets.

However, if the resulting amount is negative (net pension asset), the amount ofasset to be reported on the balance sheet is limited to the sum of any unrecognizedactuarial losses and past service cost, and the present values of any refunds avail-able from the plan and any available reduction in future employer contributions tothe plan.

Under U.S. GAAP, there is no limitation of the amount of pension asset to berecognized.


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Example: Application of the Limitation on the Recognition of the Net AssetAssume that the defined benefit plan of Fortsen Company Inc. has the followingcharacteristics at December 31, Year 9:

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Present value of defined benefit obligation . . . . . . . . . . . . . $10,000Fair value of plan assets . . . . . . . . . . . . . . . . . . . . . . . . . . . (10,800)Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (800)Unrecognized actuarial losses . . . . . . . . . . . . . . . . . . . . . . . (50)Unrecognized past service cost . . . . . . . . . . . . . . . . . . . . . . (30)Negative amount (possible asset) . . . . . . . . . . . . . . . . . . . . $ (880)Present value of available future refunds andreduction in future contributions . . . . . . . . . . . . $ 525

Unrecognized actuarial losses . . . . . . . . . . . . . . . . . . . . . . . $ 50Unrecognized past service cost . . . . . . . . . . . . . . . . . . . . . . 30Present value of available future refunds and reduction in future contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . 525

Limit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $605

The limit as to the amount of asset that may be recognized is computed as follows:

Fortsen Company recognizes a prepaid pension cost (pension asset) of $605 on its12/31/Y9 balance sheet and must disclose the fact that the limit reduced the car-rying amount of the asset by $275. Under U.S. GAAP, Fortsen Company wouldrecognize a pension asset in the amount of $880.

Exhibit A4.1 presents the note in Bayer AG’s reconciliation from IFRSs to U.S.GAAP related to the accounting for pension plans. Differences between IAS 19and U.S. GAAP resulted in adjustments related to the asset limitation includedin IAS 19, the additional minimum liability of U.S. GAAP, the amortization of atransition obligation, and the accounting for curtailment in certain plans.

Medical BenefitsIAS 19 does not provide separate guidance for other postemployment benefits suchas medical benefits. The procedures described above for pension plans is equallyapplicable for other forms of postemployment benefits provided to employees,such as medical benefits and life insurance contracts.

U.S. GAAP provides considerably more guidance than IAS 19 with regard tothe assumptions to be used and the measurement of the employer’s obligation forpostemployment medical benefits. As allowed by the IASB’s Framework, compa-nies using IFRSs could refer to the guidance provided in U.S. GAAP (or other na-tional standards) to identify an appropriate method for determining the amount ofexpense to recognize related to postemployment benefits other than pensions.

Termination BenefitsIAS 19 requires termination benefits to be recognized when an enterprise is demon-strably committed to either (1) terminating the employment of an employee orgroup of employees, or (2) providing termination benefits as a result of an offermade by the enterprise to encourage voluntary termination. A demonstrable com-mitment arises when a detailed formal plan exists from which the enterprise cannotwithdraw.

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U.S. GAAP distinguishes between three different types of termination benefitsand provides different timing recognition criteria for each:

1. Special termination benefits should be recognized when an employee acceptsthe offer.

2. Contractual termination benefits should be recognized when it is probable thatemployees will be entitled to benefits.

3. Termination benefits offered in conjunction with a restructuring should be rec-ognized when the plan is approved by management.

Adifferencealsoexistswithrespect to theamountof terminationbenefit torecognize.IAS 19 indicates that measurement should be based on the number of employ-

ees expected to accept the offer, discounted to present value if benefits fall due more

BAYER AGForm 20-F

2004 Pension Expense

Notes to the Consolidated Financial Statements of the Bayer Group

Excerpt from Note [44] U.S. GAAP Information

c. Pension Provisions

Under IFRS, pension costs and similar obligations are accounted for in accordance with IAS 19,“Employee Benefits”. For purposes of U.S. GAAP, pension costs for defined benefit plans are accountedfor in accordance with SFAS No. 87 “Employers’ Accounting for Pensions”. Using an accommodation ofthe United States Securities and Exchange Commission (“SEC”) for foreign private issuers, the Groupadopted SFAS No. 87 on January 1, 1994, for its non-U.S. plans, which was also the date of adoption forIAS 19 for those plans. It was not feasible to apply SFAS No. 87 on the effective date specified in thestandard. IAS 19 as applied by the Group from 1994 was substantially similar to the methodologyrequired under SFAS No. 87. The adjustment between IFRS and U.S. GAAP comprises required SFAS 87 amortization of the unrecognized transition obligation over the remaining average service lives ofemployees from 1994 of €238 million, the recognition of an asset limitation under IAS 19, which is notallowed under SFAS No. 87, and the recognition of an additional minimum liability under SFAS No. 87,which is not required under IAS 19. As of December 31, 2003 the unrecognized transition obligationfrom 1994 was fully amortized.

Following is a reconciliation of the balance sheet and income statement amounts recognized for IFRS andU.S. GAAP for both pension and post-retirement benefit plans:

2002 2003 2004

(€ million)

Pension benefits:

Liability recognized for IFRS . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,741) (3,812) (3,827)

Asset limitation under IAS 19 . . . . . . . . . . . . . . . . . . . . . . . . . . 1,187 1,193 1,196

Additional minimum liability under SFAS No. 87 . . . . . . . . . . . . (480) (637) (1,024)

Difference in unrecognized transition obligation . . . . . . . . . . . . 23 — —

Difference in pension curtailment . . . . . . . . . . . . . . . . . . . . . . . — — (44)

Liability recognized for U.S. GAAP . . . . . . . . . . . . . . . . . . . (3,011) (3,256) (3,699)

Net periodic benefit cost recognized for IFRS . . . . . . . . . . . . . . 521 747 581

Amortization of transition obligation . . . . . . . . . . . . . . . . . . . . 24 23 —

Difference pension curtailment . . . . . . . . . . . . . . . . . . . . . . . . . — — 48

Net periodic benefit recognized for U.S. GAAP . . . . . . . . . 545 770 629

EXHIBIT A4.1

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than 12 months after the balance sheet date. Under U.S. GAAP, measurement isbased on the number of employees that actually accept the offer and discounting isnot required.

IFRS 2, Share-based PaymentIFRS 2, Share-based Payment, sets out measurement principles and specific require-ments for three types of share-based payment transactions:

1. Equity-settled share-based payment transactions, in which the entity receivesgoods or services as consideration for equity instruments of the entity (includ-ing stock options granted to employees).

2. Cash-settled share-based payment transactions, in which the entity acquiresgoods or services by incurring liabilities to the supplier of those goods or ser-vices for amounts that are based on the price (or value) of the entity’s shares orother equity instruments of the entity (e.g., share appreciation rights).

3. Transactions in which the entity receives or acquires goods or services and theterms of the arrangement provide either the entity or the supplier of thosegoods or services with a choice of whether the entity settles the transaction incash or by issuing equity instruments.

IFRS 2 requires an entity to recognize all share-based payment transactions in itsfinancial statements; there are no exceptions.

Stock Options Granted to EmployeesIFRS 2 requires the fair value method to be used in accounting for stock optionsgranted to employees. Under this method, total compensation expense is com-puted as the fair value of the options expected to vest on the date the options aregranted. Total compensation expense is recognized (allocated) over the serviceperiod for which the employee is being compensated. The fair value of the op-tions should be based on market prices, if available. In the absence of marketprices, fair value is estimated, using a valuation technique (e.g., a Black-Scholesmodel).

The IASB and the FASB worked closely in developing new standards relatedto accounting for share-based payments. Concurrent with the IASB’s issuance ofIFRS 2, the FASB published an exposure draft in March 2004, and subsequentlyissued a final standard on this topic in December 2004. Although minor differ-ences exist between the two standards, IFRS 2 and U.S. GAAP are substantiallysimilar.

IAS 12, Income TaxesIAS 12, Income Taxes, and U.S. GAAP take a similar approach to accounting for in-come taxes. Both standards adopt an asset-and-liability approach that recognizesdeferred tax assets and liabilities for temporary differences and for operating lossand tax credit carryforwards. However, differences do exist. The accounting forincome taxes is a very complex topic, and only some of the major differences arediscussed here.

Tax Laws and RatesIAS 12 requires that current and deferred taxes be measured on the basis of taxlaws and rates that have been enacted or substantively enacted by the balance sheetdate, but it provides no guidance for determining when a law has been substan-tively enacted. U.S. GAAP requires measurement of income taxes using actually

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enacted tax laws and rates. IAS 12 provides no guidance on which tax rate to usein jurisdictions where different tax rates exist for distributed and undistributedincome, such as Germany and Greece, or how to deal with alternative tax systems,such as the alternative minimum tax in the United States. Each of these issues iscovered by U.S. GAAP.

Recognition of Deferred Tax AssetIAS 12 requires recognition of a deferred tax asset if future realization of a tax ben-efit is probable, where probable is undefined. Under U.S. GAAP, a deferred tax assetmust be recognized if its realization is more likely than not. If the word probable canbe considered to imply a probability of occurrence that is greater than the phrasemore likely than not, then IAS 12 provides a more stringent threshold for the recog-nition of a deferred tax asset.1

Exceptions in Recognizing Deferred TaxesBoth IAS 12 and U.S. GAAP contain exceptions to the general rule that deferredtaxes are recognized for temporary differences. In some cases, IAS 12 requiresrecognition of a difference that U.S. GAAP prohibits; in other cases, U.S. GAAPrequires recognition of a difference not allowed by IAS 12.

Application of IFRSsApplication of IFRSs can create temporary differences unknown under U.S.GAAP. For example, the revaluation of property, plant, and equipment for finan-cial statement purposes (in accordance with IAS 16’s allowed alternative treat-ment) with no equivalent adjustment for tax purposes will result in a temporarydifference that cannot exist under U.S. GAAP. Other differences between IFRSsand U.S. GAAP can create different amounts of temporary differences. For exam-ple, because of different definitions of impairment, differences in the amount of animpairment loss can exist under the two sets of standards. With no equivalent taxadjustment, the amount of temporary difference related to the impairment losswill be different in a set of IFRS-based financial statements form the amount rec-ognized under U.S. GAAP.

IAS 18, RevenueIAS 18, Revenue, is a single standard that covers most revenues, in particular rev-enues from the sale of goods; the rendering of services; and interest, royalties, anddividends. There is no similar single standard in U.S. GAAP. U.S. rules related torevenue recognition are found in various authoritative pronouncements; making adirect comparison between IAS 18 and U.S. GAAP is difficult.

General Measurement PrincipleIAS 18 requires revenue to be measured at the fair value of the considerationreceived or receivable.

Identification of the Transaction Generating RevenueIf a transaction consists of distinct elements, each element should be accounted forseparately. For example, if a sale of computer software is accompanied by an


1Research shows that, on average, accountants associate a probability of about 75–80 percent with theterm probable. See, for example, J. L. Reimers, “Additional Evidence on the Need for Disclosure Reform,”Accounting Horizons, March 1992, pp. 36–41.

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agreement to provide maintenance (postcontract support) for a period of time, theproceeds received by the seller should be allocated between the amount applicableto the software (recognized at the time of sale) and the amount identifiable withthe postcontract support (recognized over the period of support). Conversely,there may be situations where it is necessary to treat two or more separate trans-actions as one economic transaction to properly reflect their true economic sub-stance.

Sale of GoodsFive criteria must be met in order for revenue from the sale of goods to berecognized:

• The significant risks and rewards of ownership of the goods has been trans-ferred to the buyer.

• Neither continuing managerial involvement normally associated with owner-ship nor effective control of the goods sold is retained.

• The amount of revenue can be measured reliably.• It is probable that the economic benefits associated with the sale will flow to the

seller.• The costs incurred or to be incurred with respect to the sale of goods can be

measured reliably.

Evaluating whether significant risks and rewards of ownership have beentransferred to the buyer can sometimes be difficult and require the exercise ofjudgment. IAS 18 provides a list of examples in which significant risks and rewardsmight be retained by the seller. These include the following:

• The seller assumes an obligation for unsatisfactory performance not covered bynormal warranty provisions.

• Receipt of revenue by the seller is contingent on the buyer’s generating revenuethrough its sale of the goods.

• Goods sold are subject to installation, installation is a significant part of the con-tract, and installation has not yet been completed.

• The sales contract gives the buyer the right to rescind the purchase, and theprobability of return is uncertain.

Similarly, in determining whether the seller has relinquished managerial involve-ment or control over the goods sold, a careful evaluation is required for some typesof sales.

Rendering of ServicesWhen the outcome of a service transaction can be estimated reliably and it is prob-able that economic benefits of the transaction will flow to the enterprise, revenueshould be recognized in proportion to some measure of the extent of services ren-dered (that is, on a percentage-of-completion basis). The outcome of a transactioncan be estimated reliably when (1) the amount of revenue, (2) the costs incurredand the costs to be incurred, (3) and the stage of completion can all be measuredreliably. Guidelines provided in IAS 11, Construction Contracts, related to the appli-cation of the percentage-of-completion method are generally applicable to therecognition of revenue for service transactions.

When the outcome of a transaction cannot be estimated reliably, revenue shouldbe recognized only to the extent that expenses incurred are probable of recovery. If

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such underlying expenses are not probable of recovery, the expense should be rec-ognized, but not the revenue.

Interest, Royalties, and DividendsIf it is probable that the economic benefits of interest, royalties, and dividends willflow to the enterprise and the amounts can be measured reliably, revenue shouldbe recognized on the following bases:

• Interest income is recognized on an effective yield basis.• Royalties are recognized on an accrual basis in accordance with the terms of the

relevant agreement.• Dividends are recognized when the shareholders’ right to receive payment is

established.

Exchanges of Goods or ServicesIf the exchanged goods are similar in nature and in value, no gain or loss is recog-nized. If the exchanged goods or services are dissimilar in nature, revenue is rec-ognized at the fair value of the goods or services received, adjusted for the amountof any cash paid or received. When the fair value of the goods or services receivedcannot be measured reliably, revenue should be measured as the fair value of thegoods or services given up, adjusted for the amount of any cash paid or received.

AppendixThe appendix to IAS 18 provides examples illustrating the application of the stan-dard to most major types of revenues. Most of the examples are self-explanatoryand the relationships of the examples to the underlying provisions of the standardare straightforward.

IAS 32 and IAS 39, Financial InstrumentsIAS 32, Financial Instruments: Disclosure and Presentation, and IAS 39, FinancialInstruments: Recognition and Measurement, were developed on the basis of U.S.GAAP. Both sets of standards

• Require financial assets and liabilities to be measured and reported at fair value.• Allow the use of hedge accounting when certain criteria are met. (Hedge

accounting is discussed in Chapter 6 of this book.)

However, numerous differences exist between IAS 32 and IAS 39 and U.S. GAAP.For example, IAS 32 requires a convertible debt instrument to be split into its liabil-ity and equity components and classified accordingly, whereas U.S. GAAP treatsconvertible debt as a liability. The discussion of other differences, especially withrespect to derivative financial instruments, is beyond the scope of this book.

It should be noted that the adoption of IAS 39 met with considerable resis-tance in the European Union. The European Commission ultimately decided in2004 to endorse IAS 39, but with exceptions. The commission modified theversion of IAS 39 to be applied by publicly traded companies in the EU withrespect to certain provisions on the use of a full fair value option and on hedgeaccounting. According to the European Commission, these “carve-outs” aretemporary, in effect only until the IASB modifies IAS 39 in line with Europeanrequests.2


2Ernst & Young, “The Evolution of IAS 39 in Europe,” Eye on IFRS Newsletter, November 2004, pp. 1–4.

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Questions 1. What are two issues related to the recognition and measurement of assets forwhich IFRSs provide both a benchmark treatment and an allowed alternativetreatment?

2. How does application of the lower of cost or market rule for inventories differbetween IAS 2 and U.S. GAAP?

3. What is the alternative treatment allowed by IAS 16 for measuring property,plant, and equipment at dates subsequent to original acquisition?

4. How is an impairment loss on property, plant, and equipment determined andmeasured under IAS 36? How does this differ from U.S. GAAP?

5. What is the IAS 23 benchmark treatment with respect to borrowing costs? Howdoes this treatment differ from U.S. GAAP?

6. How do the criteria for determining whether a lease qualifies as a finance(capitalized) lease differ between IAS 17 and U.S. GAAP?

7. How do the criteria for the recognition of contingencies differ between IAS 37and U.S. GAAP?

8. What are the rules under IAS 19 for dealing with the past service cost that ariseswhen an employer improves the benefits to be paid employees in conjunctionwith a defined benefit plan? How do these rules differ from U.S. GAAP?

1. To determine the amount at which inventory should be reported on the Decem-ber 31, Year 1, balance sheet, Monroe Company compiles the following infor-mation for its inventory of Product Z on hand at that date:

Historical cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000Replacement cost . . . . . . . . . . . . . . . . . . . . . . . . $14,000Estimated selling price . . . . . . . . . . . . . . . . . . . . . $17,000Estimated costs to complete and sell . . . . . . . . . . $2,000Normal profit margin as % of selling price . . . . . . 20%

The entire inventory of Product Z that was on hand at December 31, Year 1, wascompleted in Year 2 at a cost of $1,800 and sold at a price of $17,150.

Required:a. Use the information provided in this chapter related to the accounting for in-

ventories to determine the impact on Year 1 and Year 2 income related toProduct Z (1) under IFRSs and (2) under U.S. GAAP.

b. Summarize the difference in income, total assets, and total stockholders’ equityusing the two different sets of accounting rules over the two-year period.

2. In Year 1, in a project to develop Product X, Lincoln Company incurred researchand development costs totaling $10 million. Lincoln is able to clearly distin-guish the research phase from the development phase of the project. Research-phase costs are $6 million, and development-phase costs are $4 million. All ofthe IAS 38 criteria have been met for recognition of the development costs as anasset. Product X was brought to market in Year 2 and is expected to be marketablefor five years. Total sales of Product X are estimated at over $100 million.

Required:a. Use the information provided in this chapter related to the accounting for in-

ternally generated intangible assets to determine the impact on Year 1 and

Exercises andProblems

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Year 2 income related to research and development costs (1) under IFRSs and(2) under U.S. GAAP.

b. Summarize the difference in income, total assets, and total stockholders’ eq-uity related to Product X over its five-year life under the two different sets ofaccounting rules.

3. Jefferson Company acquired equipment on January 2, Year 1, at a cost of $10million. The asset has a five-year life, no residual value, and is depreciated on astraight-line basis. On January 2, Year 3, Jefferson Company determines the fairvalue of the asset (net of any accumulated depreciation) to be $12 million.

Required:a. Determine the impact the equipment has on Jefferson Company’s income in

Years 1–5 (1) using IFRSs, assuming that IAS 16’s allowed alternative treat-ment for measurement subsequent to initial recognition is followed, and(2) using U.S. GAAP.

b. Summarize the difference in income, total assets, and total stockholders’equity using the two different sets of accounting rules over the period Year 1–Year 5.

4. Madison Company acquired a depreciable asset at the beginning of Year 1 at acost of $12 million. At December 31, Year 1, Madison gathered the following in-formation related to this asset:

Carrying amount (net of accumulated depreciation) . . . . . . . . $10 millionFair value of the asset (net selling price) . . . . . . . . . . . . . . . . . $7.5 millionSum of future cash flows from use of the asset . . . . . . . . . . . . $10 millionPresent value of future cash flows from use of the asset . . . . . $8 millionRemaining useful life of the asset . . . . . . . . . . . . . . . . . . . . . . 5 years

Required:a. Use the information provided in this chapter related to the impairment of as-

sets to determine the impact on Year 2 and Year 3 income from the deprecia-tion and possible impairment of this equipment (1) under IFRSs and (2) underU.S. GAAP.

b. Summarize the difference in income, total assets, and total stockholders’ eq-uity for the period Year 1–Year 6 under the two different sets of accountingrules.

Note: If the asset is determined to be impaired, there would be no adjustment toYear 1 depreciation expense of $2 million.

5. Garfield Company begins construction of a building for its own use on January 2,Year 1. Construction is complete and Garfield moves in to the building onDecember 30, Year 1. The total cost of construction, which is incurred evenlythroughout Year 1, is $10 million. (Weighted-average accumulated expendituresduring Year 1 were $5 million.) Garfield obtains a loan of $8 million at aninterest rate of 10 percent on January 2, Year 1. Garfield Company has no otherborrowings. The building is estimated to have a useful life of 20 years and aresidual value of $2 million.

Required:a. Use the information provided in this chapter related to borrowing costs to

determine the impact on Year 1 and Year 2 income (1) under IFRSs, assumingIAS 23’s benchmark treatment is followed, and (2) under U.S. GAAP.


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b. Summarize the difference in income, total assets, and total stockholders’equity over the 20-year life of the building under the two different sets ofaccounting rules.

6. Iptat International Ltd. provided the following reconciliation from IFRSs to U.S.GAAP in its most recent annual report (amounts in thousands of CHF):

156 Chapter Four

Shareholders’Net Income Equity

As stated under IFRSs . . . . . . . . . . . . . . . . . . . . . . . . 541,713 7,638,794U.S. GAAP adjustments(a) Reversal of additional depreciation charges

arising from revaluation of fixed assets . . . . . . . . 85,720 643,099(b) Reversal of revaluation surplus of fixed assets . . . — (977,240)As stated under U.S. GAAP . . . . . . . . . . . . . . . . . . . . 627,433 7,305,653

Shareholders’Net Income Equity

As stated under IFRSs . . . . . . . . . . . . . . . . . . . . . . . 938,655 4,057,772U.S. GAAP adjustments(a) Reversal of amortization charge on goodwill . . . . 5,655 16,965(b) Gain on sale and leaseback of building (40,733) (66,967)As stated under U.S. GAAP . . . . . . . . . . . . . . . . . . . 903,577 4,007,770

Required:a. Explain why U.S. GAAP adjustment (a) results in an addition to net income.

Explain why U.S. GAAP adjustment (a) results in an addition to sharehold-ers’ equity that is greater than the addition to net income. What is the share-holders’ equity account affected by adjustment (a)?

b. Explain why U.S. GAAP adjustment (b) results in a subtraction from share-holders’ equity but does not affect net income. What is the shareholders’ eq-uity account affected by adjustment (b)?

7. Xanxi Petrochemical Company provided the following reconciliation fromIFRSs to U.S. GAAP in its most recent annual report (amounts in thousandsof RMB):

Required:a. Explain why U.S. GAAP adjustment (a) results in an addition to net income.

Explain why U.S. GAAP adjustment (a) results in an addition to sharehold-ers’ equity that is greater than the addition to net income. What is the share-holders’ equity account affected by adjustment (a)?

b. Explain why U.S. GAAP adjustment (b) reduces net income. Explain whyU.S. GAAP adjustment (b) reduces shareholders’ equity by a larger amountthan it reduces net income. What is the shareholders’ equity account affectedby adjustment (b)?

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8. On October 1, Year 1, Clinton Company purchased all of the outstanding sharesof Gore Company by paying $250,000 in cash. Gore has several assets with mar-ket values that differ from their book values. In addition, Gore has internallygenerated intangibles that remain unrecorded on its books. In deriving a pur-chase price, Clinton made assessments of the fair value of Gore’s net assets asfollows:


Book Value Fair Value

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $30,000 $30,000Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 50,000Computer software . . . . . . . . . . . . . . . . . . . . . . . 20,000 40,000Brands . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 50,000Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (40,000) (40,000)

In addition, in-process research and development costs incurred by Gore up tothe date of acquisition were $100,000. Sixty percent of in-process research anddevelopment costs were related to research. One-half of the costs related to de-velopment were incurred prior to the technical feasibility of completing and theability to sell the product could be demonstrated.

Required:Determine the amount of goodwill to be reported in accordance with IAS 22 byClinton Company as a result of its purchase of Gore Company.

9. Buch Corporation purchased Machine Z at the beginning of Year 1 at a cost of$100,000. The machine is used in the production of Product X. The machine isexpected to have a useful life of 10 years and no residual value. The straight-line method of depreciation is used. Adverse economic conditions develop inYear 3 that result in a significant decline in demand for Product X. At Decem-ber 31, Year 3, the company develops the following estimates related toMachine Z:

Expected future cash flows . . . . . . . . . . . . . . . . $75,000Present value of expected future cash flows . . . 55,000Selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000Costs of disposal . . . . . . . . . . . . . . . . . . . . . . . . 7,000

At the end of Year 5, Buch’s management determines that there has been a sub-stantial improvement in economic conditions resulting in a strengthening of de-mand for Product Z. The following estimates related to Machine Z are developedat December 31, Year 5:

Expected future cash flows . . . . . . . . . . . . . . . . $70,000Present value of expected future cash flows . . . 53,000Selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000Costs of disposal . . . . . . . . . . . . . . . . . . . . . . . . 7,000

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Required:Apply IAS 36 to determine:a.The carrying value for Machine Z to be reported on the balance sheet at the

end of Years 1–5.b.The amounts to be reported in the income statement related to Machine Z for

Years 1–5.10. On January 1, Year 1, Holzer Company hired a general contractor to begin con-

struction of a new office building. Holzer negotiated a $900,000, five-year,10 percent loan on January 1, Year 1, to finance construction. Payments made tothe general contractor for the building during Year 1 amount to $1,000,000. Pay-ments were made evenly throughout the year. Construction is completed at theend of Year 1 and Holzer moves in and begins using the building on January 1,Year 2. The building is estimated to have a 40-year life and no residual value.

On December 31, Year 3, Holzer Company determines that the market valuefor the building is $970,000. On December 31, Year 5, the company estimates themarket value for the building to be $950,000.

Required:Using the benchmark and allowed alternative treatments provided in (1) IAS 16with respect to the measurement of property, plant, and equipment subse-quent to initial recognition and (2) IAS 23 with respect to borrowing costsattributable to the construction of qualifying assets, there are four differentcombinations that could be used to determine the carrying value of the build-ing over its useful life. For each of the four possible combinations determine:a. The carrying value of the building that would be reported on the balance

sheet at the end of Years 1–5.b. The amounts to be reported in the income statement related to this building

for Years 1–5.In each case, assume that the building’s value in use exceeds its carrying valueat the end of each year and therefore impairment is not an issue.

11. Access the most recent Form 20-F filed with the U.S. Securities and ExchangeCommission by one of the following foreign companies:

BayerChina Southern AirlinesNokiaNovartisSwisscom

Find the reconciliation from IFRSs to U.S. GAAP. Select three line items in-cluded in the reconciliation to fulfill the requirements of this exercise.

Required:For each of the three line items:a. Describe, in your own words, the difference between the rules in IFRSs and

the rules in U.S. GAAP that caused a reconciliation adjustment to be made.b. Explain the sign of the adjustments (positive or negative) related to net in-

come and stockholders’ equity. If possible, also explain the magnitude of theadjustments related to net income and stockholders’ equity and/or the rela-tive magnitude of the adjustment to net income and the adjustment to stock-holders’ equity.

158 Chapter Four

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Case 4-1

Jardine Matheson Group (Part 2)With a broad portfolio of market-leading businesses, the Jardine Matheson Group isan Asian-based conglomerate with extensive experience in the region. Its businessinterests include Jardine Pacific, Jardine Motors Group, Hongkong Land, DairyFarm, Mandarin Oriental, Jardine Cycle & Carriage and Jardine Lloyd Thompson.These companies are leaders in the fields of engineering and construction, transportservices, motor trading, property, retailing, restaurants, hotels and insurancebroking.

The Group’s strategy is to build its operations into market leaders across AsiaPacific, each with the support of Jardine Matheson’s extensive knowledge of theregion and its long-standing relationships. Through a balance of cash producingactivities and investment in new businesses, the Group aims to produce sustainedgrowth in shareholder value.

Incorporated in Bermuda, Jardine Matheson has its primary share listing inLondon, with secondary listings in Singapore and Bermuda. Jardine MathesonLimited operates from Hong Kong and provides management services to Groupcompanies, making available senior management and providing financial, legal,human resources and treasury support services throughout the Group.1

Jardine Matheson uses International Financial Reporting Standards in preparingits financial statements and has done so for a number of years.

Required:Access Jardine Matheson’s most recent annual report on the company’s Web site(www.jardine-matheson.com). Review the company’s list of principal accountingpolicies to evaluate whether the accounting policies followed are in accordance withIFRSs. Document your evaluation. In those areas in which IFRSs allow choice amongaccounting alternatives, identify the alternative selected by Jardine Matheson.


1 www.jardine-matheson.com/profile/intro.html, accessed March 2005.

References Financial Accounting Standards Board. The IASC-U.S. Comparison Project, 2nd ed.Norwalk, CT: FASB, 1999.Ernst & Young. “The Evolution of IAS 39 in Europe,” Eye on IFRS Newsletter,November 2004, pp. 1–4.Reimers, J. L. “Additional Evidence on the Need for Disclosure Reform.”Accounting Horizons, March 1992, pp. 36–41.

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