Lewis A. Dulitz, vice president of accounting policies and research at Covidien—a $10.7 billion health care products company with 42,000 employees in more than 60 countries—was part of a team that implemented the necessary technology changes in Europe to help Covidien convert to IFRS and led a similar team in the U.S. He answered questions from the JofA about the experience and provided advice for other companies to consider.
JofA: Why did Covidien begin its IFRS implementation?
Dulitz: In December 2008, Covidien announced it was relocating its principal executive office from Bermuda—which reports in U.S. GAAP—to Ireland, where local companies were required to file with the Irish authorities in accordance with either IFRS or Irish GAAP. We were preparing to file in accordance with IFRS beginning with our fiscal 2009 year-end for local purposes while maintaining our SEC filings in accordance with U.S. GAAP. Recently a change in Irish law extended our ability to use U.S. GAAP for our Irish filings, but we have continued to prepare internally for IFRS implementation.
JofA: Explain the planning process involved with technology considerations.
Dulitz: Our director of Information Services is a key member of our core project team. Once our accounting differences were identified, we discussed the type of information that we would need from each application and how best to extract the data (for example, systemic reporting vs. a workaround). This approach helped us quickly narrow the scope of impacted applications.
There is not a lot of information on which applications are best suited for IFRS—either with our existing ERP systems or new systems we were considering purchasing—or what challenges you will face during your implementation. The key feature to consider is flexibility. Most companies will continue to have the requirement to report U.S. GAAP results for a transitional period, so companies must figure out how to best layer on IFRS information without compromising the integrity of their U.S. GAAP data.
We also used a publication by Ernst & Young to compare differences in our inventory listing of applications and planned purchases. This publication highlights certain IFRS “gotchas” in various applications like Oracle, SAP and PeopleSoft.
JofA: Can you give a few examples of systems that were impacted? (See Exhibit 1 below for a summary of examples.)
Dulitz: Fixed-asset ledger: Let’s say you own a building with a historical cost of $40 million. Most U.S. companies would account for the building on a composite basis, meaning one asset record in the fixed-asset ledger with one useful life, typically 40 years. The theory behind componentization is that significant parts of large assets like buildings or manufacturing equipment have different useful lives. This is akin to a cost segregation study for tax reporting.
In the example of the owned building, it is not probable that the roof, heating and air conditioning system or elevators will last 40 years, so they will be identified separately from the building structure, assigned a relative fair value and their own useful life. The resulting income statement impact is accelerated depreciation expense as the asset is being depreciated over a shorter aggregate useful life. We approached componentization by looking at our historical data to evaluate what a component is. This process involved extracting millions of lines of data and segmenting the data into different asset value ranges. We then met with our subject matter experts to agree upon the definition of a component and align useful lives. The next challenge was to determine what system and process modifications should be made.
Systems considerations for fixed assets include:
Does your system limit the total number of fixed-asset records?
Will you be able to systemically calculate
incremental depreciation expense for your opening balance sheet assets that you componentize, or will you use Excel?
How will you reflect your adjusted carrying value in subsequent years?
Do you plan on embedding controls in your system to prevent data input errors (for example, components being assigned a useful life of a composite asset)?
How will you ensure that all components to an asset that is impaired are properly derecognized?
How will you account for impairment reversals?
Process considerations include:
If you have multiple fixed-asset systems, how do you achieve conformity?
How will you align useful lives and definitions of components?
How does componentization affect your repairs and maintenance policies?
Research and development (“R&D”) also was impacted. In the health care industry, most U.S. companies expense R&D costs until regulatory approval is received. IFRS views the accounting for the “R” and the “D” differently. Research costs are expensed, but certain costs during the development phase are eligible for capitalization at an earlier point than under U.S. GAAP—technological feasibility (the ability to produce a product that will generate cash flow that is probable and costs reliably measured). This change complicates the process for many companies as the current accounting under U.S. GAAP is simple as almost all costs, regardless of type, are expensed throughout the development cycle. Internal alignment must be reached as to when technological feasibility occurs and what types of costs are eligible for capitalization. We modified our product development system to accommodate an IFRS life cycle.
Share-based compensation was another focus area. There are many differences with respect to share-based compensation between IFRS and U.S. GAAP, but I will focus on graded vesting. If you think about a simple three-year option grant, most U.S. companies straight-line the compensation expense over the vesting period. IFRS views the grant as three separate instruments each with its own fair value and amortization period. It is very similar to the componentization concept for fixed assets.
From a systems perspective, grants will have to be split into individual tranches for each employee as well as a fair value attributed to each tranche, which may differ from your U.S. GAAP fair value as the underlying assumptions used to value an option will change (term, volatility, forfeiture rate, etc.). Companies will have to evaluate whether their current software can accommodate IFRS reporting or if an offline work-around is required. We worked closely with our external service provider to enable systemic reporting.
Exhibit 1: Systems Affected by IFRS Conversion
||Separate large assets into individual components.
||Revise mapping of useful lives to asset codes and improve asset tagging to accommodate impairment and impairment reversals.|
|Research and Development
||Certain development costs are eligible for capitalization earlier than under U.S. GAAP.
||Add fields to allow the tracking of an IFRS product life cycle to document when capitalization begins.|
||Separate grants into tranches; value and amortize.
||Properly separate grants into tranches and validate amortization expense.|
JofA: What was your most significant system change?
Dulitz: Our consolidation system. Our goal was to have system-generated IFRS-compliant financial statements. We designed reporting within our consolidation system, Hyperion Financial Management, to generate IFRS financial statements at a consolidated and individual legal-entity level as well as reports by individual IFRS difference to facilitate automatically populating our footnotes. Whether you are reporting on an individual entity or consolidating 100 entities, you have to decide how to capture the differences (gross vs. net), where the quantified adjustments will reside (inside the ledger or consolidation tool or outside) and what your approach will be in Year 2—will your adjustments roll forward, or will you have to add Year 2 adjustments to Year 1 adjustments?
JofA: How did you approach training?
Dulitz: We did not expect every person in our finance organization to be an IFRS expert. We leveraged our existing U.S. GAAP subject matter experts and created our own Web-based IFRS checklist focusing on our industry, company and IFRS 1 (First-time Adoption of IFRS) elections. For completeness, we wanted our field controllers to answer questions to assist in the identification of IFRS differences and leverage the reporting technology within the tool to improve the effectiveness of our core team’s review. For example, reports could be generated by individual entity, entity type (finance company, manufacturing, etc.) or IFRS difference (pension, restructuring, etc.).
JofA: How much time should companies budget for their implementation?
Dulitz: In my experience and speaking with some of my European colleagues, most companies compressed their implementation into 18 to 24 months. The EU only required one year of comparable financial information for initial IFRS filings. It appears the SEC will require U.S. companies implementing IFRS to provide two years of comparable information. Although much of the work is upfront, this still results in additional analyses and one more year of audited financial statements. For companies that want to have parallel reporting of IFRS and U.S. GAAP by 2013, start now.
Many companies have not and will not start until there is a date certain set by the SEC, which may result in shorter implementation windows for these companies and increased cost.
JofA: Is there any way to cut down on costs?
Dulitz: Identify what is a nice-to-have vs. a need-to-have for your company. Your documentation must be accurate and auditable. It is easier if it is system-generated, but cost is a factor that may lead companies to manual solutions in the near term.
Be realistic with your project plan. Every system does not need to be transactional on Day 1. You can continue U.S. GAAP procedures as long as you know where your differences lie, how to quantify the differences and adjust your financial statements accordingly. Say under U.S. GAAP your fixed assets are $20 million, but under IFRS it is $16 million. How will you reflect that $4 million? Where will you post it? Offline in Excel? Or ERP? What do your records support, the $16 million IFRS balance or the $4 million difference between IFRS and U.S. GAAP? How do you plan to archive that information?
JofA: Any other advice?
Dulitz: Ask your external service providers what their level of IFRS knowledge is and about their internal road map. Understand where they are from an educational and systems perspective. In particular, your actuaries are critical to the process. There are significant differences in accounting for pensions, acquisitions, business valuation for impairment testing, and share-based compensation. A lot of smaller service providers might not have even started to develop systems or expertise within their office. Most accountants and actuaries will be learning IFRS in real time. Start your diligence to ensure you have the right partners involved, communicate your expectations, and obtain their commitment to meet your needs.
Alexandra DeFelice is a JofA senior editor. To comment on this article or to suggest another article, contact her at email@example.com or 212-596-6122.