Convergence: In Search of the Best

EXECUTIVE SUMMARY

THE CONVERGENCE AGREEMENT BETWEEN FASB and the IASB is significantly affecting U.S. and international financial reporting. THERE IS NO SINGLE PATH TO CONVERGENCE , but an open-minded pursuit of the highest quality guidance should result in standards that foster superior financial reporting. CONVERGENCE WILL REQUIRE CHANGES in both U.S. and international standards. INTERNATIONAL STANDARDS MAY CHANGE to follow accounting standards in a particular country. For example, international accounting standards resemble U.S. standards in accounting for discontinued operations. U.S. STANDARDS ARE NOT ALWAYS SUPERIOR to international standards. For the reporting of accounting changes, for example, U.S. standards are converging toward international standards. CONVERGENCE DOES NOT ALWAYS RESULT IN the adoption of either U.S. or international standards, as is currently the case for extraordinary items. In some instances, the eventual solution may be convergence to a third, superior approach.

DON HERRMANN, CPA, PhD, is an associate professor of accounting in the Spears School of Business at Oklahoma State University in Stillwater and an officer of the International Section of the American Accounting Association. IAN P.N. HAGUE, CA, is a principal with the Accounting Standards Board of Canada in Toronto.

sk CPAs to name a top priority in the development of accounting standards, and some will answer, “Convergence.” Many others, though, will say the quest for global standards has little relevance for them. But international accounting standards and U.S. GAAP increasingly influence each other, making it important for all CPAs to understand how FASB’s conforming a U.S. GAAP standard to an international financial reporting standard (IFRS) can significantly affect American companies—whether or not they do business internationally.

The cross-fertilization that’s going on is the result of an agreement between the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) to make their existing financial reporting standards compatible with each other to better respond to the complexity of the world’s markets (See “ The Urge to Converge ”). The IASB and FASB have taken a flexible approach to convergence and are focusing on issuing standards of the highest quality possible, regardless of where the principles underlying them originated. To illustrate their method, we’ll look at the evolution of recent changes in FASB and IASB guidance on various aspects of accounting affecting the lower portion of the income statement.

Once a modification to a reporting standard is agreed upon, it’s crucial for firms and companies to promptly distribute the news to their staffs. Therefore, this article also offers practical tips on effectively communicating the latest convergence guidance to CPAs in companies and firms.

QUALITY TRUMPS FAMILIARITY
In developing high-quality accounting standards, standard setters may opt for either FASB or IASB guidance. If neither is adequate, they may emulate a third jurisdiction’s standard or develop a completely new rule. The approaches FASB and the IASB have taken to income below continuing operations aptly illustrate this flexible and quality-focused convergence. Income below continuing operations includes discontinued operations, accounting changes and extraordinary items. To achieve the best guidance on these topics, FASB and the IASB decided to converge IFRSs to U.S. GAAP in one instance and U.S. GAAP to IFRSs in another. In the third, they developed a new approach altogether.

IFRSs CONVERGE TO U.S. GAAP: DISCONTINUED OPERATIONS
In developing their respective positions on this subject, FASB and the IASB reviewed their pronouncements—FASB Statement no. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, and International Accounting Standard (IAS) 35, Discontinuing Operations —and jointly concluded that Statement no. 144 contained the preferable and more recent guidance. In this instance, U.S. GAAP did not change, and there were no unusual developments of significance to CPAs.

Originally, IAS 35 had defined a discontinuing operation as a component that the enterprise was disposing of or terminating through abandonment, that represented a major line of business or geographical area of operations, and that could be distinguished operationally and for financial reporting purposes.

The IAS had required a discontinuing operation to be separately disclosed on the earlier of the dates on which an enterprise entered into a binding sale agreement for substantially all of the assets attributable to the discontinuing operation or its board of directors approved a detailed formal plan for the discontinuance and for making an announcement of the plan.

Under Statement no. 144 ( www.fasb.org/pdf/fas144.pdf ), discontinued operations are no longer measured on a net realizable value basis, and future operating losses are no longer recognized in a period before they actually occur. A component of an entity includes operations and cash flows that can be clearly distinguished from the rest of the entity operationally and for financial reporting purposes. This entity component may be an operating segment, a reporting unit defined as one operating unit below an operating segment, a subsidiary or a group of assets.

To improve its guidance on this topic, the IASB issued IFRS 5, Non-current Assets Held for Sale and Discontinued Operations ( www.iasb.org/uploaded_files/documents/8_63_ifrs05-sum.pdf ), which generally converges with Statement no. 144. Like that statement, the IASB’s new guidance requires the results of operations that form a major line of business or area of geographic operations to be presented as discontinued when those operations were disposed of or when the assets in the operations were classified as “held for sale.”

Under IFRS 5, discontinued operations are reported when a component of an entity has been disposed of or is being held for sale and the entity will not have any significant continuing involvement in the component’s operations after the disposal transaction. If either criterion is not met, the component’s operations are reported under continuing operations.

The definition of a component of an entity that can be classified as discontinued under IFRS is similar to but narrower than that under U.S. GAAP, but the IASB intends to continue to work with FASB on further convergence. The requirements relating to the timing of the classification of discontinued operations are also substantially the same as those under U.S. GAAP.

U.S. GAAP CONVERGES TO IFRSs:
ACCOUNTING CHANGES
This example demonstrates how the influence of international GAAP can improve U.S. GAAP—a process CPAs should stay abreast of and understand. In the United States, companies previously followed APB Opinion no. 20, which required that changes in accounting principle generally be recognized by including the cumulative effect of changing to a new accounting principle on the last line prior to net income (that is, a current-period approach). Opinion no. 20 identified—and required retrospective restatement for—numerous specific exceptions to this rule, including a change from Lifo, a change in the method of accounting for long-term construction contracts, a change to or from the full-cost method in the extractive industries, issuance of public financial statements for the first time or a change to a new professional standard requiring retroactive restatement. As it turned out, Opinion no. 20’s treatment of these exceptions was the same as that required under IFRSs for all accounting changes, and it set the stage for U.S. GAAP’s ultimate convergence with international standards in this context.

Under IAS 8, Accounting Policies and Changes in Accounting Estimates and Errors ( www.iasb.org/uploaded_files/documents/8_63_ias08-sum.pdf ), a change in accounting policy should be applied retrospectively, and the cumulative effect of the adjustment should be reflected in the opening balance of equity for the period. This approach is superior to past U.S. GAAP because it improves comparability over time and excludes from current income the effects of accounting changes relating to prior periods.

Because FASB had identified reporting of accounting changes as an area in which it could improve the quality of financial reporting, in June 2005 it issued Statement no. 154, Accounting Changes and Error Corrections ( www.fasb.org/pdf/fas154.pdf ), which converged with the provisions in IAS 8. Statement no. 154 requires retrospective application of the direct effects of an accounting change, unless it is impracticable to determine either the cumulative effect or the period-specific effects of the change (see “ The Change Game, ” JofA , Dec.05, page 67). The standard also requires that a change in depreciation, amortization or depletion method be accounted for as a change in accounting estimate with a prospective application.

FASB’s adoption of the IASB’s approach improves comparability of U.S. companies’ financial information between periods presented by requiring retrospective application of all comparative financial statements. When full retrospective application is not practical, the new approach improves comparability between periods by requiring that a new accounting principle be applied as of the earliest date possible.

Finally, treating a change in depreciation, amortization or depletion method as a change in estimate rather than as a change in principle better reflects the nature of this type of accounting change. A new depreciation method should be adopted in recognition of a change in estimated future benefits, the pattern of consumption of those benefits or the information available to the entity about those benefits. Thus the effect of the change in depreciation method is inseparable from the effect of the change in estimate. The new FASB standard refers to this as a change in accounting estimate that is the result of a change in accounting principle.

WHEN COMPROMISE IS BEST: EXTRAORDINARY ITEMS
FASB and the IASB have been unable to achieve convergence on the subject of extraordinary items. But CPAs nevertheless should stay abreast of developments because FASB’s guidance may change.

Under APB Opinion no. 30, FASB continues to allow extraordinary-item treatment for material items that are both unusual in nature and infrequent in occurrence, taking into account the environment in which the entity operates. In the past the most commonly reported extraordinary item under U.S. GAAP was a gain or loss on early extinguishment of debt. But FASB Statement no. 145 (April 2002; www.fasb.org/pdf/fas145.pdf ) eliminated extraordinary-item treatment for most such gains and losses. A company’s early extinguishment of debt must clearly be infrequent in occurrence to receive extraordinary item treatment.

Among other things, extraordinary items include gains from the purchase of a business for less than the fair value of the identifiable net assets and uninsured casualty losses, subject to certain restrictions. Also, losses arising from the terrorist attacks on September 11, 2001, were not allowed extraordinary-item treatment by the FASB’s Emerging Issues Task Force due to the perceived difficulty of measuring the portion of losses directly attributable to the tragic event (EITF Issue no. 11-10). And the devastation wrought by Hurricanes Katrina and Rita might fail to qualify as extraordinary events because they were natural disasters “reasonably expected” to reoccur.

In its 2003 Improvements Project, the IASB prohibited the reporting of extraordinary items on the income statement. Items that might be presented as extraordinary in the United States would under IFRSs be included in the income statement as special items in ordinary income. For instance, the loss of assets due to expropriation by a foreign government would be treated as an extraordinary loss under U.S. GAAP and would be reported on the income statement, net of tax benefit, on the last line before net income. But a U.K. company filing under IFRSs would report the same situation higher on the income statement, as a loss before tax and as a component of ordinary income.

In a current joint project on financial performance reporting by business enterprises, FASB and the IASB are working toward simultaneously issuing identical standards that include consideration of the presentation of extraordinary items. The project addresses the presentation of information within financial statements, including the income statement in general and income below continuing operations and extraordinary item presentation in particular. The boards have tentatively concluded that a single statement of earnings and comprehensive income should be presented and that a subtotal of net income should be retained. But no decision has been reached as to whether extraordinary items would be retained as a separate category within this statement.

LOOKING AHEAD
The analysis of these situations reveals that convergence of accounting standards has affected and will continue to affect U.S. CPAs. Even those who have no direct interest in IFRSs will have to heed changes in U.S. GAAP that result from IFRSs. Those who want an early warning of potential changes in GAAP should keep an eye on developments at the IASB as well as at FASB.

Two practitioners—one in public accounting and one in industry—share ideas for communicating change.

Public Accounting
As IFRS topic team leader in KPMG’s department of professional practice, I—along with the other members of my team—am responsible for staying abreast of changes in U.S. and international standards. The firm’s international financial reporting group in London prepares international standards reports that are available to everyone in the firm. This information is announced in a weekly summary distributed throughout the firm. We also provide regular updates and overviews in our training programs.

The firm’s multinational clients sometimes face special challenges. It depends on which markets the companies file financial information in. Many foreign markets currently permit the use of U.S. GAAP financial information, but many are considering moving more to the use of IFRS financial information. As this process evolves, it will place an increased emphasis on the need for FASB and the IASB to work towards greater convergence of U.S. GAAP and IFRSs.

As far as the roles of auditors or accountants are concerned, we cannot do the accounting or conversion for SEC audit clients. We can work with them on applying IFRSs in their education and training process and engage in discussions with them about the appropriateness of their application of IFRSs to their specific facts and circumstances.

Here’s how we composed and distributed advance and final notice of FASB Statement no. 154’s replacing ABP Opinion no. 20 throughout the firm. One method was our publication, Defining Issues ( www.kpmg.com/aci/DI.htm ). When FASB issued Statement no. 154, we published a description of the board’s conclusions in that guidance and the changes to existing standards (that is, APB Opinion no. 20). We also mentioned it was a part of the FASB’s short-term convergence efforts with the IASB. We similarly distributed information on FASB Statement nos. 151 and 153, two other short-term convergence efforts. And when FASB and the IASB released their business combinations exposure drafts (joint convergence project by the boards), we released a description of the proposals in the exposure drafts and the boards’ convergence efforts.

—Paul H. Munter, partner,
KPMG LLP, New York.

Industry
I am responsible for corporate accounting and analysis of selected financial results for Chevron. The company’s accounting policy and external reporting staff, headed by the assistant comptroller, is responsible for following changes in U.S. and international accounting standards. The company has a dedicated internal Web site that employees refer to for details on all major income statement and balance sheet accounts and for information about accounting policies, practices and procedures or the proper recording of a particular item. The CFO, comptroller and others also issue frequent e-mail messages to accounting and finance managers to further communicate policy matters throughout the organization.

Overall, multinational companies do not face insurmountable special challenges from convergence. We operate under a single, standard approach to ensure common accounting policies and practices. That’s not to suggest there aren’t unique local reporting and compliance requirements that need to be addressed in certain jurisdictions. And there is the challenge of ensuring that communication is received and understood in a company that operates in over 180 countries.

We work very closely with both our internal and external auditors to ensure compliance with accounting policies and procedures. This has been especially true since the emergence of Sarbanes-Oxley section 404 internal control requirements. To be clear, the auditor’s role is one of review, as opposed to consulting or actual policy development and deployment.

FASB Statement no. 123(R), Share-Based Payment , is an example of a policy conformance issue Chevron recently implemented. In addition to the communications methods I mentioned earlier, the company also held special meetings to discuss specific implementation issues.

—Ronald J. Susa, manager,
corporate accounting and analysis,
comptroller’s department,
Chevron Corp., San Ramon, Calif.