International Financial Reporting Standards (IFRS) refer to a set of accounting laws formulated and maintained by the International Accounting Standards Board (IASB). The IASB came into effect in 2001 after replacing the International Accounting Standards Committee that issued the International Accounting Standards (IAS) from 1973 to 2000. The IASC was a result of the accountancy bodies from ten countries. The ten nations included Australia, Canada, France, West Germany, Japan, Ireland, Mexico, Netherlands, the United Kingdom, and the United States of America. The IASB raises issues with the IFRS, makes changes to some of the existing IASs, or introduces new IFRSs that provide regulations for topics that were not initially critical to the current IAS.
IFRSs comprise all the pronouncements of IASB including the standards and interpretations that the board has approved and versions adopted by the predecessor, IASC (Baltariu, 2015). The primary aim of the IFRS regulations is to create a universal language for business accounting (Weygandt, Kimmel, & Kieso, 2012). IFRS provides a global framework that guides public companies on how to prepare and disclose their financial statements. The IFRS offers general guidance on how companies should prepare their financial statements, rather than create rules for specific industry reporting (Baltariu, 2015). One of the projects that IASB has undertaken is the replacement of IAS 39 with IFRS 9.
IAS 39 came into effect in 2005 with the aim of prescribing unified rules for reporting of financial instruments to ensure that companies present them in a transparent and consistent approach. However, the IAS 39 brought with it major complexities as well as significant inconsistencies and exceptions. For this reason, the IASB decided to replace IAS 39 with a new standard referred to as IFRS 9 Financial Instruments. The replacement process is expected to take three phases that include classification and measurement, impairment, and hedge accounting (Huian, 2012). Huian (2012) alleges that the new regime will come into effect in 2018. It will replace IAS 39. This article will discuss the differences between IFRS 9 and IAS 39 and how the standards differ from the US GAAP. Other issues to be discussed include the classification and measurement of financial instruments, impairment of financial assets, and hedge accounting.
The Main Topics of the International Financial Reporting Standards
Classification and Measurement of Financial Instruments
In July 2014, IASB issued the final piece of IFRS 9. According to Huian (2012), “the classification and measurement determine how a company accounts for financial assets and financial liabilities in its financial statements and, particularly how it measures them on an ongoing basis” (p. 27). According to the new edition, the classification and measurement of financial instruments will be based on two main features (Mackenzie et al., 2013). The first is the business model that organizations use to manage their financial assets.
The second is the contractual monetary flow of the financial assets (Shim & Siegel, 2011). The first classification and measurement category covers debt instruments at amortized value. The second entails debt securities at fair value through comprehensive income (FVOCI). The other classifications are debt instruments, derivatives, and equity instruments at fair value through profits and loss (FVTPL), and equity instruments selected and measured at FVOCI. The measurement of financial liabilities under IFRS 9 has not changed from what was available under IAS 39. The categories used to measure financial strength that continues to apply to financial liabilities are the fair value through profit or loss and amortized cost (Huian, 2012).
Impairment of Financial Assets
An impaired financial asset has a lower market price than the worth listed on the organization’s balance sheet (Horngren, Harrison, & Oliver, 2011). According to IFRS 9, impairment an allocation on the expected credit loss model. The standard applies to liability instruments documented at amortized cost (Shim & Siegel, 2011). It may also apply to debt recorded at fair value through comprehensive earnings as well as contract assets, lease receivables, financial guarantee contracts, and some written loan commitments (Bellandi, 2012).
However, the standard does not apply to equity investments. According to IFRS 9 standards, companies should ‘identify an allowance’ of 12 months or lifetime anticipated credit losses. The rate of increase in credit risk should determine the recognition of impairment.
Hedge accounting is a technique that involves taking into consideration entries for the ownership of a security and the opposing hedge. The IASB issued the new version of hedge accounting on 19 November 2013 with the primary objective of providing new requirements. The method aims to lessen the instability that emanates from repeated alterations of a financial instrument’s value. Mackenzie et al. (2013) note that IFRS 9 will replace the rule-based hedge accounting standards in IAS 39. An objective-based test that mainly focuses on the economic relationship between the hedging instrument and the hedged item is now part of the current standards under IFRS 9. The new regulations aim to align peril management with accounting. As such, investors can understand risk management measures. Also, financiers can evaluate the amount, timing, and uncertainty of future monetary flows (Weygandt, Kimmel, & Kieso, 2012). The most significant areas that changed include the hedge effectiveness testing, the risk component, the costs of hedging, groups of items, and disclosures.
Differences between IFRS 9 and IAS 39
Some factors that differentiate IFRS 9 from IAS 39 include the scope and classification of debt and equity instruments. Other variations involve the measurement of liability and equity instruments. When it comes to the classification of debt and equity, the tools become either amortized cost or fair value through profit and loss. Under IFRS 9, financial assets are classified based on the contractual cash flow of the business model (Mackenzie et al., 2013). It is easy to note the minor change in scope between the IAS 39 and IFRS 9. Both standards apply to all entities and types of financial instruments, but the IFRS 9 adds the option of including specific contracts that can become the exemption of “own use.” It also adds some contract assets and loan contracts concerning the requirements of impairment.
The core changes of financial instruments in IFRS 9 are new classification criteria and new categories that employ OCI for the financial assets. Financial assets are measured at amortized cost, FVOCI, and FVPLT while IAS 39 categories include loans and receivables held to maturity and available for sale. In the case of financial liabilities, the only change is that the element of gain or loss on a fiscal responsibility that has measurements of FVPTL arising from variations in the credit risk is usually present in OCI. The element of change in fair value is part of the profit and loss (Huian, 2012).
Another significant difference lies in the embedded derivatives and hedge accounting. Where hedge accounting is not applied, all derivatives are required to measure at fair value, and the gains and losses recognized in profit and loss. The requirement under IAS 39 is that embedded derivative separated from its host contract. Conversely, IFRS 9 has eliminated the need to separate the embedded derivatives for financial assets that are within the scope of the standard. In the case of impairment of financial assets, IAS 39 applies multiple models while IFRS 9 uses a single impairment model. The IAS 39 uses the incurred loss model to test a financial instrument for impairment at the end of every fiscal period. The loss of impairment is obtainable by finding the difference between the carrying amounts of an asset and the present value of estimated cash flow discounted at the original effective interest rate of the financial asset (Bellandi, 2012).
The loss of impairment is recognizable in the profit or loss account, and the credit losses are recognized if there was evidence of a triggering event when they occurred. On the other hand, IFRS 9 introduces the expected losses’ model. The recognition of expected credit losses is done at all times using a forward-looking approach that illustrates the changes in the credit risk of financial instruments. The measurement basis is as a result of the increase in credit risk since the initial recognition of the financial asset. IFRS 9 also requires additional disclosures to be made for a company that prepares its reports based on the calculation of the expected credit losses and risks (Knežević, Pavlović & Stevanović, 2015). In hedge accounting, the difference between the two standards is due to the inclusion of improvements that involve the introduction of improved hedging requirements.
The improvements have resulted in a new model for hedge accounting that also concentrates on the achievement of risk management. The improvements include the replacement of the hedge effectiveness test of IAS 39 with a test that relies on objectives, thus ensuring that the economic relationship between the hedged item and hedged instrument is under close monitoring. The new model provides that the risk component is part of a hedged item for both the non-financial and financial items. The design enables larger groups of items to become the hedged item. It allows items like the time value of an option to be accounted for as part of the cost of hedging. The model also brings essential and expensive disclosure requirements in hedge accounting (Knežević et al., 2015).
Characteristics of IFRS
IFRS has critical components that enable its application to become unique. It serves the needs of the investors. They are an important group of the stakeholders who need information that is uniform. Another characteristic is that they are decision-oriented. They help the users to acquire enough information to make a decision based on the progress of the reports (Walton, 2009). They guide the board of directors of the given company to make informed decisions. They also do not come under the influence of tax and legal rules. Since they are international laws, the users can rely on them from whichever corner of the world. Local taxation standards and legal requirements cannot influence the result. The production of such results involves extensive management judgment. They are very reliable and give quality results.
IFRS is essential for all financial statements. For instance, when producing the trial balance, it is called the unadjusted trial balance. The accounting team has to correct any errors that they can find and make adjustments. The changes and adjustments are meant to bring the financial statements into compliance with the international accounting standards. In this case, it would be either the GAAP or the IFRS. It becomes an adjusted trial balance. All financial statements worldwide only become valid and acceptable after they have been revised according to the IFRS rules.
Differences between IFRS 9 and US GAAP
The majority of capital markets in the world apply IFRS. However, some nations such as the United States use GAAP. There are differences between IFRS 9 and GAAP standards. The variations involve data gaps, consolidation of additional entities, and choice of accounting policies. Other differences entail the rules related to multiple element arrangements, contingent consideration, and revenue recognition. Concerning data gaps, the preparation of an IFRS balance sheet requires using information that is not in the US GAAP. Besides, IFRS allows companies to choose between different policies (Shim & Siegel, 2011). There had been no convergence yet between IFRS 9 and US GAAP in the three phases of IAS 39 that are now defunct. The U.S GAAP and IFRS 9 handle financial assets differently. The US GAAP provides a broad range of regulations across different standards and pronouncements that are industry specific (Hlaciuc, Grosu, Socoliuc, & Maciuca, 2014). Regarding categorization of financial assets, IFRS 9 classification has categories.
The US GAAP uses a variety of pronouncements to classify financial assets. Additionally, IFRS 9 grouping of the property is determined by the nature of the financial assets while the legal form of the financial assets determines their grouping under US GAAP. In derecognitions of financial assets, the US GAAP has to evaluate whether the control over the assets both legal and efficient was given up. Conversely, IFRS derecognition of financial assets considers the passing on of their risks and rewards as well as the transfer of their control at times (Bellandi, 2012). In impairment of financial assets, U.S GAAP Current Expected Credit Loss Model (CECL) differs from the IFRS 9 Expected Credit Loss model (ECL) in one major way. Bellandi (2012) provides that the difference is identified “in the timing of credit risk recognition, whereby the CECL is based on the lifetime default risk to accrue the expected loss while the ECL model requires three stage identification of credit risk” (p.54). Comparing Hedge Accounting under IFRS9 and U.S GAAP reveals some differences.
Under US GAAP, some accounting standards apply to Special Purpose Entities. The most notable one is the FIN46R that sets out the consolidation treatment of these entities. Many other standards apply to different transactions with SPEs (Shamrock, 2012).
Under International Financial Reporting Standards (IFRS), the relevant standard is IAS 27 in connection with the interpretation of SIC12 (Consolidation—Special Purpose Entities). For periods beginning on or after 1 January 2013, IFRS 10 Consolidated Financial Statements supersedes IAS 27 and SIC 12. There are still ongoing changes that will affect the final standard laws for the IAS body (Bellandi, 2012).
IFRS 9 is condensed, providing direction that is more limited and with a smaller amount of prescription compared to those of the U.S. GAAP. Bellandi (2012) explains that the “IFRS 9 is less restrictive than the U.S GAAP when it comes to allowing the commodity sector to engage in component hedging” (p.56). While IFRS 9 supports the removal of retrospective effectiveness testing, the U.S GAAP does not. The two standards are also different in the approach they use to treat forward points and option time values. Unlike the IFRS 9, the U.S GAAP prefers not to exclude both forward points and choice time values when assessing hedge effectiveness (Christian & Ludenbach, 2013).
Table Comparisons between IAS/IFRS and US GAAP
|Accounting Issues||IAS / IFRS||US GAAP|
|Property, plant||Historical cost as the benchmark model, revaluation permitted||Historical cost required|
|Equipment||Historical cost as the benchmark model, revaluation permitted||Historical cost required|
|Inventories||Minimum of historical cost and net realisable value||Minimum of historical cost and net realizable value. LIFO is possible.|
|Depreciation Accounting||According to the pattern in which the economic benefits associated with the asset are consumed||Usually straight-line over the economic useful life of the asset|
|Construction Contracts||% of completion method||% of completion method|
Convergence of US GAAP and IFRS
The convergence of US GAAP and IFRS is an effort that is forty years in the making. In the course of this period, the IASB and the subsequent organization, the IASC, have combined efforts with the view of coming up with excellent accounting standards. The ultimate goal of these efforts is to “develop a set of high-quality, understandable, and enforceable International IFRS to serve equity investors, lenders, creditors, and others in globalized capital markets” (Chen, Ding, & Xu, 2014, p. 58). By the time the IASB morphed into IASC in 2001, only a handful of nations had incorporated the International Accounting Standards (now the IFRS) into their financial regimes. For instance, during this pre-convergence period even international deals such as sales of securities were not subject to the IFRS. However, this negative attitude was short lived as things started to change beginning with the endorsement of IFRS by the International Organization of Securities Commission (IOSCO) in regards to international trading.
Another trigger for convergence was the European Union’s decision to make IFRS mandatory for all the companies that were in the EU’s exchange market in 2005. Therefore, in Europe, all listed companies use IFRS for their consolidated accounts. In other countries, the use or convergence with the IFRSs is increasing. These two fundamental changes in the international financial atmosphere began a trend that has culminated in the current situation, whereby IFRS is a basic requirement in at least 100 countries around the world. The primary goal of the union between the IASB and the IFRS has been to entice the US into adopting its standards thereby solidifying the legitimacy of these international standards. This goal became apparent during the World Congress of Accountants in 2002 when the chairman of the congregation said it was unreasonable for the world to adopt the US GAAP and ditch a more global IASB (Tarca, 2014). Overall, efforts to achieve convergence between the IFRS and GAAP are supposed to develop universal solutions to global accounting needs. Although the US authorities appear to support the convergence movement, the success of these efforts is still in question.
Background and History of the Convergence Efforts
IFRS are available to develop and maintain, in the public interest, a single set of high quality, understandable, and enforceable global accounting standards. The rules should require transparent and comparable information in general purpose during the preparation of financial statements. Therefore, IFRS are the accounting and financial reporting standards (Shamrock, 2012). All organizations should promote the use of IFRS so that they can bring about the convergence of national accounting standards and IAS to high-quality solutions. The international standards provide a useful model for developing countries in as much as they are critical to the developed countries.
The actual trigger in the IFRS and US GAAP convergence efforts was the Norwalk Agreement of 2002 between the IASB and FASB (Mestelman, Mohammad, & Shehata, 2015). This agreement was to work as the starting point of the efforts to harmonize financial reporting standards all around the world. Furthermore, as per this agreement, the respective organizations have forwarded their formal commitment towards the achievement of high quality but harmonious accounting standards that can apply to both international and domestic accounting needs. Two key objectives were in the Norwalk Agreement the first being the need to harmonize standards within the shortest time possible. The other goal addressed the need to maintain compatibility even after there was already a convergence (Barth, Landsman, Lang, & Williams, 2012).
Another significant event in the convergence efforts was the IASB and FASB’s Memorandum of Understanding (MOU) of 2006. The MoU also became known as the Roadmap to convergence, and it addressed both long-term and short-term concerns of the impending harmonization (Christian & Ludenbach, 2013). The contents of the MoU were meant to address three main areas namely: convergence, eliminating existing differences between standards, and the needs of investors (Shamrock, 2012). Some high priority items were pointed out in the MoU, and they included matters that could get resolution within a short time. Consequently, some GAAP standards became defunct while others realigned immediately in agreement with IFRS. For example “IFRS 8 identifies reportable segments based on a ‘managerial approach,’ which is consistent with the approach adopted under US GAAP, rather than the ‘risk and returns’ approach adopted by IAS 14” (Kumar & Misra, 2016, p. 19). Also, the manner in which goodwill was calculated as well as how piecemeal acquisitions were handled was standardized to conform to both GAAP and IFRS.
Progress of the Convergence Efforts
Since the signing of the 2006 MoU, the convergence efforts have gone through a series of vicissitudes. Therefore, some convergence efforts have materialized in agreement with their intended spirit. On the other hand, some efforts have only achieved partial success, whereby gainful steps have led to significant achievements, but subtle differences still exist. It is also important to note that “some convergence projects either were discontinued or resulted in different IASB and FASB standards because, in the end, the two boards just could not agree” (Tarca, 2014). Currently, efforts to converge IFRS and GAAP are still ongoing but the initial momentum that was evident ten years ago has subsided.
The best way to gauge the progress of the convergence efforts is to assess whether the goals have led to success or some tangible improvements are evident. There have been three updates to the 2006 MoU; an update in 2008, a progress report in 2012, and an update to the events’ timeline in 2013. Although these continuous efforts indicate progress, the situation on the ground does not reflect these gains. Some observers have pointed out that “convergence may have been the most realistic way to initiate the use of IFRS in the United States, but such an arrangement is not sustainable in the long term” (Mestelman, Mohammad, & Shehata, 2015, p. 199). Consequently, it is prudent for the US to consider the outright adoption of IFRS as the ultimate solution to the issue of convergence.
GAAP’s convergence with IFRS or adoption of its strategy will ultimately require companies to restructure their management incentive contracts. It is because studies have shown that IFRS accounting numbers differ from U.S. GAAP accounting numbers. For example, IFRS-based earnings are, on average, higher than U.S. GAAP earnings and are more variable. Thus, management compensation plans that use IFRS earnings numbers would present a higher risk-return profile than U.S. GAAP-based compensation schemes.
Managers may be unwilling to undertake the higher risk, or the firm may not want to pay out additional compensation for the higher return. An additional complication is that significant changes to management incentive plans typically require shareholder approval (Walton, 2009). Thus, adoption of IFRS will be costly for companies by requiring reconsideration of management compensation agreements.
U.S. Generally Accepted Accounting Principles (GAAP) and IFRS require publicly traded companies to report operating segment information in their financial statements. IFRS requirements are more extensive than U.S. GAAP, compelling the disclosure of a measure of segment liabilities if the chief operating decision maker receives the test as regularly provided (Walton, 2009).
Accounting records provide stakeholders with the information required to analyze the financial performance of entities. The adoption of IFRS 9 is expected to improve the quality and reliability of such information. Consequently, financiers and corporations will be able to make informed economic decisions. Although IFRS 9 mainly carries forward the scope of IAS 39, from 2018, companies will be required to make significant changes in their reporting. They will have to consider the new processes and systems that will be necessary for making changes to the classification and measurement of financial assets, impairment and hedging and accounting as provided in IFRS 9. Changes to the U.S GAAP can also continue being deliberated to allow for convergence of standards in the accounting of financial instruments.
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