Fas 167 definition

95

Journal of the International Academy for Case Studies, Volume 16, Special Issue, Number 1, 2010

ACCOUNTING FOR BUSINESS COMBINATIONS AND THE CONVERGENCE OF INTERNATIONAL

FINANCIAL REPORTING STANDARDS WITH U.S. GENERALLY ACCEPTED ACCOUNTING PRINCIPLES:

A CASE STUDY

Marianne L. James, California State University, Los Angeles

CASE DESCRIPTION

The primary subject matter of this case concerns changes in accounting for business combinations and the convergence of International Financial Reporting Standards (IFRS) with U.S. Generally Accepted Accounting Principles (GAAP). The case focuses on the effect of the changes on financial statements of global entities, as well as strategic decisions made by company executives.

Secondary, continuing significant differences between U.S. GAAP and IFRS and future potential developments in accounting for consolidated multinational entities are explored. This case has a difficulty level of three to four and can be taught in about 50 minutes. Approximately three hours of outside preparation is necessary to fully address the issues and concepts. This case can be utilized in an Advanced Accounting course, either on the graduate or undergraduate level to help students understand changes in and differences between U.S. GAAP and IFRS. Two sets of questions address U.S. GAAP and IFRS and include researchable questions that are especially useful for a graduate level course. The case has analytical, critical thinking, conceptual, and research components. Utilizing this case can enhance students’ oral and written communication skills.

CASE SYNOPSIS

Financial reporting in the U.S. is changing dramatically. Consistent with the Securities and Exchange Commission’s proposed “Roadmap” (SEC, 2008), the U.S. likely will join the more than 100 nations worldwide that currently utilize International Financial Reporting Standards (IFRS), and require the use of IFRS in the U.S.

Because of the globally widespread use of IFRS, multinational entities with subsidiaries that prepare IFRS-based financial statements already have to be knowledgeable about IFRS as well as the current differences between U.S. GAAP and IFRS. Fortunately, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are working

96

Journal of the International Academy for Case Studies, Volume 16, Special Issue, Number 1, 2010

together to bring about convergence between the two sets of accounting standards. Recently, FASB and the IASB issued new and revised several existing standards that

eliminate many differences between U.S. GAAP and IFRS with respect to business combinations and consolidated financial statements. However, some significant differences persist. Until the SEC makes a final decision regarding the mandatory use of IFRS, and during the proposed multi-year transition period, current and future accounting professionals must continue to keep abreast of changes in U.S. GAAP, be knowledgeable about differences between U.S. GAAP and IFRS, and, at the same time, prepare for the likely transition to IFRS. In addition, company executives should be cognizant of developments that may affect their strategic decisions as the U.S. moves toward a likely adoption of IFRS during the next five years.

This case focuses on the effect of changes in financial reporting for business combinations. Changes as well as continuing differences between U.S. GAAP and IFRS are explored. Secondarily, strategic decisions arising from the changes and the likely future adoption of IFRS are addressed. This case, which can be utilized in Advanced Accounting on either the graduate or undergraduate level can enhance students’ analytical, technical, critical thinking, research, and communication skills.

INTRODUCTION

Financial accounting and reporting in the U.S. is changing rapidly. During the past six months, the Financial Accounting Standards Board, the primary accounting standard setter in the U.S., issued twelve (12) new standards and launched its on-line “Accounting Standards Codification,” which organizes existing GAAP into 90 topics (FASB, 2009). At the same time, a significantly more dramatic change is on the horizon for accounting professionals, company executives, and financial statement users.

Consistent with the SEC’s 2008 proposal entitled, “Roadmap for the Potential Use of Financial Statements Prepared in Accordance With International Financial Reporting Standards by U.S. Issuers,” (Roadmap) in approximately five years, public companies likely will have to utilize IFRS, instead of U.S. GAAP (SEC, 2008). In fact, some large global U.S.-based entities are permitted to early-adopt IFRS starting in 2009. The SEC expects to reach a final decision regarding the mandatory adoption of IFRS in 2011 (SEC, 2008).

If the U.S. indeed adopts IFRS as the required standard for financial accounting and reporting, the U.S. will join the more than 100 nations worldwide that currently permit or mandate the use of IFRS. For example, starting with the 2005 reporting period, all European public companies listed on any European stock exchange must prepare IFRS-based financial statements. Other nations, such as Canada, are planning to adopt IFRS in the near future.

Currently, U.S. GAAP and IFRS are not identical. However, since signing their Memorandum of Understanding, commonly referred to as the “Norwalk Agreement,” in 2002, FASB and the IASB have been working together to develop a set of high-quality globally acceptable

97

Journal of the International Academy for Case Studies, Volume 16, Special Issue, Number 1, 2010

financial accounting standards and to bring about convergence of U.S. GAAP and IFRS. Since the Norwalk Agreement was signed, many new and revised standards issued by FASB and the IASB have served the purpose of eliminating existing differences. However, while many differences have been eliminated, others persist.

Accounting for and reporting by global entities is quite complex. U.S., as well as international accounting rules require that a parent company consolidates its subsidiaries’ financial statements with the parent company’s financial statements. Recent standards issued by the IASB and FASB have eliminated many differences between U.S. GAAP and IFRS in accounting for business combinations and financial reporting for consolidated entities. However, some significant differences continue to exist.

KLUGEN CORPORATION

Irma Kuhn, CPA, CMA holds the position of Chief Financial Officer (CFO) of Klugen Corporation, a global telecommunications company. Klugen is a consolidated entity headquartered in the U.S. with four majority-owned European subsidiaries. The company has expanded primarily by acquiring majority interest in European companies and holds between 51% and 70% of the outstanding voting stock of its subsidiaries. Three of these subsidiaries were acquired in stages and consolidated once the company achieved majority ownership.

Consistent with current accounting rules, Klugen consolidates all four of its subsidiaries. In addition, Klugen also holds financial interests in several unconsolidated entities and accounts for those as investments.

Klugen’s European subsidiaries currently prepare their financial statements consistent with International Financial Reporting Standards (IFRS), which are promulgated by the International Accounting Standards Board (IASB). Klugen, the parent company, issues consolidated financial statements, which include the results of its majority-owned subsidiaries in conformity with U.S. GAAP. Preparation of Klugen’s consolidated financial statements requires that Irma and her staff convert the subsidiaries’ IFRS-based financial statements into U.S. GAAP prior to consolidating the numbers. This process is quite complex and requires many of the accounting departments’ resources.

Irma is well aware of efforts between the FASB and the IASB to bring about convergence between U.S. GAAP and IFRS. She expects that consistent with the SEC’s “Roadmap,” (SEC, 2008) within the next five years, U.S. public companies likely will have to apply IFRS, rather than U.S. GAAP. Irma welcomes this development and believes that in the long-run, use of IFRS by the parent company as well as its subsidiaries will preserve and strengthen the company’s global financial competitiveness. In addition, she believes that it will simplify the accounting and consolidation process significantly and, in the long-run, reduce financial reporting costs. She is aware, however, that in the short-run many challenges, such as conversion of the accounting and IT systems and extensive staff training will increase costs. Knowing that the SEC’s Roadmap proposes a phased-in

98

Journal of the International Academy for Case Studies, Volume 16, Special Issue, Number 1, 2010

adoption by public companies between 2014 and 2016, Irma plans to recommend adoption of IFRS at the earliest permitted time.

As the person who ultimately is responsible for financial reporting, Irma is very knowledgeable about current and proposed changes in U.S. GAAP as well as IFRS. She knows that the IASB and FASB have issued new and revised standards applicable to business combinations that affect the company’s consolidated financial statements. After in depths analysis of the new and revised standards, she determined that many of the past differences between U.S. GAAP and IFRS where eliminated when the FASB issues FAS 141 R “Business Combinations” and FAS 160 “Non- controlling interest in consolidated financial statements” (FASB, 2007) and the IASB revised IFRS 3 “Business Combinations” and IAS 27 “Consolidated and Separate Financial Statements” (IASB, 2008). She also realizes that some significant differences still persist. Klugen Corporation has properly adopted FAS 141R and FAS 160 (now codified in sections 805 and 810 of FASB’s 2009 Standards Codification) for the 2009 fiscal period and its forthcoming annual report will reflect those changes.

Irma regularly conducts in-house seminars to instruct her accounting staff regarding new developments in financial reporting. In fact, her seminars meet the Continuing Professional Education (CPE) sponsor requirements set forth by the National Association of State Boards of Accountancy (NASBA) and the Quality Assurance Service (QAS), which is required by State Boards of Accountancy and other licencing organizations for the renewal of CPA, CMA and other professional certifications.

Irma’s CPE seminars entitled “Financial Reporting Updates” are always well received by her staff. During the past six months, Irma already has held several seminars to inform her staff regarding IFRS. Those who attended all her seminars are already familiar with the SEC’s Roadmap that proposes adoption of IFRS starting in 2014, and also know about some of the most significant differences between U.S. GAAP and IFRS.

Since in about five (5) months, Klugen Corporation will issue its consolidated financial statements, which will, for the first time, incorporate FAS 160 and FAS 141R, Irma decides to schedule a seminar on “Business Combinations - Consolidated Financial Statements” for October 15, 2009. The following is a brief agenda for Irma’s Seminar:

Business Combinations - Consolidated Financial Statements - Financial Reporting Update October 15, 2009 - Agenda

1. Review of fundamental concepts of business combinations and consolidated financial statements

2. Changes to U.S. GAAP (FAS 141R and FAS 160) 3. Significant continuing differences between U.S. GAAP and IFRS 4. Developments with potential impact on future fiscal periods

99

Journal of the International Academy for Case Studies, Volume 16, Special Issue, Number 1, 2010

5. Questions

The seminar will be highly beneficial for staff members who are currently involved or planning to become involved in critical aspects of financial reporting and also for those who want to develop their knowledge of IFRS. During the seminar, Irma distributes several handouts, including the company’s prior year income statement and balance sheet for reference.

Table 1 Klugen Corporation

Consolidated Statement of Income for the year ended December 31, 2008

Numbers are in million (except share amounts)

Operating Revenues

Business service $15,500

Residential service 10,200

Wireless service 18,000 $ 43,700

Operating Expenses

Cost of services (excludes depreciation & amortization) $ 15,200

Selling, general, administrative expenses 11,100

Depreciation and amortization 7,150 $ 33,450

Operating Income $ 10,250

Other Income (Expense)

Interest expense (820)

Minority interest (1,010)

Investment income 405 (1,425)

Income Before Income Taxes $ 8,825

Income Tax 3,250

Net Income 5,575

Basic Earnings Per Share $2.08

Diluted Earnings Per Share $1.92

The accompanying notes are an integral part of the consolidated financial statements

100

Journal of the International Academy for Case Studies, Volume 16, Special Issue, Number 1, 2010

Table 2 Klugen Corporation

Consolidated Balance Sheet December 31, 2008

(Numbers are in millions)

Assets

Current Assets

Cash and cash equivalents $ 519

Accounts receivables (net of allowances of $310) 4,200

Prepaid expenses 400

Other current assets 520

Total Current Assets $ 5,639

Non-Current Assets

Property, plant & equipment (net) 25,600

Goodwill 18,500

Licenses 12,900

Customer relationships (net) 3,100

Investments in non-consolidated entities 1,000

Dividends receivables 300

Other assets 1,200

Total Non-Current Assets $62,600

Total Assets $68,239

Liabilities and Stockholders’ Equity

Current Liabilities

Accounts payable and accrued liabilities 5,200

Advanced billings and deposits 920

Accrued taxes 420

Total Current Liabilities $ 6,540

Non-Current Liabilities

Long-term debt 25,500

Post-retirement benefits 2,300

Deferred taxes 3,200

Total Non-Current Liabilities $31,000

Total Liabilities $37,540

Minority Interest 5,000

101

Table 2 Klugen Corporation

Consolidated Balance Sheet December 31, 2008

(Numbers are in millions)

Journal of the International Academy for Case Studies, Volume 16, Special Issue, Number 1, 2010

Stockholders’ Equity

Common stock ($1 par, 100,000,000 authorized, 60,000,000 issued)

60

Additional paid in capital 13,095

Retained earnings 14,588

Accumulated other comprehensive income (2,044)

Total Stockholders’ Equity 25,699

Total Liabilities and Stockholders’ Equity $68,239

The accompanying notes are an integral part of the consolidated financial statements.

The Seminar

Agenda Item 1 Fundamental Concepts of Business Combinations - Consolidated Financial Statements

During the first part of the seminar, Irma reviews several fundamental concepts relating to accounting for business combinations. She emphasizes that these concepts are common to both U.S. GAAP and IFRS.

Fundamental Concepts common to both U.S. GAAP and IFRS

The parent company issues consolidated financial statements that include the results for all subsidiaries that the company controls. Control is usually assumed when the parent holds a controlling financial interest (generally, more than 50% ownership of the outstanding voting common stock. Consolidated financial statements include 100% of the subsidiaries’ assets, liabilities, revenue, expense, gains, and losses, even if the subsidiary is only partially owned. Subsidiaries’ previously unrecognized assets are identified at time of business combination and are recognized in the consolidated financial statements. Goodwill is recognized on the consolidated balance sheet if the acquisition cost exceeds the fair value of the subsidiaries’ identifiable net assets. Goodwill is not amortized, but periodically tested for impairment. Non-controlling interest (formerly called minority interest) is recognized on the consolidated balance sheet.

102

Journal of the International Academy for Case Studies, Volume 16, Special Issue, Number 1, 2010

Agenda Item 2 Changes in U.S. GAAP

Irma discusses the most important changes in accounting and financial reporting for consolidated entities consistent with FAS 141R and FAS 160. She prepares a handout for the seminar participants, consisting of a comparative table that contrast the new rules (effective for the 2009 financial statements) with the prior rules.

Table 3 Recent Changes to U.S. GAAP - effective 2009 - FAS 141R and FAS 160

Issue Effec t ive 2009 Financia l Statements

Pre-2009 Financial Statements

Subsidiaries’ assets and liabilities All assets and liabilities are revalued to fair market value at acquisition date (100% revaluation).

Assets and liabilities were revalued based on the parent’s ownership percentage

Negative goodwill Recognized as gain for year of acquisition.

Recognized as a proportionate reduction of long-term assets.

Balance sheet classification of non- controlling interest (NCI)

NCI is classified as equity. NCI is recognized as liability, equity, or between liabilities and equity.

Income statement presentation of NCI’s share of income

Presented as a separate deduction from consolidated income to derive income to controlling stockholders.

NCI was presented as part of “Other income, expenses, gains, and losses.”

NCI valuation Is carried at fair market value of subsidiaries’ net assets, multiplied by NCI percentage.

Carried at book value of subsidiaries’ net assets, multiplied by NCI percentage.

Cost of business combinations Direct costs are expensed during year of acquisition

Direct costs were capitalized as part of acquisition cost.

In process research and development (R&D)

Are capitalized at time of acquisition.

Could be expensed at time of acquisition.

Acquisition in stages Previously acquired equity interest is remeasured when acquiring company achieves control; gain or loss is recognized in the income statement.

Measurement was based on values at time of individual equity acquisition

Terminology Minority interest is now referred to as “non-controlling interest.”

The commonly used term was “minority interest.”