1 IFRS 1: First time adoption of International Financial Reporting Standards
Adoption of International Financial Reporting Standards
Although not as significant as they once were, differences remain between IFRS Standards and national standards. Therefore, there is an accounting issue when a company adopts IFRS Standards for the first time.
An entity may adopt IFRS Standards for a number of reasons:
- An entity may be seeking a listing, and listing rules may require the use of IFRS Standards.
- Unlisted multinational corporate groups may choose to adopt IFRS Standards as the basis for financial reporting throughout the group. This may save time and resources in the preparation of management information throughout the group, and streamline group annual financial reporting requirements.
- Entities may believe that adoption of IFRS Standards could assist in their efforts to raise capital, particularly if potential capital providers are familiar with IFRS Standards.
- Entities may believe that they are ‘doing the right thing’ by adopting IFRS Standards as they are already used by many other large entities.
IFRS 1 First Time Adoption of IFRS
IFRS 1 First-time Adoption of International Financial Reporting Standards sets out the procedures to follow when an entity adopts IFRS Standards in its published financial statements for the first time.
IFRS 1 defines a first-time adopter an entity that, for the first time, makes an explicit and unreserved statement that its annual financial statements comply with IFRS Standards.
There are five issues that need to be addressed when adopting IFRS Standards:
- The date of transition to IFRS Standards
- Which IFRS Standards should be adopted
- How gains or losses arising on adopting IFRS Standards should be accounted for
- The explanations and disclosures to be made in the year of transition
- What exemptions are available.
Date of transition
The date of transition is the ‘beginning of the earliest period for which an entity presents full comparative information under IFRS Standards in its first financial statements produced using IFRS Standards’ (IFRS 1, Appendix A).
If an entity adopts IFRS Standards for the first time for the year ended 31 December 20X8 and presents one year of comparative information then the date of transition is 1 January 20X7 (i.e. the first day of the comparative period).
An opening IFRS statement of financial position should be produced as at the date of transition. This statement need not be published, but it will provide the opening balances for the comparative period.
Which IFRS Standards should be adopted?
- The entity should use the same accounting policies for all the periods presented. These policies should be based solely on IFRS Standards in force at the reporting date.
- A major problem for entities preparing for the change-over is that IFRS Standards keep changing. Therefore an entity may apply an IFRS Standard that is not yet mandatory if that standard permits early application.
- IFRS 1 states that the opening IFRS statement of financial position must:
– recognise all assets and liabilities required by IFRS Standards
– not recognise assets and liabilities not permitted by IFRS Standards
– reclassify all assets, liabilities and equity components in accordance with IFRS Standards
– measure all assets and liabilities in accordance with IFRS Standards.
- An entity’s estimates at the date of transition to IFRS Standards should be consistent with estimates made for the same date in accordance with previous GAAP unless evidence exists that those estimates were wrong.
Reporting gains and losses
Any gains or losses arising on the adoption of IFRS Standards should be recognised directly in retained earnings. In other words, they are not recognised in profit or loss.
Explanations and disclosures
- Entities must explain how the transition to IFRS Standards affects their reported financial performance, financial position and cash flows.
- When preparing its first statements under IFRS Standards, an entity may identify errors made in previous years. The correction of these errors must be disclosed separately.
- When preparing statements in accordance with IFRS Standards for the first time, the fair value of property, plant and equipment, intangible assets and investment properties can be used as the ‘deemed cost’. If so, the entity must disclose the aggregate of those fair values and the adjustment made to their carrying values under the previous GAAP.
IFRS 1 grants limited exemptions in situations where the cost of compliance would outweigh the benefits to the user. For example:
- Previous business combinations do not have to be restated.
- An entity can choose to deem past translation gains and losses on an overseas subsidiary to be nil.
- An entity need not restate the borrowing cost component that was capitalised under previous GAAP at the date of transition.
- Under IAS 32, the proceeds of convertible debt are split into a liability component and an equity component. If the debt had been repaid by the date of transition, no adjustment is needed to recognise the equity component upon adopting IFRS Standards for the first time.
- If a subsidiary adopts IFRS Standards later than its parent, then the subsidiary may value its assets and liabilities either at its own transition date or its parent’s transition date (which would normally be easier).
Test your understanding 1 – Nat
Nat is a company that used to prepare financial statements under local national standards. Their first financial statements produced in accordance with IFRS Standards are for the year ended December 20X5 and these will include comparative information for the previous financial year. Its previous GAAP financial statements are for the years ended 31 December 20X3 and 20X4. The directors are unsure about the following issues:
- Nat received $5 million in advance orders for a new product on 31 December 20X3. These products were not dispatched until 20X4. In line with its previous GAAP, this $5m was recognised as revenue.
- A restructuring provision of $1 million relating to head office activities was recognised at 31 December 20X3 in accordance with previous GAAP. This does not qualify for recognition as a liability in accordance with IAS 37.
- Nat made estimates of accrued expenses and provisions at 31 December 20X3. Some of these estimates turned out to be under-stated. Nat believes that the estimates were reasonable and in line with the requirements of both its previous GAAP and IFRS Standards.
In accordance with IFRS 1, how should the above issues be dealt with?
Implications of adopting International Financial Reporting
There are a number of considerations to be made when adopting IFRS Standards for the first time. The key considerations are discussed below.
The transition to IFRS Standards requires careful and timely planning. Initially there are a number of questions that must be asked to assess the current position within the entity.
- Is there appropriate knowledge within the entity?
- Are there any agreements (such as bank covenants) that are dependent on local GAAP?
- Will there be a need to change the information systems?
- Which IFRS Standards will affect the entity?
- Is this an opportunity to improve the accounting systems?
Once the initial evaluation of the current position has been made, the entity can determine the nature of any assistance required.
They may need to:
- engage experts in IFRS Standards for assistance
- inform key stakeholders of the impact that IFRS Standards could have on reported performance
- produce a project plan that incorporates the resource requirements, training needs, management teams and timetable with a timescale that ensures there is enough time to produce the first financial statements in accordance with IFRS Standards.
- investigate the impact of the change on computer systems and establish if the current system can easily be changed.
Aside from the practical aspect of implementing the move to IFRS Standards, there are a number of other factors to consider:
- Debt covenants
– The entity will have to consider the impact of the adoption of IFRS Standards on debt covenants and other legal contracts.
– Covenants based on financial position ratios (for example the gearing ratio) and profit or loss measures (such as interest cover) will probably be affected significantly by the adoption of a different set of accounting standards.
– Debt covenants may need to be renegotiated and rewritten, as it would not seem to be sensible to retain covenants based on a local GAAP if this is no longer to be used.
- Performance related pay
– There is a potential impact on income of moving to IFRS
Standards, which causes a problem in designing an appropriate means of determining executive bonuses, employee performance related pay and long-term incentive plans.
– With the increase in the use of fair values and the potential recycling of gains and losses under IFRS Standards (e.g. IAS 21 The Effects of Changes in Foreign Exchange Rates), the identification of relevant measures of performance will be quite difficult.
– There may be volatility in the reported figures, which will have little to do with financial performance but could result in major differences in the pay awarded to a director from one year to another.
- Views of financial analysts
– It is important that the entity considers how to communicate the effects of a move to IFRS Standards with the markets and analysts.
– The focus of the communication should be to provide assurance about the process and to quantify the changes expected. Unexpected changes in ratios and profits could adversely affect share prices.
Reasons for differences in accounting practices
The reasons why accounting practices may differ from one country to another include the following:
- Legal systems. In some countries, financial statements are prepared according to a strict code imposed by the government. This is often because the accounts are being prepared primarily for tax purposes rather than for investment.
- Professional traditions. In contrast to countries where accounting standards are embedded in legislation, other countries have a strong and influential accounting profession and can rely on the profession to draft relevant standards.
- User groups. As mentioned above, in some countries the tax authorities are the main users of accounts, and so a standardised, rule-based approach to accounting emerges. Quite often, depreciation rates will be set by law rather than being based upon useful lives. In countries where businesses are generally financed by loans (rather than by equity) then financial statements will focus on a business’ ability to service and pay back its debts. In the UK and the US, businesses are generally financed through equity. In these countries, the shareholders share the risks of profits and losses, and so they demand full disclosure of a business’ financial affairs.
- Individual countries believe that their own standards are the best.
- Differences in culture can lead to differences in the objective and method of accounting.
Culture and local custom
Financial reporting practice may be influenced by cultural factors in a number of ways.
- Religion may affect accounting practices. For example, Islamic law forbids the charging or accepting of interest.
- Different nationalities have different attitudes to risk. For example, in Japan high gearing is usual and is a sign of confidence in an entity.
- In the UK and the USA, the main objective of management and shareholders is generally to maximise profit in the short term. However, in other countries, investors and management may have different or wider objectives, such as long-term growth, stability, benefiting the community and safeguarding the interests of employees.
Benefits of harmonisation
There are a number of reasons why the harmonisation of accounting standards would be beneficial. Businesses operate on a global scale and investors make investment decisions on a worldwide basis. There is thus a need for financial information to be presented on a consistent basis. The advantages are as follows.
- Multi-national entities
Multi-national entities would benefit from closer harmonisation for the following reasons.
- Access to international finance would be easier as financial information is more understandable if it is prepared on a consistent basis.
- In a business that operates in several countries, the preparation of financial information would be easier as it would all be prepared on the same basis.
- There would be greater efficiency in accounting departments.
- Consolidation of financial statements would be easier.
If investors wish to make decisions based on the worldwide availability of investments, then better comparisons between entities are required. Harmonisation assists this process, as financial information would be consistent between different entities from different regions.
- International economic groupings
International economic groupings, e.g. the EU, could work more effectively if there were international harmonisation of accounting practices. Part of the function of international economic groupings is to make cross-border trade easier. Similar accounting regulations would improve access to capital markets and therefore help this process.
The role of standard setters
National standard setters
The harmonisation process has gathered pace in the last few years. From 2005 all European listed entities were required to adopt IFRS Standards in their group financial statements. Many other countries including Australia, Canada and New Zealand decided to follow a similar process. National standard setters are committed to a framework of accounting standards based on IFRS Standards.
National standard setters and the Board
In February 2005, the Board issued a memorandum setting out its responsibilities and those of national standard setters:
- The Board has a responsibility to ensure that it makes information available on a timely basis so that national standard setters can be informed of its plans. Sufficient time should be allowed in relation to consultative documents so that national standard setters have sufficient time to prepare the information in their own context and to receive comments from their own users.
- The national standard setters should deal with domestic barriers to adopting or converging with IFRS Standards. They should avoid amending an IFRS Standard when adopting it in their own jurisdiction. They should encourage their own constituents to communicate their technical views to the Board. They should also make known any differences of opinion that they have with a project as early as possible in the process.
Test your understanding 1 – Nat
Comparative figures prepared under IFRS Standards for year ended 31 December 20X4 must be presented. Nat’s date of transition is therefore
1 January 20X4 and an opening IFRS statement of financial position must be produced as at this date.
Some of the accounting policies that Nat uses in its opening IFRS statement of financial position differ from those that it used for the same date using its previous GAAP. The resulting adjustments arise from events and transactions before the date of transition to IFRS Standards. Therefore, Nat should recognise those adjustments directly in retained earnings.
The sale does not meet the revenue recognition criteria per IFRS 15 Revenue from Contracts with Customers because control of the asset has not transferred from the seller to the customer. In the opening IFRS statement of financial position as at 1 January 20X4, a contract liability should be recognised. The $5 million loss on recognition of this liability will be accounted for in retained earnings.
The provision does not meet the criteria in IAS 37. In the opening IFRS statement of financial position as at 1 January 20X4, the provision should be derecognised. The $1 million gain on derecognition of this provision will be accounted for in retained earnings.
Although some of the accruals and provisions turned out to be under-estimates, Nat concluded that its estimates were reasonable and, therefore, no error has occurred. In accordance with IAS 8, this issue should be accounted for prospectively. Therefore the additional expense will be recognised within the profit or loss figures prepared in accordance with IFRS Standards for the year ended 31 December 20X4.