Accounting: The Language of Business - Vol. 2 (Intermediate: Part 11)

Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable.

Warren Buffett

Financial Reporting Theory (Part E)

by

Charles Lamson

Elements: International Financial Reporting Standards (IFRS)

Recall from part 10 the Financial Accounting Standards Board (FASB) is currently revising the conceptual framework (A conceptual framework sets forth theory, concepts, and principles to ensure that accounting standards are coherent and uniform.) Exhibit 2.2, from part 10 and reintroduced below, summarizes FASB's six-topic project initiated to revise its conceptual framework. The first topic on the objective of financial reporting and the qualitative characteristics has been completed. The FASB is currently working on elements, measurement, presentation, and disclosure. The other topic is inactive. At the current time, FASB and IASB are working independently on the conceptual framework.

The second phase of the conceptual framework project builds on the objective of financial reporting and characteristics of financial information.

In this section, we discuss similarities and key differences in the elements under U.S. Generally Accepted Accounting Principles (U.S. GAAP) and IFRS.

Point-in-time elements. IFRS identifies the same three point-in-time elements as U.S. GAAP:

1. Assets

2. Liabilities

3. Equity

The definition of these elements differ slightly in IFRS. Companies usually identify the same assets and liabilities under both U.S. GAAP and IFRS, however, so we do not explore the details of the IFRS definitions. One exception in assets and liabilities reported under U.S. GAAP and IFRS is related to the accounting for research and development costs. Under U.S. GAAP, companies expense all research and development costs. U.S. standard setters view the probable future economic benefits of research and development as so uncertain that research and development cannot be considered an asset. International standard setters also view research costs as uncertain and require companies to expense them under IFRS. However, companies can record development costs as an asset under IFRS when certain conditions are met. The difference in treating development costs as an asset is not due to a difference in the definition of an asset under U.S. GAAP and IFRS. Rather, it is attributable to differences in the interpretation of what is a profitable future benefit. We will discuss the accounting for research and development costs in a later post.

 Period-of-time elements. IFRS identifies four period-of-time elements:

1. Performance

2. Income (includes both revenues and gains)

3. Expenses (includes both expenses and losses)

4. Capital maintenance adjustments 

IFRS explicitly identifies performance, or profit, as a separate element. In contrast, profit is the result of adding revenues and gains and subtracting expenses and losses under U.S. GAAP. Where U.S. GAAP identifies revenues and gains as separate elements, the income element in IFRS encompasses both revenues and gains as both increase equity. Similarly, where U.S. GAAP identifies expenses and losses as separate elements, the expense element under IFRS encompasses both expenses and losses as both decrease equity. Exhibit 2.8 illustrates the links between these definitions under U.S. GAAP and IFRS.

EXHIBIT 2.8 Links between Revenues, Gains, Income, Expenses, and Losses under U.S. GAAP and IFRS

Unlike U.S. GAAP, IFRS determines capital maintenance adjustments from period to period. IFRS defines capital maintenance adjustments as restatements or revaluations of reported amounts of assets and liabilities that companies usually report in other comprehensive income. The concept of capital maintenance relates to how a company seeks to assess changes in its equity. Capital is maintained when the amount of equity in the current year is at least as much as it was in the prior year. We exclude distributions to and contributions from owners during the period In determining whether capital has been maintained. Because capital maintenance assesses changes in equity, it is linked to how profit is determined. There are two concepts of capital maintenance:

• Financial capital maintenance

•  Physical capital maintenance

Under the concept of financial capital maintenance, capital is viewed as the financial amount, or money amount, invested in a company. A company earns profit only if the financial amount, or dollar amount, of the equity at the end of the period is higher than it was at the beginning of the period. For example, financial capital is maintained and a profit is earned when the ending balance of equity is $750,000 higher than the beginning balance.

Under the concept of physical capital maintenance, capital is viewed as the productive capacity of a company, such as units of output per day. A company earns a profit if its productive capacity is greater at the end of the period than it was at the beginning of the period. The concept of physical capital maintenance relies on current cost measurement and is consistent with the revaluation or restatement of long-lived operating assets and liabilities. For example, physical capital is maintained and a profit is earned when the output of goods produced is 200,000 units higher in the current year than in the prior year. IFRS allows the company to determine the concept of capital maintenance that is most appropriate for its business.

Finally, also note that unlike U.S. GAAP, IFRS does not treat transactions with the owners as separate elements. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 34-36*

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