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Chapter 4 Solutions

By Frederick Gomez,2014-03-11 10:59
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Xanxi Petrochemical Company Goodwill and Gain on sale and leasebackIf the lease in a sale-leaseback transaction is classified as an operating lease,

    CHAPTER 4

    INTERNATIONAL FINANCIAL REPORTING STANDARDS

Chapter Outline

    I. The International Accounting Standards Board (IASB) had 31 International Accounting

    Standards (IAS) and 6 International Financial Reporting Standards (IFRS) in force in May

    2005.

     A. In 2002, the IASB and U.S. Financial Accounting Standards Board (FASB) agreed to

    work together to reduce differences between IFRSs and U.S. GAAP.

    II. There are several types of differences between IFRSs and U.S. GAAP.

     A. Definition differences. Differences in definitions can occur even though concepts are

    similar. Definition differences can lead to differences in recognition and/or

    measurement.

     B. Recognition differences. Differences in recognition criteria and/or guidance related to

    (a) whether an item is recognized, (b) how it is recognized, and/or (c) when it is

    recognized (timing difference).

     C. Measurement differences. Differences in approach for determining the amount

    recognized resulting from either (a) a difference in the method required, or (b) a

    difference in the detailed guidance for applying a similar method.

     D. Alternatives. One set of standards allows a choice between two or more alternative

    methods; the other set of standards requires one specific method to be used.

     E. Lack of requirements or guidance. IFRSs do not cover an issue addressed by U.S.

    GAAP, and vice versa.

     F. Presentation differences. Differences in the presentation of items in the financial

    statements.

     G. Disclosure differences. Differences in information presented in the notes to financial

    statements related to (a) whether a disclosure is required and/or (b) the manner in

    which a disclosure is required to be made.

    III. A variety of differences exist between IFRSs and U.S. GAAP with respect to the

    recognition and measurement of assets.

     A. Inventory IFRSs require inventory to be reported on the balance sheet at the lower of

    cost or net realizable value; U.S. GAAP requires the lower of cost or replacement cost,

    with net realizable value as a ceiling and net realizable value less a normal profit

    margin as the floor. U.S. GAAP allows the use of LIFO; IFRSs do not.

     B. Property, plant and equipment subsequent to acquisition, IFRSs allow fixed assets to

    be reported on the balance sheet using a cost model (historical cost less accumulated

    depreciation and impairment losses) or a revaluation model (fair value at the balance

    sheet date less accumulated depreciation and impairment losses); U.S. GAAP

    requires the use of the cost model.

     C. Development costs when certain criteria are met, IFRSs require development costs

    to be capitalized as an asset and then amortized over their useful life; U.S. GAAP

    requires development costs to be expensed as incurred. An exception exists in U.S.

    GAAP for software development costs.

    McGraw-Hill/Irwin ? The McGraw-Hill Companies, Inc., 2007

    Doupnik and Perera, International Accounting, 1/e 4-1

     D. Impairment of assets an asset is impaired under IFRSs when its carrying amount

    exceeds its recoverable amount, which is the greater of net selling price and value in

    use. Value in use is calculated as the present value of future cash flows expected from

    continued use of the asset and from its disposal. An asset is impaired under U.S.

    GAAP when its carrying amount exceeds the undiscounted future cash flows expected

    from the asset’s continued use and disposal.

     1. Measurement of impairment loss the impairment loss under IFRSs is the

    difference between carrying amount and recoverable amount; under U.S. GAAP,

    the impairment loss is the amount by which carrying amount exceeds fair value.

    Recoverable amount and fair value are likely to be different.

     2. Reversal of impairment loss if subsequent to recognizing an impairment loss, the

    recoverable amount of an asset is determined to exceed its new carrying amount,

    IFRSs require the original impairment loss to be reversed; U.S. GAAP does not

    allow the reversal of a previously recognized impairment loss.

     E. Borrowing costs the benchmark treatment in IFRSs is to expense all borrowing costs

    when incurred, the allowed alternative is to capitalize borrowing costs to the extent

    they are attributable to the acquisition, construction, or production of a qualifying asset.

    The benchmark treatment is not allowed under U.S. GAAP; interest must be

    capitalized as part of a qualifying asset when certain criteria are met.

     F. Leases both IFRSs and U.S. GAAP distinguish between operating and finance

    (capitalized) leases. U.S. GAAP provides “bright line” tests to determine when a lease

    must be capitalized; IFRSs do not.

    IV. A number of IASB standards deal primarily with disclosure and presentation issues, and in

    some cases requirements differ from U.S. GAAP.

     A. IAS 1 requires presentation of a statement of cash flows. IAS 7 allows interest to be

    classified as operating, investing, or financing, whereas it always is classified as

    operating under U.S. GAAP.

     B. IAS 8 generally requires changes in accounting policies to be handled retrospectively;

    unlike under U.S. GAAP, the cumulative effect of a change is not included in income.

     C. IAS 14 requires disclosures for both business segments and geographical segments,

    with one being identified as the primary reporting format. The so-called management

    approach that requires the disclosure of operating segments used in U.S. GAAP is not

    followed.

     D. IAS 34 requires interim periods to be treated as discrete accounting periods, whereas

    U.S. GAAP treats interim periods as an integral part of the full year.

     E. IFRS 5 provides a more liberal definition of what qualifies as a discontinued operation

    than does U.S. GAAP.

McGraw-Hill/Irwin ? The McGraw-Hill Companies, Inc., 2007

    Doupnik and Perera, International Accounting, 1/e 4-2

Answers to Questions

    1. Areas where IFRSs provide a benchmark and allowed alternative treatment with respect to

    assets include:

    ; Property, plant and equipment -- measurement subsequent to initial recognition.

    Benchmark: cost less accumulated depreciation and any accumulated impairment

    losses.

    Allowed alternative: revalued amount less accumulated depreciation and any

    accumulated impairment losses.

    ; Purchased intangibles measurement subsequent to initial recognition. Same as

    property, plant and equipment. However, fair value method is only applicable for

    intangibles with an active secondary market.

    ; Borrowing costs. Benchmark: no borrowing costs are capitalized as part of the cost of a

    qualifying asset. Allowed alternative: capitalize borrowing costs to the extent they are

    attributable to the acquisition, construction or production of a qualifying asset.

2. In applying the lower of cost and market rule for inventories, IAS 2 defines market as net

    realizable value (NRV) and U.S. GAAP defines market as replacement cost (with NRV as a

    ceiling and NRV less normal profit margin as a floor).

    3. The allowed alternative is to measure property, plant, and equipment at a revalued amount,

    measured as fair value at the date of remeasurement, less accumulated depreciation and

    any accumulated impairment losses.

    4. Under IAS 36, an impairment loss arises when an asset’s recoverable amount is less than

    its carrying value, where recoverable amount is the greater of net selling price and value in

    use. Value in use is determined as the expected future cash flows from use of the asset

    discounted to present value. The amount of the loss is the difference between carrying

    value and recoverable amount.

     Under U.S. GAAP, an impairment loss arises when the expected future cash flows

    (undiscounted) from the use of the asset are less than its carrying value. If impairment

    exists, the amount of the loss is equal to the difference between carrying value and fair

    value, which can be determined in different ways.

5. The benchmark treatment under IAS 23 requires all borrowing costs to be expensed

    immediately. U.S. GAAP requires interest cost to be capitalized on so-called qualifying

    assets.

6. IAS 17 describes five situations that would normally lead to a lease being capitalized, but

    does not describe these as being absolute tests. The criteria implied in four of the situations

    are similar to the specific criteria in U.S. GAAP, but the IAS 17 criteria provide less “bright

    line” guidance. IAS 17 indicates that a lease would normally be capitalized when the lease

    term is for the major part of the leased asset’s life – U.S. GAAP specifically defines “major

    part” as 75%. IAS 17 also indicates that a lease would normally be capitalized when the

    present value of minimum lease payments is equal to substantially all the fair value of the

    leased asset U.S. GAAP specifically defines “substantially all” as 90%. Determining

    whether a lease should be capitalized is an example of the principles-based approach

    followed in IFRSs versus the rules-based approach of U.S. GAAP.

    McGraw-Hill/Irwin ? The McGraw-Hill Companies, Inc., 2007

    Doupnik and Perera, International Accounting, 1/e 4-3

    7. The criteria for the disclosure and recognition of a contingent liability (loss) are very similar

    in both IAS 37 and U.S. GAAP. The main difference is that IAS 37 defines “probable” in the

    context of recognizing a contingent liability as “more likely than not.” U.S. GAAP does not

    provide a definition for “probable.” IAS 37 allows recognition of a contingent asset (gain)

    when the gain is “virtually certain,” implying that it can be recognized prior to actual

    realization. U.S. GAAP does not allow recognition of contingent gains. The gain must be

    realized before it can be recognized.

    8. IAS 19 requires past service cost related (a) to retirees and vested active employees to be

    expensed immediately and (b) to non-vested employees to be recognized on a straight-line

    basis over the remaining vesting period. In contrast, U.S. GAAP requires the past service

    cost related (a) to retirees be amortized over their remaining expected life and (b) to active

    employees be amortized over their remaining service period.

McGraw-Hill/Irwin ? The McGraw-Hill Companies, Inc., 2007

    Doupnik and Perera, International Accounting, 1/e 4-4

Solutions to Exercises and Problems

1. Monroe Company Inventory

    IFRSs U.S. GAAP

     Historical cost Historical cost 20,000

    20,000

     Estimated selling price 17,000 Replacement cost

    14,000

     Costs to complete and sell 2,000 Net realizable value

    15,000

     Net realizable value 15,000 Normal profit margin 20%

     Inventory loss 5,000 NRV - profit margin

    11,600

     Market 14,000

     Inventory loss

    6,000

    a. (1) IFRSs: Year 1 Inventory loss $5,000

     Year 2 Cost of goods sold $16,800

     (2) U.S. GAAP: Year 1 Inventory loss $6,000

     Year 2 Cost of goods sold $15,800

    b. Year 1: IFRSs result in $1,000 larger income before tax, assets, and stockholders’ equity.

     Year 2: IFRSs result in $1,000 smaller income before tax; assets and stockholders’ equity

    are the same at the end of Year 2 under both IFRSs and U.S. GAAP.

    2. Lincoln Company Research and Development Costs

a. IFRSs Year 1 Year 2

     Research expense $6 million

     Deferred development costs (asset) $4 million

     Amortization expense deferred development costs $800,000

     U.S. GAAP

     Research and development expense $10 million --

b. IFRSs result in $4 million larger income before tax in Year 1 and $800,000 smaller income

    before tax in Years 2-6 compared to U.S. GAAP.

     Ignoring income taxes, total assets and total stockholders’ equity are larger under IFRSs by

    the following amounts:

     Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

     $4,000,000 $3,200,000 $2,400,000 $1,600,000 $800,000 $0

    McGraw-Hill/Irwin ? The McGraw-Hill Companies, Inc., 2007 Doupnik and Perera, International Accounting, 1/e 4-5

3. Jefferson Company Property, Plant and Equipment (measurement subsequent to

    acquisition)

     Cost, 1/2/Y1 $10,000,000

     Useful life 5 years

     Annual depreciation $2,000,000

     Book value, 12/31/Y2 $6,000,000

     IFRSs Allowed Alternative

     Fair value, 1/2/Y3 $12,000,000

     Remaining useful life 3 years

     Annual depreciation $4,000,000

     a. Depreciation expense IFRSs U.S. GAAP

     Years 1 and 2 $2,000,000 $2,000,000

     Years 3, 4, and 5 $4,000,000 $2,000,000

    Income before tax is the same under IFRSs and U.S. GAAP in Years 1 and 2. Income

    before tax is $2,000,000 smaller under IFRSs in Years 3, 4, and 5.

     b. End of Year

     Equipment (book value) 1 2 3 4 5

     IFRSs

     Beginning $10 mn $8 mn $6 mn $8 mn $4 mn

     Revaluation 6 mn

     Depreciation expense (2 mn) (2 mn) (4 mn) (4 mn) (4 mn)

     Ending $8 mn $6 mn $8 mn $4 mn $0

     U.S. GAAP

     Beginning $10 mn $8 mn $6 mn $4 mn $2 mn

     Depreciation expense (2 mn) (2 mn) (2 mn) (2 mn) (2 mn)

     Ending $8 mn $6 mn $4 mn $2 mn $0

     End of Year

     Stockholders’ equity 1 2 3 4 5

     IFRSs

     Beginning $0 ($2 mn) ($4 mn) ($2 mn) ($6 mn)

     Revaluation $6 mn

     Depreciation expense($2 mn) ($2 mn) ($4 mn) ($4 mn) ($4 mn)

     Ending ($2 mn) ($4 mn) ($2 mn) ($6 mn) ($10 mn)

     U.S. GAAP

     Beginning $0 ($2 mn) ($4 mn) ($6 mn) ($8 mn)

     Depreciation expense($2 mn) ($2 mn) ($2 mn) ($2 mn) ($2 mn)

     Ending ($2 mn) ($4 mn) ($6 mn) ($8 mn) ($10 mn)

    McGraw-Hill/Irwin ? The McGraw-Hill Companies, Inc., 2007 Doupnik and Perera, International Accounting, 1/e 4-6

    4. Madison Company Property, Plant and Equipment (impairment)

    IFRSs U.S. GAAP

     Carrying amount 10,000,000 Carrying amount 10,000,000

     Net selling price 7,500,000 Future cash flows 10,000,000

     Discounted future cash flows 8,000,000 No impairment 0

     Value in use (larger amount) 8,000,000

     Impairment loss 2,000,000

     a. (1) IFRSs:

     Year 1 Depreciation expense 2,000,000

     Impairment loss 2,000,000

     Years 2 - 6 Depreciation expense 1,600,000 (8,000,000/5 years)

     (2) U.S. GAAP:

     Years 1-6 Depreciation expense 2,000,000

b. Income before tax

    IFRSs Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

    (2,000,000) (1,600,000) (1,600,000) (1,600,000) (1,600,000) (1,600,000) Depreciation expense

    (2,000,000) 0 0 0 0 0 Impairment loss

    (4,000,000) (1,600,000) (1,600,000) (1,600,000) (1,600,000) (1,600,000) Impact on income

    U.S. GAAP Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

    (2,000,000) (2,000,000) (2,000,000) (2,000,000) (2,000,000) (2,000,000) Depreciation expense

    (2,000,000) (2,000,000) (2,000,000) (2,000,000) (2,000,000) (2,000,000) Impact on income

    (2,000,000) 400,000 400,000 400,000 400,000 400,000 Diff. (IFRSs-U.S. GAAP)

     Total Assets

    IFRSs Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

    12,000,000 8,000,000 6,400,000 4,800,000 3,200,000 1,600,000 Carrying value (at 1/1)

    (2,000,000) (1,600,000) (1,600,000) (1,600,000) (1,600,000) (1,600,000) Depreciation expense

    (2,000,000) 0 0 0 0 0 Impairment loss

    8,000,000 6,400,000 4,800,000 3,200,000 1,600,000 0 Carrying value (at 12/31)

    U.S. GAAP Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

    12,000,000 10,000,000 8,000,000 6,000,000 4,000,000 2,000,000 Carrying value (at 1/1)

    (2,000,000) (2,000,000) (2,000,000) (2,000,000) (2,000,000) (2,000,000) Depreciation expense

    10,000,000 8,000,000 6,000,000 4,000,000 2,000,000 0 Carrying value (at 12/31)

    (2,000,000) (1,600,000) (1,200,000) (800,000) (400,000) 0 Diff. (IFRSs-U.S.GAAP)

    McGraw-Hill/Irwin ? The McGraw-Hill Companies, Inc., 2007 Doupnik and Perera, International Accounting, 1/e 4-7

     Total Stockholders’ Equity (ignoring income taxes) IFRSs Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

    0 (4,000,000) (5,600,000) (7,200,000) (8,800,000) (10,400,000) Beginning balance

    (2,000,000) (1,600,000) (1,600,000) (1,600,000) (1,600,000) (1,600,000) Depreciation expense

    (2,000,000) 0 0 0 0 0 Impairment loss

    (4,000,000) (5,600,000) (7,200,000) (8,800,000) (10,400,000) (12,000,000) Ending balance

    U.S. GAAP Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

    0 (2,000,000) (4,000,000) (6,000,000) (8,000,000) (10,000,000) Beginning balance

    (2,000,000) (2,000,000) (2,000,000) (2,000,000) (2,000,000) (2,000,000) Depreciation expense

    (2,000,000) (4,000,000) (6,000,000) (8,000,000) (10,000,000) (12,000,000) Ending balance

    (2,000,000) (1,600,000) (1,200,000) (800,000) (400,000) 0 Diff. (IFRSs-U.S.GAAP)

    McGraw-Hill/Irwin ? The McGraw-Hill Companies, Inc., 2007 Doupnik and Perera, International Accounting, 1/e 4-8

    5. Garfield Company Borrowing Costs (capitalization)

     Borrowing 8,000,000

     Interest rate 10%

     Annual interest 800,000

     Interest to be capitalized -- Year 1 (U.S. GAAP)

     Weighted-average accumulated expenditures 5,000,000

     Interest rate 10%

     Capitalized interest 500,000

     a. (1) IFRSs Year 1 Year 2

     Interest expense $800,000 $800,000

     Depreciation expense* 0 400,000

     Total $800,000 $1,200,000

     * Cost $10,000,000

     Less: Residual value (2,000,000)

     Depreciable amount $8,000,000

     Useful life 20 years

     Annual depreciation expense $400,000

     (2) U.S. GAAP Year 1 Year 2

     Interest expense $300,000 $800,000

     Depreciation expense** 0 425,000

     Total $300,000 $1,250,000

     ** Cost (includes capitalized interest) $10,500,000

     Less: Residual value (2,000,000)

     Depreciable amount $8,500,000

     Useful life 20 years

     Annual depreciation expense $425,000

     b. IFRSs income before tax is smaller in Year 1 by $500,000; larger in Years 2-21 by

    $25,000 each year. IFRSs total assets and total stockholders’ equity are smaller at EOY

    1 by $500,000. This difference decreases by $25,000 each year through Year 21. At

    EOY 21, total assets and total stockholders’ equity are the same under IFRSs and U.S.

    GAAP.

    McGraw-Hill/Irwin ? The McGraw-Hill Companies, Inc., 2007 Doupnik and Perera, International Accounting, 1/e 4-9

6. Iptat International Revaluation of Fixed Assets

     a. Adjustment (a) relates to the depreciation of the revaluation amount on fixed assets.

    Adjustment (a) results in an addition to net income because the additional depreciation

    taken on the revaluation amount does not exist under U.S. GAAP. The addition to net

    income pertains to the current year only. The addition to net income in the current year

    plus the addition to net income in previous years is the cumulative effect on retained

    earnings, which is the shareholders’ equity account affected by adjustment (a). The

    addition to shareholders’ equity is greater than the addition to net income because of this

    cumulative effect.

     b. Adjustment (b) relates to the revaluation surplus (increase in shareholders’ equity) that is

    recorded when fixed assets are revalued. This increase does not exist under U.S.

    GAAP and shareholders’ equity must be reduced accordingly. In this case, the

    shareholders’ equity account affected is Revaluation Surplus.

7. Xanxi Petrochemical Company Goodwill and Gain on sale and leaseback

     Prior to 2004, IFRSs required goodwill to be amortized, which was not the case under U.S.

    GAAP. Adjustment (a) adds back the goodwill amortization expense deducted in

    determining IFRS net I ncome resulting in an increase in U.S. GAAP net income. The

    addition to income flows through to retained earnings increasing shareholders’ equity. The

    addition to net income pertains to the current year only. The addition to net income in the

    current year plus the addition to net income in previous years is the cumulative effect on

    retained earnings. The addition to shareholders’ equity is greater than the addition to net

    income because of this cumulative effect.

     If the lease in a sale-leaseback transaction is classified as an operating lease, IAS 17

    requires the gain on such a transaction to be reported in income immediately, whereas U.S.

    GAAP requires the gain to be amortized over the life of the lease. Adjustment (b) subtracts

    the gain on sale/leaseback in the current year that was recognized in full under IFRSs. The

    amount of adjustment (b) is the difference between the entire gain recognized under IFRSs

    and the portion of the gain that would be recognized under U.S. GAAP (including

    amortization of gains that might have been generated in earlier years). The same amount

    should be subtracted from retained earnings reducing shareholders’ equity. From the fact

    that adjustment (b) reduced shareholders’ equity by a larger amount than it reduces net

    income, we can infer that Xanxi had one or more sale/leaseback gains in previous years.

8. Clinton Company Calculation of Goodwill

     Purchase price $250,000

     Fair value of recorded net assets 80,000

     Fair value of unrecorded assets (brands) 50,000

     Fair value of in-process capitalizable development costs 20,000 *

     Excess of purchase price over fair value of

     recognized net assets (Goodwill) $100,000

    * In-process development costs amount to $40,000 ($100,000 x 40%), one-half of which are

    capitalizable under IAS 38.

    McGraw-Hill/Irwin ? The McGraw-Hill Companies, Inc., 2007

    Doupnik and Perera, International Accounting, 1/e 4-10

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