Accounting as Art of Organizing - Case Study Example

IFRS and US GAAP - Significant differences and their usefulness Introduction Peter J Eisen (2007) s that accounting is art of organizing, maintaining, recording and analysing financial activities which is widely known as 'language of business'. The financial statements prepared are useful to consider the best options available for the overall growth of business. The information is of importance to management, investors, creditors, employees and other government organizations. Financial statements are written reports describing quantitatively the financial health of a company. An income summary shows the income and expenditure of a firm or a balance sheet shows the assets and liabilities and equity of a company are all examples of financial statements. A financial statement must provide details with regard to financial position, changes in position and operations of an enterprise which may be useful for decision making. International Accounting Standards Board is development of International Accounting Standards Committee (IASC) created in 1973 with the objective of developing the uniform standards of accounting. IASB and US Financial Accounting Standards Board (FASB) congregated the IFRS and US GAAP in 2002 as part of the Norwalk agreement making their existing financial reporting standards compatible and practicable and coordinating their future work programme to ensure compatibility. The IASB provided two accounting standards for financial reporting frame works like International Financial Reporting Standards (IFRS) developed by The International Accounting Standards Board (IASB) and Generally Accepted Accounting Principles (US GAAP). The US GAAP was acknowledged extensively as the international set of standards to make certain best quality financial statements. This standard was mostly used in the US and also elsewhere, but with the entry of IFRS a debate on the virtual class of both authorities has taken place. GAAP is exceptionally comprehensive on what is acceptable and unacceptable. IFRS is used by more than hundred countries as their standard set of guidelines and principles. Still more countries, like Canada and India are projecting to follow IFRS from 2011. This paper is intended for providing some explorative information on the IFRS / US GAAP and also some demarcation and comparison of the two standards of financial reporting. More specifically, the purpose of the current study is to investigate the properties of IFRS versus US GAAP standards of accounting using the accounts of National Grid Plc that is listed both in EU and US Stock Exchange. And most importantly, the paper identifies the difference between the rules and principles of two accounting standards through the accounts of National Grid Plc and its usefulness to various stakeholders of the organization. IFRS and US GAAP - Significant differences in National Grid Plc National Grid is an energy production organization which owns and operates the electricity transmission system in England and US. National Grid distributes gas to 11 million homes and businesses in UK. The company is also engaged in business of wireless infrastructure along with other businesses like National Grid Metering, Onstream, National Grid Grain, property, etc. The main areas of operation of the company are UK and US which was created by the restructuring of UK gas industry in 1986 and electricity industry in 1990 and entered the US market in the year 2000. (www.nationalgrid.com) According to annual report for the year 2005/06, it is revealed that the group has achieved 25% increase in the revenue from 7382m to 9193m. And according to the same reports, operating profits have also increased from 2142m to 2439m (2005/06) which is 14% higher. National Grid has also entered into acquisition and merger with some companies like Keyspan Corporation. The company with its base in US and UK, the countries which adopt two different standards of accounting principles, has to prepare accounts conforming to the rules and regulations of that particular nation. However, the group accounts of the company are prepared under IFRS standards and hereby make it necessary to understand and identify the differences that will arise if the same accounts are prepared under US GAAP principles. The following reconciliation statement from IFRS to US GAAP shows the differences in relation to the profit for the year attributable to equity shareholders under IFRS. The statement shows that there is significant difference in net income if US GAAP principles are adopted. In the year 2006, the profits for the year attributable to equity shareholders under IFRS was 3484m and the value of total adjustments was 2541m, resulting in net income of 1307m under US GAAP. (www.nationalgrid.com) Regarding the differences in relation to above statement, IFRS 1 does not mention to restate any business combinations occurred before 31 March 2004 but US GAAP allows such accounting under purchase accounting resulting in fair value adjustment in relation to property, plant and equipment recognizing the goodwill. (www.nationalgrid.com) IFRS uses revalued amount or historical costs whereas US GAAP uses historical costs prohibiting revaluations. (An IAS Plus Guide) Recoverable assets that are recognized as regulatory assets under US GAAP through SFAS 71 - Accounting for the Effects of Certain Types of Regulation' are not recognized in IFRS as they do not meet the criteria for recognition as an asset. IFRS includes actual gains and losses in the income and expense statement in the occurred year. Whereas under US GAAP, the pension plan exceeds the accumulated benefit obligation, the amount is shown in liability. However the difference is that interest cost related to pension are shown within finance costs as compared to net periodic pensions cost in US GAAP. The curtailment/settlement gain that arise due to sale of distribution networks are totally included in income statement whereas only that gain is recognized which is left after exceeding the unrecognized losses. Derivatives are recognized in the balance sheet at their fair value as per IAS 39 which is similar to SFAS 133 'Accounting for Derivative Instruments and Hedging Activities. However, SFAS 133 does not include transitional provision of IAS 39. If hedges meet both SFAS 133 and IAS 39 principles, they are accounted for as hedges or else shown in the income statement under US GAAP and reconciliation statement showing the difference. Severance costs under IFRS are provided on the basis that a constructive or legal obligation has arisen probably resulting in outflow of economic benefits whereas under US GAAP such costs are recognized only when the employee accepts the severance offer. Revenue is recognized as income only when it is received or will be received in excess of maximum revenue allowed under IFRS whereas under US GAAP revenue is recognized in the period that the service is provided up to the maximum revenue allowed. Intangible assets that comply with certain criteria of IFRS are recognized as assets at fair value. US GAAP requires the same criteria as IFRS with the addition of notional tax benefits. Impairment reversals are allowed under IFRS in respect of joint venture but in US GAAP, it is not practiced. Assets in the balance are presented in ascending order of liquidity in IFRS whereas it is shown in descending order of liquidity in US GAAP. Capital contributions are recorded as deferred income under IFRS whereas it is recorded as a depreciation to asset under US GAAP Share based payments are recognized on an accelerated basis to reflect the vesting under IFRS. US GAAP provides amortization the entire grant on a straight line basis over the longest vesting period or as similar to IFRS policies Under IFRS, share based payments are mostly awarded and settled in cash terms whereas these payments are classified as liabilities in US GAAP. Pay roll taxes are recognized in the same ways as compensation costs are recognized under IFRS and in relation to US GAAP rules, it is recognized when the obligation is fulfilled. Discontinued operations are presented in the income statement as post tax income or loss in IFRS and pre-tax and post tax income in the income statement in US GAAP format. Extraordinary items are prohibited under IFRS whereas it is permissible under US GAAP. Inventory cost is not determined on the basis of Last In First Out under IFRS whereas under US GAAP, the Last In First Out Method is permitted Cash flow per share in US GAAP is prohibited whereas it is somewhat permissible under IFRS guidelines. The condensed income statement of National Grid for the year 2006 is prepared using both, IFRS and US GAAP standards, and the accumulated difference is shows in between. (Source: www.nationalgrid.com) As per the above statement, it is reported that annual turnover of the company as per IFRS is 9193m and 9216m as US GAAP standards with an adjustment of 23m conforming to US GAAP. Operating profit is reported to be 2439m under IFRS and 1810m for US GAAP with a difference of 629m. (Source: www.nationalgrid.com) The annual reports also show that companies profit before taxation was reported to be 1779 when accounted under IFRS and 1059 under US GAAP. The difference between the profits before taxation is higher in IFRS as 63% of operating profit has been deducted under US GAAP as compared to 58% under IFRS. The above diagram shows the difference between the operating profit and profit before taxation under both standards stating that profit before taxation is greater higher in IFRS as compared to US GAAP. (Source: www.nationalgrid.com) The annual profit for the year 2006 according to IFRS is reported to be 1217m as compared to 711m under US GAAP. There is not much difference between the amounts of profit as presented through the above diagrams which shows that under IFRS, 67% of deduction took place before arriving at annual profit as compared to 72% under US GAAP. Annual Reports of National Grid for the year 2007/08 presents the accounting policies of the company which states that its accounts are prepared in accordance with International Financial Reporting Standards (IFRS). However the company uses UK GAAP in reporting individual financial statements including UK subsidiary companies. Consolidated financial statements are prepared as per the IFRS standards requiring all the subsidiary companies where US GAAP prevents consolidation of controlled entities by certain types of organizations like registered investment companies or brokers/ dealers. The consolidated income statement of National Grid Plc prepared following the guidelines of IFRS. The consolidated statement shows that the company includes all the components as required by the GAAP policies but it is not mandated IFRS which allows only potential disaggregation of component pieces. The income statement is prepared by using the data from separate statements of operating profit, profit before taxation which, operating expense that included all the elements that need to be part of the accounting process such as business segments - continuing operations, geographical segments, etc. Operating costs include depreciation, payroll costs, other operating expenses, purchases, etc. which is necessary to prepare authenticated and actual financial accounts. (PricewaterhouseCoopers, 2008) (source: www.nationalgrid.com) The consolidated balance sheet as on 31 March 2008 shows that the company has presented the financial statements in form of borrowing, derivatives, trade, receivables, Goodwill, tax liabilities and equity. IFRS does not provide shortcut method which is accepted under US GAAP to prepare the documentation that supports hedge accounting. IFRS does not need to include net settlement of derivative effectively resulting in recognition of more instruments as derivative. (PricewaterhouseCoopers, 2008) The consolidated balance sheet of National Grid Plc for the year 2007/08 informs that pension asset has increased dominantly from 37m to 846m which means that last financial year saw large number of recruitment. Additionally it also states the increase in purchase of plant and machinery which has also increased. The information provided in the consolidated balance sheet is of great help to insiders as well as outsiders to analyse the growth of business. (Annual Reports, 2007/08) Usefulness to an investor or potential investor in the company's shares IFRS is principal based with limited application guidance and US GAAP is rules based with specific application guidance. The balance sheet and income statement of National Grid Plc as furnished in its annual report for the year 2005/06. The annual report of National Grid shows that US GAAP lays more information regarding the shares and stresses hard to present the correct share value of the company which makes it useful from the shareholders perspective. Whereas the IFRS principles are more based to provide assistance to management of the company which shows them their outcome irrespective of the shareholder value presented in the report. As a result of which, the total annual profit is lesser in US GAAP as compared to IFRS. What factor of IFRS will prevail in the future is a big question in the minds of all. David Tweedie, chairman of the International Accounting Standards Board stated in his interview in the July 2007 article of the Journal of Accountancy as, "By 2011-12 U.S. and international accounting should be pretty much the same with 150 countries using IFRS and several others using U.S. GAAP. That adds up to about 170 countries accounting in much the same way. The SEC's consideration of IFRS as an alternative reporting mechanism can only enhance the importance of the international standard." IFRS is not a set of best measure of global accounting standards, and their acceptance would subject enterprises to standards for which there is no participation in the standard-setting procedure. In order to terminate, on quality of a set of accounting standards they should be adequately all-inclusive and attuned with the background in which they are enforced. At present, there is direction and other accounting writing obtainable under U.S. GAAP which is not provided by the IFRS. For instance, IFRS gives limited guidance in some areas like accounting for cost-based and rate-regulated entities. Under the provisos of FASB Statement No. 71, Accounting for the Effects of Certain Types of Regulation, (SFAS 71), a synchronized entity, which includes utilities, records a rigid asset through future revenues, the synchronized entity can get back that asset from customers and enters a regulative liability for decreases in future revenues for amounts which are due to customers. Reference 1. Annual Report 2007/08 National Grid Plc, www.nationalgrid.com 2. IFRS and US GAAP similarities and differences. September 2008. Price water house coopers. 3. IFRSs and US GAAP - A Pocket Comparison. An IAS Plus Guide. July 2008. Deloitte. http://www.iasplus.com/dttpubs/0809ifrsusgaap.pdf. 4. Sir David Tweedie and Bob Herz. (2008) IFRS Conference: North America. US GAAP/IFRS Convergence Update. Toronto. 5. Peter J. Eisen (2007) Accounting. Ed. 5, Barron's Educational Series Read More