Rules in International Accounting - Essay Example

Rules in International Accounting Introduction The project of convergence between US GAAP and IFRS started way back in 2002 when international accounting standard board (IASB) and financial accounting standard board (FASB) signed what we call Norwalk agreement. The agreement was in form of memorandum of understanding. The two bodies identified two key objectives to work on; one is to make existing accounting standards compatible within short time possible, and secondly accept the new norm and maintain it once it is achieved. Both bodies committed themselves towards coming up with one financial reporting standard of high quality that can be used across borders. History of the convergence project between US GAAP and IFRS The commitment was boosted in 2006 when the two bodies set specific targets that were to be achieved by 2008; they referred to it as a roadmap of convergence between 2006 and 2008 (Bragg, 2010). The roadmap identified convergence projects that can be implemented within a short time and those that will be implemented over a long period of time. The projects were based on three principles; one is that, the convergence of financial standards between the two bodies was achievable through development of high-quality accounting and similar standards over a particular period. The second principle is that eliminating the differences between the two accounting standards was not the best way for the two bodies, but instead a new similar standard should be developed that will improve the accounting reporting to investors. The last principle was that for the interest of both local and international investors, the boards should look for convergence by replacing the existing different standards with new and improved norms (Bragg, 2010). Following the excellent progress that the two bodies was making, the U.S Securities and Exchange Commission (SEC) in 2007 remove the need for foreign investors registered in U.S to reconcile financial reports with United States GAAP (Bragg, 2010). During that time, U.S SEC published a clear roadmap on how local organizations should adopt IFRS for their use. The two bodies in 2008 gave an update on the progress of MOU implementation. The leaders from the G20 countries called upon those working on the project to boost their effort in order to complete the convergence within the shortest time possible. Following a request of the G20 leaders, the boards published the progress report detailing how far they have gone in the implementation of the project. In 2012, the two councils again published a joint report showing the progress in details, the progress touches on financial instruments and the best way of working towards converged approach on classification (Bragg, 2010). The last update was published in 2013 in it describes high-level update on the progress and timelines. Major differences between US GAAP and IFRS applications The IFRS and U.S GAAP have been seeking for convergence because the two methods of financial reporting differed primarily. This complicates the management of foreign companies in U.S. One primary reason that makes the two standards different is that U.S GAAP is rules based while IFRS is principles based (Bragg, 2010). In the principled based structure, the same transactions have different interpretations. Such situations require second-guessing hence creating uncertainty; this will need extensive disclosures in financial statements. The areas that require analysis and discussion are clarified by the accounting board and few exemptions are provided. The methodologies of accessing accounting treatment also differ, in U.S GAAP; the research done is more focused on the literature while in IFRS, the facts pattern review is thorough. The way in which intangible assets are treated shows an apparent difference between international accounting standard and United States system of accounting. Under the United States system, the intangible assets are recognized at fair value, but in the international system, the intangible assets are recognized if the assets are going to have future economic benefit and reliability (Warren, Reeve, & Fess, 2005). The cost of advertisement and R&D are a few examples of intangible assets. The LIFO accounting method in the international standard is not permitted while in the U.S system, both LIFO and FIFO methods are used in inventory estimations (Warren, Reeve, & Fess, 2005). If one method of inventory costing is used globally, it will improve comparability between different countries and the requirement for analyst to adjust inventories while doing their comparison analysis will be gotten rid of. Under the international system, once the inventory is written, changes can be made on it in future. However, under U.S system, once the inventory is written down, no reversal will be allowed in future times, it will have to remain that way henceforth. Under the U.S system, when writing financial statements, it is not a must to write income statement and balance sheet according to certain layout, organizations must only adhere to regulations provided by S-X (Warren, Reeve, & Fess, 2005). The IFRS standard also does not require any standard layout, but it has a list of minimum line items. The minimum number of line items is not prescriptive like regulation S-X requirements. In the interim financial reporting, there is a difference in which certain costs are treated. In U.S GAAP, every interim period is treated as an important part of yearly period. Because of this, some costs that give benefits to several interim periods can be put on those periods, this normally result in some cost being pushed forward. In the international accounting system, every interim period is treated as discrete reporting time (Shamrock, 2012). Any cost that does not qualify the definition of asset after that period cannot be differed, and any liability in that period represent existing obligation. How local business cultures are affecting the interpretation of International Financial Reporting Standard Several states have adopted the IFRS system, but in the process of adoption, they face several cultural problems. The countries that have approved the system include Bangladesh, Australia, South Africa, E.U, Pakistan, Japan, UAE, Russia, Singapore, Nigeria, Taiwan, Israel and many others. There is an aspect of business and finance culture. Running of business in different countries is done differently. Businesses as designed differently because of incentives and tax laws. For example in U.S, it is common in certain corporations to gain finances through leasing of assets for a long period of time. An example is that, a financial organization can lease an airline and it will be owned by that financial institution. So the plane will not appear on the balance sheet of the financial institution that leased the aircraft (Shamrock, 2012). The practice of omitting certain assets in the balance is a practicing that is carried out in several countries. This practice of omission is not allowed in IFRS but it is permitted on U.S. Different countries have different ways of conducting their businesses. Far East countries such as Japan and Korea have what we call Keiretsu and Chaebol, this represent a chain of several corporations that are similar, but the holding company is normally not clear (Shamrock, 2012). This put the question whether financial statements in the two countries can produce something that can be compared with other countries that companies have hierarchical relationship between subsidiaries and holding company. In accounting culture, for example in Germany, asset impairment losses are tax deductible and that is in contrary to many other European countries such as UK. Some companies in some countries were interested in bringing down taxable income hence taking advantage of different options by reporting a lower accounting income. Financial reporting in Europe is less detailed as compared to financial reporting using IFRS. The companies who are now using IFRS in Europe have reported that right there are more than 200 new disclosures. Transfer Pricing A fundamental aspect of decentralized organizations is responsibility centers. For example, revenue centers, profit centers or cost centers. The performance of these responsibility centers is measured by various accounting numbers such as departmental profit, standard cost or return on investments and also by other non-accounting factors such market share. Therefore a management accounting system has the responsibility of attaching a dollar figure to transaction between two different parties or centers (Bank, 2014) A transfer price is the price that one department of an organization is charged by another department within the same organization for a transaction conducted between the two departments. The main reason of transfer pricing in an organization is to promote optimal decision making within the various departments of an organization so as to maximize the profit of the organization in one piece. A profit center is any section within an organization that is responsible for both revenues and expenses. The manager of a profit center is treated as an entrepreneur. Usually, such a manager is given powers to make decisions and is answerable to the profits made by his/her center. The two primary reasons for implementing a transfer pricing scheme within an organization are: to assist in coordination of sales, production and pricing decisions of the different departments through a suitable choice of transfer prices and to generate individual profit figures for each department and in so doing evaluate each department’s performance separately. Through transfer pricing, the managers become aware of the value of goods and services that are produced from other sections of the organization. Therefore, it will increase transparency within different departments and distribution of resources within the organization will become more effective. Transfer pricing mechanics Money should not move from one department to the other, transfer price should only be used for internal documentation. Quantity of goods exchanged multiplied by the transfer price is revenue for the selling center and an expense for the purchasing center. Accounting for transfer pricing If the transactions within an organization are accounted for at prices higher than the cost, suitable elimination entries should be made for the purposes of external reporting. Some of the items to be eliminated for consolidated financial statements include: profits and inventories within the organization, intra-organization payables and receivables and intra-organization sales and cost of goods sold. Market-based transfer pricing In the event where the outside market is clearly defined, stable and competitive organizations prefer using the market price as the highest price for the transfer price. However, in situation where the outside market is neither stable nor competitive, reliance on market-based prices may distort the internal decision-making process if competitors are selling at throw-away prices. Negotiated transfer pricing In this method, rules for the determination of transfer prices are not specified by the organization. Managers from all segments are advised to discuss a jointly satisfying transfer price. Negotiated transfer pricing is commonly but together with free sourcing. However, in certain organizations, it is the mandate of the head office to mediate the price determination process and impose a unanimous decision. Transfer pricing in Multinational Corporations If a business is transacted between two unrelated organizations, the transaction’s market price will generally go up. This is referred to as ‘arms-length’ trading because it resulted from indisputable negotiation in the market. The arms-length price is usually accepted for the purposes of taxation. However, when business is transacted between two organizations that are related, they may decide artificially to alter the price at which the transaction is made to reduce the overall tax bill. While multinational corporations tend be proponents of the arms-length price method of determining transfer pricing, it gives them a golden opportunity to evade tax. It is for this reason that some private and public sector practitioners, as well as non-governmental organizations suggest an alternative way of determining transfer pricing: consolidated reporting with formulary allotment and Unitary Taxation (Murphy, 2009). While multinational corporations are given leeway by the arms-length principle to choose for themselves where to shift their profits and evade tax, the unitary taxation scheme involves taxing the several segments of a multinational corporation based on what it is doing in the real world. Multinational corporations would no longer need to regard themselves as high complex tax-driven multi-jurisdictional organizations, and would make their corporate structures simpler and boost efficiencies. Other than the multinationals, the big losers would be economic consultants and accountancy and legal firms who generate significant income from establishing and servicing complex tax-driven corporate organizations. It is a requirement of the current accounting standards that multinational corporations should publish assured financial data, but different jurisdictions have allowed them to sweep up all the results and put them into a single figure. These makes it impossible to untangle financial statements from multinational corporations to know what is exactly happening on the ground. Foreign currency Translation methods Organizations bump into the need to translate foreign currencies when they do businesses that involve use of different currencies and when they have international transactions. Consistent translation methodology is insisted by the accounting standards to ensure the underlying economic circumstances are actually reflected in the financial reports. International Accounting Standard Board rules define ‘functional currency as the one that predominates in the foreign subsidiary’s economic environment (IASB, 2012). The local currency, which is a country’s official currency, may not necessarily be the functional currency. Many large companies use ‘presentation’ currency in their financial reports. Therefore, currency translation is the conversion of functional currency to presentation currency. Current Rate Translation The methodologies of accounting standards use the functional currency translation approach, which is based on the current rate method when the local currency is the functional currency, for instance, a New York subsidiary using the American dollar. In this method, liabilities and assets use the current exchange rate existing on the translation date. Retained income and earnings statements use a mean of the period’s translation rates. Temporal rate translation Foreign operations are allowed to use temporal translation approach when the local currency is not the functional currency. For example, a subsidiary of a French company with foreign transaction in a developing country in which the U.S dollars and not the country’s local currency are used to transact business, would apply this method. When this method is used, income-generating assets on the balance sheet and the related income statement items are adjusted according to the temporal exchange rates from dates of transactions. Monetary-nonmonetary translation This method is employed by a company when there is a high integration between the parent company and a foreign subsidiary. The translated amounts are represented as if they arose from the exports sent from parent company markets of the subsidiary. Monetary liabilities and assets such as cash, accounts payable and accounts receivable are translated using the current exchange rate. Also, non-monetary items such as fixed assets, common stock and inventory are translated using the temporary rate. References Bank, E. (2014). Foreign Currency Translation Methods accessed from http://www.chron.com/ on 10/12/14 International Accounting Standard Board (2012) Murphy, R. (2009). Country by Country Reporting, Holding Multinational Corporations to Account Wherever They Are: Oxford University Press Bragg, S. M. (2010). Wiley GAAP 2011: Interpretation and application of generally accepted accounting principles. Hoboken, N.J: Wiley Warren, C. S., Reeve, J. M., & Fess, P. E. (2005). Financial & managerial accounting. Mason, Ohio: Thomson/South-Western. Shamrock, S. E. (2012). IFRS and US GAAP: A comprehensive comparison. Hoboken, New Jersey: Wiley. Read More