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Q&A: International Financial Reporting Standards for SMEs

Posted on June 6, 2012 by

Tim Finerty

Tim Finerty

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This interview with Tim Finerty, the Shareholder leading the International Financial Reporting Standards (IFRS) practice at Clayton & McKervey, P.C. in Southfield, Michigan, answers common questions our clients ask.

I thought IFRS was going o be required for financial reporting in the United States five years ago. What happened?

Until the Securities and Exchange Commission (“SEC”) issued the initial Roadmap for Convergence to IFRS in 2006 the US financial reporting community didn’t give serious consideration to the potential time and costs a company would have to spend to adopt IFRS. The SEC received over two hundred comment letters on the Roadmap for Convergence. Most agreed a single global set of reporting standards would be beneficial; however, there were plenty of different views on what the single set of standards should be. If you consider the number of different industries, accounting issues, and statement users, it’s easy to understand how there can be so many different views. However, the fact that many countries were reporting under IFRS, or were moving in that direction, caused the SEC to allow filing under IFRS, with a US GAAP reconciliation, and the FASB and IASB began a push to converge IFRS and US GAAP.

A change in leadership at the SEC and the economic decline in late 2008 continued to cast doubt on the timing of IFRS adoption in the US Companies just couldn’t cash flow a conversion to IFRS. Even though there are presently some favorable economic indicators, it isn’t practical for any regulatory body to impose that right now. Recently the FASB and IASB acknowledged they don’t anticipate convergence of IFRS and US GAAP to be completed until 2013. IFRS is coming, it’s just moved further out for the US.

What are the options for a foreign company with a US subsidiary? Do they have to convert the US numbers to IFRS for presentation with the foreign parent?

Luckily, the IASB saw this problem coming. In 2003 they started working on a scaled back set of IFRS for small and medium-sized entities (SMEs). After completing a revised draft, a working group was formed and participated in a field test of these standards and a final version was issued in mid 2009.

Who are the users of IFRS for SMEs and what are the objectives of IFRS for SME’s?

I can tell you that from our client base, users of IFRS for SMEs are domestic entities reporting to foreign parents. IFRS for SMEs recognizes that the foreign parents and their statement users are interested in shorter-term cash flow, liquidity and solvency of the domestic enterprises. The scaled back version also addressed the concern that a full IFRS adoption would be very costly. The SME version is not as costly to adopt. It’s also not meant for public companies or financial institutions.

When you say “a scaled back version of IFRS” what do you mean? Does it just not include more of the onerous financial reporting disclosure requirements of IFRS?

Some of the topics that are in the full scale IFRS are not applicable to SMEs, and are omitted. More simplified accounting policy options and recognition and measurement principles are available to SMEs, along with fewer disclosures.

Omitted topics include earnings per share, interim financial reporting, segment reporting, and special accounting for assets held for sale. Clearly these are more appropriate for publicly held companies.

More simplified accounting policy options include the absence of the financial instrument option, the revaluation model for PP&E and intangibles, and proportionate consolidation from IFRS for SMEs.

The simplified recognition and measurement principles are really cost beneficial for SMEs. They eliminate wading through the myriads of technical accounting literature we’ve created trying to achieve principles based rules. For example, IFRS for SMEs requires expensing all borrowing costs and R&D expenditures, eliminating the costly analysis of the purpose of the expenditures and determination of amortization periods.

You’ve mentioned that companies need to consider the differences in US GAAP and IFRS that impact their financial statements and the accounting systems. What else should companies consider in adopting IFRS?

A long-term conversion to IFRS is not that simple. That is what the financial reporting community discovered after the initial Roadmap for Convergence was issued.

If a company wants a strong system of internal control over financial reporting, they can’t just develop an Excel spreadsheet that converts their US GAAP trial balance to an IFRS trial balance and create financial statements and IFRS disclosures. Because the underlying accounting theory, principles, and measurements are different under IFRS, the US GAAP system simply will not accumulate the data or compute the measurements in accordance with IFRS. IFRS adoption impacts the company’s internal control over financial reporting, including process design, computer systems, segregation of duties, and monitoring all aspects of internal control. Depending on the nature of the business and industry, IFRS adoption could also require an accounting software change.

Key financial indicators for industries that have been in place in the US for years, will be subject to scrutiny and potential change. Bank covenants that are based on financial measurements will also have to be reconsidered and perhaps require bank agreement amendments or new bank agreements. Companies will also have to consider contracts they have in place, like bonus agreements based on earnings targets and all other agreements.

Can you provide a brief over view of what the IFRS adoption process should entail?

Yes, but remember that each adoption process is unique and should be tailored for the specific needs of each company. It is critical to identify an IFRS adoption team. This team will vary in size depending on the size of the company and the complexity of the accounting and financial reporting needs. If the company does not have a comprehensive understanding of IFRS internally, we highly suggest seeking outside specialists to assist you in your initial adoption. Make sure any specialist you work with also understands your industry and your specific
reporting objectives.

Generally, the process we follow with our clients is to first perform a preliminary assessment of the impact of adopting IFRS. This is very comprehensive. This phase covers accounting software, internal controls, identifying what information your present system does not capture that
will be necessary and what information will no longer need to be captured .

The next step is to quantify the impact on the financial statements. In this phase we analyze the financial statements line by line. We then go back and make sure everything we identified in the first phase includes the information we identify in this phase. For example, if revenue will be recognized earlier under IFRS, we make sure the attributes that allow for revenue recognition under IFRS are being identified in the present software and we identify what needs to change. We also analyze the footnote disclosures. Analyzing the footnotes is just as rigorous as the financial statement line item analysis. We have to make sure the accounting system captures information that
needs to be disclosed in a timely and accurate fashion.

Once we have completed our preliminary assessment and analyzed the financial statements and footnotes for the necessary changes, we develop a timeline and strategy to convert. Objectives are tasked by the responsible party, time allotted, and completion date, and include the modification of systems to accumulate information.

This is a very high level overview of the conversion process. There are many steps in the first two phases and I can’t stress enough the importance of allowing sufficient time to make sure all data is appropriately considered. Companies need to be realistic with their expectations. What I mean is there are certain phases of the conversion that will be dependent on how fast things can happen outside the company. Renegotiating debt covenants with the bank is a good example. This will require some time on the part of the bank and depending on the lender, companies may experience some aversion to changing the covenants.

Companies also need to consider that they need to comply with IFRS 1 First-time Adoption of IFRSs issued, as amended. IFRS 1 requires that at least one year of comparative prior period financial information be presented. There are also certain disclosures and de-recognition of items recorded under US GAAP that are also required.

What should companies be doing today for future adoption of IFRS and IFRS for SMEs?

Companies should be proactive instead of waiting for the final roadmap or regulatory authority mandate for adoption. Present operating decisions should include IFRS considerations because they will be impacted when IFRS is mandated. Companies should be considering the impact IFRS will have on their business. Management should be identifying IFRS adoption team members and considering the completion of the first phase of the process. For example, accounting software purchase decisions should include some consideration of IFRS capabilities. Foreign and domestic public companies will, or already have, adopted IFRS. Domestic subsidiaries of foreign public company parents will, or already have, adopted IFRS. The recent economic decline has really emphasized how interdependent all economies are. A global standard of financial reporting makes sense and is slowly converging around the globe. The US has been slow to accept IFRS, but there is no doubt that it is eminent.

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Tim Finerty

Shareholder, Industrial Automation

Tim provides tax, accounting and consulting support to help industrial automation companies maximize profitability.

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