• What key financial ratios will be affected by the adoption of FAS 141R and FAS 160? What will be the likely effect?
Read the case study indicated below, and answer the following questions:
James, M. L. (2010). Accounting for business combinations and the convergence of International Financial Reporting Standards with U.S. Generally Accepted Accounting Principles: A case study. Journal of the International Academy for Case Studies, 16(1), 95-108.
What key financial ratios will be affected by the adoption of FAS 141R and FAS 160? What will be the likely effect?
Could any of the recent and forthcoming changes affect the companys acquisition strategies and potentially its growth?
What were FASBs primary reasons for issuing FAS 141R and FAS 160?
What are qualifying SPEs? Do they exist under IFRS? What is the effect of FAS 166 eliminating the concept of qualifying SPEs on the convergence of accounting standards?
If the company adopts IFRS, what changes should management be aware of?
What are the principle differences between IFRS and U.S. GAAP?
Your submission should be a minimum of three pages in length in APA style; however, a title page, a running head, and an abstract are not required. Be sure to cite and reference all quoted or paraphrased material appropriately in APA style.
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Journal of the International Academy for Case Studies, Volume 16, Special Issue, Number 1, 2010
ACCOUNTING FOR BUSINESS COMBINATIONS
AND THE CONVERGENCE OF INTERNATIONAL
FINANCIAL REPORTING STANDARDS WITH U.S.
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES:
A CASE STUDY
Marianne L. James, California State University, Los Angeles
CASE DESCRIPTION
The primary subject matter of this case concerns changes in accounting for business
combinations and the convergence of International Financial Reporting Standards (IFRS) with U.S.
Generally Accepted Accounting Principles (GAAP). The case focuses on the effect of the changes
on financial statements of global entities, as well as strategic decisions made by company
executives.
Secondary, continuing significant differences between U.S. GAAP and IFRS and future
potential developments in accounting for consolidated multinational entities are explored. This case
has a difficulty level of three to four and can be taught in about 50 minutes. Approximately three
hours of outside preparation is necessary to fully address the issues and concepts. This case can be
utilized in an Advanced Accounting course, either on the graduate or undergraduate level to help
students understand changes in and differences between U.S. GAAP and IFRS. Two sets of questions
address U.S. GAAP and IFRS and include researchable questions that are especially useful for a
graduate level course. The case has analytical, critical thinking, conceptual, and research
components. Utilizing this case can enhance students oral and written communication skills.
CASE SYNOPSIS
Financial reporting in the U.S. is changing dramatically. Consistent with the Securities and
Exchange Commissions proposed Roadmap (SEC, 2008), the U.S. likely will join the more than
100 nations worldwide that currently utilize International Financial Reporting Standards (IFRS),
and require the use of IFRS in the U.S.
Because of the globally widespread use of IFRS, multinational entities with subsidiaries that
prepare IFRS-based financial statements already have to be knowledgeable about IFRS as well as
the current differences between U.S. GAAP and IFRS. Fortunately, the Financial Accounting
Standards Board (FASB) and the International Accounting Standards Board (IASB) are working
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Journal of the International Academy for Case Studies, Volume 16, Special Issue, Number 1, 2010
together to bring about convergence between the two sets of accounting standards.
Recently, FASB and the IASB issued new and revised several existing standards that
eliminate many differences between U.S. GAAP and IFRS with respect to business combinations and
consolidated financial statements. However, some significant differences persist. Until the SEC
makes a final decision regarding the mandatory use of IFRS, and during the proposed multi-year
transition period, current and future accounting professionals must continue to keep abreast of
changes in U.S. GAAP, be knowledgeable about differences between U.S. GAAP and IFRS, and, at
the same time, prepare for the likely transition to IFRS. In addition, company executives should be
cognizant of developments that may affect their strategic decisions as the U.S. moves toward a likely
adoption of IFRS during the next five years.
This case focuses on the effect of changes in financial reporting for business combinations.
Changes as well as continuing differences between U.S. GAAP and IFRS are explored. Secondarily,
strategic decisions arising from the changes and the likely future adoption of IFRS are addressed.
This case, which can be utilized in Advanced Accounting on either the graduate or undergraduate
level can enhance students analytical, technical, critical thinking, research, and communication
skills.
INTRODUCTION
Financial accounting and reporting in the U.S. is changing rapidly. During the past six
months, the Financial Accounting Standards Board, the primary accounting standard setter in the
U.S., issued twelve (12) new standards and launched its on-line Accounting Standards
Codification, which organizes existing GAAP into 90 topics (FASB, 2009). At the same time, a
significantly more dramatic change is on the horizon for accounting professionals, company
executives, and financial statement users.
Consistent with the SECs 2008 proposal entitled, Roadmap for the Potential Use of
Financial Statements Prepared in Accordance With International Financial Reporting Standards by
U.S. Issuers, (Roadmap) in approximately five years, public companies likely will have to utilize
IFRS, instead of U.S. GAAP (SEC, 2008). In fact, some large global U.S.-based entities are
permitted to early-adopt IFRS starting in 2009. The SEC expects to reach a final decision regarding
the mandatory adoption of IFRS in 2011 (SEC, 2008).
If the U.S. indeed adopts IFRS as the required standard for financial accounting and
reporting, the U.S. will join the more than 100 nations worldwide that currently permit or mandate
the use of IFRS. For example, starting with the 2005 reporting period, all European public
companies listed on any European stock exchange must prepare IFRS-based financial statements.
Other nations, such as Canada, are planning to adopt IFRS in the near future.
Currently, U.S. GAAP and IFRS are not identical. However, since signing their
Memorandum of Understanding, commonly referred to as the Norwalk Agreement, in 2002, FASB
and the IASB have been working together to develop a set of high-quality globally acceptable
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Journal of the International Academy for Case Studies, Volume 16, Special Issue, Number 1, 2010
financial accounting standards and to bring about convergence of U.S. GAAP and IFRS. Since the
Norwalk Agreement was signed, many new and revised standards issued by FASB and the IASB
have served the purpose of eliminating existing differences. However, while many differences have
been eliminated, others persist.
Accounting for and reporting by global entities is quite complex. U.S., as well as
international accounting rules require that a parent company consolidates its subsidiaries financial
statements with the parent companys financial statements. Recent standards issued by the IASB
and FASB have eliminated many differences between U.S. GAAP and IFRS in accounting for
business combinations and financial reporting for consolidated entities. However, some significant
differences continue to exist.
KLUGEN CORPORATION
Irma Kuhn, CPA, CMA holds the position of Chief Financial Officer (CFO) of Klugen
Corporation, a global telecommunications company. Klugen is a consolidated entity headquartered
in the U.S. with four majority-owned European subsidiaries. The company has expanded primarily
by acquiring majority interest in European companies and holds between 51% and 70% of the
outstanding voting stock of its subsidiaries. Three of these subsidiaries were acquired in stages and
consolidated once the company achieved majority ownership.
Consistent with current accounting rules, Klugen consolidates all four of its subsidiaries. In
addition, Klugen also holds financial interests in several unconsolidated entities and accounts for
those as investments.
Klugens European subsidiaries currently prepare their financial statements consistent with
International Financial Reporting Standards (IFRS), which are promulgated by the International
Accounting Standards Board (IASB). Klugen, the parent company, issues consolidated financial
statements, which include the results of its majority-owned subsidiaries in conformity with U.S.
GAAP. Preparation of Klugens consolidated financial statements requires that Irma and her staff
convert the subsidiaries IFRS-based financial statements into U.S. GAAP prior to consolidating the
numbers. This process is quite complex and requires many of the accounting departments resources.
Irma is well aware of efforts between the FASB and the IASB to bring about convergence
between U.S. GAAP and IFRS. She expects that consistent with the SECs Roadmap, (SEC, 2008)
within the next five years, U.S. public companies likely will have to apply IFRS, rather than U.S.
GAAP. Irma welcomes this development and believes that in the long-run, use of IFRS by the parent
company as well as its subsidiaries will preserve and strengthen the companys global financial
competitiveness. In addition, she believes that it will simplify the accounting and consolidation
process significantly and, in the long-run, reduce financial reporting costs. She is aware, however,
that in the short-run many challenges, such as conversion of the accounting and IT systems and
extensive staff training will increase costs. Knowing that the SECs Roadmap proposes a phased-in
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Journal of the International Academy for Case Studies, Volume 16, Special Issue, Number 1, 2010
adoption by public companies between 2014 and 2016, Irma plans to recommend adoption of IFRS
at the earliest permitted time.
As the person who ultimately is responsible for financial reporting, Irma is very
knowledgeable about current and proposed changes in U.S. GAAP as well as IFRS. She knows that
the IASB and FASB have issued new and revised standards applicable to business combinations that
affect the companys consolidated financial statements. After in depths analysis of the new and
revised standards, she determined that many of the past differences between U.S. GAAP and IFRS
where eliminated when the FASB issues FAS 141 R Business Combinations and FAS 160 Non-
controlling interest in consolidated financial statements (FASB, 2007) and the IASB revised IFRS
3 Business Combinations and IAS 27 Consolidated and Separate Financial Statements (IASB,
2008). She also realizes that some significant differences still persist. Klugen Corporation has
properly adopted FAS 141R and FAS 160 (now codified in sections 805 and 810 of FASBs 2009
Standards Codification) for the 2009 fiscal period and its forthcoming annual report will reflect
those changes.
Irma regularly conducts in-house seminars to instruct her accounting staff regarding new
developments in financial reporting. In fact, her seminars meet the Continuing Professional
Education (CPE) sponsor requirements set forth by the National Association of State Boards of
Accountancy (NASBA) and the Quality Assurance Service (QAS), which is required by State
Boards of Accountancy and other licencing organizations for the renewal of CPA, CMA and other
professional certifications.
Irmas CPE seminars entitled Financial Reporting Updates are always well received by
her staff. During the past six months, Irma already has held several seminars to inform her staff
regarding IFRS. Those who attended all her seminars are already familiar with the SECs Roadmap
that proposes adoption of IFRS starting in 2014, and also know about some of the most significant
differences between U.S. GAAP and IFRS.
Since in about five (5) months, Klugen Corporation will issue its consolidated financial
statements, which will, for the first time, incorporate FAS 160 and FAS 141R, Irma decides to
schedule a seminar on Business Combinations – Consolidated Financial Statements for October
15, 2009. The following is a brief agenda for Irmas Seminar:
Business Combinations – Consolidated Financial Statements – Financial Reporting Update
October 15, 2009 – Agenda
1. Review of fundamental concepts of business combinations and consolidated financial
statements
2. Changes to U.S. GAAP (FAS 141R and FAS 160)
3. Significant continuing differences between U.S. GAAP and IFRS
4. Developments with potential impact on future fiscal periods
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Journal of the International Academy for Case Studies, Volume 16, Special Issue, Number 1, 2010
5. Questions
The seminar will be highly beneficial for staff members who are currently involved or
planning to become involved in critical aspects of financial reporting and also for those who want
to develop their knowledge of IFRS. During the seminar, Irma distributes several handouts,
including the companys prior year income statement and balance sheet for reference.
Table 1
Klugen Corporation
Consolidated Statement of Income
for the year ended December 31, 2008
Numbers are in million (except share amounts)
Operating Revenues
Business service $15,500
Residential service 10,200
Wireless service 18,000 $ 43,700
Operating Expenses
Cost of services (excludes depreciation & amortization) $ 15,200
Selling, general, administrative expenses 11,100
Depreciation and amortization 7,150 $ 33,450
Operating Income $ 10,250
Other Income (Expense)
Interest expense (820)
Minority interest (1,010)
Investment income 405 (1,425)
Income Before Income Taxes $ 8,825
Income Tax 3,250
Net Income 5,575
Basic Earnings Per Share $2.08
Diluted Earnings Per Share $1.92
The accompanying notes are an integral part of the consolidated financial statements
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Table 2
Klugen Corporation
Consolidated Balance Sheet
December 31, 2008
(Numbers are in millions)
Assets
Current Assets
Cash and cash equivalents $ 519
Accounts receivables (net of allowances of $310) 4,200
Prepaid expenses 400
Other current assets 520
Total Current Assets $ 5,639
Non-Current Assets
Property, plant & equipment (net) 25,600
Goodwill 18,500
Licenses 12,900
Customer relationships (net) 3,100
Investments in non-consolidated entities 1,000
Dividends receivables 300
Other assets 1,200
Total Non-Current Assets $62,600
Total Assets $68,239
Liabilities and Stockholders Equity
Current Liabilities
Accounts payable and accrued liabilities 5,200
Advanced billings and deposits 920
Accrued taxes 420
Total Current Liabilities $ 6,540
Non-Current Liabilities
Long-term debt 25,500
Post-retirement benefits 2,300
Deferred taxes 3,200
Total Non-Current Liabilities $31,000
Total Liabilities $37,540
Minority Interest 5,000
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Table 2
Klugen Corporation
Consolidated Balance Sheet
December 31, 2008
(Numbers are in millions)
Journal of the International Academy for Case Studies, Volume 16, Special Issue, Number 1, 2010
Stockholders Equity
Common stock ($1 par, 100,000,000 authorized, 60,000,000
issued)
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Additional paid in capital 13,095
Retained earnings 14,588
Accumulated other comprehensive income (2,044)
Total Stockholders Equity 25,699
Total Liabilities and Stockholders Equity $68,239
The accompanying notes are an integral part of the consolidated financial statements.
The Seminar
Agenda Item 1 Fundamental Concepts of Business Combinations – Consolidated
Financial Statements
During the first part of the seminar, Irma reviews several fundamental concepts
relating to accounting for business combinations. She emphasizes that these concepts are
common to both U.S. GAAP and IFRS.
Fundamental Concepts common to both U.S. GAAP and IFRS
The parent company issues consolidated financial statements that include the results
for all subsidiaries that the company controls.
Control is usually assumed when the parent holds a controlling financial interest
(generally, more than 50% ownership of the outstanding voting common stock.
Consolidated financial statements include 100% of the subsidiaries assets, liabilities,
revenue, expense, gains, and losses, even if the subsidiary is only partially owned.
Subsidiaries previously unrecognized assets are identified at time of business
combination and are recognized in the consolidated financial statements.
Goodwill is recognized on the consolidated balance sheet if the acquisition cost
exceeds the fair value of the subsidiaries identifiable net assets.
Goodwill is not amortized, but periodically tested for impairment.
Non-controlling interest (formerly called minority interest) is recognized on the
consolidated balance sheet.
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Agenda Item 2 Changes in U.S. GAAP
Irma discusses the most important changes in accounting and financial reporting for
consolidated entities consistent with FAS 141R and FAS 160. She prepares a handout for
the seminar participants, consisting of a comparative table that contrast the new rules
(effective for the 2009 financial statements) with the prior rules.
Table 3
Recent Changes to U.S. GAAP – effective 2009 – FAS 141R and FAS 160
Issue Effec t ive 2009 Financia l
Statements
Pre-2009 Financial Statements
Subsidiaries assets and liabilities All assets and liabilities are
revalued to fair market value at
acquisition date (100%
revaluation).
Assets and liabilities were
revalued based on the parents
ownership percentage
Negative goodwill Recognized as gain for year of
acquisition.
Recognized as a proportionate
reduction of long-term assets.
Balance sheet classification of non-
controlling interest (NCI)
NCI is classified as equity. NCI is recognized as liability,
equity, or between liabilities and
equity.
Income statement presentation of
NCIs share of income
Presented as a separate deduction
from consolidated income to
derive income to controlling
stockholders.
NCI was presented as part of
Other income, expenses, gains,
and losses.
NCI valuation Is carried at fair market value of
subsidiaries net assets, multiplied
by NCI percentage.
Carried at book value of
subsidiaries net assets, multiplied
by NCI percentage.
Cost of business combinations Direct costs are expensed during
year of acquisition
Direct costs were capitalized as
part of acquisition cost.
In process research and development
(R&D)
Are capitalized at time of
acquisition.
Could be expensed at time of
acquisition.
Acquisition in stages Previously acquired equity interest
is remeasured when acquiring
company achieves control; gain or
loss is recognized in the income
statement.
Measurement was based on
values at time of individual equity
acquisition
Terminology Minority interest is now referred
to as non-controlling interest.
The commonly used term was
minority interest.
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Agenda Item 3 Significant Continuing Differences Between U.S. GAAP and IFRS
Irma highlights continuing significant differences between U.S. GAAP and IFRS.
This information is particularly important for those staff members who are involved in the
consolidation process and those who wish to prepare for the future adoption of IFRS. The
following table represents a handout based on Irmas PowerPoint presentation:
Table 4
Summary of Current Differences Between U.S. GAAP and IFRS
Issue U.S. GAAP IFRS
Definition of control Defined as controlling financial
interest (ARB 51).
Usually interpreted as majority
voting interest.
Focuses on power to govern
financial and operating policies
(IFRS 3, par. 19); The goal is that
activities generate benefits for
controlling entity.
Shares considered for determining
control
Only existing voting rights are
considered.
May include exercisable shares.
Calculation of non-controlling
interest (NCI)
NCI interest is measured at fair
value of total net assets and
includes share of goodwill.
Choice between (1) fair value
and (2) proportionate share of fair
value of identifiable net assets.
Calculation of goodwill at time of
acquisition
Goodwill (if it exists) also includes
share attributed to NCI.
If second option is chosen,
goodwill is only attributed to
controlling interest (parent).
Contingencies – initial measurement Contractual contingent assets or
liabilities are valued at fair market
value. Non-contractual contingent
assets and liabilities that meet the
more likely than not test are
accounted for consistent with SFAC
6.
Non-contractual assets and
liabilities: If they do not meet more
likely than not test are accounted
for consistent with FAS 5.
Recognition of contingent liability:
Contingent liability is recognized
even if it is does not meet the
probable test if the present
obligation
arises from a past event and is
reliably measured.
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Table 4
Summary of Current Differences Between U.S. GAAP and IFRS
Issue U.S. GAAP IFRS
Journal of the International Academy for Case Studies, Volume 16, Special Issue, Number 1, 2010
Goodwill impairment test Two-step approach: (1) compare
book value of reporting unit to fair
market value of reporting unit; (2) if
book value is larger, impairment is
equal to book value less implied
fair value of goodwill.
One-step approach
Compare book value to larger of
cash generating units (a) fair value
less selling cost and (b) value in use
[value in use = PV of expected
future cash flows].
Agenda Item 4 Developments with Potential Impact on Future Fiscal Periods
Irma briefly mentions other developments in the consolidation area. She mentions
that in June 2009, FASB issued FAS 166, Accounting for Transfers of Financial Assets,
and FAS 167, Amendments to FASB Interpretation No. 46R (FASB, 2009). FAS 166
eliminates the concept of qualifying special purpose entities (SPE); FAS 167 deals with the
consolidation aspects of this elimination. Specifically, companies with formerly classified
qualifying SPEs must now assess these entities for possible consolidation.
FAS 167 focuses on control and the primary beneficiary of the SPE in determining
whether a company, such as Klugen Corp., must consolidate its SPE. A primary beneficiary
is (1) able to direct activities of the SPE and is required to absorb significant gains and
losses. A company is assumed to have control if (1) it has the power to direct activities, (2)
has the most significant impact on the entitys performance, and (3) is required to absorb
losses, and benefit from gains (FAS 167, par. 14A-G). Irma reminds her staff that currently
Klugen Corporation does not have investments in qualifying SPEs; thus, the new standards
will not affect the company.
Irma also mentions that in December 2008, the IASB issued Exposure Draft 10 (ED
10) Consolidated Financial Statements, (IASB, 2008), which proposes a single definition
of control that is very similar to the FAS 167 definition. Once this exposure draft is finalized,
convergence between U.S. GAAP and IFRS likely will be further enhanced. Irma promises
to keep her staff informed about developments in that area.
Agenda Item 5 Questions
At the end of the seminar, many questions arise from the staff and some from the
CEO, who attended the second half of the seminar. Irma answers as many questions as
possible and promises to prepare a short question/answer briefing sheet for all those who
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Journal of the International Academy for Case Studies, Volume 16, Special Issue, Number 1, 2010
were present at the seminar. During the seminar she summarizes the following questions as
shown in the Assignments section.
ASSIGNMENTS
Answer the questions specifically assigned by your instructor.
U.S. GAAP Questions
1. How will adoption of the new accounting standards (FAS 141R and FAS 160) affect Klugen
Corporations financial statements in the forthcoming reporting period?
2. Utilizing the 2008 numbers, prepare (1) a partial income statement starting at income from
operations and (2) the equity section of the balance sheet consistent with the requirements
of FAS 141R and FAS 160 (FASB Accounting Standards Codification sections 805 and
810).
3. How will adoption of FAS 141R and FAS 160 affect Klugen Corporations financial
statements in the long-run?
4. What key financial ratios will be affected by the adoption of FAS 141R and FAS 160? What
will be the likely effect?
5. What additional estimates have to be made consistent with the new accounting standards?
6. Could any of the recent and forthcoming changes affect the companys acquisition strategies
and potentially its growth?
7. What were FASBs primary reasons for issuing FAS 141R and FAS 160? (Research
question)
8. What are qualifying SPEs? Do they exist under IFRS? What is the effect of FAS 166
eliminating the concept of qualifying SPEs on the convergence of accounting standards?
9. FASB and IASB recently issued an updated Memorandum of Understanding. Retrieve the
updated memorandum and identify several issues that the two standard setting boards are
jointly focusing on to facilitate convergence. (Research Question)
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IFRS Questions
1. From the consolidation perspective, what would be the likely overall effect of adopting IFRS
on the companys financial statements?
2. What potential effect would arise if Klugen were to select the option under IFRS 3 to value
non-controlling interest at the proportionate share of its subsidiaries net identifiable assets?
3. Do you believe that an impairment of goodwill would be more likely under IFRS or under
U.S. GAAP? Why, or why not?
4. What challenges would arise for the accounting staff if the company adopts IFRS? Do you
believe that he company is making progress toward meeting some of these challenges?
5. What opportunities would arise for the accounting staff if the company adopts IFRS?
6. What other (non-staff related) factors should Klugen Corporation consider prior to adopting
IFRS? Differentiate between advantages and disadvantages.
7. Two of Klugens non-consolidated entities regularly grant stock options to its employees.
How could this affect Klugens accounting for these entities under IFRS?
8. As indicated in the case, Irma previously highlighted some other significant differences
between IFRS and U.S. GAAP. Research the issue and find three (3) differences other than
those related to business combinations. You may want to consider accounting for inventory,
extraordinary items, property, plant and equipment, and research and development.
9. Assume that the SEC provides a choice in the timing of the adoption of IFRS. What ethical
issues could arise for the CFO in deciding whether to adopt IFRS at the earliest possible, or
at a later required date? (Research question)
10. Review comment letters received by the SEC regarding its Roadmap. List two concerns
mentioned by those offering comments. (Research question)
REFERENCES
Committee on Accounting Procedures (1959). Accounting Research Bulletin No. 51. Consolidated Financial Statements.
Original Pronouncement. Financial Accounting Standards Board: Stamford: CT.
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Financial Accounting Standards Board (2009). FASB Accounting Standards Codification. Http://www.fasb.org.
Financial Accounting Standards Board (2009). FASB Statement No. 167. Amendments to FASB Interpretation 46R.
Retrieved on July 7, 2009, from http://www.fasb.org.
Financial Accounting Standards Board (2009). FASB Statement No. 166. Accounting for the Transfer of Financial
Assets – an amendment of FASB Statement No. 140. Retrieved on July 7, 2009, from http://www.fasb.org.
Financial Accounting Standards Board (2007). FASB Statement No. 160. Non-Controlling Interest in Consolidated
Financial Statement. Retrieved on January 5, 2008, from http://www.fasb.org.
Financial Accounting Standards Board (2007). FASB Statement No. 141R. Business Combinations. Retrieved on
January 5, 2008, from http://www.fasb.org.
Financial Accounting Standards Board (2002). Memorandum of Understanding. The Norwalk Agreement. September
18. Retrieved on June 18, 2008, from fasb.org/newsmemoradum.pdf.
International Accounting Standards Board (2008). ED 10 Consolidated Financial Statements. December 2008. Retrieved
on March 30, 2009, from http://www.iasb.org.
International Accounting Standards Board (2008). International Financial Reporting Standard No. 3. Business
Combinations. London, England: IASB.
International Accounting Standards Board (2008). International Accounting Standard No. 27. Consolidated and Separate
Financial Statements. London, England: IASB.
Securities and Exchange Commission (2008). Roadmap for the Potential Use of Financial Statements Prepared in
Accordance With International Financial Reporting Standards by U.S. Issuers. Release No.: 33-8982, File No.
S7-27-08. Retrieved on November 19, from http://www.sec.gov.
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AUTHORS NOTE
This is a fictitious case. Any similarities with real companies, individuals, and situations are solely
coincidental.
Reproducedwith permission of the copyright owner. Further reproduction prohibitedwithout permission.
