Question

Financial Reporting and Analysis
Assignment #1

Q1. What is IFRS? ? What is the IASB? ? How widespread is the adoption of IFRS around the world? ? What is the possibility of the Securities and Exchange Commission substituting IFRS for GAAP? ? What are the advantages of converting to IFRS?
? What could be the disadvantages of converting to IFRS? ? What is the difference between convergence and adoption? ? When comparing IFRS and GAAP, what are some overall key differences I should be aware of? ? What are some of the most important specific differences between IFRS and U.S. GAAP? ? Is the possible conversion to IFRS from U.S. GAAP solely a financial reporting issue? ? What are Basic Traditional assumptions of accounting? Barriers of convergence.

Q2. Current Liabilities and Contingencies

Case Study

The purpose of this activity is to expose students to the varying treatment of specific items under U.S. GAAP versus IFRS. This activity will focus on accounting for current liabilities and contingencies.
As you know, a contingency is an event with uncertain outcomes that may represent potential liabilities. A contingency that results in a gain under both U.S. GAAP and IFRS is generally disclosed in the footnotes until realized, however losses that meet the criteria specified under U.S. GAAP or IFRS guidance must be recognized in the financial statements. In general, both
IFRS and U.S. GAAP have similar recognition criteria for contingencies recognized as a liability; however, the point at which the accrual of a loss contingency is recognized in the financial statements may be interpreted differently under the two standards.

Part 1: Guidance

Below shows the specific guidance for recognition of a loss contingency in the financial statements as a liability and expense or in the notes to the financial statements under U.S. GAAP and IFRS.
U.S. GAAP Statement of Financial Accounting Standards No. 5 (SFAS No. 5) stats that “an estimated loss from a contingency shall be accrued by a charge to income if both of the following conditions are met:
1. Information available prior to issuance of the financial statements indicates that it is probable
2. The amount of loss can be that an asset had been impaired or a liability had been incurred at the date of the financial statements...reasonably estimated.”
Also under SFAS No. 5, disclosure of loss contingencies should be made “if no accrual is made for a loss contingency because one or both of the conditions listed above are not met...disclosure of the contingency shall be made when there is at least a reasonable possibility that a loss or an additional loss may have been incurred.” SFAS No. 5 defines probable as “the future event or events are likely to occur” and reasonably possible as “the chance of the future event or events occurring is more than remote but less than likely” where remote is defined as “the chance of the future event or events occurring is slight.” IFRS IAS 37, Provisions, Contingent Liabilities, and Contingent Assets, distinguishes between a provision and a contingent liability. If the transaction qualifies as a provision, it is formally recognized in the financial statements, and if it qualifies as a contingent liability, it is disclosed in the notes to the financial statements. Formal guidance from IAS 37 relating to provisions and contingent liabilities are shown below.
Provisions are those liabilities for which amount or timing of expenditure are uncertain. A provision should be recognized if:
•The entity has a present obligation (legal or constructive) as a result of a past event;
•It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and
•A reliable estimate can be made of the amount of the obligation.
IAS 37 sets the threshold for accrual and defines probable as “more likely than not”. If the obligation is more likely to exist than to not exist, it will need to be formally recognized as a provision if an amount can be reasonably estimated for it.
Contingent liability
•A possible obligation arising from past events, the outcome of which will be confirmed only on the occurrence or nonoccurrence of one or more uncertain future events which are not wholly within the control of the reporting entity; or is an obligation that is either:
• A present obligation arising from past events, which is not recognized either because it is not probable that an outflow of resources will be required to settle an obligation or the amount of the obligation cannot be measured with sufficient reliability.
A reporting entity is not to give formal recognition to a contingent liability. Instead, it should disclose in the notes to the financial statements the following information:
1. An estimate of its financial effect
2. An indication to the uncertainties relating to the amount or timing of any outflow; and 3. The possibility of any reimbursement.
Whether recognized in the financial statements or in the notes to the financial statements, the entity needs to record an estimate of the amount of the possible future obligation. Under IAS 37, this should be the company’s best estimate, at the end of the reporting period, of the amount of expenditure that will be required to settle the obligation. This is often referred to as the “expected value” of the obligation, which may be operationally defined as the amount the entity would pay, currently, to either settle the actual obligation or provide consideration to a third party to assume it.
Therefore, U.S. GAAP defines probable as “likely” and IFRS defines probable as “more likely than not”. In general, under U.S. GAAP “likely” has been interpreted as greater than a 70% chance of occurring and under IFRS “more likely than not” has been interpreted as more than a 50% chance of occurring.

Part 2: Questions of case study

1.) When should a contingency be recognized as a contingency in the financial statements or in the notes to the financial statements under U.S. GAAP and IFRS? How is the guidance for a contingency under U.S. GAAP similar to IFRS? How is it different?
2.) After a wedding in 2010, 10 people died as a result of food poisoning from products sold by Kims Catering Inc. (KCI). Legal proceedings started, seeking damages from the company. Up to the date of authorization of the
financial statements for the year ended December 31, 2010, the company’s lawyers advised that it was 40% probable that the company would not be found liable. However, when the company prepared its financial statements for the year ended December 31, 2011, its lawyers advised that, owing to developments in the case, it was 85% probable that the company would be found liable.
a. Assuming the attorneys can arrive at a reasonable estimate of the potential damages, should KCI recognize a provision using U.S . GAAP in 2010 and in 2011?
b. Should KCI recognize a provision using IFRS in 2010 and in 2011?
c. If you were a user of financial statements comparing two companies with a similar transaction, but one company operated under U.S. GAAP and the other operated under IFRS, as it relates to this transaction, how would their income statement and balance sheet differ?
When there is a continuous range of possible outcomes and each point in the range is as likely as any other to occur, under U.S. GAAP (FASB Interpretation No. 14), the minimum amount in the range is used to measure the provision. Under IFRS (IAS 37), the midpoint of the range is used.
Using this information and the information above, complete the following questions:
3.) Although we noted that in general under U.S. GAAP “likely” has been interpreted as greater than a 70% chance of occurring and under IFRS “more likely than not” has been interpreted as more than a 50% chance of occurring, it is not formally written in the standards what the appropriate interpretation of “likely” and “more likely than not” should be. What would be your
range of possible percentages for the phrases “likely” and “more likely than not”? As discussed in Lesson 1, U.S. GAAP is known to be more “rules
-based” and IFRS is known to be more “principles-based”. Given the guidance above, do you think U.S. GAAP or IFRS is more rules-based when it comes to accounting for contingencies?
4.) In general, when accounting for contingencies which treatment (U.S. GAAP versus IFRS) better meets the definition of conservatism? Which treatment provides companies more room for earnings management? Which treatment provides more transparent figures? Which treatment allows more comparability across countries? Which treatment do you prefer and why?

Please Answer the Part 2: Questions of case study.

Thanks

Answer 1

1.

A contingency should be recognized as a contingency in the Financial Statements under US GAAP if both of the following conditions are met:

a) Information available prior to issuance of the financial statements indicates that the occurrence of the contingency resulting in a loss is probable;

and

b) The amount of loss can be that an asset had been impaired or a liability had been incurred at the date of the financial statements and the amount of the same can be reasonably estimated.

IFRS IAS 37, Provisions, Contingent Liabilities, and Contingent Assets, distinguishes between a provision and a contingent liability. If the transaction qualifies as a provision, it is formally recognized in the financial statements. According to IAS 37, Provisions are those liabilities for which amount or timing of expenditure are uncertain and a provision should be recognized if:

a) The entity has a present obligation (legal or constructive) as a result of a past event;

b) It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation;

and

c) A reliable estimate can be made of the amount of the obligation.

A contingency must be disclosed in the notes to financial statements under US GAAP if:

a) No accrual is made for a contingent loss because one or both of the conditions listed under SFAS No. 5 for such recognition are not met;

and

b) There is at least a reasonable possibility that a loss or an additional loss may have been incurred.

A contingent liability must be disclosed in the notes to financial statements under IFRS if:

a) It is a possible obligation arising from past events, the outcome of which will be confirmed only on the occurrence or non-occurrence of one or more uncertain future events which are not wholly within the control of the reporting entity;

or

b) It is an obligation that is either a present obligation arising from past events, which is not recognized either because it is not probable that an outflow of resources will be required to settle an obligation or the amount of the obligation cannot be measured with sufficient reliability.

The guidance under US GAAP and IFRS is similar in relation to formal recognition of a contingency in the financial statements if a loss to the organization is probable and if the amount of such loss can be reliably estimated.

The guidance under US GAAP and IFRS is different in relation to the respective definitions of the term "probable". Under US GAAP, "probable" is defined as “likely to occur”. IFRS defines "probable" as “more likely than not”. Further, in general, under U.S. GAAP “likely to occur” has been interpreted as greater than a 70% chance of occurring and under IFRS “more likely than not” has been interpreted as more than a 50% chance of occurring.

2.

a. The probability of the company being found liable to damages as advised by the company's lawyers was 60%. Under US GAAP, for the occurrence of an event to be considered probable, it must be likely to occur, which, in general, has been interpreted to have more than a 70% chance of occurrence. In light of the same, KCI must not recognize a provision in the financial statements in 2010. However, in 2011 the company's lawyers advised that the probability of the company being found liable to pay damages was 85%. Since the occurence of an event of this probability is considered likely to occur, KCI will have to recognize a provision in its financial statements in 2011.

b. Under IFRS, a transaction is to be recognized as a provision in the financial statements if the three conditions listed under IAS 37 are satisfied. In both 2010 and 2011, the lawyers have advised that the probability of the company being found liable to pay damages is greater than 50%, which, under IFRS, may be considered as a probable event or an event that is more likely to occur than not. Therefore, in light of the same, KCI would be required to a recognize a provision for such a contingency in its financial statements for both years 2010 and 2011.

c. A user of the financial statements of two companies, where one company adopts IFRS and the other US GAAP, would observe that in the financial statements of the first company, in the year 2010, this transaction is formally recognized as a provision while the same transaction in the financial statements of the other company is not formally recognized as a provision but disclosed as a contingency in the notes to the financial statements. However, there would not be any difference in the financial statements of the two companies with regards to this transaction in the year 2011.

3.

The ranges of possible percentages for the term "Likely" and the phrase "More likely than not" may be 75-100% and 50-75%, respectively.

In relation to accounting for contingencies, it may be said that IFRS is more rule-based than US GAAP as it lists more conditions to be met and considers more specific possibilities to define contingencies and provisions and to distinguish between them.

4.

In general, it may be said that the treatment under IFRS better meets the definition of conservatism primarily because it considers formal recognition of provisions in a more prudent manner than the treatment under US GAAP. This is illustrated by the generally interpreted definitions of the term "probable" under the two systems, where under US GAAP it is taken to mean "likely to occur" (70% or more probability of occurrence) and under IFRS, it is taken to mean "more likely to occur than not" (50% or more probability of occurrence).

It may be said that US GAAP provides companies with more room for earnings management or a more positive view of the company's financial position as it may be considered more lenient in terms of prudence in accounting, in comparison to IFRS.

It may be said that IFRS provides more transparent figures than US GAAP as it stresses slightly more prudence in accounting and makes repeated reference to reliable estimations and quantifications of various transactions.

IFRS allows more comparability across countries as it is more universally accepted and pervasive.

In my opinion, IFRS may be preferred over US GAAP as it may promote better global standardisation and is already more universally accepted and pervasive.