| This article contains references to some items that are not included in the syllabus for Paper 2.5, Financial Reporting. These are: foreign currency translation reserves, employee benefits (pensions and other
post-retirement benefits), derivative
financial assets and liabilities, and hedge accounting. Candidates studying Paper 2.5 should note that they will not be examined on these items.
IFRS 1, First-time Adoption of International Financial Reporting Standards was issued by the International Accounting Standards Board (IASB) on 19 June 2003 and comes into effect for periods beginning on or after 1 January 2004, although earlier adoption is encouraged.
It is particularly relevant to European listed companies because they will be required to apply International Financial Reporting Standards (IFRS) to their consolidated financial statements for accounting periods beginning on or after
1 January 2005. The requirements for UK entity financial statements and non-listed companies have yet to be determined.
The standard applies to an entity that, for the first time, makes an explicit and unreserved statement that its general purpose financial statements comply with IFRS. In the context of this article the term IFRS should be taken to include all IFRS, International Accounting Standards (IAS) and all interpretations issued by the International Financial Reporting Interpretations Committee (IFRIC), formerly the Standing Interpretations Committee (SIC). First time financial statements must comply with all IFRS and they must contain the unreserved statement of compliance. Financial statements that comply with some (but not all) IFRS, or financial statements in local GAAP with reconciliation to IFRS, do not meet the criteria of first-time IFRS financial statements. Nor do IFRS financial statements that have a prior period qualified (modified) audit report.
The standard sets out the procedures that an entity must follow when it adopts IFRS for the first time. Its objective is to ensure that those financial statements contain high quality information that is transparent and comparable, and can be generated at a cost that does not exceed the benefits to users. The general principle is that the (first time) financial statements should be prepared on the basis that the entity had always applied IFRS. This is in effect retrospective application. However, as it may be difficult, expensive or impossible to rigidly apply this principle, the standard contains some important exceptions and exemptions to the basic measurement principles of some other IFRS.
There is sometimes confusion between what the standard refers to as the 'first reporting date' and the 'transition date'. If we take a UK company with a December year end, under the European Union regulation its first reporting date for IFRS financial statements will be 31 December 2005 (ie its first IFRS financial statements will be drawn up to that date). The Standard requires that any comparative figures presented must also comply with IFRS. So for the above company its transition date would be 1 January 2004, ie the opening date of the earliest presented statements (given that one year's comparatives are required).
In the above example, IFRS 1 would require the company to prepare (but not present) an opening balance sheet at 1 January 2004 (the transition date) that complies with the IFRS in force at the first reporting date of 31 December 2005. This causes at least two problems. The first and most obvious is that the IFRS in force at the transition date of 1 January 2004 will not be the same as those in force at the reporting date of 31 December 2005. It is therefore sometimes said that managers are trying to hit a moving target. The IASB has attempted to alleviate this problem by creating what it describes as a stable platform (this is also sometimes referred to as 2005 GAAP). The standards that are part of the stable platform have their effective dates (ie the date from which the standards come into force) no later than for accounting periods beginning on or after 1 January 2005. A second problem for the above company is that when it presents its financial statements for the year to 31 December 2004, they will still have to be reported under UK GAAP. Thus its accounting systems for the period from 1 January 2004 to 31 December 2004 will have to be capable of generating UK GAAP information for reporting at 31 December 2004, and IFRS GAAP for the comparative financial statements of the year to 31 December 2005.
The process of transition
There are several steps in the process of transition to IFRS.
Accounting policies
The entity should select accounting policies that comply with IFRS in force at the reporting date.
De-recognition of existing assets and liabilities
It may be that under previous GAAP an entity had some assets and liabilities in its balance sheet that do not qualify for recognition under IFRS. For example, IFRS do not permit the following assets to be recognised: research, start-up and pre-operating costs, staff training, deferred advertising expenditure, and relocation costs.
Liabilities that are not permitted to be recognised under IFRS are: general or contingency provisions, future restructuring costs and operating losses, and provisions for major overhauls of assets.
Recognition of new assets and liabilities
IFRS may require the recognition of assets and liabilities that were not recognised under previous GAAP. The most important of these are likely to be derivative financial assets and liabilities, and deficits or surpluses under defined benefit plans. These would include not just pension plans but also items such as medical care costs and life insurance. Other recognisable liabilities might be deferred tax balances and certain provisions such as environmental and decommissioning costs.
Reclassification of assets and liabilities
Assets and liabilities recognised under previous GAAP may need to be reclassified under IFRS.
- Certain intangible assets recognised on a business combination would need to be reclassified as goodwill if their recognition does not meet IAS 38, Intangible Assets criteria. It is also possible that the reverse could occur.
- Items classified as share capital may need to be reclassified as debt. IAS 32 requires redeemable preference shares to be classified as debt, and compound financial instruments (eg convertible loan notes) may have to be split between debt and equity.
- IAS 10 does not allow dividends proposed after the balance sheet date to be treated as a liability.
- The definition of a reportable segment may change - this would cause a reclassification of segment information.
- Some investments that may not have been consolidated under previous GAAP may meet the definition of a subsidiary under IFRS and have to be consolidated.
Measurement
The value at which an asset or liability is measured may differ between IFRS rules and previous GAAP. For example, while IAS 12 does not allow deferred tax assets or liabilities to be discounted to a present value, other jurisdictions do allow discounting.
The net effect of the above adjustments should be recognised in retained earnings or other appropriate category of equity.
Exemptions
IFRS 1 grants limited exemptions to the above principles where the cost of compliance would outweigh the benefits to users. These are made up of optional and mandatory exemptions.
Optional exemptions
Business combinations
Previous business combinations (occurring before the opening balance sheet) do not have to be restated to comply with IFRS. Mergers (pooling of interests) do not have to be
re-accounted for as acquisitions, previously written off goodwill does not have to be reinstated, and the fair values of assets and liabilities may be retained. However, an impairment test for any remaining goodwill (after reclassifying any necessary intangibles as goodwill) must be made in the opening balance sheet.
Property, plant and equipment, investment properties and intangibles
An entity may elect to use the fair value of the above items as the deemed cost under IFRS. Fair values may have been a
market-based revaluation or an indexed amount under previous GAAP. IFRS allow the carrying value of the above assets to be based on a cost or revaluation model. This exemption has the effect of allowing a revalued amount to be used under the cost model. One advantage of the cost model is that there is no obligation to keep asset values up-to-date. Thus this exemption means that an entity could use fair value as the deemed cost and not have to revalue each year end.
Actuarial gains and losses on employee benefits
An entity may choose to recognise all actuarial gains and losses on employee defined benefit plans at the opening balance sheet date. Under IFRS a 'corridor' approach can be used to smooth out fluctuations in the actuarial valuations of defined benefit plans. This exemption has the effect of resetting any corridor to zero.
Accumulated translation reserve
This exemption allows all translation gains and losses relating to foreign entities to be recognised in retained profits at the opening balance sheet date. Similar to the above, the effect is to reset the translation reserve to zero.
Mandatory exceptions to retrospective application
IFRS 1 refers to three areas where retrospective application of IFRS is prohibited. These relate to the derecognition of certain financial assets and liabilities, aspects of hedge accounting, and requiring IFRS estimates to be based on the assumptions made under previous GAAP. In addition, IFRS 5, Non-current Assets Held for Sale and Discontinued Operations requires an entity with a transition date before 1 January 2005 to apply the transitional requirements of IFRS 5. Those with a transitional date after 1 January 2005 should apply IFRS 5 retrospectively.
Compliance of interim reports
Although not required under IFRS, an entity required to publish an interim report in the year of first-time adoption should do so in compliance with IFRS 1 if the financial statements state that the interim reports conform to IFRS. This means that a company with a first-time reporting date of
31 December 2005 should publish its June 2005 interim reports, and their comparatives, in compliance with IFRS. The standard contains detailed transitional requirements (which are beyond the level of this article) where subsidiaries and associates and joint ventures adopt IFRS at an earlier or later date than the parent/investor.
Disclosures
IFRS 1 requires disclosures that explain how the transition to IFRS has affected the entity's financial position, performance and cash flows. This is achieved by:
- a reconciliation of equity under previous GAAP to equity under IFRS GAAP, both at the date of transition and at the end of the last reported period under previous GAAP. For a 31 December 2005 adopter this would be at 1 January 2004 and 31 December 2004
- a reconciliation of profit from previous GAAP to IFRS GAAP for the last reported period under previous GAAP. For the above company this would be for the year to 31 December 2004.
The reconciliations should be supplemented by explanations and disclosure of:
- material adjustments made to the financial statements in adopting IFRS for the first time
- correction of errors discovered in previous GAAP
- the recognition or reversal of any impairment losses in preparing the opening balance sheet
- any specific exemptions it has elected to use under IFRS 1 (eg the use of fair values as deemed cost).
Conclusion
IFRS 1 is a complex accounting standard consisting of three parts (as do all IFRS):
- the standard itself
- a basis for conclusions which summarises the IASB's considerations in arriving at the requirements of the standard
- an implementation guide which explains, with the aid of many practical examples, how the standard's requirements should be implemented and how IFRS 1 interacts with other IFRS.
This article can only serve as a summary. A detailed understanding can be achieved by studying the three components of IFRS 1.
Steve Scott is examiner for Paper 2.5
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