International Financial Reporting Standards (IFRS) have been around since June 2003, starting in the European Union and gradually expanding overseas, with over 100 countries having adopted IFRS. The United States (US) expects to make the decision of whether to incorporate IFRS into the U.S. financial reporting system by 2011, and estimates that the first time that U.S. companies would report under an IFRS system would be no earlier than 2015. However, the Securities and Exchange Commission (SEC) already allows foreign registrants to report under IFRS, without reconciliation to generally accepted accounting principles (GAAP) in the US. China and Japan are contemplating adoption of IFRS before 2014. Canada will adopt IFRS already as of January 1, 2011.
Despite this being a future date, a company is required to prepare and present an opening IFRS statement of financial position at the date of transition to IFRS. This will be January 1, 2010 for Canadian companies with December 31 year ends that are adopting IFRS on January 1, 2011 with one comparative period. This date has already past. For the avoidance of doubt, the financial statements in previous GAAP will need to be prepared up to December 31, 2010. The first interim report, which is typically not audited, will cover the interim period starting January 1, 2011. In case of quarterly interim reports, the first IFRS publication will be that of the period January 1, 2011 to March 31, 2011.
IFRS provides several opportunities upon adoption of IFRS. The focus of this article is on one of the optional exemptions, which allows companies to elect to restate the carrying amount of items or classes of plant, property and equipment (PP&E) to fair value upon adoption of IFRS. Furthermore, "cherry picking" of the fair value election for specific items or classes of PP&E is possible. Companies may use this option to their benefit.
IFRS 1 is the financial reporting standard under IFRS that stipulates the requirements for a company that is preparing IFRS compliant financial statements for the first time. IFRS 1 only applies once, at the time of changeover or adoption of IFRS and is mandatory. IFRS 1.10 more or less stipulates that the opening financial statements under IFRS are prepared as if the company had always been using IFRS. Full retrospective application of each and every IFRS standard will, for many companies, not be a simple task. IFRS 1 therefore includes relief through a series of mandatory and optional exemptions from retrospective application. The exemptions are based on the acknowledgement that the costs to adopt IFRS should not be unduly high or impracticable. Hence, first time adoption of IFRS may seem cumbersome at first, but it allows an opportunity through optional exemptions that companies can use to their benefit. These benefits may be from a preparation perspective, but also from a presentation point of view, which potentially might lead to economic benefits.
The exemptions in IFRS 1 provide companies certain alternatives to applying the "normal" IFRS requirement retrospectively. Management of companies adopting IFRS for the first time should therefore carefully consider the impact of the optional exemptions in IFRS 1, as they could potentially be used to their benefit. As mentioned above, one optional exemption is the ability to restate the carrying amount of PP&E to fair value.
Opening balance sheet accounting of fixed assets under IFRS
The "normal" standard for the accounting of PP&E is International Accounting Standard 16 Plant, Property and Equipment (IAS 16). However, IAS 16 includes detailed rules on the elements of cost. Some companies may not have all information required to determine the appropriate cost under the rules of IAS 16. The same holds true for accumulated depreciation. Hence, IFRS 1 allows companies to account for items of PP&E in its IFRS opening balance sheet at a "deemed cost" as an alternative to the cost proscribed in IAS 16.
In accordance with IFRS 1, a company may elect to record the carrying amount of an item of PP&E as deemed cost at fair value at the date of transition (IFRS 1.D5). This is regardless of whether IAS 16's "cost model" is elected or the "revaluation model".
The cost model features a component approach. This means that each part of an item of PP&E, with a cost that is significant in relation to the total cost of the item, should be recorded separately, as these need to be depreciated separately (IAS 16.43). IAS 16.44 provides an example where it may be appropriate to depreciate an airframe separately from the engine of an aircraft. In this example, the item is the aircraft and the airframe and engine are parts of the item. IAS 16.45 indicates further that a significant part of an item of PP&E may be grouped together with another significant part of that same item if the remaining useful life and depreciation method are the same.
The revaluation model is applied to an entire class or classes of PP&E rather than a per item of basis (IAS 16.36). This is to prevent selective revaluation of only those assets whose revaluation would lead to a particular result (IAS 16.BC45). The revaluation model also requires upon the transition date to assess whether the carrying value of an entire class or classes is not materially different from fair value. If this is the case a revaluation for the entire class or classes is required (IAS 16.31). In essence, this means that adoption of the revaluation model would require revaluation to fair value of the entire class or classes of PP&E as of the transition date to IFRS rather than an item as allowed by IFRS 1. After adoption, the revaluation model requires regular fair value measurements. The frequency depends on when fair value of a revalued asset class differs materially from its (revalued) carrying amount. Specifically a term of three to five years is mentioned (IAS 16.34).
The fair value elections are also available for (a) investment property (IAS 40), such as land held for long-term capital appreciation or buildings leased out under an operating lease, and (b) intangibles assets (IAS 38) that meet the criteria for recognition for revaluation (including the existence of an active market). The exemption of fair value or revaluation at deemed cost may not be used for any other assets or liabilities. In practice, few companies have used the intangible asset exemption upon first-time adoption of IFRS, therefore this article does not contain any further discussion of intangible assets. Fair value or revaluation exemption elections for the mentioned assets may provide opportunities for companies. However, the magnitude of the available opportunities may depend on the choices for accounting under IAS 16 and IAS 40 after initial recognition. Please note that if the "fair value model" of IAS 40 is applied for investment property, the IFRS 1 deemed cost elections do not apply.
If the fair value of an item or class of PP&E or investment property upon the transition date is different than the carrying amount, the adjustment will be made through equity rather than through earnings in the profit and loss statement. Other PP&E assets would remain to be recorded at cost under previous GAAP, without any effect to the equity or earnings.
Where fair value is higher than the carrying amount, the election to use fair value would increase equity. Most other accounting standards do not typically allow such a situation to result in any change of the financial statements (with an exception of the revaluation model in IAS 16). Where fair value is lower than the carrying amount, the election to use fair value would decrease equity, rather than recognizing an impairment in the profit and loss statement.
The fair value election may have several advantages. When fair value is greater than the carrying amount, with all other things being equal, equity is increased, which may lead to improved solvency ratios. This could ultimately lead to improved credit ratings and lower interest rates on debt capital. Alternatively, when fair value is less than the carrying amount, again with all else equal, equity is decreased. However, and more importantly, the revaluation under IFRS 1 does not result in impairment losses being recognized in the profit and loss statement. The absence of an impairment loss may mitigate scrutiny from analysts and/or investors. This election is limited to the transition date. Therefore, avoiding an impairment with the adoption of IFRS accounts does not preclude an impairment in the last financial statements in the previous GAAP.
The election element itself may have advantages as well. If management is of the opinion that fair value of an item or class of PP&E may be lower than the carrying amount, it may elect to not use the option to fair value. Under the assumption that a fair value less than the carrying amount would not have resulted in an impairment under previous GAAP, a downward adjustment to equity would be avoided by not making the election to use fair value. Hence, the option to not elect fair value in this case would avert a negative impact on the solvency ratio of the company. This may have led to the company paying higher interest rates on debt capital. The disadvantage in this case is that a future impairment after adoption of IFRS would not have been mitigated. Future impairments, as with previous GAAP, would flow through the profit and loss statement in accordance with IAS 36 Impairment of Assets. So, the ability to use the election for an item or class of PP&E allows for cherry picking.
In both the cost model and revaluation model of IAS 16 the assets continue to be depreciated. The fair value election therefore also impacts future depreciation amounts upon adoption of IFRS. All else being equal, where the fair value is greater than the carrying amount the increased depreciation would decrease earnings per share. An election not to fair value would mitigate this effect. Alternatively, where fair value is less than the carrying amount the reduced depreciation would increase earnings per share.
Timing to benefit from the opportunity
As mentioned above, IFRS 1 has several possibilities to create benefits to companies. These benefits are not limited to a preparation and presentation point of view, but may even result in economic gains such as lower interest expenses. Furthermore, the cherry picking option not to elect the fair value option in and of itself provides a planning opportunity. The timing is also an important item. Any fair value election would be as of the transition date, which is January 1, 2010 for Canadian companies with a December 31 year end, which most companies have. So for practical reasons, an election to fair value should be made quickly. Despite the fact that the January 1, 2010 IFRS opening balance sheet is only required in the 2011 annual financials, the transition date has already passed and information as of this date may become increasingly difficult to reproduce once a revaluation effort gets farther away from the transition or valuation date. Hence, it is better to make the decision now to benefit from the opportunities that IFRS 1 provides.