Distinguishing between debt and equity on a corporation’s balance sheet has been no easy task for CFOs and their staffs over the years. Financial instruments today can have features of both, a situation that can lead to misreporting and dire repercussions for senior management, particularly at multinationals. Some say clearer definitions could make accounting easier for U.S.-based multinationals that report under international financial reporting standards (IFRS).
In December, the International Accounting Standards Board (IASB) agreed with respondents from its public consultation (a study that reached out to industry professionals at all levels in more than 80 countries in 2011) that it needs to better clarify definitions of assets and liabilities for debt instruments. The revised definitions should help eliminate some uncertainty when accounting for assets and financial liabilities or nonfinancial liabilities, which can include land and equipment leases.
Respondents said they consider clearer definitions of assets and liabilities a prerequisite for resolving many of the issues they have had in international financial reporting. Corporate executives and their accountants have routinely questioned the classification for holdings such as hybrid instruments or convertible bonds, for example, where the conversion option is classified as equity and the bond is classified as a liability, as well as what defines accounting treatment for hedging derivatives.
Salvatore Collemi, quality-control senior manager at accounting firm Rothstein Kass, says a clear understanding of what are considered assets and liabilities under IFRS would be a big help. “They do have to have better definitions for the CFO — or anybody else dealing with financial reporting — to make sure they understand what their boundaries are and what the rules are,” he says.
Aside from financial instruments, ambiguity in the definitions of other balance-sheet items has also troubled CFOs and their staffs. In particular, accounting for revenue recognition, leases, and insurance contracts has been tricky, because the IASB and FASB have not fully melded IFRS with U.S. generally accepted accounting principles in those areas. The IASB study respondents also cited accounting for intangibles, such as intellectual property, as an area that is creating challenges during financial reporting.
Corporate accounting for trademarks or patents acquired in a merger becomes difficult in cases where IFRS has one definition for intangibles and U.S. GAAP has another. Under the latter, development costs for an intangible, for example, are expensed as incurred, while they are capitalized under IFRS in certain circumstances.
Keith Peterka, a shareholder with audit and attestation firm Mayer Hoffman McCann, blames cultural differences for the divide over accounting definitions for intangibles, noting that the United States has sharper definitions for intellectual property than other countries do. “If you look at the way we define intangibles here in the U.S., it’s well defined,” Peterka says. “But in other parts of the world, you don’t have the intellectual-property protections.”
Often a single word has been at the heart of differences between the IASB and FASB. A case in point is an IASB definition for investment entities, including firms that obtain funds from investors in exchange for professional management services. The IASB staff has said that an entity should not be disqualified from investment-entity status simply because it provides “substantive” investment-related services to third parties. FASB has a similar definition, but does not include the word substantive.
According to an Ernst & Young report issued last spring, the IASB’s word choice creates “uncertainty about what the IASB means,” since some firms meet the definition of an investment entity only when considering their third-party services, and under the current wording some firms may not qualify.
While more clarity in definitions should help in the financial-reporting process, respondents to the IASB study also recommended that the IASB make standard-setting and increased cost-benefit analysis priorities. Most respondents believe the IASB’s principles-based framework for setting standards is better than the rules-based standards typically applied under U.S. GAAP.
Rothstein Kass’s Collemi thinks the former will become the dominant system. “U.S. GAAP is not the gold standard anymore,” he says. “IFRS is what’s accepted in global capital markets.”