International Financial Reporting and Disclosure Issues in the Division of Corporation Finance
November 1, 2004
Under the Multi-Jurisdictional Disclosure System, Form F-10 for Canadian issuers requires any financial statements included in the registration statement to be reconciled to US GAAP using Item 18 of Form 20-F. A literal application of the instructions would result in MJDS filers reconciling interim information on a more current basis than Canadian or other foreign private issuers filing on the regular system. The staff will not object if a MJDS issuer reconciles to US GAAP only those periods that would be required if the filing was made on a regular foreign form. That is, the issuer may apply the age of financial statement requirements in Item 8 of Form 20-F.
Similarly, the staff will not object if financial statements of entities other than the registrant that are included in the Form F-10 are reconciled to US GAAP in the manner that would apply to a filing on a regular foreign form. For example, financial statements of foreign business acquirees or equity method investees need only be reconciled if they are significant at the 30% level, and the reconciliation may be based on Item 17 of Form 20-F. Under the MJDS rules, the inclusion of an entity’s financial statements in Form F-10 is based on Canadian filing requirements. SEC financial reporting requirements such as Rules 3-05 and 3-09 of Regulation S-X do not apply to MJDS filings.
Small Canadian exploration stage companies typically issue “flow through shares”. The shares permit the investor to claim deductions for tax purposes related to expenditures incurred by the issuer. The issuer explicitly renounces the right to claim these deductions. The investor's tax basis is reduced by the amount of deductions taken.
The Canadian Institute of Chartered Accountants recently issued a new standard on income taxes (Section 3465 of the Handbook). Under the new Canadian GAAP standard, shares are recorded at their face value when issued. When the entity acquires assets the carrying value may exceed the tax basis as a result of the enterprise renouncing the deductions to the investors. The tax effect of the temporary difference is recorded as a cost of issuing the shares.
The FASB staff has taken the view that under FAS 109 the proceeds from issuance should be allocated between the offering of shares and the sale of tax benefits. The allocation is made based on the difference between the quoted price of the existing shares and the amount the investor pays for the shares. A liability is recognized for this difference. The liability is reversed when tax benefits are renounced and a deferred tax liability is recognized at that time. Income tax expense is the difference between the amount of the deferred tax liability and the liability recognized on issuance.
Attachment B to the minutes of the November 1999 meeting of the AICPA International Practices Task Force illustrates the differences between the Canadian GAAP model and the FASB staff model. The SEC staff expects registrants to follow the FASB staff model for US GAAP purposes.
Canadian issuers that elect to change reporting currency are encouraged strongly to discuss their particular facts and circumstances with the staff. Rule 3-20 of Regulation S-X states that the primary financial statements should be recast as if the new reporting currency had always been used. This method differs from the Canadian GAAP method, which uses a convenience translation to recast prior periods. The level of additional information that will be necessary to comply with the Commission's requirements will depend on the differences in exchange rates that would be used to recast prior periods. The additional information could range from addressing differences in the methodology as part of the reconciliation to US GAAP to complete restatement of prior year financial statements using the methodology required by Rule 3-20. Additional information in MD&A using the US GAAP balances also may be necessary.
Bulletin D-3 addresses pension accounting under Mexican GAAP. The guidance is generally similar to FASB Statement 87. Bulletin D-3 specifies the use of real (net of inflation) rates in determining plan assumptions. For purposes of reconciling to US GAAP, Mexican registrants should use real rates and treat the pension plan liability/asset as non-monetary.
Prior to issuance of Bulletin D-4 in Mexico effective January 1, 2000, two methodologies for accounting for deferred profit sharing were in use in Mexico. Some registrants use an accrual methodology and others use a balance sheet methodology. Under the accrual methodology, a liability is recognized for deferred employee profit sharing purposes on timing differences between income for financial reporting purposes and income for purposes of computing the current amount of the employee profit sharing payment. The balance sheet methodology determines the liability based on the difference between assets and liabilities in the financial statements and assets and liabilities determined in accordance with the law relating to the employee’s profit sharing. This methodology is conceptually consistent with FAS 109.
For US GAAP purposes, beginning January 1, 1997, all registrants should calculate deferred employee profit sharing plan obligations using the balance sheet methodology. It would be inappropriate for a registrant to change from the balance sheet methodology to the accrual methodology.
Bulletin D-4 (effective January 1, 2000) requires the accrual methodology. As a result, a US GAAP reconciling item is necessary to report the effects of the use of a balance sheet methodology. Profit sharing expense should be classified as an operating expense for purposes of the US GAAP reconciliation.
Mexican Accounting Principles Commission Bulletin B-15 requires Mexican companies to report the assets and operations of consolidated foreign (non-Mexican) subsidiaries by price-level adjusting the accounts based on the inflation rate in the foreign country, then translating into pesos using the year-end exchange rate. For example, a Mexican registrant with a US subsidiary would price-level adjust that subsidiary by the US inflation rate, not the Mexican inflation rate. This method applies to all comparative periods presented. Thus the unit of measure (reporting currency) for the financial statements is impacted over time by the location and relative size of a Mexican registrant’s foreign subsidiaries. The Bulletin B-15 method differs from the approach in virtually all other countries that permit or require price-level adjusted accounting.
The issue is whether the methods of consolidation and translation specified by Bulletin B-15 under Mexican GAAP are consistent with (1) a comprehensive basis of price-level adjusted accounting, and (2) the requirement of Rule 3-20(e) of Regulation S-X to present financial statements for all periods in the same reporting currency.
For the most recent period being presented, the methods specified by Bulletin B-15 are considered to be consistent with a comprehensive basis of price-level adjusted accounting. For the most recent period being presented, the staff has not objected to the use of the accommodation in Form 20-F that permits registrants to not remove the effects of inflation accounting when reconciling to US GAAP.
The staff believes that the Bulletin B-15 methods do not comply with Rule 3-20(e) with respect to comparative periods. However, since Bulletin B-15 accomplished the goal of establishing consistent principles for Mexican companies, and there is no definitive guidance in US GAAP, the staff has not objected to comparative financial statements prepared in conformity with Bulletin B-15, provided that the registrant quantifies the aggregate effects of the departure from Rule 3-20(e) in its reconciliation to US GAAP and includes the following disclosures:
The method permitted by the Fifth Amendment to Bulletin B-10 for restating fixed assets of foreign origin is not consistent with a comprehensive basis of price-level adjusted accounting. The staff has concluded that a reconciling difference should be reported based on the amount using the Mexican consumer price index.
For periods beginning after December 31, 1996, Mexico was considered a highly inflationary economy. For periods beginning after December 31, 1998, Mexico is no longer considered highly inflationary.
In 1995 the staff became aware that numerous inflation indices were being used to prepare financial statements in Brazil and those indices varied considerably. In order for financial statements of registrants to be comparable, the IGP index should be used. Companies that are registered with the SEC should use the IGP index prospectively in financial statements of periods beginning with January 1, 1996. Brazilian companies that file with the Commission for the first time and include audited financial statements for periods subsequent to January 1, 1996 should use the IGP for each period that US GAAP information is presented. To illustrate, if a Brazilian company files a registration statement with audited financial statements that are reconciled to US GAAP for 1998 and 1999, the company should use the IGP at a minimum for these two years. For periods prior to 1998, any comprehensive index that reflects actual inflation during the applicable period that the company represents is most appropriate in their circumstances would be acceptable.
For periods beginning after December 31, 1997, Brazil should no longer be considered a highly inflationary economy. Issuers will need to measure their Brazilian operations using the appropriate functional currency rather than the reporting currency.
Under BT 64, the new Chilean foreign currency standard effective January 1, 1999, investments that are considered to be an extension of the Chilean parent's operations continue to be remeasured in Chilean pesos and price-level adjusted for the effects of inflation in Chile. Investments in stable countries, which are not considered to be an extension of the Chilean parent's operations, continue to use the local currency as the currency of measurement.
The primary difference between BT 64 and its predecessor relates to foreign investments made in unstable environments. Under BT 64 such investments are required to adopt the US dollar as the "functional currency", as the Chilean peso itself is not considered to be a stable currency.
The staff has not objected to the view that the adjustments made in respect of investments in unstable countries are part of a comprehensive basis of adjusting for inflation. Accordingly, differences between BT 64 and US GAAP do not need to be eliminated in the reconciliation to US GAAP.
The staff expects Chilean filers to disclose the following in the financial statements:
In addition, MD&A should discuss the effects of the application of BT 64 on the registrant's results of operations and explain how the results are affected by changes in currency exchange rates and inflation rates.
Where material and necessary to an understanding of the registrant's results of operations, MD&A should also disclose the following:
Chilean companies are required to distribute 30% of their net income to shareholders unless a majority of shareholders approve the retention of the profits. The amount of retained earnings that is required to be distributed should not be considered permanent equity for purposes of US GAAP.
As of January 1, 1992, Colombia began using price level accounting on a prospective basis. The effects of inflation not recognized in periods prior to 1992 when Colombia was hyperinflationary would result in a US GAAP difference. When presenting comparative financial statements in the US, Rule 3-20 of Regulation S-X requires all financial statements be retroactively restated to reflect constant currency as of the balance sheet date. Under Colombian GAAP, prior year financial statements are not restated. The requirement regarding the use of a constant currency of equivalent purchasing power must be applied in the primary financial statements. That is, it cannot be “corrected” in the reconciliation to US GAAP.
Capital Transactions – Earnings per Share
In most of Latin America, within the equity accounts is a “Restatement” account which represents the effect of restating capital stock to constant currency. There may also be designated reserve accounts and other accounts, such as “Results of Holding Non-Monetary Assets” in Mexico, which represent differences in appraisal values and indexation for inflation. It is not uncommon to transfer these reserves to capital stock and issue new shares to existing holders on a pro rata basis. These transactions are most similar to a stock split or stock dividend, since each holder’s pro rata ownership and total shareholders’ equity remains unchanged. Therefore, these issuances should be treated as if they were outstanding for all periods presented for basic and diluted earnings per share, as required under FASB 128, paragraph 54.
Presentation of Comparative Periods in Euros
As indicated in Topic D-71, the staff will not object if a registrant presents comparative financial statements for periods prior to January 1, 1999 by recasting previously reported financial statements into Euros using the exchange rate between the Euro and the prior reporting currency as of January 1, 1999.
Generally, when financial statements are stated in a currency different from the one used in previous filings with the Commission, SEC rules require a registrant to recast its financial statements as if the newly adopted currency had been used since at least the earliest period presented. However, Commission rules did not contemplate the introduction of a new, cross-border currency that would replace multiple existing currencies. Because the Euro did not exist prior to January 1, 1999, the retroactive application of the January 1, 1999 exchange rate to previously reported financial statements would not result in the remeasurement of previously reported results and therefore, would not alter previously reported trends and relationships.
It is important to note that the financial statements of multinational registrants that report in different currencies generally are not comparable. Recasting financial statements into Euros based on the January 1, 1999 exchange rate will depict the trends and relationships in a registrant's accounts in the same way as those trends and relationships previously were reported prior to the introduction of the Euro. However, because the recasted amounts do not take into consideration foreign exchange risk, investors may assume inappropriately that the financial statements of various registrants that report in Euros are directly comparable. Therefore, to highlight the potential lack of comparability in periods prior to January 1, 1999, the staff would expect that the disclosures outlined in Topic D-71 be made.
In addition, the staff believes that the use of the ECU (European Currency Unit) as a surrogate for the Euro for prior reporting periods would be inappropriate. The relationship between the legacy currency of a country participating in the EMU and the ECU would not necessarily have been the same as the relationship between the legacy currency and the Euro in periods prior to the introduction of the Euro. Therefore, the staff would object to the adoption of the ECU as the reporting unit for comparative periods prior to the introduction of the Euro as that would be likely to result in a remeasurement of the prior period amounts.
The staff will not object if a registrant that previously presented its financial statements in the currency of a country that is not an EMU member uses the Euro as its reporting currency, provided that the registrant follows the presentation and disclosure guidance in Topic D-71. A registrant reporting in Euros that has operations with functional currencies other than the Euro or EMU legacy currencies will experience foreign currency translation effects for periods after January 1, 1999. These effects should be disclosed in the financial statements and highlighted in MD&A.
Item 18 Disclosures
UK registrants should consider the need to provide disclosures stipulated by the Companies Act in filings with the Commission. The staff has been informally advised by the staff of the UK Accounting Standards Board that compliance with UK GAAP necessitates inclusion of disclosures required by the Companies Act to the extent that the disclosures relate to the balance sheet or income statement. Registrants that disclose that the financial statements filed with the Commission do not comply with the Companies Act are encouraged to explain the nature of the departure. In addition, the registrant should be able to justify why the departure does not affect the representation that the financial statements comply with UK GAAP.
Accommodation for Period of Goodwill under UK Accounting Standards
Prior to the adoption of Financial Reporting Standard No. 10, most U.K. issuers that filed with the Commission charged goodwill against shareholders’ equity upon acquisition. For purposes of the US GAAP reconciliation, goodwill was capitalized and amortized over its estimated useful life. Under FRS 10, goodwill is required to be capitalized and amortized over its useful life. However, in certain cases, goodwill may have an indefinite life. Depending on the circumstances, the goodwill amortization period in FRS 10 may or may not be the same as that under IAS 22 or US GAAP.
Form 20-F does not address specifically whether a registrant may use the 20-F accommodation for IAS 22 when primary financial statements are restated to adopt a recently issued accounting standard. Use of the accommodation in some of these circumstances could result in the presentation of reconciled income and equity amounts that differ from those previously reported. However, the instructions to Items 17 and 18 of Form 20-F contemplate use of this accommodation upon voluntary restatement of primary financial statements to adopt provisions of IAS 22 (or standards consistent with IAS 22).
Therefore, the staff will not object if a registrant that prepares its financial statements in conformity with U.K. GAAP, including FRS 10, omits the US GAAP reconciling disclosures specified by Item 17 or Item 18 with respect to the amortization period of goodwill and negative goodwill, provided that all of the following conditions are met:
This guidance applies only to the amortization period of goodwill and should not be applied by analogy to any other situations.
UK GAAP and Market Risk Disclosures
UK Financial Reporting Standard 13 “Derivatives and other financial instruments: disclosures” requires certain quantitative and qualitative information about market risk to be included in, or incorporated into, the audited financial statements. Similar information is required to be presented under the SEC's market risk disclosure rules (Item 11 of Form 20-F) but General Instruction 6 of that Item states that such information must be presented outside of, and not incorporated into, the financial statements.
The staff has determined that it will waive the requirement of General Instruction 6 to Items 11(a) and 11(b) of Form 20-F that the quantitative and qualitative information about market risk be presented outside of, and not incorporated into, the financial statements. This waiver is limited solely to those disclosures under Items 11(a) and 11(b) whose inclusion or incorporation in the financial statements is necessary for compliance with FRS 13.
Israel has a tax incentive program for “approved enterprise zones”. Under the alternative system of tax benefits, a company has a tax holiday for a specified period provided the profits generated during the exempt period are retained. If those profits subsequently are distributed, the company generally would owe taxes at the applicable rate.
Under FAS 109, a deferred tax liability normally would be recorded relating to taxes that would be owed on the distribution of profits even if management does not intend currently to declare dividends. However, under Israeli tax law, a company could be liquidated and profits distributed with no tax liability to the company; rather, the shareholders would incur the tax liability. If the registrant can represent that profits could be distributed tax free in a liquidation, and the undistributed earnings are essentially permanent in duration, a deferred tax liability does not need to be recorded.
If the approved enterprise benefit relates to a domestic (Israeli) subsidiary, the parent company would be liable for the taxes upon distribution. Accordingly, a deferred tax liability should be recorded unless the subsidiary could be merged with the parent in a tax free merger or if there is some other manner in which the earnings could be distributed tax free.
If deferred taxes are not provided for amounts that would be owed on distribution of profits, the following disclosures may be appropriate:
A typical Israeli retirement arrangement contains elements of both defined contribution and defined benefit plans. The arrangement includes deferred vested benefits that supplement primary benefits provided by the Government. While companies are not obligated to pre-fund the liability, many pre-fund it through managers’ insurance and/or mutual funds. There is no legal defeasance, since the sponsor typically is the beneficiary of the funding arrangement.
Israeli registrants have properly not followed FASB Statement 87 in accounting for the deferred vested portion of the arrangement. EITF 88-1 applies to this arrangement. Under EITF 88-1, companies not using Statement 87 for deferred vested benefits should record the obligation as if it was payable at each balance sheet date (the so called “shut-down method”). The liability should be recognized on an undiscounted basis as contemplated by EITF 88-1.
Israeli registrants should disclose their accounting method for the deferred vested benefit arrangement, the amount of the related liability accrued and the related assets, if funded. Under Israeli GAAP the balance sheet amounts are shown net. US GAAP would require gross reporting. Registrants should also disclose the components of the net expense (income), that is, the gross expense and the income from the funding arrangement.
The Office of the Chief Scientist provides grants for research and development efforts. Under Israeli law, royalties on the revenues derived from products and services developed using such grants are payable to the Israeli Government. Royalties payable are capped at a percentage of the grants received on grants received before 1999. Royalties payable with respect to grants received under programs approved after January 1, 1999 are subject to interest on the dollar-linked value of the total grants received at an annual rate of LIBOR applicable to dollar deposits.
The amounts of grants received and recorded into income should be disclosed for each period presented. The research and development grants are presented in the statement of operations as an offset to related research and development expenses. If material, the amount of grants should be presented separately on the face of the statement, i.e., gross R&D less grants equals net R&D. Royalty expense should be classified as part of cost of sales, not as marketing expense.
In addition, the Government of Israel awards grants to Israeli companies for overseas marketing expenses. The companies are required to pay royalties in connection with such grants at specified rates up to the total dollar-linked amount of such grants. The marketing grants are presented as an offset to sales and marketing expense.
If it is probable that the registrant will have to repay any amount of the grants received, those amounts should be recorded as a liability and not recorded in income.
Most Israeli registrants derive a significant portion of their revenues outside Israel and report in US dollars. However, some registrants that operate largely within Israel report financial results in New Israeli shekels. Israeli GAAP allows companies to price level adjust financial statements prepared in New Israeli Shekels based on either (i) inflation as measured by the consumer price index or (ii) the devaluation of the Shekel to the US dollar. The staff believes the devaluation method does not reflect the change in the value of the currency in the primary economic environment and may be misleading in some circumstances if not supplemented with additional information relating to performance, liquidity and financial condition on a basis adjusted for changes in the consumer price index.
The currency of measurement, or functional currency, is the US dollar for many entities in Israel and certain other countries with price-indexed tax systems. The provisions of paragraph 9(f) of FAS 109 are applicable unless the registrant has elected to pay its taxes based on US dollar amounts. Paragraph 9(f) is an exception to the liability approach and stipulates that the effects of changes in exchange rates and indexing for inflation are excluded from the temporary differences in determining the deferred tax balances. The staff has been advised that a similar concept does not exist under Israeli GAAP. The staff has also concluded that the Israeli Inflationary Taxation System has the same effect as indexing. This issue may also arise for registrants that use IAS. While similar to FAS 109 in most respects, IAS 12 does not contain an exception comparable to paragraph 9(f). Registrants are encouraged to clearly describe how deferred taxes are determined, and if appropriate, address the provisions of paragraph 9(f) in the reconciliation to US GAAP.
Foreign-owned businesses in the People’s Republic of China are often conducted through foreign “joint venture” arrangements. The joint ventures are formed by the contribution of capital by the registrant, and contribution of an underlying project or business by a PRC municipal government entity (PRC partner). The joint venture typically acquires a long-term concession to operate the project or business.
Generally, the registrant owns the majority of the voting shares of the joint venture, and the PRC partner owns the remaining shares. The registrant also selects a majority of the directors of the joint venture. However, unanimous approval by the board of directors is required for numerous operating decisions. Examples include selection and termination of key operating and financial officers, approval of budgets, capital expenditures and borrowings in the ordinary course of business. One arrangement required unanimous approval of all matters pertaining to the planning, construction, operation, and maintenance of the joint venture’s only revenue generating project.
Where the PRC partner’s rights are substantive and pervasive, they should not be considered “protective” as contemplated in EITF 96-16. Where the PRC partner retains significant rights and authority over operating decisions despite relinquishing majority ownership, the staff believes that the registrant does not have a controlling financial interest in the joint venture.
These arrangements also create various presentation issues. If consolidation is permitted under home-country GAAP, reconciliation of all financial statement captions likely will be required. In the selected financial data, the staff would expect home-country and US GAAP amounts to be presented with equal detail and prominence.
Separate audited financial statements of each joint venture under Rule 3-09 of Regulation S-X may be necessary. If consolidation is permitted under home-country GAAP, the staff will consider accepting expanded footnote disclosures about the joint ventures, such as separate condensed balance sheet, income statement, and cash flow information for each joint venture, in lieu of Rule 3-09 financial statements. Also MD&A should address the significant presentation differences between home-country GAAP, and include meaningful discussion of the results of operations, liquidity and cash flows of the ventures and their impact on the registrant.
In some of these arrangements, an affiliate of the PRC municipal government provides financial support in certain circumstances. Where significant, financial statements or other financial information about the affiliate may be required.
Government-owned enterprises in the Peoples Republic of China contemplating a public offering of securities undergo a process of “corporatization”. As part of that process, property, plant and equipment are adjusted to fair value shortly before the filing of the registration statement. Unlike government owned enterprises in certain countries, PRC government-owned enterprises generally maintain historical cost records for property, plant and equipment, although government policy rather than market forces may have determined those costs. Property, plant and equipment typically are not revalued prior to the time of corporatization.
IAS 16 allows property, plant and equipment to be measured subsequent to initial recognition at historical cost (benchmark treatment) or at revalued amounts (allowed alternative). When the revaluation method is used, IAS 16 requires revaluations to be made “with sufficient regularity such that the carrying amount does not differ materially from that which would be determined using fair value at the balance sheet date.”
The staff has distinguished this fact pattern from the establishment of cost by appraisal at the beginning of the earliest period presented in the context of a privatization when historical costs might not be possible to ascertain. The staff has taken the following position where historical cost can be ascertained:
More detailed guidance is provided in the highlights of the May 2000 meeting of the AICPA International Practices Task Force.
Under Taiwan GAAP, employee bonuses and remuneration to directors and supervisors are paid in accordance with a company’s articles of incorporation subsequent to year-end and are subject to shareholder approval. The bonuses may be settled in either cash or stock depending on the provisions of the articles of incorporation. In many cases, the bonuses are settled in stock. For local valuation purposes, only the par value of the stock is considered. As a result, it is common in Taiwan for shares to be issued whose value would significantly exceed the amount of the cash compensation. Some believe that for US GAAP purposes, the fair value of the shares should, at a minimum, be accrued at December 31, with the difference between that amount and the amount ultimately paid (based on the value at the shareholders’ meeting) charged to income in a subsequent period. The staff places significant weight on shareholder approval. Accordingly, absent unusual facts and circumstances, the fair value of the stock issued should be recorded at the date of shareholder approval.
Note – this Appendix has been reproduced from Sections II.C and VI of the May 2001 edition of International Financial Reporting and Disclosure Issues in the Division of Corporation Finance without revision or update.
The Commission has been working with the International Accounting Standards Committee (IASC) through the International Organization of Securities Commissions (IOSCO) since 1987 in an effort to develop a set of accounting standards for cross-border offerings and listings. The IASC is an independent, private sector body that was formed in 1973 by the professional accounting bodies in the US and eight other industrialized countries to improve and harmonize accounting standards.
In July 1995, IOSCO and the IASC joined in an announcement that the IASC had developed a work program focusing on a core set of standards previously identified by IOSCO as being the necessary components of a reasonably complete set of accounting standards.
In April 1996, the IASC announced that it had accelerated its work program, and the Commission responded with a press release expressing support for the IASC's objective. The Commission's statement noted that the standards should include a core set of accounting pronouncements that constitute a comprehensive, generally accepted basis of accounting; that the standards be of high quality, i.e., they must result in comparability and transparency, and they must provide for full disclosure; and that the standards must be rigorously interpreted and applied.
On February 16, 2000, the Commission issued a concept release on the elements of a high quality financial reporting framework, one of which is high quality accounting standards (Securities Act Release No. 7801). The release solicits comment regarding the quality of the IASC standards and raises questions regarding what supporting infrastructure is necessary in an environment where issuers and auditors often are multinational organizations, providing financial information in many countries. The release seeks to identify what important concerns would be raised by acceptance of IASC standards; and then asks for comment on whether the Commission should modify its current requirement for all financial statements to be reconciled to U.S. GAAP. The release emphasizes a desire to gain knowledge of respondents’ first hand experience with IAS. In particular, it asks about experiences that (a) issuers have had with applying IASC standards when preparing financial statements; (b) public accountants have had with auditing the application of the standards; and (c) investors have had with using financial statements prepared using those standards. The deadline for comments was May 23, 2000.
In May 2000, IOSCO completed its assessment of the suitability of 30 core IASC standards (the "IASC 2000 standards") for use in cross-border offerings and listings. IOSCO approved a resolution recommending that its members permit the use of 30 IASC standards, supplemented by reconciliation, disclosure and interpretation as necessary to address outstanding substantive issues at a national or regional level. Supplemental treatments may include reconciliation to show the effects of applying a different accounting method, additional disclosure, and use of a particular interpretation of an IASC standard. At the same time, the IOSCO Technical Committee issued a report that identifies about 120 substantive issues relating to the IASC 2000 standards and outlines one or more supplemental treatments that might be applied to address each issue. The IOSCO resolution is non-binding and implementation is subject to rule-making processes by the individual national members.
Under IAS 1 (revised 1997), Presentation of Financial Statements, enterprises that comply with IAS must disclose that fact. IAS 1 also indicates that financial statements should not be described as complying with IAS unless they comply with all the requirements of each applicable standard and each applicable interpretation of the Standing Interpretations Committee.
Some registrants have prepared financial statements in accordance with home country GAAP and in footnotes assert that the financial statements “comply, in all material respects, with” or “are consistent with” IAS. In some of these situations, the registrant may have applied only certain IAS or omitted certain information without explaining why the information was excluded. Where the assertion of compliance with IAS cannot be sustained, the staff will require either changes to the financial statements to conform to IAS, or removal of the assertion of compliance with IAS.
The staff has noted a number of situations involving reconciling items that appear to be the result of non-compliance with IAS and not the result of a difference between IAS and US GAAP. As such, there should not be a reconciling item. In many of these situations, the registrant asserted that the application of IAS was insignificant or immaterial; yet they were significant enough to be identified as a reconciling item in the US GAAP reconciliation. The US GAAP reconciliation cannot be used in lieu of full compliance with the IASC standards.
The criteria to determine the method of accounting for a business combination under IAS 22 are different than US GAAP. However, Form 20-F provides that a foreign private issuer that consummates a business combination that qualifies as a uniting of interests under IAS 22, and consistently applies IAS 22 to all business combinations, may use the uniting of interests method to report the transaction in filings with the SEC, without reconciling the method of accounting to US GAAP. That is, no reconciliation of the method of accounting is required even though the transaction may be a purchase under US GAAP.
Similarly, a foreign private issuer that consummates a business combination that qualifies as an acquisition under IAS 22 may use the acquisition method to report the transaction in filings with the SEC, without reconciling the method of accounting to US GAAP. That is, no reconciliation of the method of accounting is required even though the transaction may be a pooling under US GAAP.
The accommodation does not extend to certain types of transactions such as promoter transactions, leveraged buyouts, mergers of entities under common control, reverse acquisitions and other transactions that are not addressed by IAS 22. In these instances, an issuer would be required to quantify the differences in applying US GAAP.
The accommodation applies only to the determination of the method of accounting. Once the method is determined, an issuer would be required to quantify all resulting differences in the reconciliation to US GAAP. To illustrate, if a business combination is an acquisition under IAS 22, the issuer would be required to apply the provisions of US GAAP purchasing accounting using US GAAP balances to determine the US GAAP reconciled amounts.
Because of the IASC Board’s clear intent to restrict uniting of interests accounting to certain limited and rare circumstances, uniting of interests should not be presumed simply because ambiguity may exist about whether one shareholder group dominates the combined entity. An exhaustive search for an acquirer must be performed that considers all the relevant facts and circumstances. The staff believes that in virtually all business combinations an acquirer can be identified.
Standing Interpretations Committee Interpretation 9, issued in July 1998, indicates that all relevant facts and circumstances should be considered in determining the classification of a business combination. This includes an exhaustive search for an acquirer. SIC-9 clarifies that a business combination should be classified as an acquisition unless all the characteristics in IAS 22.15 (revised 1998) exist and it can be demonstrated that an acquirer cannot be identified.
The issuance of SIC-9 provides an important benchmark in establishing a more rigorous application of IAS 22. SIC-9 is effective for business combinations given initial accounting recognition in periods beginning on or after August 1, 1998. For December 31 year-end registrants, it applies to business combinations consummated on or after January 1, 1999.
Recently, several companies seeking to enter the SEC reporting system for the first time have accounted for a previously consummated business combination as a uniting of interests in their IAS financial statements. While not yet public in the US, the companies’ shares have long been publicly traded on various major stock exchanges outside the US. In each case, the business combination transaction resulted in one of the shareholder groups owning more than 50% but less than 60% of the combined company. Because board and management representation was divided equally, the companies believed that an acquirer could not be identified. These business combinations were consummated before the effective date of SIC-9, and the companies did not consider SIC-9 in applying the requirements of IAS 22.
In each case, the staff was unable to concur that the transaction should have been accounted for as a uniting of interests under IAS 22. If SIC-9 had been effective at the time the business combination was given initial accounting recognition, restatement of the financial statements would have been required to reflect the business combination as an acquisition under IAS 22. However, the staff recognized that practice at the time of the business combination was diverse in the application of IAS 22.
Therefore, the staff did not require restatement of the financial statements to be filed with the Commission. However, the companies were required to reconcile the method of accounting for the business combination to the purchase method of accounting under US GAAP. That is, the staff concluded that it was not appropriate to permit the companies to use the accommodation in Form 20-F to avoid reconciliation.
Registrants that have consummated business combinations after the effective date of SIC-9 are expected to strictly comply with the requirements of IAS 22 and SIC-9. The staff also will challenge presentations in the primary financial statements of uniting of interests consummated before the effective date of SIC-9 where it appears that IAS 22 has been misapplied egregiously. Egregious misapplication may be indicated, for example, where one of the shareholder groups obtains greater than 60% of the combined voting shares, where terms of the combination or related transactions are designed to provide a relative advantage to any shareholder group, or where terms of the combination or related transactions do not result in the combination of effectively the whole of the combining companies’ net assets and operations.
Under IAS 22 (revised 1993), goodwill and negative goodwill generally are amortized over a period not exceeding 5 years unless a longer period, not exceeding 20 years, can be justified. Items 17 and 18 of Form 20-F currently provide relief from the reconciliation requirements for the amortization period of goodwill and negative goodwill. The accommodation permits US GAAP reconciling disclosures to be omitted with respect to the amortization period of goodwill and negative goodwill if the period of amortization used in the primary financial statements conforms to the requirements of IAS 22 (revised 1993). Because of differences in the methods for determining and allocating purchase price, the amount of goodwill or negative goodwill under the IAS acquisition method may differ from the amount under the US GAAP purchase method. Accordingly, the amount of goodwill or negative goodwill that is subject to the IAS 22 amortization period in the US GAAP reconciliation is the amount determined under US GAAP. The rule requires consistent application for all business combinations consummated after January 1, 1995. However, for business combinations entered into before this date, issuers have the option of retroactively applying IAS 22 in the primary financial statements or reconciling to US GAAP.
The accommodations in Form 20-F do not allow a foreign issuer to reconcile to IAS 22. To illustrate, a foreign issuer that charges off goodwill directly to equity would not be allowed to reinstate it in the reconciliation and amortize it under the provisions of IAS 22. Rather, the amortization period would need to comply with US GAAP.
IAS 22 (revised 1998) eliminates the 20-year maximum life on goodwill. Under IAS 22 (revised 1998), goodwill is to be amortized over its estimated useful life, which is presumed to be 20 years or less. However, this presumption may be overcome in certain cases. Where the presumption is overcome, an enterprise is required to test goodwill for impairment at least annually and disclose the reasons why the presumption is overcome. These disclosures would include a discussion of the factors that played a significant role in determining the useful life of the goodwill.
In IAS 22 (revised 1998), the IASC Board emphasized that only in rare cases will an enterprise be able to support a goodwill life in excess of 20 years. Registrants should be prepared to justify assertions that the 20-year presumption has been rebutted. The staff is likely to challenge situations where a registrant changes its estimate of the useful life of goodwill to a longer period upon adoption of IAS 22 (revised 1998).
Goodwill lives of 20 years or less would continue to be eligible for the accommodation under Form 20-F. The accommodation in Form 20-F is based on IAS 22 (revised 1993). When this accommodation was originally adopted, the staff did not contemplate situations where the goodwill amortization periods under IAS could be significantly longer than those under US GAAP. In the rare case where a registrant concludes under IAS 22 (revised 1998) that goodwill lives exceed 20 years, the need for a reconciliation adjustment to US GAAP lives will depend on the specific facts and circumstances.
The accommodation applies only to amortization periods for goodwill, and not to other types of capitalized intangible assets. IAS 38 addresses amortization periods for other intangible assets. Consistent with IAS 22 (revised 1998), IAS 38 presumes that useful lives of intangible assets will not exceed 20 years, except in rare circumstances where a specific life in excess of 20 years can be clearly demonstrated.
Accounting for Negative Goodwill
IAS 22 (revised 1998) also eliminates the benchmark treatment in the existing standard for accounting for negative goodwill, and requires that negative goodwill be measured as the difference between the acquirer’s cost and its interest in the fair value of the identifiable assets acquired and liabilities assumed. It also requires that negative goodwill be recognized in the income statement as follows:
An entity recognizing negative goodwill in the income statement on a method other than straight-line amortization, under either version of IAS 22, would be required to reconcile these differences to US GAAP.
Impairment of Goodwill
The revisions to IAS 22 also include a new requirement to reverse impairment losses on goodwill under certain conditions. Entities adopting IAS 22 (revised 1998) that reverse any prior goodwill impairments also would be required to reconcile these reversals to US GAAP.
Under IAS 28, Accounting for Investments in Associates, an entity is presumed to have significant influence if it acquires 20% or more of the voting power of an investee. This presumption may be overcome in exceptional circumstances where it is demonstrated clearly that such influence does not exist.
IAS 28 defines significant influence as “...the power to participate in the financial and operating policy decisions of the investee . . .” The phrase “power to participate” contemplates having the capacity or ability to participate in the decision-making process. An investor that holds this power has significant influence, even if it elects not to actively participate.
In some European countries, enterprises have a two-board structure -- a supervisory board and a management board. The responsibilities of the supervisory board in these systems typically include, among other things, the ability to appoint the members of the management board and consent to or approve major corporate decisions. The supervisory board may not make the day-to-day decisions, which generally are the responsibility of the management board. However, the supervisory board has the power to participate in the decision-making process. The staff believes that participation on a supervisory board generally confirms rather than rebuts an investor’s ability to influence an associate.
While there are differences in how the equity method is applied under IAS versus US GAAP, the staff does not believe there is a difference between IAS and US GAAP in determining when the equity method should be applied. IAS 28 and US GAAP list the same factors that are indicative of significant influence. FASB Interpretation No. 35, Criteria for Applying the Equity Method of Accounting Investments in Common Stock (FIN 35), provides additional guidance on circumstances when application of the equity method may not be appropriate. Although IAS 28 does not include the examples of indications outlined in FIN 35, those indications are implicit in the IAS 28 definition of significant influence.
IAS 28 generally requires a registrant and its associates to use the same accounting policies. If an associate uses accounting policies other than those adopted by the registrant for like transactions and events, the registrant ordinarily makes appropriate conforming adjustments to the associate’s financial statements when applying the equity method. Paragraph 20 of IAS 28 provides an exception if it is impracticable to make such adjustments. This exception refers to acceptable differences in accounting policies that may arise within IAS. IAS 28 does not contemplate the use without adjustment of associate financial statements prepared on a basis of accounting other than IAS.
IAS 28 also states that procedures appropriate for the application of the equity method are similar to the consolidation procedures set out in IAS 27. As stated in IAS 27, the financial statements are usually drawn up as of the same date. When the reporting dates are different, statements as of the same date are generally required to be prepared. When it is impracticable to do this, financial statements with different reporting dates may be used provided the difference is no greater than three months.
Therefore, the date of the financial statements used by the investor to capture the associate's net income should ordinarily be the same date as the investor's financial statements. If an associate and an investor have different year-ends, the investor should use financial statements of the associate that have a difference in dates that is no greater than three months. Foreign registrants that propose a difference that is more than three months should consult in advance with the staff.
If a time lag exists between dates of the financial statements of the investor and the associate, that fact must be disclosed. In the absence of disclosure, an investor will be entitled to presume that no lag exists. The staff's view regarding disclosure of a registrant's accounting policy regarding time lags applies equally to registrants that present financial statements under home-country GAAP.
IAS 27, Consolidated Financial Statements and Accounting for Investments in Subsidiaries requires consolidation of all subsidiaries. Control is presumed to exist when the parent owns, directly or indirectly, more than one half of the voting power of an enterprise unless, in rare and exceptional circumstances, it can be clearly demonstrated that such ownership does not constitute control. Paragraph 13 of IAS 27 outlines the circumstances whereby an enterprise would exclude a subsidiary from consolidation. These exceptions relate to instances where (i) the parent has acquired the subsidiary with the view to sell it in the near future or (ii) there are severe long-term restrictions which significantly impair the subsidiary’s ability to transfer funds to the parent.
IAS 27 does not include an exception for subsidiaries that operate in different industries from the parent. Excluding subsidiaries from full consolidation is not justified just because those subsidiaries operate in different business activities or industries. IAS 27 also does not permit nonconsolidation as a matter of “industry practice”.
IAS 27 does not permit controlled subsidiaries to be proportionately consolidated. Further, majority-owned subsidiaries should not be characterized as joint ventures and accounted for using either the equity method or proportionate consolidation unless they meet the definition of a joint venture in IAS 31.
A registrant may establish special purpose entities (SPEs) to conduct research and development or other activities in the areas in which an enterprise and its affiliates are active. While the SPE may have its own governing body, the original sponsor may have the right of first refusal regarding the purchase of intellectual property rights developed by the SPE.
Companies with arrangements like this must consider the requirements of SIC-12, Consolidation – Special Purpose Entities (SIC-12). SIC-12 indicates that an SPE should be consolidated when the substance of the relationship between an enterprise and the SPE indicates that the SPE is controlled by that enterprise. The definition of control in IAS 27 encompasses the concepts of both governance and economic benefits and risks. SIC-12 expands on these concepts as they relate to SPEs by providing several indicators of control. These include the following:
The staff believes that consolidation of an SPE is required in cases where (1) the SPE provides an enterprise with a service (e.g., research or marketing) that is consistent with the enterprise’s ongoing central operations which, without the existence of the SPE, would be provided by the enterprise itself, and (2) the enterprise has the right to the economic benefits of the SPE through, for example, a right of first refusal.
In some cases SPEs may be established to facilitate transfers or securitizations of financial assets. Under US GAAP, an SPE to which financial assets have been transferred (or sold) often is not consolidated by the transferor. In these situations, even if the transfer of assets was accounted for as a sale under IAS, the application of SIC-12 could require the transferor to consolidate the SPE. Therefore, applying US GAAP in accounting for the sale or transfer of financial assets will not necessarily result in compliance with IAS. In these cases, a registrant would be required to provide a reconciling item in the US GAAP reconciliation.
Consolidation of German Special Funds under IAS
Special Funds are widely used investment vehicles in Germany. Special Funds are used to provide tax benefits because the sponsor of a Special Fund is taxed when the Special Fund makes distributions to the sponsor, rather than when investment income on an underlying portfolio is earned. The staff has been advised that these investment vehicles currently have underlying portfolios valued at 500 billion EUR. While the following discussion is based on a fact pattern for a German investment vehicle, similar investment vehicles in other jurisdictions may exist and are likely to be impacted by the staff's views related to the German investment vehicle.
A sponsor forms the Special Fund, whose structure and operation are specified by German law. A Special Fund may not have more than 10 investors. However, the sponsor may fund and own up to the entire economic interest in the Special Fund. The underlying assets held by the Special Fund consist of marketable debt and equity securities.
The sponsor appoints an investment management company. Under German law, the investment management company has authority over all operating and financial decisions related to the Special Fund, including the acquisition, disposition, and voting of the underlying marketable securities. By law, neither the sponsor nor the owner of the investment management company is permitted to dictate or influence the investment management company's decisions. Once appointed, the investment management company cannot be removed except in extraordinary circumstances, such as insolvency.
The sponsor also appoints a depositary bank, which acts as custodian of the Special Fund's assets. Under German law, the depositary bank is responsible for ensuring that the investment management company complies with applicable laws in its administration of the Special Fund. However, the depositary bank must generally comply with instructions of the investment management company.
In some cases, there may be no unrelated third party other than the depositary bank involved in the structure or operation of the Special Fund. That is, no party outside the sponsor and its consolidated subsidiaries has a substantive ownership interest, financial interest, or decision-making authority with respect to the Special Fund. For example, the sponsor, through a consolidated subsidiary, may fund and own the entire Special Fund, and may also own, control, and consolidate the investment management company.
For periods prior to the effective date of SIC-12, we understand that German companies adopting IAS have concluded that neither the sponsor nor the investment management company should consolidate the Special Fund. Instead, the sponsor's investment in the Special Fund has been viewed as an investment under IAS 25, Accounting for Investments (IAS 25). We also understand that companies generally view Special Funds as SPEs falling within the scope of SIC-12. They generally believe that paragraph 10(c) of SIC-12 introduces a new criterion that applies to the Special Funds, but was not contemplated by IAS 27.
The staff has objected to that view in circumstances where majority ownership in and decision-making authority over the Special Fund reside in different subsidiaries within the same consolidated group. The staff believes that when there is evidence pointing to the principle of control under IAS 27, registrants should consolidate the entity subject to that control. The staff believes that SIC-12 only clarifies concepts and principles that currently exist within IAS 27.
IAS 25 has multiple alternative treatments. Depending upon how IAS 25 has been applied, there may be significant differences between IAS 25 and consolidation in the measurement and classification of balance sheet and income statement amounts.
If the sponsor's investment in a wholly-owned Special Fund has been carried at market value with unrealized gains and losses recorded in stockholders' equity, the principal difference between IAS 25 and consolidation is that investment income and realized gains and losses on the underlying securities held by the Special Fund are not recognized in the sponsor's income statement. In this circumstance, the staff generally requested the registrant to adopt SIC-12 using the benchmark treatment under IAS 8, which requires retroactive restatement. Registrants considering the use of the allowed alternative treatment should consult with the staff prior to filing.
IAS 14 is effective for periods beginning on or after July 1, 1998. IAS 14 defines a business segment as a distinguishable component of an enterprise that is engaged in providing an individual product or service (or a group of related products or services) and that is subject to risks and returns that are different from those of other business segments. Similarly, geographical segments are defined as a distinguishable component of an enterprise that is engaged in providing products or services within a particular economic environment and that is subject to risks and returns that are different from those of components operating in other economic environments.
Companies must choose either a business segment or geographic segment approach for their primary segment reporting. The choice is generally governed by the nature and source of an enterprise's risks and returns. This decision affects the required disclosures under IAS 14 because more limited information is required for the secondary segment reporting.
Some have asserted an "impracticability" exception not contained in IAS 14 regarding certain secondary segment disclosures. For example, an enterprise maintains a production facility for different business segments that cut across different geographic segments. Assuming that the primary segment reporting was on a geographic basis, the staff has objected to the general assertion that such an asset could not be allocated to the enterprise's business segments because of impracticability.
Some have asserted that research and development departments, which carry out these activities for the enterprise as a whole, could be grouped as a separate business segment. These research and development activities did not generate separately identifiable revenues for the consolidated group and therefore did not separately generate returns for the enterprise. Under IAS 14, segment expenses include those costs incurred at the enterprise level on behalf of a segment that relate to the segment's operating activities and can be directly attributed or allocated to the segment on a reasonable basis. The staff believes these research and development activities do not meet the definition of a business segment, but do meet the definition of a segment expense. Therefore, under these circumstances, research and development activities should not be designated as a separate segment and should be allocated in accordance with paragraph 16(f).
Another concern relates to the non-disclosure of pension liabilities as a segment liability. Under IAS 14, interest-bearing liabilities are not required to be allocated to the segments presented under the primary disclosure requirements. The standard on employee benefits, IAS 19, permits enterprises to disaggregate their pension cost among several income statement line items, for example, classifying the interest component as a financing expense. The staff recognizes that pensions have an interest component; however, pensions also have a significant component representing benefit obligations to employees of the business and geographic segments. The staff does not believe that there is interplay between IAS 14 and IAS 19. Therefore, a registrant should not assume that pension liabilities are interest-bearing obligations for purposes of excluding them from allocation to business or geographic segments.
Since IAS 14 requires the inclusion of direct and reasonably allocable expenses within segment result, the staff would object to the disclosure of non-GAAP measures of profitability such as operating profit before goodwill amortization within the IAS 14 disclosures. If, in this example, the registrant actually manages the business based on operating profit before goodwill amortization, that measure would be presented as part of the Item 18/FAS 131 segment disclosures.
IAS 38 is effective for periods beginning on or after July 1, 1999. Intangible assets are to be amortized on a systematic basis over the best estimate of the intangible's useful life. There is a rebuttable presumption that the useful life of an intangible asset would not exceed 20 years from the date when the asset is available for use.
The rebuttable presumption within IAS 38 is a limited exception and depends on the facts and circumstances; however, the staff believes that only in rare cases will the 20-year rebuttable presumption be overcome. The staff believes that this is consistent with paragraph 83 of IAS 38. That paragraph states that there may be persuasive evidence that the useful life of an intangible asset will be a specific period longer than 20 years. This guidance contemplates assets such as the exclusive contractual rights granted for a specific period, for example, a long-term concession to operate a public utility. As such, the staff will object to the assertion that the expected life is in excess of 20 years but that the length of time in excess of that 20 years is not specific.
Registrants using IAS 38 need to be sure that, contemporaneously with acquisition, they document their determination of the estimated life of an intangible asset, including the reasoning and basis for the conclusions reached. In addition, auditors should ensure sufficient, competent, and verifiable evidence is obtained to provide a basis for the auditor's conclusion that the estimated life management has chosen to assign to an intangible asset is reasonable and supportable.
IAS 1 allows an enterprise to present an analysis of expenses using a classification based on either the nature of expenses or their function within the enterprise. Under the nature of expense method, expenses are aggregated in the income statement according to their type (e.g., depreciation, purchases of materials, salaries, advertising, etc.) and are not reallocated among the various functions within the enterprise. On the other hand, the functional or “cost of sales” method classifies expenses according to their function as part of cost of sales, distribution, or administrative activities, for example. The functional method is generally required under Regulation S-X. In cases where expenses are classified based on their nature, sufficient disclosure about functional expense classifications should be presented as part of the US GAAP reconciliation to provide an information content substantially similar to an income statement presentation under US GAAP and Regulation S-X. This disclosure would be required both for Item 17 and Item 18 filers.
In several instances, enterprises have asserted that recurring expenses such as depreciation, amortization or changes in estimates of accrued liabilities should not be included in profit from operating activities. The staff believes the exclusion of these types of expenses is inappropriate and would object to the use of income statement line items such as “Operating Income Before Depreciation and Amortization” and Income Before Taxes and Amortization.”