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U.S. Securities and Exchange Commission

Remarks by

Donald J. Gannon

Professional Accounting Fellow, Office of the Chief Accountant
U.S. Securities & Exchange Commission

27th Annual National AICPA Conference on Current SEC Developments

December 8, 1999

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its members or employees. The views expressed herein are those of Commissioner Johnson and do not necessarily reflect the views of the Commission or its staff.

Thank you. It's a pleasure to have the opportunity to address you again this year. I'd like to spend my time this morning discussing issues relating to the application of International Accounting Standards (IASs).1 More specifically, I will cover issues relating to accounting for subsidiaries, accounting for associates, consolidation policies and special purpose entities, income statement and balance sheet presentation, and disclosures of issued but not yet adopted accounting standards.

Let me begin with a couple of issues relating to the accounting for subsidiaries.

Accounting for Subsidiaries

The staff has noted a number of situations where an entity appropriately was considered a subsidiary2 but was not accounted for in accordance with IAS 27, Consolidated Financial Statements and Accounting for Investments in Subsidiaries (IAS 27). Like U.S. GAAP, IAS 27 requires consolidation of all subsidiaries. IAS 27 does provide certain limited exceptions to the general rule of full 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.3

In some situations we've seen, the subsidiaries were accounted for using proportionate consolidation – a method not allowed in accounting for subsidiaries under IAS 27. In these cases the registrants asserted that proportionate consolidation was used for all investments as a matter of accounting policy because the effect of not using full consolidation was immaterial.

In other situations, the registrants asserted that the policy of not consolidating the subsidiaries was industry practice. This was particularly true in cases where the subsidiaries operated in different industries from the parent. While that may be practice, it isn't in compliance with IAS 27, which is clear: exclusion from full consolidation of subsidiaries is not justified just because those subsidiaries operate in different business activities or industries.4

In still other situations, subsidiaries were characterized inappropriately as joint ventures and accounted for using either the equity method or proportionate consolidation. In many of these instances, the parent owned more than a simple majority interest in the subsidiary. In one instance the registrant indicated in its footnotes that " [a]lthough certain of the ventures do not meet the technical requirements of joint control, they have been proportionally consolidated as the impact of the difference between proportional and full consolidation or equity accounting is not material." This type of application is not consistent with the requirements of IAS 27.

In all of these situations the U.S. GAAP reconciliation included a material reconciling item adding in the effect of full consolidation. In each of these instances, the staff was unable to concur with the registrants' conclusions and required restatement of the primary financial statements.

Let me turn now to accounting for associates.

Accounting for Associates

The staff recently dealt with a couple of issues involving the accounting for certain investments in associates under IAS 28, Accounting for Investments in Associates (IAS 28). Under IAS 28, 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.

Some registrants have asserted that "significant influence" as defined in IAS 28 requires active participation. That is, one must actually take steps to influence the investee and that passive participation and simply having the ability to influence is not enough. The staff disagreed with these assertions. IAS 28 defines significant influence as "...the power to participate in the financial and operating policy decisions of the investee..." [emphasis added]5 The phrase "power to participate" implies having the capacity or ability to accomplish something – in this case participation in the decision-making process. We do not believe this requires active participation.

Another issue that the staff has addressed relates to the kind of circumstances that would demonstrate clearly that the presumption of significant influence has been overcome. In one case the staff considered how corporate governance would impact the determination of whether the presumption of significant influence was overcome.

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 the consent to or approval of major corporate decisions. The supervisory board may not make the day-to-day decisions, which generally are the responsibility of the management board. However, this does not mean that the supervisory board does not participate in the decision-making process. The staff believes that participation on a supervisory board confirms rather than rebuts an investor's ability to influence an associate.

We also have noted circumstances where registrants have asserted that a difference exists between IASs and U.S. GAAP regarding the applicability of the equity method of accounting and how the presumption of significant influence should be assessed. Both IAS 28 and U.S. GAAP6 list the same factors that are indicative of significant influence. However, some have argued that the existence of FASB Interpretation No. 35, Criteria for Applying the Equity Method of Accounting Investments in Common Stock (FIN 35), creates a difference in when the equity method of accounting is applied under IASs and U.S. GAAP.

FIN 35 lists examples of indications that an investor does not have significant influence despite a presumption of significant influence. These include:

  • opposition by the investee [associate];

  • an agreement by the investor surrendering significant shareholder rights;

  • operation of the investee [associate] by the majority owners without regard to the views of the investor;

  • demonstrated inability of the investor to obtain financial information about the investee [associate]; and

  • demonstrated inability to obtain representation on the investee's [associate's] board of directors.

Although IAS 28 does not include the examples outlined in FIN 35, the staff believes that is not significant as those indications are implicit in the IAS 28 definition of significant influence.

While there are differences in how the equity method is applied under IASs versus U.S. GAAP, the staff does not believe there is a difference between IASs and U.S. GAAP in determining when the equity method should be applied.

Let me now turn to a couple of issues relating to consolidation policies and special purpose entities (SPEs).

Consolidation Policies and SPEs

The staff is beginning to see more issues relating to the consolidation of SPEs under IASs. For example, these entities may be established to conduct research and development 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 notion 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.7 These include the following:

  • the activities of the SPE, in substance, are being conducted on behalf of the reporting enterprise according to the reporting enterprise's specific business needs,

  • the reporting enterprise, in substance, has the decision-making powers of the SPE or its assets, including certain decision-making powers coming into existence after the formation of the SPE, or by setting up an "autopilot" mechanism as part of the formation of the SPE,

  • the reporting enterprise, in substance, has the rights to obtain a majority of the benefits of the SPE's activities, or

  • the reporting enterprise, in substance, retains the majority of the residual or ownership risks related to the SPE or its assets.

The staff believes that consolidation of an SPE would be appropriate – and required under IASs – in cases where the SPE provides an enterprise with a service (e.g., research) 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 the enterprise has the right to the economic benefits of the SPE through, for example, a right of first refusal.

Another consolidation issue I'd like to discuss briefly relates to SPEs and financial asset securitizations. Under U.S. GAAP,8 an SPE9 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 IASs10 , the application of SIC-12 could require the transferor to consolidate the SPE. Therefore, applying U.S. GAAP in accounting for the sale or transfer of financial assets will not necessarily result in compliance with IASs, because of the differences in the consolidation policies under IASs and U.S. GAAP. In these cases, the staff would expect a reconciling item in the U.S. GAAP reconciliation.

I'd now like to make some remarks about income statement and balance sheet presentation under IASs. Let me first address a presentation issue involving the classification of expenses in the income statement.

Income Statement and Balance Sheet Presentation

Classification of Expenses

IAS 1 (revised 1997), Presentation of Financial Statements (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 the method required under Regulation S-X.11

The staff noted one situation where a registrant was using the functional method under IAS 1 but asserted that certain line items, for example, depreciation and amortization and certain other costs, would have been reclassified and included in "cost of sales" under U.S. GAAP. These "reclassifications" had a significant impact on gross margin and operating profit. The staff agreed with the classification proposed for U.S. GAAP purposes but challenged this presentation under IASs and ultimately required restatement of the primary financial statements.

The staff does not believe that there is a difference in the application of the functional method under IASs and U.S. GAAP and therefore would expect the same expense classification. In cases where expenses are classified based on their nature, sufficient disclosure about functional expense classifications should be presented as part of the U.S. GAAP reconciliation to provide an information content substantially similar to an income statement presentation under U.S. GAAP and Regulation S-X.12

The other presentation issue I would like to discuss relates to deferred tax items in the balance sheet.

Deferred Tax Assets and Liabilities

IAS 12 (revised 1996), Income Taxes (IAS 12), became effective for periods beginning on or after 1 January 1998. The staff has seen a number of instances where the presentation requirements of IAS 12 have not been complied with. For example, the staff has noted situations where registrants have not disclosed separately deferred tax assets and liabilities in the balance sheet, but rather have included these amounts in "other assets" or "other liabilities". The staff also has seen cases where deferred tax assets or liabilities have been classified as current in a classified balance sheet. I mention these issues because IAS 12 is clear on these points – deferred tax assets and liabilities should be presented separately from other assets and liabilities in the balance sheet and may not be classified as current.13

The staff also has noted issues with the offsetting of deferred tax assets and liabilities. The staff has identified a number of cases where deferred tax assets and liabilities relating to different taxation authorities were offset. Again, IAS 12 is clear on this – the offsetting of deferred tax assets and liabilities is appropriate if, and only if, a legally enforceable right to set off exists and the income taxes are levied by the same taxation authority.14

Next, I'd like to make some comments on disclosures about recently issued but not yet adopted accounted standards.

Disclosures About Recently Issued Accounting Standards

The IASC's core standards work program has generated 15 new or significantly revised standards since 1996, a number of which have 1999 or 2000 effective dates. Many of these standards are complex, and represent a significant change in practice. As a result, the staff would expect fairly extensive disclosures under Staff Accounting Bulletin No. 74 (SAB 74).

SAB 74 requires registrants to disclose the nature and expected effects of recently issued but not yet implemented accounting standards. This requirement applies not only to new standards under U.S. GAAP, but also to new standards where the primary financial statements filed in the United States are prepared using home-country GAAP, including IASs. As a reminder, the following disclosures should be considered:

  • a brief description of the new standard, the date that adoption is required, and the date the registrant plans to adopt the standard, if earlier;

  • a discussion of the method of adoption allowed by the standard and the method expected to be utilized by the registrant, if determined; and

  • a discussion of the impact that adoption of the standard is expected to have on the financial statements, unless not known or reasonably estimable. In that case, a statement to that effect should be made.

In addition, disclosure of the potential impact of other significant matters that the registrant believes might result from the adoption of the new standard (e.g., technical violations of debt covenants, planned or intended changes in business practices) is encouraged.

The staff notes that in the case of a number of the IASC standards, the impact of adopting the new or revised standard is known as it may be an item included in the U.S. GAAP reconciliation.

Many of the issues I have discussed this morning are areas where the staff has seen non-compliance with IASs. Let me close with some general remarks relating to the assertion of compliance with IASs and U.S. GAAP reconciliations.

Compliance With International Accounting Standards

Last year I commented on the situation where the staff had become aware of foreign registrants preparing their financial statements in accordance with home-country GAAP and in the footnotes asserting that the financial statements "comply, in all material respects, with" or "are consistent with" IASs. I explained our concern with situations where registrants may have applied only certain IASs or omitted certain information without giving any explanation of why the information was excluded. Let me update you with a brief comment about auditor reporting on assertions of compliance with IASs.

Auditors have addressed clients not fully complying with IASs in a variety of ways. Some auditors simply do not comment explicitly on compliance with IASs. This is common practice when the statement of compliance (or partial compliance) with IASs is in the footnotes. In other cases auditors may express an opinion on conformity with the "accounting principles described in the footnotes" which typically is a mix of IASs and other principles. We also have seen situations where the auditors have appropriately issued a qualified opinion. In any case, there appears to be a wide variety of practices by both preparers and auditors in dealing with compliance with IASs.

If financial statements are represented to be in compliance with IASs either on their face or in the footnotes, nothing less than full compliance with IASs is acceptable. The requirements of IAS 1 are clear on this point. Besides requiring enterprises who comply with IASs to disclose that fact, IAS 1 also indicates that financial statements should not be described as complying with IASs unless they comply with all the requirements of each applicable standard and each applicable interpretation of the Standing Interpretations Committee (SIC). This also would preclude presentation of financial statements where a departure from IASs is disclosed in either the auditor's report or in the notes to the financial statements.

Let me now end with a couple of remarks about U.S. GAAP reconciliations.

U.S. GAAP Reconciliations

The staff has noted a number of situations involving reconciling items that appear to be the result of non-compliance with IASs and not the result of a difference between IASs and U.S. GAAP. As such, there should not be a reconciling item. In many of these situations, the registrant asserted that the application of IASs was insignificant or immaterial; yet they were significant enough to be identified as a reconciling item for purposes of the U.S. GAAP reconciliation. The staff has challenged these situations and will continue to do so. The U.S. GAAP reconciliation can not be used in lieu of full compliance with the accounting standards used to prepare the primary financial statements. In addressing these issues the staff has required restatement of financial statements to conform with IASs.


The first step in promoting convergence of accounting standards is developing a body of standards that are internationally accepted. However, convergence will not be realized until those standards are rigorously interpreted and applied. This means settling for nothing less than full compliance. The bottom line is – compliance matters. Thank you. That concludes my prepared remarks.


1 Promulgated by the International Accounting Standards Committee (IASC).
2 Under IAS 27, a subsidiary is defined as, "an enterprise that is controlled by another enterprise." IAS 27.12 establishes various presumptions of control. These include (i) power over more than half of the voting rights by virtue of an agreement with other investors, (ii) power to govern the financial and operating policies under a statute or agreement, (iii) power to appoint or remove a majority of the board of directors or equivalent body, or (iv) power to cast the majority of votes at meetings of the board of directors or equivalent body.
3 See IAS 27.13.
4 See IAS 27.14.
5 See IAS 28.3.
6 See APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock.
7 See the Appendix of SIC-12 for examples of the control indicators.
8 See EITF 96-20, Impact of FASB Statement No. 125 on Consolidation of Special-Purpose Entities.
9 A "qualifying" SPE under FASB Statement No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities.
10 See IAS 39, Financial Instruments: Recognition and Measurement.
11 See Rule 5-03, "Income Statements."
12 See items 17 and 18 of Form 20-F.
13 See IAS 12.69 and .70.
14 See IAS 12.71 and .74.


Modified: 07/07/2005