Convergence: hurdles remain; With convergence a necessity in a global economy, it is likely to be some time before all are 'singing from the same song sheet'--and it will take time and commitment for standard setters to work together to remove differences.

The benefits of adopting a common worldwide accounting language are numerous and widely accepted. The approach benefits investors by presenting enhanced comparability of investment targets, while reduced costs and complexity in preparing financial statements and filings benefit international companies that list securities in multiple countries. Yet, as the Jan. 1, 2005 deadline for implementing the new International Financial Reporting Standards (IFRS) approach, questions remain.

A big one: Will adopting international accounting standards always achieve the benefits? A close look shows some subtle--and not so subtle--differences between IFRS and accounting standards in countries such as the U.S. Companies that list securities in both a market that follows IFRS, such as members of the European Union (EU), and those that follow U.S. standards, may be surprised to learn that they still have major differences to contend with and explain to investors.

Same Issue, Different Approaches

The impairment of assets to be held and used--including intangibles and goodwill--is one of the most significant accounting issues companies face today. At some point, an asset's value may have diminished to the point where an accounting charge is necessary. But when should a company consider an impairment charge, how is the size of the charge calculated and when should it be taken?

The International Accounting Standards Board (IASB) debated these questions, and subsequently issued the amended IAS 36, Impairment of Assets, in 2004. Earlier, in 2001, the Financial Accounting Standards Board (FASB) debated the same points and issued FAS 141, Goodwill and Other Intangible Assets and FAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets (superseding an earlier impairment standard issued in 1995). While the issues debated by the two boards were the same, the conclusions they reached were quite different.

Both the international and U.S. standards require impairment tests to be performed on assets whenever certain impairment indicators are present--such as signs that suggest an asset's value may have fallen below its carrying amount. Both standards also require impairment tests to be performed at least annually for goodwill and other intangible assets with indefinite lives, regardless of indicators. Not a lot of difference here. It is in how the test is performed where the differences between the two standards become apparent.

Under the U.S. standard, the impairment test for assets (other than goodwill and indefinite-lived intangibles) is commonly referred to as a "two-step approach." First, a company compares the undiscounted cash flows to be derived from the asset's use and eventual disposition to the carrying amount of the asset. Second, only if the undiscounted cash flows are less than the carrying amount is a company required to measure an impairment loss. That loss is the difference between the asset's carrying amount and its fair value--that is, the amount at which it could be sold in a transaction between willing parties.

The international standard has only one step. For assets other than goodwill or indefinite-lived intangibles, an impairment charge is recognized whenever an asset's recoverable amount (the higher of its fair value less costs to sell, and its value in use) exceeds its carrying amount. Value in use is the future cash flows to be generated by the asset, discounted at a current market interest rate, adjusted for risk inherent in the asset. The amount of the loss is the excess of the carrying amount over the recoverable amount.

Thus, in addition to different steps to determine whether an impairment charge is needed, the measurement of the charge itself may differ between the standards. While the U.S. standard measures the impairment charge based on the asset's fair value as derived from a sale, the international standard also considers the asset's value as derived from its use.

Both standards acknowledge that the impairment test cannot always be made at the individual asset level. When it is not possible to estimate the recoverable amount at the individual asset level, the IFRS approach determines the recoverable amount of the cash-generating unit (CGU) to which the asset belongs. The CGU is the smallest identifiable group of assets that generates cash inflows that are largely independent of cash inflows from other assets. While the definition appears straightforward, the determination of the CGU is not, and is subject to much judgment. However, this same challenge exists under the U.S. standard, which also allows for grouping assets in determining cash flows.

Goodwill and Other Intangibles

As mentioned earlier, both standards require annual impairment testing of goodwill and intangibles with indefinite lives, regardless of the existence of impairment indicators. Under both standards, total entity goodwill is allocated to portions of the entity, and impairment testing of goodwill is done at that level.

However, the guidance as to what constitutes an appropriate level is different. IFRS refers to testing of goodwill at the CGU or group of CGUs' level, but requires that the level be the lowest at which goodwill is managed for internal management purposes, with the further requirement that it cannot be larger than a segment under IFRS definitions. U.S. standards refer to goodwill testing at the reporting unit level, which is an operating segment or one level below, provided that the "level below" is a business with discrete financial information for which management regularly reviews operating results.

The two standards also differ in the manner in which an impairment loss for goodwill is measured. Again, the IFRS standard is a one-step test in which the carrying amount of the CGU (to which the goodwill has been allocated) is compared to the CGU's recoverable amount, and any excess carrying amount is written off against goodwill and then to the other assets of the CGU.

The U.S. standard is a two-step test. First, the carrying amount of the reporting unit is compared to its fair value. If it exceeds the fair value, the second part of the test is required. In this part, the company must allocate the fair value of the reporting unit to its existing assets and liabilities as if there were a new business combination. Any excess is the "implied value" of goodwill. The implied value of the goodwill, as calculated, is compared to its carrying amount, and any excess carrying amount is recognized as an impairment loss.

Clearly, it is quite possible that statements prepared under IFRS and U.S. GAAP could assess goodwill impairment at dissimilar levels with in the entity using a different calculation methodology. This divergence of approach could yield very different results.

Regarding indefinite-lived intangibles, the international rule compares the intangible's carrying amount to its recoverable amount, as defined above. The U.S. standard compares the intangible's carrying amount only to its fair value, a divergence that could also yield very different results.

The two standards also differ in what to do if an asset's value later recovers. Both standards bar reversal of a goodwill impairment loss. However, IFRS requires an entity to assess at each reporting date whether there is any indication that a previously recognized impairment loss no longer exists or may have lessened. If so, the reversal of all, or a portion of this loss is recognized as a gain in income. By contrast, U.S. standards do not allow for the reversal of any previously recognized impairment loss.

Further Implications

For years now, the arrival of international standards has been heralded as a way to achieve consistency and conformity of financial reporting across the world. As a result, some companies are surprised to learn that the conversion to international standards will not eliminate all differences between IFRS financial statements and those prepared under U.S. generally accepted accounting principles (GAAP).

Since many in the U.S. have argued that U.S. standards represent the single most comprehensive body of accounting literature existing in the world today, some presumed that international standards would essentially embrace all U.S. rules and practices. However, that is not the case, as has been described with respect to only one area--asset impairment.

And there are other areas of difference. A sizable number of companies list their securities both on EU and U.S. exchanges. Beginning in 2005, virtually all EU-listed companies will be required to follow IFRS. As part of the U.S. filings, the U.S. Securities and Exchange Commission (SEC) will require foreign filers to reconcile their results of operations from IFRS to U.S. GAAP. This process will require dual filers to incur the time and expense to analyze certain transactions under two separate bases of accounting.

For example, it is possible for a company to recognize an asset impairment under IFRS, while a different amount, or possibly no impairment loss at all, would be recognized under U.S. GAAP. Similarly, a company could reverse a previous impairment under IFRS, but not be permitted to do so in a U.S. filing.

At a time when users of financial statements increasingly confounded by complex accounting requirements and ever-burgeoning disclosures, this will present yet another challenge to companies who will want to be in a position to explain such differences to users and investors. Because both bases of accounting have been through rigorous deliberation and public exposure, some users may be confused as to how results between the two could materially differ.

Notwithstanding a mutual commitment to convergence, both the IASB and FASB continue to revisit new and previously issued standards. Further, the SEC frequently interprets U.S. GAAP, and will probably also develop interpretations of international standards for filings within its jurisdiction. As these events unfold, other areas of diversity between IFRS and U.S. GAAP can also be expected to arise.

So while convergence remains an admirable intention, and one that some consider an "absolute necessity" of a global economy, it is not likely that the entire world will be singing from the same song sheet any time soon, not even for filings between the EU and the U.S. Worldwide convergence is a process that will take time and commitment, and a willingness for standard setters to work together to remove differences. In the meantime, preparers, users and auditors need to be aware that when it comes to international accounting, "convergence" doesn't always converge!

David L. Holman is National Director, Accounting Standards for Ernst & Young LLP in New York. He can be reached at [e-mail] or 212.773.2346.