Financial analysis: the project to harmonise IFRS and US Gaap is seven years old this month and still making steady progress. Tony Sweetman tells the story so far.

The convergence of international financial reporting standards (IFRS) and US Gaap was examined by the P8 paper in November 2005, May 2007 and May 2009. The process remains an important and examinable topic. It was the subject of articles in the June 2007 and December/January 2007/08 issues of FM, but there have been significant developments in the field since those were published, so it's worth revisiting.

It all began in September 2002 when the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) signed an agreement in Norwalk, Connecticut, as the starting point for a project to converge their respective sets of standards. They stated their commitment to developing high-quality, compatible standards suitable for both domestic and cross-border reporting. The Norwalk agreement identified two key goals: to make existing standards compatible as soon as practicable and to maintain compatibility once this had been achieved.

In February 2006 the two boards published a memorandum of understanding, which they called a road map, that identified short-term and long-term convergence projects. This was based on three principles:

* Convergence of accounting standards can best be achieved through the development of high-quality, common standards over time.

* Trying to eliminate differences between two standards that require significant improvement is not the best use of the boards' resources. Instead, a new common standard should be developed that improves the financial information reported to investors.

* Serving the needs of investors means that the boards should seek convergence by replacing standards requiring improvement with jointly developed new ones.

The boards then identified areas that were a high priority for convergence. In particular:

* IAS23 permitted borrowing costs on the construction of an asset to be either capitalised or written off. US Gaap required such costs to be capitalised. IAS23 was amended in 2007 and is now in line with US Gaap.

* IAS14 has been superseded by IFRS8, dealing with segmental reporting. The new approach identifies reportable segments based on a "managerial approach", which is consistent with that of US Gaap, rather than the "risk and returns" approach used by IAS14.

* IAS1 was revised in September 2007. The balance sheet is renamed the statement of financial position. The income statement is renamed the statement of comprehensive income and now includes items of income and expense that aren't recognised in profit or loss but are directly recognised in equity--eg, revaluation gains.

* IAS27 and IFRS3 were amended in January 2008. The new standards alter the calculation of goodwill and the treatment of piecemeal acquisitions. Along with changes to US Gaap, these changes bring the accounting treatment of goodwill into line, although some differences remain, such as the definition of control and fair value. A review is scheduled for 2012, by which time the revised standards will have applied for two years.

A second convergence road map was agreed in November 2008. Its aim was to enable companies to file statements prepared in accordance with IFRS to be accepted by the US Securities and Exchange Commission (SEC). This followed an announcement in 2007 that the SEC would no longer require IFRS-compliant statements filed with it to include a reconciliation to US Gaap.

Based on the 2008 road map, a small number of companies will begin to prepare their financial statements using IFRS with effect from years starting December 15, 2009. To be eligible, a company must be one of the 20 largest in its industry by market capitalisation. Those 20 must use IAS as the major basis for their financial reporting.

At the start of this year the SEC stated that a mandatory two-year dual-reporting period would begin for most companies in 2012, with IFRS required only by 2014. Its decision reflects the increasing acceptance of IFRS as a widely used and high-quality reporting language.

The global financial crisis has been an additional driver of convergence in recent months. Although there were already proposals to harmonise accounting for financial instruments, this issue took on greater significance and priority after the credit crunch. Amendments to IAS39 and IFRS7 dealing with derecognition of financial assets and related disclosures have been approved and will become effective this year.

As the table on the facing page shows, there are still numerous areas where differences between IFRS and US Gaap persist. There are also several longer-term projects to continue the harmonisation process. These cover aspects including:

* The measurement of fair value. The objective is to clarify the definition of fair value and to establish a single source of guidance for measuring it.

* Post-employment benefits. The boards intend to move to a common standard on this topic, but significant differences remain between their positions.

* Revenue recognition. The objective is to develop a single model that can be applied across industries and regions. This would improve the comparability of financial reporting information.

* Leases. A new standard may lead to the treatment of operating leases as an asset for the right to use an item, while also recognising the liability to make rental payments. A standard on this topic is not expected until 2011.

* Earnings per share. Both boards have reviewed proposed changes to the calculation of diluted EPS.

* Conceptual framework. To date, work has focused on the aims of financial reporting and the qualitative characteristics of reporting information.

It's clear, then, that the IASB and FASB have made significant strides towards their goal of producing compatible standards that are suitable for both domestic and cross-border financial reporting. While there is still some way to go and there are numerous obstacles to be negotiated, it seems that they will maintain their momentum over the coming years.

Three for the future

Candidates should note that the revised IAS1, IAS27 and IFRS3 won't be examined in this November's P8 paper, but they will become examinable in May 2010 under the new syllabus 

The examiner for P8 offers some hints and tips for maximising your marks in November's exam.

To revise effectively for the P8 exam you

must first consider the "learning outcomes" that the paper is designed to assess. They are as follows:

* Prepare consolidated accounts and explain the accounting principles associated with this area.

* Appropriately employ the relevant accounting standards. m Evaluate an entity's financial statements and analyse its performance.

* Discuss and evaluate current developments in external reporting.

CIMA provides indicative weightings to help you assess how much coverage each area will be given in any exam diet.

The consolidation and analysis of financial statements each account for 35 per cent of the syllabus, so it shouldn't come as a surprise to you that the exams reflect this every year.

Section A: group financial statements

Accounting for investments in consolidated accounts makes up 35 per cent of the syllabus. The learning outcome is all-encompassing and totally logical: you must be able to prepare the primary financial statements for a group of companies. The disclosures are not required in this paper, but a detailed knowledge of the primary financial statements--ie, the income statement, balance sheet, cash flow statement and statement of changes in equity--is essential.

The main adjustments in the balance sheet are likely to be for goodwill on acquisition and its subsequent impairment, minority interest and retained earnings. The main adjustment for preparing an income statement is the split between profit available for shareholders of the parent and profit attributable to minority interests. You will not be forgiven for not knowing these basic adjustments.

As well as the basic consolidation adjustments, there are numerous factors that can make the preparation of group accounts more complex. They include:

* Acquisitions in the period.

* Disposals in the period.

* Inter-company trading.

* Associated companies and joint ventures.

* Foreign subsidiaries and sub-subsidiaries.

The key to dealing with these complexities is to think about how they will affect the key consolidation adjustments and the elements within the group financial statements. Ask yourself: what headings in the income statement or balance sheet will be affected by this transaction/adjustment? And how will this transaction/adjustment affect the key consolidation calculations: goodwill, minority interest and consolidated retained earnings?

You can't predict which of these complexities you'll face in the exam, of course, but you can ensure that you are able to draft the basic calculations for the big three: goodwill, minority interest and group retained earnings.

This paper is designed to test your application of skills, so learning consolidation by rote is a dangerous game. By taking the time to understand the basic consolidation adjustments, you will have prepared yourself for adapting your knowledge to preparing the primary financial statements for the group.

Section B: the measurement of income and capital

The syllabus content for this section includes substance over form, profit measurement and asset valuations financial instruments and employee benefits. The weighting (about 20 per cent of each diet) requires me to include one or more of these areas in the exam and to ensure that the paper meets the second main learning outcome. Why, then, are students often unprepared for such questions when it's obvious that they will be asked?

The two areas that you need to be comfortable with here are initial recognition an(] measurement, and the rules for subsequent measurement. When you feel that you've studied them fully, ask yourself: do I know when this asset/liability/cost/ revenue will be included in the statements? And how it will be valued year on year?

You will be expected to classify financial instruments, record them and measure them according to that classification. You should be able to apply substance over form to a range of transactions, justifying your conclusion by referring to international guidance and making your answer specific by discussing each detail of the transaction provided in the question. The ability to make your answer specific to the scenario is the difference between "identify" and "apply". P8 is a test of practical skills, so few marks will be awarded for general accounting knowledge.

Section C: Analysis and interpretation of financial accounts

Traditionally, P8 candidates have been poor at analysis--surprising, given that they know it constitutes 35 per cent of the syllabus--although I have seen a significant improvement in recent exams.

Candidates are often required to read a scenario, study the financial information it provides, calculate some common ratios and comment on the company's performance etc. The key to scoring well on such questions without wasting valuable time is to focus on the most relevant information. Scan the financials to get a feel for the entity. Choose the most appropriate ratios to its situation--eg, is it raising external debt, mounting a takeover, considering an investment etc? You'll usually score one mark per pair of ratios, so don't waste time preparing pages of them. To ensure that your report meets the client's needs, ask yourself the following questions: would the recipient be happy to pay for my report? Have I addressed their main concerns? And have I highlighted the main features and risks of the entity?

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Higher-level skills are again being tested here, so it's important to be able to pinpoint the relevant factors and explain their impact on the entity. A colleague once said to me: "Students would score well in these questions if their reports contained the word 'because' repeatedly." She was right because that would signify that the candidates were not only identifying an issue but also discussing its effects.

An appreciation of the time scales implied by the scenario is also important. For example, there is little point in suggesting a share issue as the main solution if the business has a cash crisis and has breached its banking agreements. That could take months and the firm would have gone bust by then. Attaching schedules to your recommendations can add relevance and authenticity to your report.

Section D: developments in external reporting

This part carries a ten per cent weighting in the syllabus. Now that you're working towards being a professionally qualified accountant, it's important to keep abreast of significant technical changes in external reporting. The learning system covers the main ones, but you should also set aside some time to check for updates. Half an hour every month isn't a lot of time to dedicate to this, yet it would be so worthwhile. Use it to browse the IASB's web site (www.iasb.org) for new standards and news about the project to converge IFRS and US Gaap. Also look out for relevant articles in Financial Management and other CIMA publications.

If I had to give only one piece of advice to P8 candidates, it would be to attempt as many practice questions as possible. You will start to see a pattern in terms of how the various areas are tested and what skills you have to demonstrate in order to pass the exam. As Gary Player, one of golf's all-time greats, once said when a spectator shouted that he had been lucky to hole a difficult bunker shot: "Yes, it's amazing. The more I practise, the luckier I get."

P8 further reading

C Gowthorpe, Financial Analysis CIMA Official Learning System (2009 edition), CIMA Publishing, 2008.

Tony Sweetman is a content specialist with Kaplan Publishing and a tutor with Kaplan Financial in Glasgow.

Key remaining differences between IFRS and US Gaap

Topic                 IFRS/IAS               US Gaap

Inventory valuation   Lifo not permitted     Lifo permitted
Development costs     Capitalise when        Expensed
                        criteria met
Non-current assets    Historical cost or     Historical cost
                        valuation
Extraordinary         Prohibited             Permitted under
  items                                        specific
                                               circumstances
Joint ventures        Equity accounting or   Equity accounting
                        proportional
                        consolidation
Fair value            The value at which     Exit or disposal
                        the asset can be       value
                        exchanged in an
                        arm's-length
                        transaction