Toward global standards on consolidation and recognition.

This International Financial Reporting Standards section discusses another area where significant differences between United States generally accepted accounting principles and IFRS exist: global standards on consolidation and recognition.

As highlighted by the recent global financial crisis, assessing whether a financial asset or liability may be derecognized can be extremely difficult when dealing with complex structures. Thus, the complexity continues for multinationals that monitor both IFRS and U.S. GAAP.

Here, Eva K. Jermakowicz, Ph.D., CPA, professor of Accounting and head of the Department of Accounting and Business Law at Tennessee State University; and Homiyar Wykes, Group Financial controller for Stolt-Nielsen S.A, detail some differences.

--IFRS Section co-developers Cheryl de Mesa Graziano, CPA, vice president-Operations, Financial Executives Research Foundation, and Ellen Heffes, editor-in-chief, Financial Executive.

Responding to the recent recommendations of the Financial Stability Forum and conclusions of the Group of Twenty (G-20) Finance Ministers and Central Bank Governors leaders, the International Accounting Standards Board accelerated its projects on consolidation, derecognition and required disclosure for off-balance sheet activities. Since the derecognition of financial instruments often involves the use of special purpose entities, the projects on consolidation and derecognition are closely related.

Off-balance sheet treatment in financial reports can result from the standards for consolidation accounting (e.g. special purpose entities) or derecognition (e.g., removing assets from the balance sheet through securitizations). When dealing with complex structures such as special purpose vehicles used for the securitization of financial assets, assessing derecognition of such financial assets and liabilities becomes increasingly difficult.

Inconsistencies Add to Complexity

For companies that have to monitor both IFRS and U.S. GAAP, there are significant differences between the two sets of standards on consolidation and derecognition. Disclosure requirements relating to off-balance sheet activities also exist. Both IFRS and U.S. GAAP require the consolidation of entities by the reporting entity, which controls--directly or indirectly--the majority of voting rights.

But, IFRS and U.S. GAAP have different approaches to consolidation in certain situations when there are no voting rights, when potential voting rights exist or the voting rights are significantly disproportionate to the risks and rewards of the entity.

Under IFRS, consolidation is based on a "control" model; under U.S. GAAP, a "controlling financial interest" model. Unlike IFRS, de facto control is not a basis for consolidation under U.S. GAAP, and potential voting rights are not taken into account in assessing control for nonvariable interest entities.

For example, one current presumption in IFRS is that presently exercisable options or convertible instruments give control to the holder Further, U.S. GAAP until recently, had the concept of a qualifying special purpose entity Entities that met the definition were exempt from consolidation. There is no concept of a QSPE under IFRS.

In addition, certain transferred financial assets to parties other than QSPEs do not qualify for derecognition under IFRS, though they are derecognized under U.S. GAAP Transferred financial assets meeting the derecognition criteria are removed from the balance sheet; any consideration received--including retained interest, is recognized--and gains or losses from the sale of financial assets are recognized in income. As a result of these differences, companies that switched from U.S. GAAP to IFRS, reported significant impacts on their financial statements.

For example, Deutsche Bank Group and DaimlerChrysler AG (now "Daimler AG"), European firms reporting in accordance with U.S. GAAP, adopted IFRS in 2007. Transitioning to IFRS, Deutsche Bank consolidated 205 more entities as of Dec. 31, 2006 under IFRS than under U.S. GAAP Consequently, the consolidated group reported [euro]40 billion more total assets and [euro]40 billion more total liabilities under IFRS than under U.S. GAAP

The IFRS consolidated balance sheets of DaimlerChrysler as of Dec. 31, 2006 and 2005, reported receivables of [euro]21.7 billion and [euro]21.3 billion (primarily receivables from financing services), respectively, and liabilities of [euro]21.7 and [euro]21.3 billion (primarily financing liabilities), that were not presented in the balance sheet In accordance with U.S. GAAP.

But, the potential differences do not end there. In fact, they will evolve as a result of the 2006 and 2008 Memoranduums of Understanding between IASB and the U.S. Financial Accounting Standards Board. The MoUs included the consolidation project as well as the derecognition project among priorities within the boards' joint work program. The boards currently cooperate on those projects on an informal basis, but in the future they may decide to conduct the projects jointly.

FASB Response

Responding to the financial crisis and to address inconsistencies applied in practice, in June, FASB issued FAS 166, Accounting for Transfers of Financial Assets, and FAS 167, Amendments to FASB Interpretation No. 46(R). Statement 166 amends the derecognition guidance in Statement 140 and eliminates the exemption from consolidation for QSPEs.

Statement 167 amends the consolidation guidance applicable to variable interest entities. In the ED, prior to issuing the new statements, FASB explained that it viewed the proposed amendments as a short-term solution and that it intends to join IASB in producing a single standard on consolidation and on derecognition.

As a result of the Financial Stability Forum recommendations, last December IASB published Exposure Draft 10, Consolidated Financial Statements, which proposes a cohesive control-based model that would be applicable to all types of entities (including structured financing and investment vehicles, such as SPEs).

The proposed standard would replace IAS 27, Consolidated and Separate Financial Statements, (which focuses on control), and SIC-12, Consolidation--Special Purpose Entities, (which focuses more on risks and rewards), and eliminate perceived inconsistencies.

ED 10 proposes a revised definition of control, including additional application guidance and enhanced disclosures about consolidated and unconsolidated entities. It would require a greater level of judgment to be applied and result in changes in the composition of the consolidated group. Comments letters to IASB request making this project a joint project with FASB, with the goal of identical outcomes and aligning the timetables of the consolidation and derecognition projects.

Then, in March, IASB published ED (ED/2009/3), Derecognition: Proposed amendments to IAS 39, Instruments: Recognition and Measurement, and IFRS 7, Financial Instruments: Disclosures, which proposes to replace the existing guidance on derecognition of financial assets and financial liabilities and the related disclosures.

The proposed approach to derecognition is based on a single concept, "control, "as opposed to the complex current requirements in IAS 39 that combine elements of several derecognition concepts (risks and rewards, control and continuing involvement). Proposed amendments may bring significant conceptual change for derecognition of financial assets by removing analysis of risks and rewards, and could lead to significant changes in accounting for repurchase agreements and securities lending transactions.

In a comment letter to this ED, Canada's First National Financial LP reported its total assets as of March 31, 2009 are approximately CAD$1 billion and liabilities CAD$850 million, in accordance with Canadian GAAP Estimated proforma balance sheets, prepared in accordance with the ED, would report an increase in assets to more than CAD$35 billion (to 4 billion under the current IAS 39), which suggests a debt-to-equity ratio of approximately 235:1.

Similarly, the income statements would report over-inflation of revenue and expense and that, according to the chief financial officer, is not indicative of the nature of the company's operations and business plan.

As the U.S. contemplates IFRS, careful planning and consideration of the complexities and differences between consolidation and derecognition of liabilities is critical to avoid unwelcome surprises or higher debt due to consolidation of some long forgotten liability.