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International standards for Small and Medium-Sized Entities: analyzing the IASB exposure draft.

On February 15, 2006, the International Accounting Standards Board (IASB) issued for public comment the exposure draft (ED) of its International Financial Reporting Standard (IFRS) for Small and Medium-Sized Entities (SME). The stated aim of the proposed standard is to provide a simplified, self-contained set of accounting principles derived from the full IFRS to be used by smaller, nonlisted companies. If this proposal is adopted, the full IFRS would become primarily of interest for listed companies, although SMEs could make reference to the more expansive set of standards as necessary or desirable.

The perceived need for a standalone set of simplified standards has become increasingly manifest in recent years, and FASB is also weighing development of such a streamlined group of financial reporting requirements. This latest development follows by about a decade a similar undertaking in the United Kingdom, where Financial Reporting Standards for Smaller Entities (FRSSE) have been successfully implemented.

Responses to the Proposal

The support for the IASB's project from national accounting standards setters throughout the world stems mostly from the widely perceived complexity of the full IFRS, and from the different statutory requirements for financial reporting in many countries, compared to the United States. The complexity of the full IFRS (or, for that matter, full U.S. GAAP) imposes a high cost of implementing and applying these standards. In addition, in most countries, in contrast with the United States, SMEs are legally required to file statutory financial statements prepared in accordance with national GAAP, and to make them available to all users. For example, in the European Union about 7,000 listed companies were implementing the IFRS in 2005, but more than 5 million SMEs have to prepare their financial statements in accordance with national GAAP (resulting in a lack of comparability). Additionally, many believe that the IFRS for SMEs would allow companies as well as countries an easier transition to the full IFRS.


Some commentators do not support the approach taken in the development of IFRS for SMEs (or private companies). They argue that, rather than simply streamlining existing standards, the IASB should have taken a user-based, more conceptual approach in creating "differential accounting" for SMEs. They insist that fundamental differences exist between the objectives of financial reporting for SMEs (being primarily focused on the role of stewardship) and those of reporting by large public companies, and that these differences should be incorporated into the conceptual framework.

Opponents of a separate set of standards for SMEs believe that all entities should follow the same basic accounting principles for the preparation of general purpose financial statements, whether the IFRS or U.S. GAAP. Some have noted that complexity in accounting is merely a symptom--the inevitable result of the ever-increasing complexity of transactional structures, such as the widespread use of "engineered" financial products. Based on observations of the difficulties faced by companies implementing and applying the full IFRS, others have concluded that the problem is not that SMEs need simpler accounting, but that all entities need reporting requirements that are less complex and more principles-based.

In addition, some opponents note that SME standards would adversely affect accounting education, by shifting the focus from preparing professionals to choose the best means of reporting the economic effects of any given transaction or event, to merely following what the "single solution" rulebook says. A worst-case scenario result would be a two-tiered accounting

profession, wherein some practitioners would be seen as capable of handling only "little GAAP" assignments.

Because the IASB lacks the power to require any company to use its standards, the adoption of IFRS for SMEs will be a matter for each country to decide; that is, a country's government legislators and regulators, an independent standards setter, or a professional accountancy body. Each country will have to set criteria to determine eligibility.

Definition of SMEs

After debate over the appropriate threshold criteria, the IASB determined that the proposed standard should be intended for entities that do not have public accountability. An entity has public accountability--and therefore should use the full IFRS--if it meets the following conditions: 1) It has issued debt or equity securities in a public market; or 2) it holds assets in a fiduciary capacity for a broad group of outsiders. The latter category of entity would include banks, insurance companies, securities broker/dealers, pension funds, mutual funds, and investment banks. The proposed standard does not impose a size test in defining SMEs, notwithstanding the nomenclature used.

Modifications of Full IFRS Reflected in the Exposure Draft

Compared to the full IFRS, the length of this proposed standard has been reduced by more than 85%. This was achieved by eliminating topics deemed to be not generally relevant to SMEs, by eliminating certain choices of accounting treatments, and by simplifying methods for recognition and measurement. These three sets of modifications to the content of the full IFRS, discussed below, respond to both the needs of users of SMEs' financial statements and to cost-benefit concerns. According to the IASB, the set of standards in the proposed IFRS for SMEs would be suitable for a typical enterprise having 50 employees, but would also be valid for so-called micro-entities having only a single employee or a few employees.

Omitted topics. Certain topics covered in the full IFRS were viewed as not relevant to typical SMEs (e.g., pertaining to transactions thought unlikely to occur in an SME context), and have been omitted in the ED. Because SMEs would have the option of applying a cross-reference to the relevant IFRS if needed, SMEs would not be precluded from applying any of the financial reporting standards and methods currently found in the IFRS. In other words, use of IFRS for SMEs would effectively be optional.

Topics addressed in the full IFRS that are omitted from the proposed IFRS for SMEs, with cross-references to the full IFRSs if needed, are as follows:

* General price-level-adjusted reporting in a hyperinflationary environment;

* Equity-settled, share-based payment;

* Determining the fair value of agricultural assets;

* Extractive industries;

* Interim reporting;

* Lessor accounting finance leases (finance lessors are likely to be financial institutions, which would be ineligible to use IFRS for SMEs);

* Recoverable amount of goodwill (SMEs would test goodwill for impairment much less frequently, but if an SME is required to perform such a test, it must follow IAS 38, Intangible Assets); and

* Earnings per share, segment reporting, and insurance contracts (insurers would not be eligible to use proposed IFRS for SMEs, because they hold assets in a fiduciary capacity for a broad group of outsiders).

Only the simpler option. Where the full IFRS provides an accounting policy choice, only the simpler option is included in the proposed IFRS for SMEs. SMEs would be permitted to use the other options, obtaining needed guidance by cross-reference to the relevant IFRS. Because most of the underlying principles incorporated into the full IFRS would be retained, the same interpretation and application issues are likely to arise when applying these standards.

The simpler options selected for inclusion in IFRS for SMEs are as follows:

* The cost-depreciation model for investment property (fair value through profit or loss is permitted by reference to IAS 40, Investment Property).

* The cost-amortization-impairment model for property, plant, equipment, and intangibles (the revaluation model is allowed by references to IAS 16, Property, Plant and Equipment, and IAS 38, Intangible Assets).

* Expensing of borrowing costs (capitalization allowed by reference to IAS 23, Borrowing Costs).

* The indirect method for reporting operating cash flows (the direct method permitted via reference to IAS 7, Cash Flow Statements).

* One method (based on IAS 41) of accounting for all government grants (the use of any of the alternatives in IAS 20, Accounting for Government Grants and Disclosure of Government Assistance, is allowed).

Note that, even if the draft standard is adopted, it would remain up to each jurisdiction to mandate what financial reporting methods would be permitted. Thus, in adopting the proposed IFRS for SMEs, an individual jurisdiction could decide to proscribe an option that is cross-referenced in the full IFRS.

Recognition and measurement simplifications. The IASB proposed significant simplifications to the recognition and measurement principles included in the full IFRS. This area is perhaps the most controversial aspect of the proposal, because earlier attempts at simplification (e.g., omitting earnings per share and segment data for private reporting entities under both the IASB and FASB standards) have been directed only at differential disclosures.

Examples of the proposed simplifications to the recognition and measurement principles found in the IFRS are as follows:

* Financial instruments.

** Classification of financial instruments. Only two categories of financial assets are provided, rather than the four found in the full IFRS. Because available-for-sale and held-to-maturity classifications under IAS 39 would not be available, there would be no need to deal with all of the "intent-driven" held-to-maturity rules or related "tainting" concerns, and no need for an available-for-sale option, among other simplifications.

** Derecognition. In general, the principle to be applied would be that, if the transferor has any significant continuing involvement, derecognition would not be permitted. The IASB believes that the complex "pass-through testing" and "control retention testing" of IAS 39, Financial Instruments: Recognition and Measurement, relate to transactions in which SMEs are typically not engaged, and thus can be omitted.

** Simplified hedge accounting. The ED includes simplified hedge accounting and less strict requirements for periodic recognition and measurement of hedge effectiveness than IAS 39.

* Goodwill impairment. An indicator approach would supersede the mandatory annual impairment calculations in IFRS 3, Business Combinations.

* R & D. All research and development costs would be expensed as incurred. IAS 38 requires capitalization after commercial viability has been assessed.

* Joint ventures. The cost method of accounting for associates and joint ventures would be used, rather than the equity method or proportionate consolidation.

* Simplified accounting for deferred taxes. The "temporary difference approach" for recognition of deferred taxes under IAS 12, Income Taxes, is proposed.

* Agriculture. The ED would not require the use of fair value for agriculture unless it were readily determinable without undue cost or effort.

* Defined benefit plans. Only one option of the four available under IAS 19, Employee Benefits, would be used: the recognition of actuarial gains and losses in full in the profit and loss statement when they occur. The complex "corridor approach" would be omitted.

* Share-based payment. The intrinsic-value method is prescribed.

* Finance leases. Simplified measurement of a lessee's rights and obligations.

* First-time adoption. Less prior-period data would have to be restated than under the IFRS 1, First-time Adoption of International Financial Reporting Standards.

Because under IFRS for SMEs the pro-posed default accounting treatment for financial instruments would be fair value on the profit and loss statement, some users of SME standards might actually be required to apply more fair-value measurements than those reporting under the full IFRS.

Other Issues

In addition to the explanations of SME reporting requirements in the body of the ED, disclosure requirements have been comprehensively set forth in the Draft Implementation Guidance: Illustrative Financial Statements and Disclosure Checklist.

SMEs have expressed concerns not only over the complexity of the IFRS, but also about the frequency of changes to standards. To respond to these issues, the IASB intends to update IFRS for SMEs approximately once every two years via an omnibus standard. Users are thus being assured of having a moderately stable platform of requirements.

The ED posed 12 questions and invited comments to be submitted to the IASB in writing no later than October 1, 2007. During the exposure period, the IASB conducted roundtable meetings with SMEs and small firms of auditors to discuss the proposals. It also conducted field tests and field visits on the proposals in the ED. Enactment of the standard is expected in mid-2008.

Implications of IFRS for SMEs

The exposure draft IFRS for SMEs is a significant development that may have a real impact on the future accounting and auditing standards issued by organizations participating in the standards-setting process.

On March 6, 2007, FASB and the AICPA announced that a newly established Private Company Financial Reporting Committee (PCFRC) will address the financial reporting needs of private companies and the users of their financial statements. The primary objective of the PCFRC will be to help FASB determine whether and where there should be specific differences in prospective and existing accounting standards for private companies.

The International Federation of Accountants (IFAC) strongly supports the IASB's project on SMEs. At its meeting in New York City on February 26, 2007, the IFAC board agreed to assist the IASB in obtaining feedback on its proposed IFRS for SMEs through field testing and other means.

The Australian Accounting Standards Board (AASB), the Institute of Certified Public Accountants of Ireland, and the U.K. Accounting Standards Board have strongly supported the IASB publication of the exposure draft IFRS for SMEs. The AASB tentatively decided that Australia should adopt a two-tiered approach in relation to Australian corporate entities, as follows:

* Australian equivalents to the IFRS will be required for corporations that are publicly accountable; and

* An Australian version of IFRS for SMEs will be adopted by corporations that are not publicly accountable but that prepare general-purpose financial reports.

In many European countries, a close link exists between the statutory financial statements and the results reported for income tax purposes. The successful implementation of SME standards would require breaking the mandatory link between the financial statements and the income tax return, and would also trigger a need to amend the country's applicable laws.

Because it is imperative that international convergence of accounting standards be accompanied by international convergence of audit standards, differential accounting for SMEs would affect regulators such as the Public Company Accounting Oversight Board (PCAOB) and SEC. The ultimate success of IFRS for SMEs will depend on the extent to which users, preparers, and their auditors believe the standards meet their needs.

Barry Jay Epstein, PhD, CPA, is a partner in the Chicago firm of Russell Novak & Company, LLP. Eva K. Jermakowicz, PhD, CPA, is a professor of accounting and the chair of the department of accounting and business law at Tennessee State University, Nashville.

Note: Epstein and Jermakowicz are the coauthors of Wiley IFRS 07: Interpretation and Application of International Financial Reporting Standards (book and CD-ROM set, Wiley).
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Title Annotation:international accounting
Author:Epstein, Barry Jay; Jermakowicz, Eva K.
Publication:The CPA Journal
Date:Oct 1, 2007
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