The Switch from US GAAP to IFRS - Implications for Analysis Involving Inventories

The Switch from US GAAP to IFRS - Implications for Analysis Involving Inventories Agatha E. Jeffers Mengyu Wei Sidney Askew Montclair State University Montclair State University Borough of Manhattan jeffersa@mail.montclair.edu weimi7978@yahoo.com Community College saskew@bmcc.cuny.edu ABSTRACT The SEC has proposed the full adoption of International Financial Reporting Standards (IFRS) by U.S. filers by 2014. In this study, an examination is undertaken of the previous assertions of Jeffers & Askew () that the switch from U.S. GAAP to IFRS will produce significantly different financial statement analysis and inventory valuation results. We also examine the assertions made by the International Accounting Standards Board (IASB) that IFRS is superior to U.S. GAAP with regard to IFRS being a more accurate predictor of market risk based accounting measures and expectations as well as the assessment of a company s liquidity, financial stability and strength. Our findings indicate that IFRS will indeed produce different inventory valuation results that may appear to be superior to those provided under GAAP. Keywords IFRS, U.S. GAAP, SEC, Accounting valuation,,, Average Cost, Income Taxes, Financial statement analysis, Profitability, Liquidity, Utility, Solvency, Market-based ratios, Market-risk, Stability, Financial strength and Cash Flows. 1 INTRODUCTION One of the most important policy initiatives currently faced by the SEC is the consideration whether to require or permit U.S. based companies to use International Financial Reporting Standards (IFRS) in the very near future. The SEC has proposed the full adoption of IFRS by U.S. filers by 2014. The selling point of adapting IFRS is that it may provide better financial reporting and financial statement data than U.S. GAAP. The International Accounting Standards Board (IASB) has claimed that IFRS could offer comparability to investors in the international financial markets and provide flexibility to managers since IFRS is principles-based rather than rules-based as under GAAP (Niemeier, 2008). There are several significant differences between IFRS and U.S. GAAP worthy of identification in order to better understand the underlying implications of switching from U.S. GAAP to IFRS. One important change to U.S. accounting standards would be the elimination of the Last-in First-out () accounting method for inventory. Under U.S. GAAP, companies are allowed to choose among the,, and average cost methods for inventory valuation. However, under IFRS, is prohibited. Based upon research of Georgia Tech s Financial Analysis Lab, approximately 36% of U.S. companies presently use for at least a portion of their inventories (Fink, 2008). Given the timetable proposed by the SEC, a movement from current U.S. GAAP to IFRS would present important implications for financial statement analysts and auditors. In this study, an examination is undertaken of the previous assertions of Jeffers & Askew () that the switch from U.S. GAAP to IFRS will produce significantly different financial statement analysis and inventory valuation results. We also examine the assertions made by the International Accounting Standards Board (IASB) that IFRS is superior to U.S. GAAP with regard to IFRS being a more accurate predictor of market risk based accounting measures and expectations as well as the assessment of a company s liquidity, financial stability and strength. 2 INVENTORY TREATMENT: DIFFERENCES BETWEEN IFRS & U.S. GAAP The root differences between IFRS and U.S. GAAP regarding inventory reporting are the valuation methodology and inventory treatment. IFRS does not allow the use of in determining the cost of inventory. Instead, IFRS opts for the use of and average costing. However, U.S. GAAP prominently allows and it also gives the choice to use the or average inventory costing method. under U.S. GAAP (See Chart 1: ) During periods of inflation, companies using under U.S. GAAP transfer the higher cost of goods sold to the income statement to match sales revenues in the current period. As a result, produces a lower gross profit and net income. It also provides a lower base for income taxes. Companies which use are also required to disclose the Accounting, Law & Taxation Page 48

difference between inventory and inventory. The amount of this difference is called the reserve. Further, may not be a good indicator for the value of ending inventory because the reserve may be comprised of layers attributed to extremely old and perhaps obsolete inventory. Therefore, the ending inventory balance on the balance sheet using may not be a true representation of a firm s investment on its inventories. $4 $3 $2 $1 Chart 1: Cost at $5 Cost of Goods Sold under IFRS (See Chart 2: ) Conversely, firms using will report a lower cost of goods sold in the income statement because the costs of inventories that might be several years old and hence cheaper are assigned to cost of goods sold first, thus creating a higher gross profit, net income and income taxes. Unlike, provides a better indication of the true value of ending inventory on the balance sheet since the value is closer to the current market value of newly purchased inventory. $5 $4 $3 $2 Chart 2: Cost at $1 Cost of Goods Sold Switching From under U.S. GAAP to under IFRS Switching from to requires various adjustments on the balance sheet and income statement. These changes need to occur retrospectively to maintain consistency throughout the financial statements. When a based company discloses the reserve, a firm can then derive the adjustments required on the balance sheet and income statement. The following four adjustments on the balance sheet are necessary (Bloom, Robert, and Cenker, 2009): ustment # 1 1 The ending inventories of under = IFRS Reported inventory under U.S. GAAP + reserve 2 Increase of income tax payable =1/4* reserve * Tax rate (Assuming extra tax payment spreading over four years) 3 Increase of Deferred tax payable = 3/4* reserve * Tax rate 4 Retained earnings = Reported retained earning under U.S.GAAP + [ reserve * (1-Tax rate)] The result of switching is: (1) an increase in the ending inventory; (2) an increase in current income taxes because of an increase in income, and (3) an adjustment to retained earnings from the increase in net income. Based on Revenue Procedure 2008-52, section 5.04, if the cumulative effect of the change from to under IFRS increases the company s tax liability, the increase of income tax may be taken into account over four years beginning with the year of the change. Therefore, one-fourth of increased tax would be treated as a current liability (Bloom, Robert, and Cenker, 2009). After the switch, cost of goods sold will be lower, and the gross profit and net income will be higher. A change to can have a significant positive income effect because the accumulated costs in prior years in beginning inventory will replace the cost of goods sold valued at current costs (Bloom, Robert, and Cenker, 2009). The following one adjustment on income statement is possible: Cost of Goods Sold under = Cost of Goods Sold under reserve For the year of change, gross profit would increase by the entire amount of the reserve and net income will finally rise by the reserve * (1- tax rate). The Accounting, Law & Taxation Page 49

following examples show the impact of these changes: Example #1: ABC Company using the method reports the reserve at $10 million in. The decision to voluntarily adopt IFRS in will eliminate the use of. Assuming the income tax rate is 35%, ABC must restate inventory from to for its balance sheet and income statement. The following adjustments will be shown on ABC s balance sheet for : ustment # 2 Balance Sheet of ABC Company In Million $s Assets Reported Inventory Debit Credit 80.00 10.00 90.00 Total Assets 80.00 90.00 Liabilities Income tax Payable 3.00 0.88 3.88 Deferred tax payable 12.00 2.63 14.63 Equity Retained Earnings 65.00 6.50 71.50 Total Liab & Equity 80.00 90.00 The following adjustments will be shown on ABC s balance sheet and income statement for : ustment # 3 Income Statement of ABC Company In Million $ Debit Credit Sales Revenue 100.00 100.00 Cost of Goods Sold 50.00 10.00 40.00 Gross Profit 50.00 60.00 Operating Expense 20.00 20.00 EBIT 30.00 40.00 Income tax 10.50 3.50 14.00 Net Income 19.50 6.50 26.00 3 THE IMPACT OF SWITCHING TO IFRS ON TAX LIABILITY & CASH FLOWS As noted earlier, one third of U.S. companies choose to use to value inventory since usually creates a lower taxable income than other inventory costing methods. Firms facing relatively lower taxable income can invest tax savings into the operations of the business. Hence U.S. companies would reduce their need to borrow and incur additional financial costs (Gibson, 2002). However, U.S. companies who adopt IFRS will have to change from to either the or average cost methods. The decision to change can lower operating cash flows by increasing current tax payments and future tax liabilities. Example # 2: In, ABC Company receives cash revenues of $90 million and pays $50 million for new inventories. ABC has a 10% tax rate before switching to IFRS. The impact on cash flows is as follows: The Cash Flow ct In Million $s Cash from Sales 90.00 90.00 Cost of new inventory -50.00-50.00 Operating expense -20.00-20.00 Cash income tax (10%) (1) -3.00 (2) -5.16 (3) Net income in Cash 17.00 14.84 Cash income tax = EBIT x Cash tax rate Cash income tax under = 30 x 10% Cash income tax under = 40 x 12.9% When the SEC finalizes its decision to adapt IFRS, U.S. companies will be subjected to possible sizable tax consequences. The tax effect is due in part to the difference in cost of goods sold reported under when compared to that of. For example, under, a corporation matches sales with the higher priced inventory first, thus reducing income and the related tax liability. In contrast, under, a corporation matches sales with the first and often lower priced inventory. As noted above, ABC s total tax liability and current tax payable would increase by 33.33% and 29%, respectively when it changes to. Since income tax payable is a current liability, the tax rate will rise approximately 29% after switching to under IFRS. The new tax rate after the adjustment will be 12.9%. 4 IMPLICATIONS OF THE SWITCH ON VARIOUS Accounting, Law & Taxation Page 50

RATIOS For many companies, a large portion of assets is inventory, and it makes up an important part of the balance sheet (Brinlee, 2009). Hence, over the long term, because prices tend to increase, the switch of inventory valuation method can dramatically affect valuation ratios. Many lenders rely on ratios involving inventory and/or current assets to evaluate a company s liquidity and financial stability prior to issuing credit. Therefore, the adoption of IFRS will undoubtedly influence the evaluation of borrowing money and borrowing costs especially since creditors are concerned about the financial strength of the balance sheet. Based on the effe created on financial reports, under U.S. GAAP, and under IFRS will cause the various ratios to produce significantly different results. Profitability Ratios Since under, the last or more recent purchases are assigned to cost of goods sold first, the method will provide the most recent or highest value for cost of goods sold. Conversely, cost of goods sold under is based on the first or early purchases which are lower during periods of rising prices. Therefore, produces lower gross profit and net income than. Since the gross margin, net income, and earnings per share are lowest under, companies save taxes when using. On the balance sheet, however, since the value of ending inventory under is based on the earlier or lower prices, current assets under are lower when compared to. Given the higher the ratio, the more cash the company has available to invest in their organization, the overstated cash return on assets ratio could mistakenly signal that a higher return can be expected. When switching to under IFRS, a company records the costs of inventory which are several years old as the cost of goods sold. Thus it generates lower cost of goods sold, higher gross profit and net income. As a result, gross margin, profit margin, and earnings per share will be higher and overstated. These numbers imply the higher levels of profitability. However, gives a more accurate value of the ending inventory because inventory is valued at the most recent costs. On the other hand, since higher taxable income under bring the higher tax liability and cash tax payment, cash flow from operation declines, and the cash return on assets ratio is understated, which could indicate that a lower return will be expected since the company has less cash available to reinvest. Example # 3: Using information from the same example of ABC Company, we can calculate various profitability ratios assuming the following: Assets (not including inventory) Current assets (not including inventory) Current liability Total liability Common Stock Outstanding common shares Annual dividends per share $0.50 The profitability ratios will be as follows: Mea sure Switching $400 million $260 million $120 million $315 million $100 million $10 million Change GM 0.5 U 0.6 O Inc 20.00% F PM 0.195 U 0.26 O Inc 33.33% F EPS 1.95 U 2.6 O Inc 33.33% F CRA 0.035 O 0.030 U Dec -14.49% U Gross margin (GM); Profit margin (PM); Earnings per share (EPS); Cash return on Assets (CRA); Understated (U); Overstated (O); Increase (Inc); Decrease (Dec); Favorable (F); Unfavorable (U). From the ratios calculated, after switching to under IFRS, profitability ratios could improve, and the overall profitability picture of the firm improve, although cash return on assets decrease slightly. Liquidity Ratios As inflation raises prices in the economy, under inventory method, the layers left over within inventory account could be very old because layers of inventory with current costs transfer as cost of goods sold are matched sales revenue when inventory is sold. As a result, the ending inventory amount will be understated under, and it is not an accurate representation of the actual flow of physical items through inventory. This fact could indicate that current assets of the company using under US GAAP will be understated as well. Since the current ratio is equal to current assets over current liability, this ratio will be understated under. The higher the current ratio, the more capable the company is of paying its short-term obligation, this understated ratio could be inaccurate to imply that the firm is in the less favorable position regarding to its liquidity and financial health. For the same reason, working capital under could also be understated which would not be a good indicator for the company s underlying operational efficiency. However, tax saving from using method will increase cash flows from operations. Therefore, operating cash flow ratio is higher under. Accounting, Law & Taxation Page 51

Under, as the older and cheaper goods are sold, the more expensive and newer goods remain as ending inventory on the company s books. Having the higher valued inventory on the company s balance sheet will increase current assets. So the current ratio and working capital will be greater under which could mean that the firm has a greater capacity to manage its short-term liabilities. The company may receive a more favorable evaluation for its liquidity and financial health. Although it has the doubt to be overstated, and still not to be an appropriate indicator for operational efficiency, the number is the more accurate value to reflect the company s reality, comparing with the one under. On the other hand, as the lower cost of goods sold under causes the higher taxable income as well as the greater cash tax amount, the lower cash flows from operations will create the lower operating cash flow ratio. This could imply that the company s liquidity is not as desirable and flexible. Example # 4: Using the information from ABC Company, various liquidity ratios could be calculated as follows: Liquidity Ratios Measu re Switching Change CR 2.764 U 2.825 O Inc 2.21% F WC 227 U 226.1 3 O Inc 4.21% F OCF 0.138 O 0.120 O Dec -13.32% U Where CR = Current ratio; WC = Working Capital; OCF = Operating cash flow ratio. From the ratios calculated above, it is easy to see that after switching to under IFRS, most of the liquidity ratios increase in a favorable direction. Although the improvements are not huge, they may still increase the chances of getting a loan from creditors. Utility Ratios As previously discussed, under, cost of goods sold is determined by the last and usually higher priced purchases, and ending inventory is valued by the first and usually lower priced purchases. Therefore, the inventory turnover ratio is dramatically under when compared to. This ratio could be misleading to gauge the number of times a company sells its inventory. This higher or arguably overstated inventory turnover ratio could misleadingly indicate that the product is selling well. Since inventory could be a significant portion of a company s total assets, the understated inventory values will cause an understatement of total assets as well. As a result, the asset turnover ratio is overstated. This higher asset turnover ratio might be interpreted that the company has a good condition for efficiency at using its assets in generating sales. Also as previously discussed, gives a more accurate value of inventory, and bolsters the company s balance sheet. However, cost of goods sold is understated under since the older and cheaper layers of inventory are transferred to cost of goods sold. As a result, the inventory turnover ratio will be understated. This understated or lower inventory turnover ratio could indicate that inventory turnover is declining and sales are not as strong as expected. Because provides a more accurate valuation for the inventory balance and the total asset amount is close to a more precise value, total asset turnover could give a more realistic picture about the company s efficiency in creating revenue. Example # 5: Using the information from ABC Company, various utility ratios could be calculated as follows: Utility Ratios Accounting, Law & Taxation Page 52 Measu re Inv Turn Switching Change 0.625 O 0.444 U Dec - 28.89% TAT 0.208 O 0.204 More accurate Dec, not obvious U -2.04% SU Where Inv Turn = Inventory turnover ratio; TAT =Total Assets Turnover ratio; MA = More Accurate; SU = Slightly Unfavorable. From the ratios calculated above, we can see that after switching to, the utility ratios declined. On the one hand, the dramatic decline in the inventory turnover ratio could impact the assessment of the company s efficiency in turning inventory into sales. On the other hand, the small decline in the total asset turnover ratio is less significant in this instance. Therefore, the evaluation of the company s efficiency to utilize its assets will not be affected significantly because of switching. Solvency Ratios Under, since prices generally will rise over time because of inflation, this method will record the sale of the most expensive inventory first, and thereby decreases net profit as well as reducing taxes. Retained Earnings is understated because of the lower net income as well as the value of equity on the company s balance sheet. So the debt to equity ratio, perhaps the most important solvency ratio, becomes overstated. It could be misleading for this ratio to

show that the company has been more aggressive in financing its growth with debt when in fact this is not the case. Since total assets under are understated due to the lower value for inventory, the debt to total asset ratio is overstated as well. Companies with higher solvency ratios will place themselves at risk because a higher ratio could mean a highly debt leveraged firm. Creditors may get worried and demand that the company pay some of its debt back. In general, these two ratios could reflect a company s leverage level. The overstated ratios can result an inaccurate interpretation in volatile earnings because of the additional interest expense. However, for the solvency ratio, it is understated since it is equal to (after tax net profit + depreciation) over (long term liability + short-term liability), and after tax net profit is understated because of the overstated cost of goods sold. The solvency ratio provides a gauge about how a company will meet its debt obligations. The understated solvency ratio will be easily interpreted by creditors as increasing the probability that the company will default on its debt obligations. Using, in an economy of rising prices, will match the less expensive inventory to sales first, and thereby increase net profit and taxes. The balance of equity on the balance sheet is overstated while the amount of retained earnings is also overstated by the higher net income. So the debt to equity ratio is understated. This could indicate that the company is in a better position to finance its assets by debt. Because the value of inventory under has a more precise number, the value of total assets under is more accurate. The debt to total asset ratio will be a good indicator for the company s leverage condition. However, the solvency ratio will be overstated since after tax net profit is higher under than under. The higher ratio could become a positive sign to let creditors believe that the company has less of a chance to encounter problems on meeting its debt obligations. Market Measures In this case, we picked the dividend payout ratio to test the effe of switching from to under IFRS. Under, since the dividend payout ratio is equal to the yearly dividend per share over earning per share, it is a higher number under because of the understated earning per share. This overstated ratio could mean that a higher fraction of the firm s net income is paid to stockholders in dividends. Investors who prefer high current income and limited capital growth would prefer the switch. Under, earning per share is overstated because of the lower cost of goods sold. So the dividend payout ratio is lower which could indicate that a higher part of earning is left for reinvestment to create for future growth. Investors seeking capital growth may prefer this lower payout ratio. Example # 6: Using the information from same example of ABC Company, various solvency ratios and market measures could be calculated as follows: The profitability ratios will be shown as follows: Measure Accounting, Law & Taxation Page 53 Switchi ng Change D/E 1.909 O 1.857 U Dec -2.72% F D/TA 0.656 O 0.650 MA Dec -0.95 F Solvency 0.062 U 0.082 O Inc 31.87% F Div Payout 0.256 Higher 0.192 Low er Dec -25.00% F Where D/E=Debt to Equity; D/TA = Debt to total assets; MA = More Accurate. 5 IMPLICATIONS OF FINDINGS From the ratios previously calculated, it is clear that after switching to, all of the solvency ratios and market measures changed favorably. In particular, the debt to equity ratio and the solvency ratio improved significantly. According to Derstine and Huefner (1974), the dividendpayout ratio is negatively related to a company s market risk. The decreased ratio after switching to will reduce the expectations of market risk, especially while using accounting risk measures. In addition, financial leverage ratios such as debt to equity and debt to total assets have a positive relationship with market risk, based on Derstine and Huefner (1974). Therefore, decreasing the financial leverage ratios could lower the prediction of market risk in the desirable direction. Furthermore, all favorable effe of solvency ratios and market measures after switching could verify the conclusion reached by Elgers and Murray (1984) that based accounting risk measures are able to improve the quality of market based prediction of systematic market risk, while the -based ratios do not offer such improvements. Based on our analysis and examples discussed above, we can easily see that a company will gain the beneficial impact on the aspe of profitability, liquidity, solvency, and market measures in ratio analysis while switching to under IFRS. Predictions of market risk based on accounting risk measures will be superior to market based expectations after making the switch from to for inventory costing and valuation. In general, assessment of the company s liquidity, financial stability and strength will be presented in a more desirable picture. Does IFRS provide better financial reporting and financial data than U.S.GAAP? Based on the effe emanating from

the switch in inventory methods, we could confirm the findings of Jeffers and Askew () that the switch to IFRS will produce significantly different financial statement analysis and inventory valuation results. We also could conclude that the IFRS framework provides a flexible and high quality method for financial reporting, which allows business entities to provide relevant information about its financial position and performance to shareholders and the public. Moreover, IFRS users will discover that in some cases IFRS provides more flexibility than U.S. GAAP. This is because some International Accounting Standards (IAS) permits corporations to select between two alternatives treatments in accounting for specific items such as inventory valuation methods. Aside from this flexibility, the use of IFRS can be more advantageous than U.S. GAAP for business entities especially for international enterprises on valuation assessment. For these reasons, we feel that IFRS could be a better method for reporting financial data and producing financial statements. 6 CONCLUSION From our analysis, we confirm the findings of Jeffers and Askew () that the switch to IFRS will produce significantly different financial statement analysis and inventory valuation results. We were also able to verify the conclusion reached by Elgers and Murray (1984) that based accounting risk measures are able to improve the quality of market based prediction of systematic market risk, while the -based ratios do not offer such improvements. Hence, we conclude that IFRS accounting standards may possibly present a fairer concept of reporting of financial information than under U.S. GAAP. Our findings in this paper regarding the switch from to can be of considerable benefit to investors, creditors and other financial statement users in the U.S. as well as in the international capital markets and could lead to better informed decision making. REFERENCES Boehlje, M.. Economic Profit Model. Retrieved on February 10. Available at: http://www.agecon.purdue.edu/extension/sbpcp/resources/ creatingvalue.pdf Bloom, R., and W. J. Cenker. 2009. The death of? Journal of Accountancy. January. Available at: http://www.journalofaccountancy.com/issues/2009/jan/de athof Brinlee, D. 2009. versus accounting. Inventory Management. Retrieved on January 26,. Available at: http://www.askdeb.com/inventorymanagement/accounting/fifo-lifo/ Colias, C. 2009. Ernst & Young Roundtable: IFRS. Journal of International Taxation 20 (5): 18. Deloitte, LLC. 2009. Summaries of International Financial Reporting Standards. Retrieved on November 27, 2009. Available at: http://www.iasplus.com/standard/ias02.htm Derstine, R., and R. Huefner. 1974. -, accounting ratios and market risk. Journal of Accounting Research 12 (2): 216-234. Durant, M. 1999. Economic Value Added: The Invisible Hand at Work. Credit Research Foundation. Available at: www.crfonline.org/orc/pdf/ref8.pdf Elgers, P., and D. Murray. 1984. -, accounting ratios and market risk: a re-assessment. Journal of Business Finance & Accounting 11(3):313-325. Economic Value Added Method. Retrieved on November 27, 2009. Available at: http://www.valuebasedmanagement.net/methods_eva.html Fink, R. 2008. IFRS suction could mean thinner cash flows, fatter tax bills. Financial Week. December 22. Available at: http://www.financialweek.com/article/20081222/reg/812 229977/1028/MA Gibson, S.C. 2002 (updated). vs. : a return on the basics. RMA Journal: 23-25. Investopedia.com. Inventory valuation for investors: and. Retrieved on November 27, 2009. Available at: www.investopedia.com Jeffers, A., and S. Askew.. Analyzing financial statements under IFRS opportunities & challenges. National Business & Economic Society (NBES) Annual Conference Official Proceedings, Kauai, Hawaii, March 10-13,. Niemeier, C.D. 2008. Keynote Address on Recent International initiatives 2008 Sarbanes-Oxley, SEC and PCAOB Conference, September 10. Public Company Accounting Oversight Board. White IV, W.C. 2009. The conundrum: Convergence of US GAAP with IFRS and its implication on US company competitiveness. QFINANCE. Available at: http://www.qfinance.com/contentfiles/qf01/g4fqn4jz/10/ 0/the-lifo-conundrum-convergence-of-us-gaap-with-ifrsand-its-implications-on-us-company-competitiveness.pdf Accounting, Law & Taxation Page 54

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