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"Convergence Doesn't Necessarily Mean the Same."

The IASB and FASB are hoping to write accounting principles that match up word-for-word. But the devil may be in the rules governing implementation. Here are two examples.
Marie Leone, CFO.com | US
November 5, 2009

The world's two most influential accounting rulemaking organizations sat down for a joint meeting last week to figure out how to resolve persistent differences in their standards. What's interesting, say experts, is that while the International Accounting Standards Board and the Financial Accounting Standards Board are working to craft identical accounting principles, differences in the rules governing the implementation of those principles remain.

"Convergence doesn't necessarily mean the same," says D.J. Gannon, a Deloitte audit partner and the firm's expert on international financial-reporting standards. In fact, Gannon says, there is no expectation that any of "the lingering differences" between rules that are already converged will be handled through standard-setting. "So the bottom line is that companies [reporting results under U.S. generally accepted accounting principles] are going to have to deal with those differences if they apply international financial-reporting standards at some point in the future."

Gannon points to the already merged standards that govern the accounting treatment for share-based payments as an example. The standards, IFRS 2 and Topic 718 (formerly FAS 123R), were converged in 2008 — meaning they operate under the same principles — and essentially went into effect for companies at the beginning of this year. The principles governing both standards say the fair value of stock options must be treated as an expense on corporate income statements.

IFRS 2, one of the first projects the IASB worked on after the board was formed in 2001, required the expensing of stock options. "From that point on, FASB was under some pressure from the convergence effort to move in that direction," adds Gannon. By 2006 FASB issued its revision of FAS 123, requiring companies to expense the value of stock options.

According to Gannon, the way companies measure the options expense under the two standards is similar. But the rules diverge with respect to how a company must recognize the expense. For example, consider a situation in which a company issues an employee a stock-option grant worth $1,000 on the grant date, under a four-year graded-vesting scheme, which means the total grant vests in equal parts and is allocated proportionately over the course of four years.

In practice, the employee earns 25% of the grant in the first year, another 25% in the second year, and so on until the employee is 100% vested at the end of four years. The graded-vesting plan is in contrast to a cliff-vesting scheme, in which the employee does not earn any part of the grant until the four years are up.

Under FASB 's Topic 718, the company has a choice in how it attributes graded-vesting stock options. Most companies, says Gannon, elect the straight-line method of accounting, in which the company parcels out the expense in equal portions over the vesting period. So, in the example, with all things being equal, the company would recognize $250 a year for the next four years.

But Topic 718 also allows companies to choose an accelerated method of recognition for graded-vesting options, which is more complicated but allows the company to take a larger expense earlier in the vesting period and less of a hit as the option matures.  

Using the same example, a company choosing the accelerated-recognition method would be required to book the first tranche of the grant during the first year, which would comprise the one-quarter portion ($250) plus a fraction of each of the other three tranches not yet recognized. Mathematically, the company would be recognizing about 52% of the grant in the first year versus 25% under the straight-line method.

In year two, the company would recognize roughly 27%of the grant, then about 15% in year three, and the remaining percentage in year four under the accelerated method. Ultimately, a company would recognize the same amount over four years regardless of the accounting method, with the difference being when it attributes the expense.

By contrast, IFRS 2 does not allow a choice, but rather requires companies to use the accelerated-recognition method for graded-vesting options. "While the difference [between the standards] is a simple concept on the surface, how you implement the rule as a company could be a pretty daunting task in terms of the systems side of things," asserts Gannon, noting that most corporate accounting systems today are based on the straight-line method. "So having to retool the system for each grant will be a challenge for many companies," he adds.

Indeed, if a company's systems are operating on a straight-line accounting basis, processing and tracking the option expense under the accelerated method involves making adjustments that could include reworking everything from the enterprise resource planning system right down to the bookkeeping system. The adjustment "has to be made on a grant-by-grant basis, and it's not necessarily something that is going to be done on a spreadsheet if you issue a lot of grants," emphasizes Gannon.

The Business of Stock Options
Further, there could be a business repercussion for companies that issue graded-vesting options and make the switch from U.S. GAAP to IFRS. If those companies are keen on using the straight-line method, they will likely consider changing vesting terms and issuing cliff-vesting options, says Gannon, which are recognized on more of a straight-line basis under both IFRS 2 and Topic 718. But switching to a cliff-vesting scheme creates a different economic scenario for the employee, who must stick with a company until the end of the vesting period to collect the award. In the end, that's a less-desirable carrot for attracting and retaining talent.


A more subtle, but still tangible, difference between the two standards relates to the valuation of the stock options. To value the option under the accelerated-recognition model, a company must look into the future to estimate the potential fair value of the tranche. Depending on the volatility of a company's stock price, there could be a material difference between the estimated value at the time of recognition and the actual valuation. That difference must eventually be reconciled.

Companies certainly perform such forward-looking valuations today. But the accelerated methodology required under IFRS 2 adds complexity and cost to the process of tracking the fair value of the estimated expense, something that is avoidable under Topic 718, says Gannon.

There's also a difference between the two standards in the way share-based payments are treated for tax purposes, says Deborah Walker, a Deloitte tax partner. The schism exists because the tax base is different under Topic 718 than it is under IFRS 2. The U.S. GAAP tax calculation for share-based payments is computed on the company's book expense, which is the GAAP expense recognized in the income statement. The GAAP stock-option expense would only change if the option is considered a liability, and it has to be remeasured every period under fair-values rules. If the stock option is deemed to be equity, it is measured only once at the grant date. (The tests for whether an option is an equity or liability also differ under IFRS from the tests under U.S. GAAP.)

From an IFRS perspective, however, taxes are tied to the deduction the company receives, which is often a moving target. That's because the deduction is calculated on the spread between the current share price and the stock-option's strike price (or exercise price), explains Walker. As a result, stock-price volatility causes increased effective tax-rate volatility under IFRS. Add to that the myriad statutory variations that each country imposes on tax deductions, and IFRS 2 becomes a much more complex rule to implement from a tax perspective than Topic 718.

Fair-Value Split
Other accounting standards in their final stages of convergence may also diverge in practice, says David Larsen, a managing director at independent advisory firm Duff & Phelps. They include the boards' fair-value measurement standards, FASB's Topic 820 (formerly FAS 157), and the exposure draft on the same topic from the IASB.

Topic 820 and the international proposal are nearly identical in terms of the wording of the principle, in that they both assume that the asset or liability is being exchanged in an orderly transaction between market participants and valued as of the measurement date. Keeping the wording aligned was a deliberate effort on the part of the IASB, which released its draft in May for a four-month public-comment period that closed September 28. "The reason this is interesting is because IASB has proposed the exact same definition for fair value that is used in U.S. GAAP. But then you start digging down underneath the covers a bit and you see that there are some nuances [that create practical differences]," notes Larsen.

For example, Topic 820 requires that when a company looks to markets to establish the fair value of a transaction, it should first consider the "principal market" (the market having the greatest volume and level of activity for the asset or liability). In the absence of a principal market, U.S. GAAP says the company should look to the most advantageous market (defined as the market that maximizes the amount that a company would receive for selling the asset, or minimizes the amount that it would pay to transfer the liability, minus transaction costs).

Under the IFRS proposed standard, a company need only look at the most advantageous market. That subtle variation should not make a big difference in valuation measurement, reckons Larsen. Still, he thinks a case can be made for eliminating the difference before the final IASB rule is issued to avoid confusion on what could turn out to be a highly subjective determination.

IASB chairman David Tweedie may be thinking along the same lines. He told CFO.com that if the Securities and Exchange Commission decides to require U.S. companies to file financial results using IFRS, it will be up to the two boards to "go through the tension points" and tidy up rule disparities that may cause implementation problems. The SEC plans to make its decision in 2011, the same year the IASB and FASB expect to complete the major projects in their convergence effort.

 




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