CSCMP's Supply Chain Quarterly
October 19, 2018

Get out your calculators

The new International Financial Reporting Standards may require you to change the way you value inventory and measure other performance indicators.

Electronic communication and low-cost transportation have made the world a smaller place than it was in the past, and businesses of all sizes are now able to buy, sell, and source internationally. In this increasingly international business environment, there is a pressing need for standardized financial statements that will be understandable worldwide. This is the reasoning behind the push to adopt the International Financial Reporting Standards (IFRS) as the new global accounting system.

Since 2005, 114 nations, including all of the European countries, have adopted IFRS. Many other nations will require adoption of IFRS soon, including Canada in 2011, Mexico in 2012, and Japan in 2014. As of this writing, more than 12,000 companies, including many international subsidiaries of U.S. corporations, have already adopted the international system.

IFRS is not just a matter for accountants. Adoption of this system will make it easier for companies to obtain international financing, compete in global markets, and streamline their foreign operations. It's important for you, as a supply chain manager, to be aware of IFRS. Its eventual implementation is likely to change everything from the way you value inventory and negotiate long-term leases to your method of determining the tax consequences of supply chain activities, and even how you calculate employee bonuses.

What is IFRS?
International Financial Reporting Standards are the accounting standards developed and overseen by the International Accounting Standards Board (IASB). Located in the United Kingdom, the IASB has a strong relationship with the Financial Accounting Standards Board (FASB), which is responsible for developing and overseeing the accounting standards for the U.S. Generally Accepted Accounting Principles (U.S. GAAP). U.S. companies registered with the U.S. Securities and Exchange Commission (SEC) must file financial statements that are prepared in accordance with U.S. GAAP.

U.S. GAAP is seen as the "gold standard" of accounting systems, as it provides detailed rules and guidelines for how financial information must be collected and reported. When using U.S. GAAP, accountants first determine which rules and guidelines apply to a specific situation. Once they have made that decision, they follow the appropriate rules and guidelines when reporting the financial information

IFRS, however, provides "principles-based standards" that are much less specific than the U.S. GAAP's rules. When using IFRS, management first determines how to report a specific situation to provide the best understanding of the situation. The objective is that, when the company's financial information is reported, stockholders, investors, regulators, and others will have the best information for understanding and analyzing the company's financial position. While IFRS does specify particular treatments for certain situations, in general it simply provides a framework for following its principles. The flexibility of this approach is evident in this excerpt from IASB's web site:

In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgment in developing and applying an accounting policy that results in information that is relevant and reliable.

The instruction manuals for U.S. GAAP's detailed rules and IFRS's principles clearly illustrate their differing approaches. It takes many notebooks to contain all 17,000 pages of U.S. GAAP's rules—and a large bookshelf to hold them all. IFRS's guidelines, by contrast, fit into a single, 2-inch binder.

IFRS adoption in North America
While many countries have already adopted IFRS, others still have not. For instance, the Financial Accounting Standards Board in the United States and the Accounting Standards Board (AcSB) of Canada do not yet adhere directly to IFRS but are moving in that direction.

Canada has chosen to require all publicly traded companies to report financial information using IFRS by 2011. To meet that deadline, most Canadian companies have implemented strategic transition programs that have the sponsorship and support of top leadership. Before switching completely to IFRS, Canadian companies must issue financial statements using both GAAP and IFRS. This is hard work, but it will limit disruption of Canadian firms' business and ongoing operations.

The U.S. SEC, meanwhile, has developed a "roadmap" for IFRS adoption, which offers U.S. companies three options:

  1. Adopt early (2014)
  2. Wait until adoption is mandated by the SEC
  3. Wait and hope that U.S. GAAP and IFRS converge (become equivalent).

In 2002, the IASB and FASB met and signed the Norwalk Agreement, which stipulates that both parties will work toward reducing differences between IFRS and the U.S. GAAP. In February 2006, IASB and FASB issued a Memorandum of Understanding that identified the differences between the two standards and stated that the two bodies would attempt to resolve them in an effort to achieve convergence by 2008.

That deadline has passed, and although much progress has been made, convergence between GAAP and IFRS remains an ongoing process. The two accounting standards are very close in many respects and differences continue to be removed. Yet there are still—and most likely there always will be—a few areas of difference, such as accounting practices that are specific to U.S. tax law.

Under these circumstances, then, if a U.S. company determines that the economic benefits of the IFRS are greater than the adoption costs, it can elect to adopt the new standard beginning in 2014. If the benefits are less than the adoption costs, the company can choose to wait until mandated to adopt by the SEC or until the two accounting standards converge.

Currently, the benefits of IFRS are greatest for large companies with global operations. Large, global companies can realize significant cost savings because IFRS fosters consistency in statutory reporting and allows them to develop a single, companywide reporting system. Accordingly, they are able to streamline their reporting and reduce the related accounting costs. Additionally, adapting to IFRS will provide greater access to foreign capital markets and investments, which can facilitate international acquisitions, business expansion, joint ventures, and spin-offs.

Large, global companies that adopt IFRS could also require their suppliers to do the same as a condition of continuing to do business with them. To maintain sales, therefore, smaller publicly traded companies will have to adopt IFRS.

SEC officials expect that adoption will be economically driven; the agency predicts that most publicly traded U.S. companies will choose to adopt IFRS by 2020. At the current rate of convergence, U.S. GAAP and IFRS will be very similar by then. At that time, the SEC could require the remaining companies reporting under GAAP to switch to IFRS.

How will IFRS impact supply chains?
The implementation of IFRS has many implications for supply chain professionals. One of the most significant changes is that supply chain managers will need to play a role in determining the best way to measure and report financial information concerning supply chain activities. Under GAAP, there is little room for interpretation—detailed accounting rules define inventory valuation and accounting for leasing agreements, for example. Under IFRS, management will have to decide how to ensure that the best financial information is consistently reported and recorded on an ongoing basis. Supply chain managers, therefore, will need to be extensively involved in these decisions; otherwise accounting procedures will be established by employees with little understanding of their decisions' effects on supply chain activities.

Negotiated agreements may have to be rescinded or revised under IFRS. For example, to obtain a reliable source of supply for scarce or costly materials and services, a supply chain manager may have negotiated and established unique and creative agreements. Under IFRS, some of these agreements may no longer be possible because they separate the party that has ownership of an item from the party that has the responsibility, risk, and beneficial use of that item. This prevents the best information from being reported accurately, thus it is not allowed under IFRS. Lease agreements, long-term supply contracts, barters, and consignment agreements all need to be analyzed to determine if they can continue, and, if so, what will be the best accounting method to use for them.

When companies that report under U.S. GAAP adopt IFRS, they will find that the differences between the two systems can significantly impact supply chain operations, operating metrics, and key ratios. The following are some examples of those differences:

Consider the ways the two systems address different types of assets. For accounting purposes, these include property, plant and equipment, leased assets, inventory, investment property, and intangibles.

In most cases, inventory valuation remains the same under GAAP or IFRS, but there are some significant differences. U.S. GAAP generally utilizes historical cost and prohibits revaluation. But under IFRS, in cases where a large market-price increase occurs, as happened with oil, inventory values might need to be revalued at the higher market price. Moreover, when an inventory item is used sparingly—such as emergency or safety items—the historic price paid might be significantly different than current market prices. In such a case, management will decide on the best, consistent method for valuing the inventory.

Moreover, IFRS prohibits the Last-In, First-Out (LIFO) inventory-valuation method. If a company is using LIFO, it must switch to another inventory-valuation method (a major exercise with many ramifications) before IFRS can be implemented.

IFRS uses a one-step impairment (change in value) test while U.S. GAAP requires a two-step test. The differences in testing for impairment of long-lived assets that are held for use may lead to an earlier reduction in value for expense or revenue recognition under IFRS.

Depreciation is another area where the change to IFRS will impact supply chain operations. Under IFRS:

  • Tracking and accounting for property, plant, and equipment in greater detail is required to meet guidelines for each major component of each asset. The guidelines include a requirement to review residual values at each balance-sheet date.
  • Separate, significant components of an item of property, plant, and equipment with varying economic lives (the period of time during which an asset produces a service of value) must be recorded and depreciated separately.
  • Earlier disposal or retirement activity may be triggered when portions of a larger asset group are replaced.

Leasing practices are likely to be affected by IFRS. For instance, one of the accounting regime's basic principles is that classification is based on whether the lease substantially transfers all of the risks and rewards of ownership to the lessee. For example, renting is a simple lease in which no ownership of the item is transferred, therefore it is classified as a straightforward transaction. Long-term leases in which ownership of and responsibility for an item are transferred are classified such that they require reporting of detailed information. There are no U.S. GAAP testing criteria for classifying leases.

IFRS records operating and finance (capital) leases using sale/leaseback accounting. For example, airlines might sell their airplanes to obtain large cash infusions, and then lease back the use of the aircraft. The large cash infusion will result in a profit or earlier gain recognition, which is taxable.

Under IFRS, lease classification by the lessor and the lessee should typically be symmetrical. That is, when an item's ownership and responsibility are transferred from the lessor to the lessee, the same financial numbers should be reported to their corresponding accounts.

IFRS requires splitting leases involving both land and buildings into two components, with separate classification considerations and separate accounting for land and buildings. U.S. GAAP permits more flexibility in structuring and defining leases, and this flexibility is often used to reduce taxes.

Consolidation, which occurs when two companies combine through merger or acquisition, is another area where supply chains could be affected under IFRS. In a consolidation, the companies' supply chains usually will be modified in some way. The degree of change will be determined by the power one company has to govern the financial and operating policies of the other company. IFRS focuses on a different, "control-based" model, which considers risks and rewards when, due to a merger, the source of control is not apparent.

Under IFRS, the smaller company in a merger or acquisition can be determined to have power over the larger company. For example, in a merger, the smaller company's supply chain might have excellent information technology systems that will be adopted by the larger company. In this case, the smaller company's supply chain would be deemed to have power over the larger company's supply chain.

IFRS does not permit the U.S. GAAP rules allowing companies to achieve off-balance-sheet treatment in certain circumstances. For example, special arrangements with suppliers must be accounted for in a way that ensures the physical location of the inventory is matched up with the location of responsibility and risk for that inventory.

Companies with international operations could face "intragroup" tax liabilities—liabilities that arise when different entities of a corporation conduct business with each other. That's because the tax assessment on inventory belonging to a consolidated group depends on the country in which the goods are physically located. Under IFRS, taxes on intragroup profits are deferred rather than paid immediately, and the tax rates are determined by reference to the buyer's tax rate. When reporting under U.S. GAAP, any income tax effects resulting from intragroup profits are deferred at the seller's tax rate.

Even construction contracts for very large inventory items, warehouses, distribution centers, and manufacturing facilities could be affected. The commonly used accounting method for such contracts under U.S. GAAP is based on the signed (or completed) contract amount. IFRS prohibits accounting for the completed contract and instead requires the accounting to be based on the percentage of completion.

IFRS also mandates changes in the way borrowing costs are accounted for. If the borrowing costs are directly attributable to the acquisition, construction, or production of a qualifying asset, then the borrowing costs must be capitalized as part of the cost of that asset. For example, if you borrow money to build equipment, the borrowing cost is added to the equipment's cost and capitalized. Under U.S. GAAP, borrowing costs are not tracked to individual items or capitalized.

IFRS requires companies to measure the value of barter transactions by first considering the fair value of items received from the supplier. Only when the value of those items cannot be reliably determined can the receiver use the value of the goods or services surrendered to measure the transaction. For example, if you have an expensive item and trade it for something that has a lower market value, the price of the item you receive is valued at the market price of that item. Thus, the barter will result in a loss being recorded. If, however, the item you receive does not have a fair market value, you can value the item received at the same price as the item traded.

When it comes to extended warranties, IFRS requires that companies report value for each component of an asset or product when the component has the potential to affect separately priced extended warranties or maintenance contracts. For example, when buying a car, there are separate warranties for the tires, the transmission, and the radio. In this situation, the company must report and track the value of each component separately.

Adapting to IFRS: Advice from Europe
A recent survey of supply chain managers at European and Australian electric utilities that had converted to IFRS offers clues to the potential ramifications of the accounting conversion. The survey asked managers the following questions: "What would you recommend to supply chain managers who are going to implement IFRS?" and "What would you do over if you could?"

Their responses indicated that adapting to IFRS results in a very large project with a significant, companywide impact. For many of the European companies, adoption of IFRS took more time and resources than anticipated because they had treated the implementation as purely an accounting and financial project. Companies that failed to consider the companywide impact in their implementation plans often experienced delays.

In addition, the survey respondents recommended that the adoption of IFRS be taken as an opportunity to reassess supply chain policies and practices, with the aim of improving efficiencies and streamlining operations. Respondents also recommended that the supply chain organization get involved early on, because the IFRS implementation team inevitably will make decisions about how supply chain operations are measured.

By becoming involved and supporting the IFRS conversion, respondents suggested, supply chain managers can help define the accounting of supply chain activities, understand and manage the scope of implementation, and ensure a smooth transition. To do that, they will need to learn about and understand IFRS as well as monitor the impact of the IFRS implementation on supply chain operations. Under the umbrella of the IFRS project, therefore, supply chain organizations may be able to obtain training, information technology, and other resources that may not normally be available to them.

The respondents also made this specific recommendation: Identify and solve supply chain problems early. Long-term inventory, obsolete inventory, returned material, damaged goods, "unwritten" supply agreements, multivendor supply agreements, and consignment agreements could all become potential accounting liabilities. It is much easier to solve these problems under the current accounting system than later, when the problem must be reported using both GAAP and IFRS.

Because the switch in the accounting system changes how supply chain activities are reported, respondents noted, the conversion affects the key performance indicators (KPIs) that are used to determine the efficiency and effectiveness of a company's supply chain. For instance, the change in valuation methods under IFRS will affect an organization's ability to meet or exceed KPIs. Just one example: when inventory valuation changes, the KPI for the number of inventory turns also will change. Another example: because the way a company tracks the monthly value of inventory will change when IFRS is implemented, the KPI for that activity also will have to change.

For these reasons, it's important that the IFRS project team run simulations to determine the effects of the new accounting standards on all KPIs to learn how they will change. This approach recognizes that converting to IFRS may affect many aspects of the supply chain throughout the company.

Get ready now for IFRS
To help your company remain competitive in the global economy, and to keep your personal skill set current, you need to learn about IFRS and how it will affect your company's supply chain. Avail yourself of IFRS-related workshops and seminars, and begin drafting a proposal for implementation you can present to upper management.

IFRS is coming—it is no longer a question of "if," but rather "when." There is not much time left to prepare for an implementation. A U.S. company that intends to report using IFRS in 2014 will have to first run two years of financials under both GAAP and IFRS. If 2014 is your target date, then you will need to implement IFRS by 2012—just two years away. The best time to begin an implementation plan, therefore, is now.

Editor's note: This article is intended to provide a general overview of IFRS and should not be construed as financial advice. For specific questions, consult your company's financial department or outside auditors.

Where to learn more about IFRS

The following web sites provide additional information about IFRS:

To encourage U.S. businesses to move forward with IFRS, in November 2008 the U.S. Securities and Exchange Commission (SEC) issued guidelines for implementing the accounting regime in U.S.-based publicly traded companies. The SEC's Roadmap for the Potential Use of Financial Statements Prepared in Accordance with International Financial Reporting Standards by U.S. Issuers, Release No. 33-8982 (November 14, 2008) can be downloaded here.

Todd Neely is president of Nanoimproved.

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