Appendix D: US GAAP Reconciliation and Restatement - Case Study

Appendix D: US GAAP Reconciliation and Restatement—Case Study

Hyderabad International Inc. prepares its financial statements in accordance with International Accounting Standards. The company wants to seek a listing on a US stock exchange. Therefore, it has approached an international accounting consultant, who specializes in both IAS and US GAAP, to guide it in the reconciliation and restatement of its IAS-based financial results to US GAAP. The approach taken by the consultant in restating the financial statements is very systematic and is based on the fundamental principles of double entry bookkeeping. In order to understand the logic behind the method employed by the consultant, one has to visualize the "opening" of the company's general ledger for the accounting period and debiting and crediting various accounts. The objective is to restate the IAS-based financial results to financial statements prepared in accordance with US GAAP. The balance sheet and the income statement of Hyderabad International Inc. for the latest financial period are presented below.

Exhibit 1: Hyderabad International Inc. Balance Sheet (under IAS) December 31, 2001

	(In USD Millions)	(In USD Millions)
Current assets:
Cash and bank	$ 500
Accounts receivable	7,500
Inventories	3,500
Total current assets		$ 11,500
Current liabilities:
Bank overdraft	(1,000)
Accounts payable	(5,000)
Accruals and provisions	(4.000)
Total current liabilities		(10,000)
Net current assets		$ 1,500
Property, plant, and equipment	15,500
Accumulated depreciation	(9,000)
		6,500
Intangible assets	3,000
Accumulated amortization	(1,000)	2,000
		10,000
Long-term loans		(3,000)
		7,000
Shareholders' equity:
Equity capital	4,000
Retained earnings	2,000
Revaluation reserve	1,000
Total shareholders' equity		$ 7,000

Exhibit 2: Hyderabad International Inc. Income Statement (under IAS) For the Year Ended December 31, 2001

	(In USD Millions)	(In USD Millions)
Sales		$27,000
Less: Cost of sales		(15,000)
Gross profit		13,000
Distribution costs		5,000
Administrative expenses		1,500
Operating expenses:
Depreciation	$1,000
Amortization	1,000
Staff costs	1,500
Other operating expenses	1,500	5,000
Total distribution, admin & operating expenses		$11,500
Income from operations		1,500
Interest expense		(700)
Interest income		200
Net income for the period		$ 1,000

Based on the differences noted between the two accounting frameworks, the IAS/US GAAP consultant undertakes a restatement of the financial results. The following is a summary of some differences between IAS and US GAAP identified by the consultant:

Revaluation of buildings. Under IAS 16, based on the "allowed alternative" treatment, property, plant, and equipment (PPE) can be revalued and carried from year to year at depreciated revalued amounts (instead of depreciated historical cost which is the prescribed treatment under the "benchmark treatment" of IAS 16). Although this treatment is followed in many countries including the UK, under US GAAP this practice would be regarded as a departure from GAAP. Consequently, when restating financial statements (initially prepared according to IAS to financial statements prepared under US GAAP), the carrying amount of PPE that is revalued could be vastly different from the PPE carried at depreciated historical cost. Furthermore, depreciation charged to the Income Statement (when PPE is carried at revalued amounts) is comparatively higher. Thus, had the PPE been carried at depreciated historical cost (the way it is accounted for in the United States), the gross carrying amount of PPE would be lower by USD 1,000 million compared to the IAS-based figure. Also, for the year 2001, the depreciation charge would be lower by USD 200 million compared to the IAS-based depreciation expense.

The following journal entries are required in order to adjust the above:

• Journal Entry 1

  	Debit	Credit
  Revaluation reserve	1,000
  Property, plant, & equipment		1,000
  Accumulated depreciation	200
  Retained earnings		100
  Depreciation		100

Research and development. During the current year, the company incurred research and development (R&D) expenditure. Part of this qualified as development expenditure under IAS 38. Such expenses amounting to USD 1,000 million were, in accordance with IAS 38, treated as intangible assets. This is not the treatment prescribed by US GAAP that mandates that such expenses should be expensed when incurred and not allowed to be carried forward. Thus, on restating financial statements prepared in accordance with IAS (to financial statements based on US GAAP), USD 1,000 million would need to be reversed from intangible assets and charged to expenses (e.g., to "Other Operating Expenses"). The company amortized these capitalized "development costs" (treated as an intangible asset) over a period of five years using the straight-line method. For the year 2001, it charged an amortization expense of USD 200 million to the income statement. This needs to be reversed.

The following journal entry illustrates the above adjustment:

• Journal Entry 2

  	Debit	Credit
  Other operating expenses	1,000
  Intangible assets		1,000
  Accumulated amortization	200
  Amortization		200

Expensed "in-process" R&D versus intangible asset or goodwill. During the previous financial year the company acquired a "dot.com" enterprise. Part of the acquisition price was attributed to in-process research and development (R&D). Under IAS 22, acquired in-process R&D is either a separately identifiable intangible asset or part of goodwill. However, under US GAAP, acquired in-process R&D is never recognized as an asset but is separated from goodwill and recognized as an expense in the year of acquisition. The company's accounting policy is to initially capitalize acquired in-process R&D as an intangible asset and later amortize it. Thus, the company capitalized in-process R&D of USD 1,000 million on the acquisition of the dot.com enterprise in the previous financial year. It amortized this intangible asset over a period of five years using the straight-line method. Considering the treatment required under US GAAP (i.e., to expense acquired in-process R&D), the IAS/US GAAP consultant (retained by the company) estimated that intangible assets were overstated (as of December 31, 2001) by USD 600 million and that the net income for 2001 was understated by USD 200 million. Further, the previous year's net income was overstated by USD 800 million according to the consultant.

Based on the opinion of the consultant the following journal entry was recorded:

• Journal Entry 3

  	Debit	Credit
  Retained earnings	1,000
  Intangible assets		1,000
  Accumulated amortization	400
  Retained earnings		200
  Amortization		200

Borrowing costs. Under IAS 23, borrowing costs relating to qualifying assets can either be expensed (under the benchmark treatment) or capitalized (under the allowed alternative treatment). In the United States, such borrowing costs are capitalized and added to the carrying amount of the related qualifying asset. During the current year, the construction of a qualifying asset (as defined in IAS 23) was completed. Interest expense on long-term borrowings utilized in the construction of the qualifying asset were expensed by the company in accordance with the benchmark treatment of IAS 23. The interest expense that was charged to the income statement in the previous financial period amounted to USD 75 million and the interest expensed during the current year totaled USD 25 million. The qualifying asset has a useful life of five years and is depreciated using the straight-line method.

The following adjusting entry is required in order to adjust the above treatment of borrowing costs under IAS:

• Journal Entry 4

  	Debit	Credit
  Property, plant, & equipment	100
  Retained earnings		75
  Interest expense		25
  Depreciation	20
  Accumulated depreciation		20

Foreign exchange differences—capitalization of losses from severe currency devaluation. At the end of the previous financial year the company imported machinery on deferred credit terms. The liability in foreign currency was carried forward to the current financial year. During the current financial year the currency of the country importing the machinery underwent severe devaluation. As a result, the company paid an extra sum of USD 25 million over and above the contracted foreign currency liability relating to the imported machinery that was carried forward (as a foreign currency denominated payable) from the previous year. There was no practical means of hedging against this devaluation. Since this machinery was placed in service on the last day of the current financial year, no depreciation was charged on this asset.

According to the allowed alternative treatment in IAS 21, in rare circumstances, foreign exchange losses are allowed to be included in the carrying amount of a recently acquired asset. Such foreign exchange differences should, however, result from "severe devaluation or depreciation of a currency against which there is no practical means of hedging and that affects liabilities which cannot be settled and which arise directly on the recent acquisition of an asset invoiced in a foreign currency." SIC 11 clarifies, among other issues, the meaning of the term "recent acquisition" used in IAS 21 and interprets it as a period not exceeding twelve months.

Under US GAAP, capitalization of foreign currency losses is not permitted. In other words, while restating financial statements in accordance with US GAAP, such foreign exchange differences would need to be charged to the income statement.

The consultant has suggested the following journal entry to take care of the above IAS treatment:

• Journal Entry 5

  	Debit	Credit
  Other operating expenses	25
  Property, plant, & equipment		25

Exhibit 3: Hyderabad International Inc. Restated Balance Sheet (per US GAAP) December 31, 2001 (in USD Millions)

	Before restatement (per IAS)	Debit	JE#	Credit	JE#	Restated (per US GAAP)
Assets
Current assets:
Cash and bank	$ 500					$ 500
Accounts receivable	7,500					7,500
Inventories	3,500					3,500
Total current assets	$11,500					$ 11,500
Property, plant, & equipment	$15,500	100	4	1,000	1	$14,575
				25	5
Accumulated depreciation	(9,000)	200	1	20	4	(8,820)
	6,500					5,755
Intangible assets	3,000			1,000	2	1,000
				1,000	3
		200	2
Accumulated amortization	(1,000)	400	3			(400)
	2,000					600
Total	$20,000					$17,855
Liabilities & Equity
Current liabilities:
Bank overdraft	$ 1,000					$ 1,000
Accounts payable	5,000					5,000
Accruals and provisions	4,000					4,000
Total current liabilities	$10,000					$10,000
Long-term loans	$ 3,000					$ 3,000
Shareholders' equity:
Equity capital	$ 4,000					$ 4,000
Retained earnings	2,000	1,000	3	100	1
				200	3
				75	4
Decrease in net profit (1,000-480)		520				855
Revaluation reserve	1,000	1,000	1			0
	$ 7,000					$ 4,655
Total	$20,000					$17,855

Exhibit 4: Hyderabad International Inc. Restated Income Sheet (per US GAAP) Year Ended December 31, 2001 (in USD Millions)

	Before restatement	Debit	JE #	Credit	JE #	Restated (per US GAAP)
Sales	$27,000					$27,000
Less: Cost of sales	(15,000)					(15,000)
Gross profit	$13,000					$13,000
Distribution costs	5,000					5,000
Administrative expenses	1,500					1,500
Operating expenses:
Depreciation	$ 1,000	20	4	100	1	$ 920
Amortization	1,000			200	2
				200	3	600
Staff costs	1,500					1,500
		1,000	2
Other operating expenses	1,500	25	5			2,525
	5,000					5,545
Total distribution, admin & operating expenses	$11,500					$12,045
Income form operations	$ 1,500					955
Interest expense	(700)			25	4	(675)
Interest income	200					200
Net income for the period	$1,000					$ 480

Exhibit 5: Hyderabad International Inc. Reconciliation of Net Profit Determined under International Accounting Standards to Net Income in Accordance with US GAAP

(in USD millions)

Net Income determined under International Accounting Standards		(1,000)
Adjustments to conform to US GAAP
JE #
1	Excess depreciation on revalued PPE reversed	(100)
2	Capitalized R&D expensed (plus reversal of amortization)	800
3	Adjustment relating to acquired in-process R&D	(200)
4	Expensed borrowing costs on qualifying assets capitalized	(25)
	(plus depreciation on capitalized borrowing costs adjusted)	20
5	Capitalized foreign currency losses (from severe devaluation) reversed	25
Net income in accordance with US GAAP		(480)