April 2010 Katherine Schipper, Duke University

1. How Might US Adoption of IFRS Affect Quantitative Models used by Financial Analysts? 2010 CARE Conference April 2010 Katherine Schipper, Duke University 1

2. Overview • Process issues • Current status of International Financial Reporting Standards (IFRS) use in the US and elsewhere • SEC proposals for permitting/requiring the use of IFRS by US SEC registrants • Substantive issues • Examples of differences between US GAAP and IFRS that could affect investment analyses • Convergence efforts of the IASB and FASB • Attempts to eliminate differences and improve guidance could lead to substantial changes in format and content of financial reports • Summary of several joint IASB/FASB major projects • Financial statement presentation • Consolidation policy • Revenue recognition • Lease accounting • Financial instruments: An example of (likely) nonconvergence • Comment: This presentation uses Statement numbers not Codification numbers. 2

3. Process issues: IFRS use and convergence • Over 100 jurisdictions use some version of IFRS or have announced plans to do so • In some jurisdictions, phased adoption based in part on size of firm • In some jurisdictions, the standards in use may differ from IFRS as promulgated by the IASB • Differences in the standards themselves and/or differences in implementation • Of large economies, only Japan and the United States have not either adopted IFRS (or some version of IFRS) or announced a planned date/schedule of adoption • The FASB and IASB are committed to working toward convergence to a single set of high quality financial reporting standards • Several major joint projects are underway that are intended to replace both US GAAP and IFRS standards with converged and improved guidance • In the US, non-US SEC registrants have a choice • File with US GAAP • File with IFRS, as promulgated by the IASB • File with another set of standards and reconcile portions of the balance sheet and income statement to US GAAP Observation: This free choice creates explicit noncomparability 3

4. SEC proposals for IFRS use in the US • Proposal issued Nov 14, 2008, with comments due Feb 19, 2009 • Feb 3, 2009, extended comment deadline to April 20, 2009 • Feb 24, 2010, the SEC reaffirmed a commitment to “a single set of high-quality globally accepted accounting standards” • Release Nos. 33-9109; 34-61578 available on the SEC’s website • Perhaps of greatest interest is the Appendix that describes the “Work Plan” to be executed by the SEC staff • The “Work Plan” describes how the SEC staff will investigate areas of concern identified in comment letters on the Nov 2008 proposal • Comprehensiveness, auditability and enforceability of IFRS; comparability of IFRS applications within/across jurisdictions • Governance and oversight of the IFRS Foundation and the IASB, including funding, composition of the trustees and the board, and IASB processes • Investor knowledge • Regulatory considerations • Impact on US SEC registrants (accounting systems and internal controls; contractual arrangements; governance, including audit committee IFRS knowledge) • Human capital readiness 4

5. SEC proposals for IFRS use in the US • Based on the Feb 2010 decisions: • The SEC will decide in 2011 whether to permit or require IFRS for US SEC registrants • Lengthy transition—no earlier than 2015 • Unclear whether the decision would be wholesale adoption or standard-by-standard phase-in • A key condition: Completion of the convergence projects • The FASB’s website lists joint IASB-FASB standards projects (information in parentheses is stated date for a final standard) • Statement of comprehensive income (3Q 2010) • Financial statement presentation (2011) • Consolidation policy and procedures (4Q 2010) • Revenue recognition (2011) • Leases (2011) • Fair value measurement (3Q 2010) • Financial instruments (4Q 2010) • Financial instruments with characteristics of equity (2011) • Emissions trading schemes (2011) • Insurance contracts (2011) • Discontinued operations (3Q 2010) 5

6. Differences between IFRS and US GAAP with potential effects on investment analysis • LIFO inventory accounting: IFRS does not permit LIFO and the US permits LIFO for tax purposes only if it is used for financial reporting • Observation: There are periodic proposals to disallow LIFO for tax accounting in the US • Observation: The majority of US firms do not use LIFO, but LIFO users tend to be large, with substantial LIFO versus FIFO differences (LIFO reserves) • Examples include Exxon Mobil, Chevron, Valero Energy, Caterpillar, Dow Chemical, Deere, Alcoa and United States Steel • Asset impairments: Nonfinancial assets • IFRS one-step impairment testing is based on fair value-type measurement while US GAAP impairment testing is based on the ability to recover undiscounted cash flows • The IFRS approach is believed to result in more impairments, compared with US GAAP two-step approach • IFRS permits recovery of certain impairment losses; US GAAP does not • Observation about impairment recoveries generally: IFRS permits recovery of certain impairments of financial and nonfinancial assets; US GAAP does not. The FASB has proposed changing US GAAP to converge with IFRS, at least for financial assets. 6

7. Differences between IFRS and US GAAP with potential effects on investment analysis • Loss contingencies • IAS 37 defines “probable” for loss contingencies as more likely than not while practice in the US (SFAS 5) has applied a higher threshold. Measurements of recognized loss contingencies may also differ • Observation: The IASB is close to issuing a revised standard that would largely remove the “probable” criterion for recognition of losses/obligations with uncertain amounts and timing and would change the measurement to be more like an expected value. • Possible implication: more contingent obligations recognized under IFRS than under US GAAP • Covenant violations: IFRS does not permit curing debt covenant violations after year-end, while US GAAP does • Implication: Current liabilities could contain long term debt that is not due to be paid • Convertible debt: IFRS requires separate accounting for the call option embedded in convertible debt in most cases, while US GAAP specifies separate accounting for certain convertible debt instruments with a cash-settlement provision (effective 2009; FSP APB 14-1) • Implication: IFRS applied to convertible debt usually results in lower debt and larger equity, at least at inception 7

8. Differences between IFRS and US GAAP with potential effects on investment analysis • Intangible assets: IFRS requires capitalization of development costs that meet certain criteria. US GAAP does not permit capitalization of any development costs other than certain costs of software development (SFAS 86) • Implication: R&D intensive IFRS firms have more intangible assets (that are subject to amortization and impairment) • Depreciation: IFRS requires that components of an asset with differing patterns of benefit consumption be depreciated separately (component depreciation); US GAAP permits but does not require this treatment • Implication: Differing patterns of depreciation charges for the same (composite) asset • Measurement requirements (or choices) • IFRS permits property, plant and equipment to be measured at fair value or historical cost; US GAAP requires historical cost • IFRS permits investment property to be measured at fair value with changes included in net income; US GAAP requires historical cost • IFRS requires that certain agricultural assets (crops, livestock, orchards, forests) be measured at fair value with changes included in net income; US GAAP permits fair value only for certain agricultural items (e.g., livestock held for sale) 8

9. Differences between IFRS and US GAAP with potential effects on investment analysis • Classification and display—selected examples • IFRS permits expenses to be shown by nature (e.g., personnel costs, raw materials costs) or by function (e.g., selling costs, R&D costs) while US GAAP requires display by function • IFRS does not specify where to display an excess tax deduction associated with a share based payment arrangement while US GAAP requires display in Cash from Financing • IFRS requires all deferred tax assets and deferred tax liabilities to be classified as noncurrent while US GAAP requires classification as current or noncurrent based on the nature of the item that underlies the deferred tax item • IFRS lease classification guidance does not contain the numerical thresholds in US GAAP (although the qualitative considerations are similar) • IFRS requires that an obligation that is settled by issuing a variable number of shares be classified as liability; US GAAP permits equity classification under certain circumstances • IFRS requires that debt issue costs must be expensed; US GAAP permits capitalization as an asset for debt measured at amortized cost • Observations: • Existing classification and display differences between US GAAP and IFRS suggest that balance sheet and income statement analysis may require pre-analysis adjustments. • IFRS contains more guidance for presentation than does US GAAP 9

10. Differences between IFRS and US GAAP with potential effects on investment analysis • For those who are accustomed to US GAAP detailed implementation guidance: • IFRS lacks the level of specificity and detail, and the amount of implementation guidance, that characterizes US GAAP. • Example: The IFRIC provides limited guidance (analogous to the EITF, but less active) • Example: There does not appear to be an IASB analog to the FASB’s FSPs (although the annual improvements project may serve a similar purpose) • Example: IFRS contains two broad revenue recognition standards; US GAAP contains approximately 200 pieces of industry-specific and transaction-specific guidance • Question to consider: What should be the source of implementation guidance for IFRS, if IFRS is required in the US? • Should the US proceed without this detailed guidance? • Should the FASB remain as a US-implementation-guidance organization? • What are the implications for comparability, both within the US and across jurisdictions, of either: • Substantially reduced implementation guidance and specificity • Implementation guidance for US firms that is established outside the IASB’s organizational control 10

11. Joint IASB-FASB projects on financial statement presentation and comprehensive income • Objective is to achieve convergence by creating a single standard for how to present information on the face of financial statements • US GAAP contains only limited guidance, and that is dispersed across standards; IFRS contains IAS 1 • Preparers of financial statements use a variety of formats/displays and levels of aggregation, which users find confusing • Displays are not linked across statements. The Statement of Cash Flows separates operating, investing and financing activities but the other statements do not. • The Boards issued a preliminary views discussion paper on financial statement presentation late in 2008 • Comment period ended April 2009; exposure draft expected 2010; final standard 2011 • A related project on presentation of Comprehensive Income • Two-section single statement that contains profit or loss (or net income/loss) and other comprehensive income (OCI) • No planned changes in what is included in OCI • Continue the free choices between net-of-tax and pre-tax presentation of OCI and between display of tax effects on the statement or in the notes • Final standard expected Q3 2010

12. IASB-FASB project on financial statement presentation Discussion paper proposed format for financial statement presentation

13. Joint IASB-FASB project on financial statement presentation • Discussion paper proposals are based on a “management approach” • Management would determine what items belong in the Business (that is, the Operating and Investing sections) and the Financing section and explain the reasons for the classifications • Management would decide the order of sections and categories and use that order consistently across statements • Management would classify income, expenses and cash flows in the same section/category as the related asset or liability • Management would be required to relate the presentation of assets and liabilities to the entity’s business • Observations and questions to consider: • As of Sept 2009 the term “management approach” was abandoned but the idea it represents appears to have been retained • Segment reporting, the accounting for certain assets and IFRS 9 (discussed later) are also based on approaches that seem similar to the management approach described here. • Accounting is linked to the entity’s business model, so that the same item could receive different accounting treatment if business models differ • How is this idea connected to management intent (as, for example, in the HTM classification for debt securities in SFAS 115)? • What are the implications of a management approach for decision usefulness of financial reports?

14. Joint IASB-FASB project on financial statement presentation • As of February 2010, the IASB and FASB are also proposing: • Required analysis (in the notes) of changes in balances of all significant asset and liability line items • Distinctions between remeasurement changes and other changes • Remeasurements arise from a change in current prices or values, or transactions at current prices or values (except for selling inventory); certain changes in estimates • Creation of a subcategory, financing arising from operating activities • Appears to include long term items with a time value of money component that do not qualify as financing items • The proposed guidance also contains a definition of financing items, based on (a) assets and liabilities that qualify as financial items and (b) management views the items as providing funding

15. Consolidation policy and procedures • Joint IASB-FASB project in which the IASB has taken the lead, with an exposure draft (ED 10) issued December 2008, to replace IAS 27 and SIC 12 • Apply a qualitative definition of control with two criteria: the ability to direct the activities of an entity so as to generate returns • Direct activities = determine strategic operating and financing policies • Recent FASB-IASB decisions, for entities that are controlled through voting rights • Holding more than half the votes meets the ability criterion of control, absent other arrangements • Holding less than half the votes also meets the ability criterion of control if the investor has the ability to direct those activities of the entity that significantly affect returns • Issues to consider: • How to consider options and conversion rights in assessing the ability criterion • How to analyze the ability criterion—must an entity demonstrate that it is in control and that it can perpetuate that control? • Observations: • Consolidation policy determines which assets and liabilities of entities that are linked by ownership or contract are included on the consolidated balance sheet • The qualitative control definition proposed by the IASB is similar to definitions proposed in 1995 and 1999 FASB exposure drafts • US GAAP currently sharply distinguishes entities controlled through voting rights and other entities. The proposed guidance does not appear to make this same distinction.

16. Joint IASB-FASB project on revenue recognition • Objective is to create a single converged revenue recognition standard that would replace the voluminous US GAAP guidance and IAS 11/IAS 18 • After several years of effort, the Boards issued preliminary views in December 2008 • Comment period ended June 2009 • Focus is on a contract with a customerin which the seller obtains a right to payment and incurs an obligation to deliver goods/services • Revenue would be recognized as performance obligations are satisfied by delivering goods and services • Observation: As written, that rule would preclude methods like the percentage-of-completion method. The IASB and FASB are currently reconsidering the implications of this rule. • The amount the customer pays (customer consideration) would be allocated to each performance obligation using a variant of relative-fair-value that is based on the stand-alone price for each good or service (including estimates, if necessary) • Observation: That allocation method is similar to practice around EITF 08-1 • After contract inception, a seller would remeasure a contract if it became onerous, in the sense of incurring a loss

17. Joint IASB-FASB project on revenue recognition • Revenue recognition based on accounting for a contract with a customer • Based on recognition and measurement of contract assets and contract liabilities • Contract asset arises if the entity performs before the customer pays • Contract liability arises if the customer pays before the entity performs • It may be necessary to combine two or more contracts, if the arrangements are interdependent • Seller recognizes revenue only when it has satisfied a performance obligation by transferring a good or service to the customer • Transfer occurs when the customer obtains control of the good or service • Observations: • Revenue recognition, as proposed, turns on the definition of control. The IASB and FASB have proposed several indicators of control, for example: • Customer has an unconditional obligation to pay, and the payment is nonrefundable • Customer has legal title, or can sell or exchange the asset, or has physical possession (or the practical ability to take possession) • Customer specifies the design of the asset, or has continuing managerial involvement with the asset or can secure or settle debt with the asset

18. Joint IASB-FASB project on lease accounting • Objective is to create a single converged standard that would replace SFAS 13 and IAS 17 with improved guidance • The operating lease versus capital/financing lease distinction gives rise to substantial accounting differences for very small changes in lease contracts • Even though rights and obligations associated with operating leases may qualify as assets and liabilities, there is no balance sheet recognition of these items • The Boards issued a preliminary views discussion paper in March 2009 • Comment period ended July 2009 • Current proposals focus more on lessees than on lessors • Leases give rise to right-to-use assets and obligation-to-pay liabilities that should be recognized • Separate recognition would not be required for renewal, termination or purchase options. Instead, the lessee would be required to determine the most likely outcome and incorporate that outcome into the lease accounting • Example: A five-year lease has a renewal option for an additional five years. If renewal is the most likely option, account for the lease as a 10-year lease • The measurement of the obligation would include contingent rentals and residual value guarantees

19. Joint IASB-FASB project on lease accounting • Other aspects of current proposals • A lessor would initially recognize a receivable from the lessee and a performance obligation and it would not derecognize the leased asset (per an October 2009 tentative decision) • The basis for this conclusion is that the lessor does not transfer control of the leased item at inception of the lease, so it continues to recognize the leased item as an asset • The measurement of the receivable and the obligation would be the rentals discounted at the implicit rate of the lease • The lessor would remeasure (reduce) its performance obligation as it permitted the lessee to use the leased item • However, the IASB and FASB are considering whether some leases are “in-substance sales” in which revenue would be recognized at inception of the lease • However, at a March 23, 2010 meeting, the IASB and FASB agreed to continue to consider an approach in which lessors would derecognize the leased asset and recognize a lease receivable • A sale-leaseback arrangement would require the lessee/seller to analyze the arrangement to determine if it should derecognize the leased asset. • If yes, account for the lease (recognize a right-to-use asset and an obligation-to-pay liability) • The proposals are not specific as to how to reach the derecognition determination • A lessee would amortize its right-to-use asset and also test it for impairment

20. Joint IASB-FASB project on financial instruments • Objective is to replace both FASB and IASB guidance for financial instruments with a common standard • Recognition and measurement of financial assets and financial liabilities • Reduce complexity • Impairment • Needed only for instruments that are not accounted for at fair value with changes included in earnings • Hedge accounting • Resolve practice issues • Address differences in the accounting for derivatives versus hedged items or hedged transactions • The IASB has promulgated a standard that addresses recognition and measurement of financial assets • The FASB has not promulgated a standard as yet • The scope of the FASB project includes both financial assets and financial liabilities

21. Joint IASB-FASB project on financial instruments—IFRS 9 • The IASB issued IFRS 9 (November 12, 2009), effective January 1, 2013, early adoption is permitted • Eventual goal: replace IAS 39 in its entirety; IFRS 9 is just the first step • Scope => financial assets (exposure draft included financial liabilities) • Includes certain hybrid instruments (host + embedded derivative) • Account for the instrument as a whole (do not separate the derivative) • Decision to eliminate financial liabilities based on constituent concerns about recording the effects of changes in the issuing entity’s credit risk • Both the FASB and the IASB are considering how to (re)measure financial liabilities for changes in the issuer’s credit risk • Credit risk includes the effects of changes in the issuer’s credit quality and changes in the price of credit, holding credit quality constant • IFRS 9 requires: Measure financial assets at amortized cost or fair value on the balance sheet except that the fair value option in IAS 39 is retained • Fair value option: designate at initial recognition a qualifying financial asset to be measured at fair value with changes included in profit or loss if doing so eliminates or significantly reduces an inconsistency (accounting mismatch) that would otherwise arise

22. Joint IASB-FASB project on financial instruments—IFRS 9 • IFRS 9: Measure financial assets at amortized cost or fair value • Amortized cost items must meet two criteria: • Business model test: Asset is held within a business model whose objective is to hold the assets to collect contractual cash flows • Reclassification is required if the business model changes • Analysis is neither at the individual instrument level nor at the reporting entity level (the portfolio level?) • The entity need not hold the asset to maturity • Contractual cash flows test: Contractual terms of the asset specify principal and interest only • Except that management must look to the assets and liabilities of the issuing entity if the financial asset is linked to other securities in a way that affects the concentration of credit risk (for example, arrangements that specify the order in which losses are allocated) • Initial measurement is fair value + transaction costs • Assets are subject to impairment (impairments can be reversed) • Application of the classification criteria is illustrated by means of examples

23. Joint IASB-FASB project on financial instruments—IFRS 9 • IFRS 9: Measure financial assets at amortized cost or fair value • Fair value items: • Debt instruments held as assets and not classified as being measured at amortized cost (either because of not qualifying or because of applying the fair value option) • Equity instruments • Except, possibly, equity instruments where cost might be the best estimate of fair value (refer to paragraphs B5.5 to B5.8) • Fair value changes included in net income • Except that management can designate an equity instrument not held for trading as measured at fair value with changes included in OCI, with no recycling and with dividends included in profit and loss • Observations: • IFRS 9 eliminates the trading, AFS and HTM classifications, impairment testing except for items measured at amortized cost and the recycling of unrealized gains and losses when securities are sold • The dividend and price change components of return on certain equity securities will be reported separately (dividends in profit/loss and price changes in OCI)

24. Joint IASB-FASB project on financial instruments—FASB tentative decisions • The FASB proposed to address all three components of the financial instruments project in a single standard • Measure all financial instruments in the scope of the standard initially and subsequently at fair value with changes in income, except for core deposits • Except that if an entity’s business strategy is to hold debt instruments to collect (or, if a liability, to pay) contractual cash flows rather than to sell or settle the instruments with a third party, certain changes in fair value of those instruments may be recognized in OCI • Amount that may be recognized in OCI = the total change in fair value except for interest accruals and except for effects of credit losses. • Realized changes are always in net income • The business strategy test is based on how the instruments are managed, as opposed to management’s intent for an individual instrument and on whether the entity holds a high proportion of similar instruments for long periods relative to their contractual terms • Except that equity method investments may not be measured at fair value • An equity method investment is one in which the investor has significant influence and the investment is considered related to the investor’s consolidated businesses • Except that the effective date for nonpublic entities with <$1 billion in assets would be delayed 4 years, during which time the entities would measure loans and core deposit liabilities at amortized cost

25. Joint IASB-FASB project on financial instruments—FASB tentative decisions • Core deposit liabilities • Measure at the present value of the average balance discounted at a rate = the difference between the alternative funds rate and the all-in-cost-to-service rate • Changes in value except for interest accruals may be recognized in OCI • Credit impairments receive special treatment • Credit impairment exists when a consideration of all past and current events indicates that the entity will not be able to collect all the contractually promised cash flows • Entity’s own debt • Measured at amortized cost if the entity’s business strategy is to owe the instrument to maturity and fair value measurement would result in a measurement attribute mismatch • Hybrids (arrangement contains an embedded derivative) • If the derivative does not meet the “clearly and closely related” criterion, and therefore must be separated under SFAS 133, measure the entire arrangement at fair value with changes in earnings • However, if the derivative need not be separated, apply the business strategy test • Fair value option will be reconsidered in the future • Reclassifications would not be permitted

26. Concluding comments While the SEC has proposed a timetable for considering, and possibly adopting, IFRS for registrants domiciled in the US, it is possible that the timetable could change Comment letters cite the cost of moving to IFRS and suggest that the FASB continue its convergence activities with the IASB It is not clear how many of the existing major convergence projects will be completed, or nearly completed, by 2011, the proposed date for the SEC decision The FASB and IASB have undertaken major projects to improve and converge guidance in several key areas, including lease accounting, revenue recognition and financial statement presentation Revenue recognition and financial statement presentation have been on the FASB’s agenda for several years. Due process documents have been issued, so constituents now have a sense of the Boards’ thinking. Proposals to apply fair value measurement to more financial assets A final process issue: As of summer 2009, the FASB has replaced the system of numbered statements US GAAP has been codified into numbered sections, by topic, and authoritative guidance is now to be referred to by those section numbers The IASB has not adopted a similar codification approach (it continues the use of standard-by-standard numbering) 26