International Financial Reporting Standards (IFRS) for small and medium-sized entities (SMEs) is a simplified version of full IFRS. In creating IFRS for SMEs, the International Accounting Standards Board (IASB) eliminated many accounting topics that are not generally relevant to private companies (for example, earnings per share and segment reporting).

In preparation for the conversion to IFRS, it’s important that US companies understand how the conversion will affect them. I’ll take you through a three-step process that explains how an SME should handle its conversion to IFRS, keeping in mind these and other differences. Before I delve into that, I’ll explain a few basics about US Generally Accepted Accounting Principles (US GAAP) and IFRS for SMEs.

US GAAP and IFRS for SMEs

In areas where US GAAP and IFRS are mostly converged (e.g., business combinations), the differences between US GAAP and IFRS for SMEs likely seem very similar to the differences between full IFRS and IFRS for SMEs. However, there are other examples of differences between US GAAP and IFRS for SMEs in the areas of inventory, borrowing costs, and revenue on construction-type contracts.

Under US GAAP, last-in, first-out (LIFO) is an acceptable method of valuing inventory. In addition, impairments to inventory value are permanent. Under IFRS for SMEs, use of LIFO is not allowed, and impairments of inventory can be reversed under certain circumstances. US GAAP requires capitalization of borrowing costs directly attributable to the acquisition, construction, or production of qualifying assets. Under IFRS for SMEs, all borrowing costs must be expensed, not capitalized.

Under US GAAP, the revenue percentage of completion method is preferable, although the completed construction-type contract method is required in certain situations. Under IFRS for SMEs, the completed contract method is prohibited.

Under US GAAP, complex equity instruments such as puttable stock and mandatorily redeemable preferred shares can qualify as equity, particularly for private companies. Under IFRS for SMEs, these types of instruments are more likely to be classified as a liability, depending on the specifics of the individual instrument.

If a small or medium company is contemplating implementing IFRS for SMEs, it should take three steps:

• Step 1. Conduct a business impact analysis
• Step 2. Perform an operational risk analysis

• Step 3. Set up life cycle management processes

Step 1. Conduct a Business Impact Analysis

In a business impact analysis, you answer questions about how changes in accounting policies, standards, and practices can affect the business processes of changing from one accounting method to another. Some sample questions include:

• How well does the finance department understand the differences among US GAAP, the full IFRS, and IFRS for SMEs?
• What is the impact of parallel processing of the existing legacy financial system and the system being converted to full IFRS and IFRS for SMEs?
• How many resources should be assigned to the IFRS conversion team?
• Does the company have sufficient or flexible policies to handle controls testing?
• Other than the finance department, what other stakeholders should be involved with the IFRS conversion plan?

Understanding the Differences

The finance department includes not only accountants, but also the staff responsible for operational audits and internal control over financial reporting (ICFR) under section 404 of the Sarbanes-Oxley Act, as well as other stakeholders. Section 404 requires CEOs, CFOs, and auditors to confirm the effectiveness of ICFR on retained data.

One way of achieving their confirmation is to send them questionnaires or interview them. If the results show that they do not fully understand the differences, then training should be mentioned in the business impact analysis as a possible recommendation. The business impact analysis should also include which actions the ICFR staff should take based on both operational risks and the risk of material weakness in ICFR.

Impact of Parallel Processing

Companies that have not yet begun parallel processing of IFRS and US GAAP need to determine how IFRS, if implemented, will affect business operations, including IT operations. They need to determine how parallel processing affects existing legacy financial systems and the system being converted to full IFRS and IFRS for SMEs (e.g., SAP ERP Financials).

One potential effect may be company-wide changes that spawn new risks. These include system changes, modifications to processes affecting employees’ day-to-day duties, and new accounting policies.

Adequacy of Resource

Before implementing IFRS, assess SAP ERP Financials and consolidation systems to determine if they can handle not only the requirements of dual ledgers and reporting, but also the higher volume of data that will pass through the SAP ERP system. For example, a parallel accounting environment structured to process a single transaction into two separate accounting streams may cause processing lags due to volume, bandwidth limitations, insufficient storage, inadequate memory, and other inadequate resources.

You need to check if your bandwidth is sufficient to process transactions during parallel processing in a timely manner. If not, you need either to upgrade the bandwidth or get more advanced network technologies at an additional cost. You may need to stagger the use of bandwidth until parallel processing is completed. Beyond systems, you may need additional resources to modify the company’s accounting processes for simultaneous IFRS and US GAAP accounting, as well as to consolidate financial statements.

Internal Control Testing

Controls through the conversion process, such as new policy approvals and reviews of conversion calculations, are equally important. Testing of ICFR during the conversion to IFRS may take a long time to perform. You need to test and document each set of changes to your accounting systems as well as the effectiveness of internal control testing. Documentation should show the status of tests as either a success or a failure. If the tests failed, you should include recommendations on fixing the problems and repeat the process of testing the changes.

During IFRS conversion, your ICFR or operational audit staff needs to continually monitor risks and test controls. In the US, the oversight of financial reporting stays with the US Securities and Exchange Commission. Other countries may allow home-country variations of IFRS for SMEs as issued by the IASB.

The first set of financial statements published under IFRS may be subject to Sarbanes-Oxley section 302 and section 906 certification rules. Section 302 requires CEOs, CFOs, or persons performing similar functions to certify, in each annual or quarterly report, that the signing officer has reviewed the report. Section 906 mandates corporate officers to certify financial reports — otherwise, they face penalties.

Stakeholders' Perspectives

One of the first concerns in the business impact analysis is to determine which stakeholders should be included in the IFRS conversion plan. Although finance professionals may fully understand the differences between the standards, their perspective may not be broad enough to capture the results of their decisions. Some stakeholders with unique perspectives on IFRS conversion include:

• IT experts who can determine system capacity during parallel processing
• Internal auditors who can determine what policies and processes are in place to maintain industry consistency
• Internal control certifiers who can determine the adequacy of disclosures
• CIOs, CFOs, and other corporate officers who can determine if their strategic plans have been adequately converted into tactical conversion plans
• ICFR staff who can determine operational risks and the risk of material weakness in ICFR

Step 2. Perform an Operational Risk Analysis

You need sufficient IT knowledge to assist in identifying and analyzing risks that may arise from system modifications for the parallel accounting period. For the first step in risk management, you need to identify who the stakeholders are (in addition to the finance department) to address the enterprise-wide impacts of an IFRS for SMEs conversion. Then you start with risk analysis by identifying risks (e.g., ineffective organizational structure, inadequate resources, and poor communication) as threats to successful IFRS adoption.

Next, you need to determine which risks depend on others and which risks interrelate with others. You need to assess and measure each risk and examine inherent risks and any new vulnerabilities that may arise during risk analysis. To prioritize these risks according to impact and vulnerability, you need to develop a plan to address topics such as mitigation of risks, residual risk handling, and disaster recovery. Include specific tasks, required resources, and time frames.

Then, build a monitoring system with established risk thresholds to allow you to quickly detect significant risk changes and take corrective actions. Include in the monitoring system a repository of prioritized risks that will act as a reference point for monitoring risks throughout the conversion process.

Step 3. Set Up Life Cycle Management Processes

SAP ERP Financials helps companies comply with accounting standards such as US GAAP and IFRS. The system architecture of the SAP General Ledger supports organizations that seek to reduce the costs of parallel accounting. 

Because the complexity of parallel accounting could spawn new risks, consider the Lifecycle Management capabilities of SAP NetWeaver to track the progress of parallel processing of US GAAP  and IFRS for SMEs (or full IFRS) in each stage of a life cycle. This platform offers tools to support all life cycle stages, from design to operations. You can use the results to compare business processes of the two existing accounting systems — one running in the format of US GAAP and the other in the format of IFRS for SMEs — for consistency and accuracy of information before removing the older financial system.

You can analyze accounting standard differences, the impact of parallel processing, adequacy of resources, internal control testing, and stakeholders’ perspectives. For an update on the application platform, process integration, information integration, and people integration as you move from one life cycle stage to another, you can also conduct risk analysis. If the analyses show that risks need to be mitigated in any stage, you can always return to a previous stage to fix the problem before proceeding to the next stage. For this reason, you need to maintain the progress of parallel processing in each stage by documenting the updated version of the conversion application.