Paper 908497 – Evaluating the potential accounting issues raised by a combination of Kraft Heinz (hereafter ‘Kraft’) and Unilever
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Table of Contents
- Executive Summary. 1
- Evaluation of selected measurement model 1. 1
- Evaluation of selected measurement model 2. 2
- Discussion of influence of institutional context on permitted measurement choices. 3
- Discussion of influence of social context on permitted measurement choices. 6
- Recommendations concerning the implications of differences in IFRS and US GAAP. 7
This assignment evaluates the potential accounting issues raised by a combination of Kraft Heinz (hereafter ‘Kraft’) and Unilever. The work considers revenue recognition principles and differences permitted in inventory valuation, both in general and in the specific case of Kraft and Unilever. This is followed by a discussion of the influence of the institutional context on permitted measurement choices and the influence of social context on permitted measurement choices. Finally, the assignment presents recommendations concerning the implications of differences in IFRS and US GAAP.
The first measurement model to be evaluated in this assignment is the revenue recognition model. Revenue recognition under US GAAP begins by determining whether revenue from a sale is realisable by the company, and then determining whether it has been earned. This in theory means that revenue recognition only occurs once the underlying value has been exchanged, in that whatever goods or services are being provided for revenue have passed to the buyer. However, the rule based nature of GAAP means that this results in different rules for each industry, which need to be interpreted in the accounts (Atrill and McLaney, 2011). In the case of Kraft Heinz (hereafter ‘Kraft’), “we recognize revenues when title and risk of loss pass to our customers. We record revenues net of consumer incentives and trade promotions and include all shipping and handling charges billed to customers. We also record provisions for estimated product returns and customer allowances as reductions to revenues within the same period that the revenue is recognized. We base these estimates principally on historical and current period experience factors” (Kraft, 2017, n. p.). This hence represents a detailed process for recording revenues, including estimates for returns based on experience.
In contrast, in the case of Unilever (2016, p. 90), “turnover is recognised when the risks and rewards of the underlying products have been substantially transferred to the customer. Depending on individual customer terms, this can be at the time of dispatch, delivery or upon formal customer acceptance”. This is in line with IFRS rules on revenue recognition, whereby revenue is recognised as a sale of goods, or rendering of services, completion of contracts or use of other assets. The principles based approach of IFRS means that recognition is consistent and straightforward regardless of industry, and based on the transfer of risks and rewards from the underlying sale. However this simplicity can result in a lack of detail allowing for a range of interpretations and managerial discretion (Bohusova and Nerudova, 2009, p. 12). As such, Unilever has simpler rules for recognising revenue, with less need to consider variables such as returns.
However, despite the appearance of differences in revenue recognition across the two companies, it should be noted that in fact there are close similarities, particularly in a simple consumer goods industry like Kraft and Unilever operate in. This is a result of efforts by the IASB and FASB to develop “a single revenue recognition model which can be applied to all types of revenue transactions” (Munter, 2011, p. 22). These efforts have helped to drive convergence in the recognition of revenue for goods based transactions, including around the substantial transfer of risk and rewards, and considering factors such as when the title has passed to the owner and returns are no longer possible except in the case of defects (Holzmann and Munter, 2015, p. 101). This has addressed previous divergences, such as IFRS lacking detail around how transactions should be treated and GAAP being overly prescriptive. Indeed, as a result of this the main revenue recognition differences between IFRS and GAAP tend to manifest themselves in the recognition of revenue from contracts and intellectual property, whilst the transfer of goods and services are now more converged in nature (Sedki et al, 2014, p. 120). As such, in the event of a combination of Kraft and Unilever, revenue recognition would not need to change significantly for the majority of the revenues of the companies, with only revenue from brand licensing and similar intellectual property sources potentially being affected.
The second selected measurement model is that of inventory valuation. In this regard, under US GAAP, inventory must be recorded as the lower of cost and market value, with market value being the lower of current replacement cost and the net realisable value of the inventory. When measuring cost, GAAP allows for a number of inventory costing methods, with the main ones being FIFO (first in, first out), LIFO (last in, first out) and the weighted average cost of all inventory (Ryan, 2012, p. 24). These costing methods have a range of implications for the value of inventory, depending on which inventory the company chooses to count as being sold first and the respective cost of the different items of inventory it holds. In the case of Kraft (2017, n. p.), “Inventories are stated at the lower of cost or market. We value inventories primarily using the average cost method”. This is in line with the allowances of US GAAP and thus helps to ensure compliance.
In contrast, under IFRS there are slightly different inventory valuation rules and principles. Specifically, IFRS states that inventory must be valued at the lower of cost and net realisable value. As such, inventories under IFRS cannot be valued at current replacement cost, even if this is lower than net realisable value. At the same time, the use of LIFO is not permitted under IFRS, thus ensuring companies cannot manipulate their inventory valuations by keeping old inventory on the books using LIFO (Atrill and McLaney, 2011, p. 91). In the case of Unilever, “inventories are valued at the lower of weighted average cost and net realisable value. Cost comprises direct costs and, where appropriate, a proportion of attributable production overheads. Net realisable value is the estimated selling price less the estimated costs necessary to make the sale” (Unilever, 2016, p. 108). This thus meets the requirements of IFRS.
Despite the differences which exist between inventory valuation under GAAP and IFRS, there are some consistent principles. In particular, under GAAP, companies are required to use the valuation methods which best reflects their periodic income and role of inventory in achieving this (Atrill and McLaney, 2011, p. 93). As such, whilst companies in GAAP can use replacement cost and LIFO, this is only acceptable if it can be shown to reflect their periodic income. In the case of Kraft, a company which earns income very regularly from the sale of consumer goods in a mass market, this limits the use of LIFO and replacement cost, as inventory is turned over rapidly on the market, so there is little justification for using these methods. Indeed, this can be seen to be a reflection of the convergence between GAAP and IFRS, with the fact that IFRS prohibits the use of LIFO and replacement cost meaning that US companies with significant international operations such as Kraft do not tend to use these methods to allow for consistency in global reporting (Satin and Lin, 2009, p. 53). As such, despite the potential differences in inventory valuation, these do not appear to have an influence on any Kraft / Unilever combination due to Kraft not choosing to use LIFO as its primary inventory valuation method. However, there may be some implications if Kraft’s market measure of valuation results in some of its inventory being valued at replacement cost.
In general, the accounting bodies which set the relevant accounting standards, the FASB in the case of GAAP and the IASB in the case of IFRS, are influenced by the institutional context. For example, the development of GAAP in the United States has been influenced by the financial crisis and need to be more open to international convergence. This can be seen in the 2007 ruling by the Securities and Exchange Commission (SEC) that foreign companies in the US can now “file IFRS-based financial statements without reconciling to U.S. GAAP” (Alon and Dwyer, 2016, p. 1). This represented a result of interactions between national and transnational institutions, boosting global convergence. Similarly, the development of IFRS has been influenced by institutions, particularly the European Union whose adoption of IFRS in 2005 played a major role in the spread of these standards around the world. The support of the EU has boosted the prominence of IFRS, but also allowed EU institutions to exert influence on the IASB to meet the needs of EU companies, including Unilever (Haller and Wehrfritz, 2013, p. 39). At the same time, the development of global institutional arrangements, including cooperation and economic interactions between nations, has created a supporting institutional background which has contributed to convergence between GAAP and IFRS, including revenue recognition rules, in an effort to create a more harmonised environment for multinational companies to operate in (Eva, 2014, p. 604).
Despite this convergence in the institutional environment, the underlying institutional contexts do influence financial reporting. In particular, US GAAP is influenced by the institutional environment in the US, including the support for free enterprise and discretion by businesses in reporting. This results in regulatory choices to adopt a rule based system with multiple different options which can be followed, such as supporting the use of LIFO which allows firms to build up valuable LIFO reserves on their balance sheets (Leuz, 2010, p. 229). At the same time, some aspects of US GAAP have been developed due to the responsive regulatory approach of the US institutions, including the passage of legislation such as Sarbanes-Oxley and the Dodd-Frank Act. These laws resulted in the development of additional accounting regulations which were imposed on top of existing rules, thus resulting in a reporting system with a large number of rules, rather than a smaller set of principles as under IFRS (Khan et al, 2015, p. 276). This hence creates a degree of flexibility, whilst also increasing the need for US companies to state the methods they use to report, thus giving Kraft longer explanations for its measurement methods than Unilever.
In contrast, the international nature of IFRS means that it has been developed in a global institutional context, under the influence of multiple national institutions. This is reflected in the use of principles based standards, providing for broader principles which can be adapted to the reporting environment in each country and the national institutional environment (Hope et al, 2006, p. 1). As such, IFRS focuses on determining which methods are not acceptable, such as LIFO, and then allowing flexibility within the permitted methods and principles. At the same time, IFRS adoption does create some institutional convergence between nations, thus helping drive towards the overall IFRS goal of convergence and harmonisation within an evolving institutional context (Brown, 2016, p. 679).
When considering the social context, it is important to consider the nature of US society and the general resistance towards substantial government intervention in the market. In light of this, US GAAP has been developed primarily to provide rules which businesses must follow, rather than principles which govern them. This in turn results in the expanding nature of US GAAP, with rules being developed primarily to respond to identified issues, rather than to attempt to prevent them through additional accounting requirements (Weinstein and Goldstein, 2016, p. 6). Another important social consideration in the US is that it has a culture which is less open to global influences, with Americans tending to see themselves as influencing the world rather than being influenced by it. This hence hinders the process of convergence of US GAAP with IFRS, as the US resists giving up its unique accounting methods such as LIFO due to the differentiation it provides for US companies (Okafor, 2016, p. 136). It also sees the US continue to impose individual rules around specific reporting requirements, such as the 75% requirement for a financial lease versus and operating lease rather than the majority principle under IFRS.
In contrast to this, the nature of IFRS adoption by a country implies a degree of global social acceptance. Specifically, IFRS adoption represents a decision to allow national accounting principles to be placed under the direction of an external body, in order to gain economic and trade benefits from convergence. As such, countries which adopt IFRS tend to have more open acceptance of this principle, such as the EU nations which have already accepted the supervision of the European Commission and other EU bodies (Fearnley and Gray, 2015, p. 271). At the same time, IFRS does allow some accounting choices to be influenced by cultural values and the social environment, such as around revenue recognition and the transfer of risks and rewards which can depend, for example, on consumer rights in a given country. As such, the functioning of IFRS has been defined as representing “a mutually reinforcing relationship between the introduction of new accounting requirements and the application of these requirements in complex social settings characterised by a ‘logic of resistance’” (Maroun and van Zijl, 2016, p. 220). In other words, the development of IFRS has been a process of attempting to introduce new accounting standards within the confines of what is socially acceptable for the adopters of IFRS. This can be reflected in the growing focus on sustainable development, with attempts to introduce social accounting into IFRS hindered by a lack of social acceptance of this expansion of standards (Hales and Johnson, 2015, p. 12). As such, whilst the development of GAAP and reporting practices in the US can be seen as a manifestation of American social cultural values, the development of IFRS and reporting practices in adopting nations can be seen as a function of how well accounting standards can be developed to be acceptable and overcome social resistance in these nations.
In general, the main recommendation concerning the differences in IFRS and GAAP is that evidence indicates that the adoption of IFRS “will indeed produce different inventory valuation results that may appear to be superior to those provided under GAAP” (Jeffers et al, 2010, p. 48). As such, in the case of a convergence between Kraft and Unilever, the recommendation would be to move towards the adoption of IFRS methods of inventory valuation, which are not significantly different from those already used by Kraft. There is no such significant evidence for revenue recognition, however it is important to note that both sets of standards require revenue be recognised based on the substantial transfer of risks and rewards, which is determined by the local institutional context around the sale of goods. The two parts of a combined business could thus continue to use their current revenue recognition principles potentially with only minor changes. At the same time, the adoption of a dominant set of accounting standards would depend upon the converged company’s listing status. In general, if the listing remains in the US then the cultural and institutional context of the US would demand the use of GAAP (Tarca, 2004, p. 60). As such, if Kraft took over Unilever, the resulting reporting standards would either need to be based on US GAAP, or the company would have to move its primary listing out of the United States.
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