The coming changes to financial accounting standards mean that you need to reconsider how SAP ERP software addresses regulatory changes. The most prominent change is International Financial Reporting Standards (IFRS). IFRS is widely based on International Accounting Standards (IAS), but with some changes.

I’ll review how the SAP ERP system can address some elements of IFRS and IAS standards, including:

• Financial Instruments: Presentation (IAS 32)
• Financial Instruments: Recognition and Measurement (IAS 39)
• Financial Instruments: Disclosures (IFRS 7)
• Foreign Exchange Rates (IAS 21)
• Financial Reporting in Hyperinflationary Economies (IAS 29)
• Cash Flow Statement (IAS 7)
• Inventories (IAS 2)
• Employee Benefits (IAS 19)
• Share-Based Payments (IFRS 2)

Some of the functionalities that can help you enhance IFRS compliance include multi-currency support, SAP Hedge Management, SAP Exposure Management, SAP Balance Analyzer, SAP Market Risk Analyzer, SAP Payroll, and SAP Liquidity Planner.

In my previous article, “How SAP ERP Combats the Challenges of Global Accounting and Financial Reporting Standards,” I discussed other elements of these standards.

Financial Instruments

The objective of these standards is to provide guidelines for financial instruments (e.g., derivatives, finance lease receivables) and accounting in the areas of classification, offsetting, recognition, derecognition, investment, hedging, and disclosures.

IAS 32: Presentation

IAS 32 specifies that a financial instrument should be classified based on the substance of the contract as either a financial liability or an equity instrument. An equity instrument reveals evidence of a residual interest in the entity’s assets after the deduction of all its liabilities. For a compound financial instrument that consists of both liability and equity components, the parts must be separately recognized and presented based on the substance of the definition of liability and equity. IAS 32 also states that a financial asset and liability should be offset and the net amount reported only when an entity has a legally enforceable right to set off the amounts and intends to settle either on a net basis or simultaneously.

IAS 39: Recognition and Measurement

To determine how financial assets are accounted for and presented in the financial statement, IAS 39 classifies financial assets as one of the following: financial assets at fair value via profit or loss, available for sale financial assets, loans and receivables, or held-to-maturity investments. On the other hand, two categories of financial liabilities are recognized by IAS 39: financial liabilities at fair value via profit and loss, and other financial liabilities measured at an amortized cost via the effective interest method. Furthermore, a financial asset or a financial liability is recognized by an entity at the time it becomes a party to a contract, and they are also recognized on the balance sheet. You can derecognize financial assets and financial liabilities based on certain conditions. A financial asset is derecognized if the right to cash flow from the asset has expired, all the risks and rewards have been transferred, and the control of the asset is not retained. You should remove a financial liability from the balance sheet only if the specifications in the contract are no longer valid as a result of expiration, cancellation, or discharge. A gain or loss following the derecognition of the original financial liability should be recognized in the income statement.

IAS 39 allows the use of hedge accounting only if the hedging relationship:

• Is formally designated and documented, including the objectives of the entity’s risk management and hedging approach, identification of the hedging instrument, the hedged item, and the nature of risk being hedged. You also need to explain how the entity will assess the hedging instrument’s effectiveness.
• Is capable of being effective in meeting offsetting changes in fair value or cash flows that can be linked to the defined hedged risk
• Allows hedge effectiveness to be reliably assessed

The standard requires hedge effectiveness to be accessed prospectively and retrospectively and all hedge ineffectiveness should be recognized in the income statement. Three types of hedging relations are prescribed in IAS 39:

• Fair value hedge: exposures to changes in the fair value of a recognized asset or liability or firm commitment
• Cash flow hedge: exposures to variability in cash flow of a recognized asset or liability or a highly probable forecast transaction
• Net investment hedge: hedge of the foreign currency risk on a net investment in a foreign entity

Some financial instruments and other contracts combine in a single contract as both derivative and non-derivative. The derivative component of the contract is called embedded derivative. An embedded derivative is a feature within a contract that prompts the cash flow associated with the contract to vary in a way that is similar to a standalone derivative. It must be accounted for at fair value with the fair value changes reflected in profit or loss. IAS 39 stipulates that embedded derivatives should be separated from their host contract and accounted for as standalone derivatives.

IFRS 7: Disclosures

IFRS 7 allow users to objectively access how financial instruments have affected an entity’s financial position and performance while carrying out comprehensive risk assessment and management. It requires the disclosure of an entity’s financial position and performance that covers a broad range of elements, such as financial assets, financial liabilities, recognized income, impairment losses, reclassification, pledge of assets, and embedded derivatives. Also, disclosure is needed in the areas of qualitative and quantitative exposures to different classes of risk including credit risk, liquidity risk, and market risk.

Hedge accounting should be discontinued prospectively if the:

• Hedging instrument is expired, sold, terminated, or exercised
• Criteria for hedge accounting is not longer applicable
• Forecast transaction is no longer expected to occur for cash flow hedges
• Hedge designation is revoked

SAP Hedge Management is an invaluable tool for adhering to the financial instruments disclosure requirements of IFRS. It is a central component of the SAP Bank Analyzer, which is used for the management and processing of hedging transactions. It provides monitoring services for hedges in IAS accounting and performs a reconciliation of hedging data with the information in the financial database, thus providing information about the risk hedged under IAS. SAP ERP helps to effectively manage financial risk by integrating financial and treasury reporting thereby effectively managing hedging. Furthermore, you can use the prospective effectiveness test in SAP Hedge Management to ascertain the effectiveness of hedges. SAP ERP supports different methods of testing the effectiveness of hedges, including the retrospective testing method (offset methods and regression analysis/historical data), prospective method (market data shift), residual maturity check, and tolerance value check. SAP Hedge Management supports hedge designation, hedge categorization, hedge maintenance, and effectiveness testing.

The balance analyzer component of SAP Best Practices for IAS and IFRS enables enterprises, especially banks, to achieve compliance with global reporting standards with ease. Before IFRS-compliant reports and disclosures are generated, the inherent accounting functionality performs business transaction processing, valuation, and automatic posting based on IFRS hedge accounting requirements. The balance processing functionality performs account balances merging and assignment of reporting data to the balance sheet, IAS statement, or notes. SAP Best Practices for IAS and IFRS are invaluable in managing the embedded derivatives requirement of IFRS. The accounting module in SAP Best Practices for IAS and IFRS distinguishes embedded derivatives from the host contract and allows you to perform a separate valuation. With the integration possibilities provided for SAP NetWeaver Business Warehouse (SAP NetWeaver BW), you can generate IAS- or IFRS-based reports easily.

Furthermore, the market risk analyzer component of SAP Corporate Finance Management is designed to satisfy the risk management requirements of an internal reporting standard by carrying out effective risk analysis and management based on risk elements such as exchange rates, interest rates, and price volatilities. You can use the market risk analyzer to calculate the net present value of common financial instruments and consequently store them for accounting and reporting purposes by the valuation functions of the transaction manager. It has capability for performing varying risk analysis, including portfolio analysis, position analysis, and liquidity analysis.

Foreign Exchange Rates (IAS 21) and Financial Reporting in Hyperinflationary Economies (IAS 29) 

The objective of these standards is to define accounting treatment for foreign currency transactions and overseas operation of an entity, as well as reporting requirements in the currency of a hyperinflationary economy. IAS 21 requires that the functional currency of an entity is determined as a matter of priority because that forms the basis for the treatment of foreign currency transactions in the operational business location of an entity based on the exchange rate of the transaction date.

At the end of a subsequent reporting period, foreign currency balances of monetary items are reported using the closing rate. Foreign currency balances of non-monetary items carried at historical cost are reported using the exchange rate at the transaction date, and foreign currency balances of non-monetary items carried at fair value are reported using the exchange rate at the date of fair value determination. Disclosure requirements of IAS 21 include analysis of translation differences in equity, differences in rate after balance sheet date, and foreign exchange risk management policies.

IAS 29 stipulates that equity’s financial statement reported in the currency of a hyperinflationary economy should be based on the measuring unit amount at the end of the reporting period. An economy is hyperinflationary when there is 100% inflation over three years.

The SAP system supports the definition and use of multiple currencies for transaction processing and financial reporting. This functionality allows global businesses to operate without currency boundaries. Exchange rate differences are properly managed in SAP ERP Financials to ensure that financial statements and reports are accurate and consistent across the enterprise. It is important to state that support is also provided for the revaluation of foreign currency elements on the day of running the balance sheet. You can perform foreign exchange valuation for balance sheet account and open items (e.g., vendors, customers, and general ledger accounts) posted in foreign currency via transaction OB59 based on the defined valuation method, which allows you to define parameters for valuation procedures and exchange rate determination (Figure 1).

Figure 1

Foreign currency valuation method

Also, SAP ERP Financials supports the consolidation and translation of financial reports based on foreign currencies. You can use SAP Exposure Management to manage foreign currency exposures while adhering to IFRS reporting and disclosure requirements on foreign currency transactions. You can make transfers to SAP Hedge Management after you have performed objective exposure analysis based on defined hedging policies and procedures. The benefits accruable from leveraging SAP Exposure Management functionality for IFRS compliance include the centralized management and documentation of foreign currency exposures.

Cash Flow Statement (IAS 7)

The objective of this standard is to describe how the historical changes in cash and cash equivalents of an entity via cash flow are handled and presented. The cash flow statement contains an analysis of the changes in cash and cash equivalents and classifies them as operating, investing, and financial. Operating cash flow is reported using either the direct or indirect method. Cash flow related to the taxation of income is classified as operating unless it can be specifically associated with investing or financing activities.

The capability to generate the cash flow statement is built into the standard SAP ERP Financials system. Both direct and indirect cash flow methods are supported. For direct cash flow, follow menu path Accounting > Financial Accounting > General Ledger > Information System > General Ledger Reports (New) > Financial Statement/Cash Flow > General > Cash Flow > S_ALR_870112271 – Cash flow (direct method) (Figure 2). For indirect cash flow, follow menu path Accounting > Financial Accounting > General Ledger > Information System > General Ledger Reports (New) > Financial Statement/Cash Flow > General > Cash flow > S_ALR_87012272 – Cash flow (indirect method) (Figure 3).

Figure 2

Sample cash flow statement — direct method

Figure 3

Sample cash flow statement — indirect method

Furthermore, you can adapt standard cash flow reporting templates to suit IFRS reporting requirements. Also, SAP Liquidity Planner is an excellent planning and reporting tool for achieving IFRS requirements on cash flow statement presentation. This functionality allows you to plan and report cash flows based on the value date. Its integration with SAP NetWeaver BW or SAP Strategic Enterprise Management (SAP SEM) provides financial data analysis and reporting capabilities.

Inventories (IAS 2)

The aim of this standard is to define the accounting principle for the treatment of an inventory cost (e.g., purchase cost, conversion cost, import duties, and non-refundable taxes and rebates). Inventories are to be valued at the lower cost and net realizable value (NRV). For inventory items that are not interchangeable, the cost is determined on a per-item basis. For inventory items that are interchangeable, cost is determined using either first in, first out (FIFO) or weighted average. Last in, first out (LIFO) is prohibited and should not be used. On sale of an inventory item, the carrying amount is recognized as an expense in the period in which revenue is recognized. Written-down NRV is recognized as an expense in the period in which the write down was done. Furthermore, the standard stipulates that reversals as a result of increase in NRV must be recognized as a reduction in the inventory expense in that period.

An SAP ERP system offers support for the acceptable methods of inventory valuation under IFRS, namely FIFO and weighted average. Inventory valuation is tightly linked with core SAP modules such as materials management (MM), sales and distribution (SD), production planning (PP), and of course FI and Managerial Accounting (CO). The Material Ledger functionality supports product cost by period, which allows for the valuation of work in process (WIP) using target cost. During a period, the Material Ledger aggregates all material-centric transaction data and calculates preliminary valuation for these materials up to three currencies and valuation methods. You can use the valuation variant to define the calculation used to determine target cost for WIP valuation by following the path SAP Customizing Implementation Guide > Controlling > Product Cost Controlling > Cost Object Controlling > Product Cost by Period > Period End Closing > Variance Calculation > Variance Calculation for Product Cost Collectors > Define Valuation Variant for WIP and Scarp (Target Costs). The change in WIP is transferred to FI when the settlement is carried out. To ensure accurate disclosures, the system supports the valuation of unfinished stocks and period-end closing for inventory valuation processes.

Employee Benefits (IAS 19) and Share-Based Payments (IFRS 2)

The objective of IAS 19 is to provide guidelines for the accounting treatment and disclosure of employee benefits. The standard is based on the principle that employee benefit costs are recognized in the period in which the entity receives services from the employee and not when the benefits are paid or payable. Post-employment benefits are characterized as either a defined contribution plan or a defined benefit plan. Long-term employment benefits and post-employment benefits are recognized in the same manner under a defined benefit plan.

IFRS 2 stipulates that all share-based payments are recognized in the financial statements using a fair value measurement basis and that an expense is recognized when the goods or services received are consumed. This standard is applicable to an employee share program and other areas in which shares are used as payment for assets or services rendered. For equity-settled, share-based transactions, fair value is estimated at grant date and for non-employee transactions, fair value is estimated at the date of receipt of those goods and services. If it is impossible to reliably measure the fair value of goods and services, the entity uses the fair value of the equity instrument granted.

You can use the Payroll and Compensation Management components of SAP ERP Human Capital Management (SAP ERP HCM) to drive IFRS compliance with the accounting and reporting requirements that deal with employee benefits and employee share based payments. Payroll is used to calculate the gross and net payment of employees based on defined parameters or elements over a particular period of time, usually the period in which service is delivered by the employee.

To guarantee transparency in financial reporting, the system automatically posts modifications to employees’ salary master data to Payroll. To effectively manage a long-term service award, you can use the integration capabilities of SAP ERP HCM with SAP Treasury Management, which allows you to use awards and offset them in Payroll against the employee’s remuneration and to also review the current value of stocks.

The core areas supported by Compensation Management include job pricing, budgeting, compensation administration, and long-term incentives. The compensation administration functionality in SAP ERP HCM allows an enterprise to share wage increase, shares, bonus, profit, and so on. Budgeting allows for controlled planning of changes to employee compensation. The long-term incentive is used to cater for long service award. Follow menu path SAP Customizing Implementation Guide > Personnel Management > Compensation Management > Planning and Administration > Compensation Packages > Define Compensation Components to be able to define the types of compensation that you can give to your employees (Figure 4).

Figure 4

Compensation component

SAP ERP HCM supports three guidelines — fixed, matrix, and user-defined — that control compensation adjustment, such as salary increase, bonus payment, and stock options to which employees are entitled.

Follow menu path SAP Customizing Implementation Guide > Personnel Management > Compensation Management > Planning and Administration > Compensation Packages > Define Long-Term Incentive Plans to be able to define long-term incentive plans, including the number of shares that the shareholders approve to be allocated (Figure 5). You can use HR reporting tools such as Ad Hoc Query and SAP Query to adapt standard reports to IFRS format.

Figure 5

Long-term incentive plans

Kehinde Eseyin

Kehinde Eseyin is a security architect. He holds a bachelor’s degree in computer science. He has about 12 years of IT security, governance framework, IS risk, and compliance experience gained by working in numerous global organizations. Over the years, he has demonstrated competencies in security design, information assurance, cyber security, data privacy, threat and vulnerability management, penetration testing, business architecture, project management, IT audit, IS controls framework, and identity and access management.
 

You may contact the author at eseyinok@gmail.com.

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