Mastering the transition from US GAAP to HGB

The globalization of corporate accounting has long been part of the finance scene. In Germany, large capital market-oriented companies have been required to prepare their consolidated financial statements in accordance with IFRS for years. In the US, the Securities and Exchange Commission (SEC) generally requires financial statements to be prepared in accordance with US GAAP (Generally Accepted Accounting Principles); however, IFRS financial statements are also accepted for foreign groups.

In practice, consolidated financial statements in accordance with HGB remain of central importance: on one hand, the individual financial statements of German parent companies continue to be prepared predominantly in accordance with HGB commercial law provisions (e.g., SAP, BMW, Siemens, and Deutsche Bank). On the other hand, many unlisted but internationally active German groups prepare their financial statements in accordance with HGB. As a result, we are increasingly encountering the following situation:

 

For consolidated financial statements, international balance sheets must be converted into local accounting standards.

This is the case in our following fictional case study of SpielSchön GmbH, a long-established company from Freiburg. The toy company generated sales in the double-digit millions in 2022. It has several subsidiaries in Germany and Austria. Until now, there has been no need to deal with international accounting in any great detail. Until now, that is.

 

Practical example: SpielSchön GmbH acquires a US subsidiary (US GAAP according to HGB)

Let's assume you are the head of group accounting at SpielSchön GmbH. As the company grew, you introduced Lucanet as its planning and consolidation software a few years ago. Your company management has now decided to buy a competitor in the US – KiddyToy Inc. The aim is to drive forward the group's strategic focus on innovative business areas internationally.

What does this mean for you as head of group accounting? Currency translation, of course! But that comes at the very end. First, you have the arduous task of preparing a commercial balance sheet II (HB II) in accordance with HGB for a US GAAP company. 

The thing is, anyone who is reasonably familiar with both accounting systems knows that the differences between the two could hardly be greater.

 

US GAAP and HGB: Historical development of accounting

Why is that? As is so often the case, a look at history helps. At the beginning of the 20th century, the state still had sovereignty over monetary policy and the money supply in Germany. Since the state coffers were more often empty than full even back then, a lot of money was printed. This led to inflation with all its devastating consequences for the economy. As a lesson learned from this, legislators in this country placed a strong emphasis on creditor protection in commercial law.

The situation is different in the United States. There, the focus of accounting has always been on investors and their interest in information. The principle of “fair presentation,” i.e., economically appropriate presentation, applies rather than the “principle of prudence.” After the stock market crash of 1929, the Securities and Exchange Commission (SEC) was founded to regulate securities trading in the United States.

 

Accounting shaped by tax law and legal tradition

Accounting systems also reflect historically developed differences in legal traditions and tax law conditions. While case law in this country is based on the German Civil Code (BGB), case law based on precedents prevails in Anglo-Saxon countries. It is therefore not surprising that German accounting rules are enshrined in law; the German Commercial Code (HGB) came into force together with the Civil Code (BGB) on January 1, 1900.

The American accounting rules are different. Until the 1970s, the American Institute of Certified Public Accountants (AICPA), the national professional association of American accountants, was tasked with creating uniform accounting standards. Today, the Financial Accounting Standards Board (FASB) is responsible for the US GAAP rules. However, these are not laws. And the application of US GAAP is not generally mandatory. However, an unqualified audit opinion from the auditor requires compliance with it. And the SEC requires its application for listed companies.

 

Differences in the distribution and taxation function between US GAAP and HGB

There are also differences regarding the distribution and taxation function. In Germany, this is always based on the individual financial statements. Companies in the United States follow the regulations of the state in which they are based. And these state laws sometimes differ significantly in terms of distribution. There was and is no equivalent to the German principle of authoritativeness in the US.

It is therefore not surprising that, despite all international efforts toward convergence, significant differences still exist between the individual accounting standards.

US GAAP according to HGB – transition from one accounting system to another

There are two ways to transition from American to German accounting:

• Parallel accounting (In addition to US GAAP financial statements, original financial statements are prepared simultaneously in accordance with HGB.)
• Classic transition to HGB based on US GAAP financial statements

 

Back to our fictional case study: Since KiddyToy Inc.'s accounting department does not seem motivated or technically capable of parallel accounting, you quickly decide on the transition. True to the motto: better to do it wrong yourself than to be completely wrong.

You discuss with your trusted auditor whether the reconciliation to HGB could be dispensed entirely with reference to Section 308 (2) No. 3 f. HGB. Because the differences are not that material, you say. He sees it differently. Too bad.

Shortly after July 31, 2023, the first reporting date after the acquisition, you find the following in your email inbox: an Excel file with the file name “KiddyToy Financial Statements July 2023 (Prelim)”. But, surprise! Unfortunately, the file does not quite meet your format requirements. Thanks to Lucanet's flexible import function, your experienced team was able to import the file into Lucanet a short time later.

Don't forget: Americans use a period as a comma and vice versa when writing numbers. Internationally, balance sheets are often structured in descending order of liquidity. This means that they begin with short-term liquid assets (cash).

In order to be able to analyze KiddyToy's figures in Lucanet in the original US GAAP structure, a derived balance sheet and income statement (profit and loss statement) is created in accordance with US GAAP. To ensure that the transition in Lucanet remains transparent, a new valuation level “Transition” is created.

Practical tip for transitioning from US GAAP to HGB: The transformation of an international balance sheet into a commercial balance sheet can be transparently displayed in Lucanet by mapping the transition entries in separate valuation levels. When reorganizing local accounts into an HGB structure, it is advisable to check the assignment status to ensure that all accounts are transferred completely.

After successfully importing and assigning the items in Lucanet, you can view KiddyToy's US GAAP balance sheet in the Lucanet Consolidation and Financial Planning solution: 

KiddyToy Inc.'s balance sheet: Inventories, property, plant, equipment, and hidden reserves

Inventories at the US subsidiary are valued using the first-in, first-out (FIFO) method. The last-in, first-out (LIFO) method or weighted average cost method could also have been used. FIFO is also permitted under the German Commercial Code (HGB). However, SpielSchön's group policy stipulates that valuation must be carried out using the last-in-first-out (LIFO) method. As the procurement prices for KiddyToy Inc.'s goods have been falling for years, the inventory item is increasing. Profits are rising because the cost of materials is lower.

The situation becomes paradoxical when it comes to property, plant, and equipment. In the past, the US subsidiary made an unscheduled write-down on a specialized production machine. In the current year, it turns out that this machine can be converted to produce virtual pets, which are currently in high demand again on the market. It will be used again in the next production cycle. Your US colleagues explain that, according to US GAAP, no write-up may be made. Under commercial law, KiddyToy Inc. can book a write-up up to the amount of the amortized cost of the machine in this example.

This item also includes two properties used by KiddyToy for operational purposes. As is often the case in this country, these may contain material hidden reserves. As under HGB, US GAAP does not allow for the revaluation of land and other property, plant and equipment. The hidden reserves must therefore be disclosed later during revaluation and capital consolidation.

 

Accounting for trademark rights

The US subsidiary holds rights to various toy brands, including both self-created and purchased rights, the latter of which are partially recognized in intangible assets.

According to Section 248 (2) No. 2 HGB, self-created trademarks may not be recognized.

The consolidated financial statements must also include the trademark rights created by the subsidiary prior to initial consolidation. This is because the individual acquisition of assets and liabilities is simulated during initial consolidation.

 

Treatment of provisions under commercial law and US GAAP

KiddyToy Inc. is currently involved in a legal dispute with a US competitor over an alleged trademark infringement. The US company management estimates the probability of losing the case and having to pay the compensation demanded of USD 80,000 at just over 50 percent but less than 75 percent. Accordingly, it has not recognized any provision for this risk. Since commercial law (prudence principle!) requires provisions to be recognized even for predominantly probable liabilities, you recognize this entry in the income statement.

Regarding provisions for retirement benefits, there is an international requirement to recognize pension commitments as liabilities – under HGB, this only applies to new commitments made after January 1, 1987. The amount of the provision for defined benefit plans is also determined in accordance with US GAAP using actuarial reports. However, the underlying assumptions, such as mortality tables, discount rates, and calculation methods, may differ from those used under commercial law and lead to material differences over the long calculation horizon, which must be taken into account in the reconciliation.

Please note: Assumptions and probabilities may have a significant impact on the balance sheet figures.

 

KiddyToy Inc.'s income statement: total cost method vs. cost of sales method

While the reconciliation of the balance sheet was relatively easy to accomplish, the income statement is noticeably more complex:

SpielSchön GmbH has always used the total cost method. However, KiddyToy Inc. is required to use the cost of sales accounting method in accordance with US GAAP.

Your team has therefore already created a reconciliation matrix in preparation for the acquisition. Each combination of account and cost center of the subsidiary was assigned a target combination of account and cost center adapted to the group's GKV (total cost method) scheme.

With the help of this reconciliation matrix, the correct allocation of the individual P&L items can be carried out via a script when importing data into Lucanet. As an alternative to cost center-dependent reconciliation, Lucanet also offers reconciliation based on fixed percentages.

Practical tip for displaying the income statement in Lucanet: In Lucanet, both methods of displaying the income statement can be displayed in parallel in one workspace. The transition is carried out by assigning the cost centers to functional areas or cost types. In Lucanet, this can be done automatically as part of a script-based transformation. Consolidation can also be carried out using the cost of sales method via the corresponding wizards.

 

US GAAP and HGB: What accountants need to consider when recognizing revenue

Revenue is also a complex issue. The HGB only specifies the generic standard of Section 252 (1) No. 4. According to this, profits (or income) must be taken into account if they are realized on the balance sheet date. Under US GAAP, revenue recognition is regulated in ASC 606. This is the result of a convergence project with the IASB and is therefore largely similar to IFRS 15 Revenue from Contracts with Customers. ASC 606 replaces numerous industry-specific standards on revenue recognition and introduces a uniform 5-step model that accountants must follow when recognizing revenue. According to ASC 606, revenue must be recognized at the point in time when control over a good or service is transferred to the customer.

Among other things, KiddyToy Inc. develops electronic components for several model vehicle manufacturers as a service. These are long-term service contracts in which control is transferred to the customer on a period-based basis. Revenue recognition must therefore also be period-based (“over time” recognition according to ASC 606). One possible method of period-based revenue recognition under US GAAP is the percentage-of-completion (POC) method. This means that revenue per period is recognized as a percentage of the ratio of costs incurred to total costs.

Commercial law generally provides a different approach here, namely revenue recognition upon completion. (The contracts in the example do not contain any interim acceptances or similar, which would be suitable for bringing forward revenue recognition under HGB as well.) Your team works with their US colleagues to identify all POC revenues of KiddyToy Inc. and to reverse the revenues that are not permitted under HGB.

In our example, the transition led to a lower reported profit for the company under HGB (prudence principle!). In practice, of course, the opposite case can also occur.

 

Conclusion: The most important differences between US GAAP and HGB

Only a handful of the differences between US GAAP and HGB are easy to identify because they are obvious. For example, under HGB, provisions for omitted maintenance must be recognized as liabilities if the maintenance is carried out in the first three months of the following year. Changes in estimates for pension obligations and plan assets must be recognized in other comprehensive income (OCI) under US GAAP, which has no direct equivalent in commercial law.

Apart from such obvious differences, however, most of the deviations are to be found deep in the details of the accounting standards – often with material consequences. It can therefore be helpful to analyze the differences between the two systems in detail. In practice, existing options and accounting policy leeway are often used to achieve the greatest possible consistency between international and local accounting.

However, the targeted use of this flexibility to pursue accounting policies can also be observed.

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