Chapter 8

Additional Financial Reporting Issues

Additional International Financial Reporting Issues

Inflation accounting Business combinations and consolidated financial statements (group accounting). Segment reporting.

Inflation

Monetary inflation occurs when the money supply of a country is increased over and above the demand and need for currency (too much money chasing too few goods). This results in depreciation in the value of currency. The impact of monetary inflation on prices is usually not evenly distributed across all goods and services within an economy.

Inflation

Inflation distorts, or eradicates, the meaning of financial statement numbers. As such, when inflation is a substantial problem, its effects need to be removed/adjusted so that financial reports remain useful.

Inflation Accounting Conceptual Issues

Impact of inflation on financial statements

Understated asset values. Overstated income and overpayment of taxes. Demands for higher dividends. Differing impacts across companies resulting in lack of comparability.

Learning Objective 1

Inflation Accounting

Inflation creates two basic reporting mistakes when traditional accounting methods are alone employed:
Purchasing

power gains/losses are not detected and reported. Historical cost numbers lose their relevance.

Inflation Accounting Conceptual Issues

Impact of inflation on financial statements

Historical cost ignores purchasing power gains and losses.

Purchasing power losses result from holding monetary assets, such as cash and accounts receivable. Purchasing power gains result from holding monetary liabilities, such as accounts payable.

The two most common approaches to inflation accounting are general purchasing power accounting and current cost accounting.

Learning Objective 1

Inflation Accounting Conceptual Issues

Net Income and Capital Maintenance

Historical cost, general purchasing power and current cost accounting all flow from different concepts of capital maintenance. Net income represents the amount of dividends that can be paid out while still maintaining the companys capital balance.

Learning Objective 1

Inflation Accounting Conceptual Issues

Net Income and Capital Maintenance

Historical cost net income maintains a nominal, not adjusted for inflation, amount of contributed capital. General purchasing power net income maintains the purchasing power of contributed capital. Current cost net income maintains the productive capacity of physical capital.

Learning Objective 1

Inflation Accounting -- Methods

General Purchasing Power (GPP) Accounting

Updates historical cost accounting for changes in the general purchasing power of the monetary unit. Also referred to as General Price-Level-Adjusted Historical Cost Accounting (GPLAHC). Nonmonetary assets and liabilities, stockholders equity and income statement items are restated using the General Price Index (GPI). Requires purchasing power gains and losses to be included in net income.

Learning Objective 1

Inflation Accounting -- Methods

Current Cost (CC) Accounting

Updates historical cost of assets to the current cost to replace those assets. Also referred to as Current Replacement Cost Accounting. Nonmonetary assets are restated to current replacement costs and expense items are based on these restated costs. Holding gains and losses included in equity.

Learning Objective 1

Inflation Accounting Internationally

United States and United Kingdom

SFAS 33, Financial Reporting and Changing Prices briefly required large U.S. companies to provide GP and CC accounting disclosures. This information is now optional and few companies provide it. In the UK, SSAP 16 required current cost information, this was also was only briefly required. Both countries have experienced low rates of inflation since the 1980s.

Learning Objective 2

Inflation Accounting Internationally

Latin America

Latin America has a long history of significant inflation. Brazil, Chile, and Mexico have developed sophisticated inflation accounting standards over time. Like the U.S. and UK, Brazil has abandoned inflation accounting. Mexicos Bulletin B-10, Recognition of the Effects of Inflation in Financial Information, is a well-known example.

Learning Objective 2

Inflation Accounting Internationally

Mexico Bulletin B-10

Requires restatement of nonmonetary assets and liabilities using the central banks general price level index. An exception is the option to use replacement cost for inventory and related cost of goods sold. Another exception is imported machinery and equipment. This exception allows a combination of country of origin price index and the exchange rate between Mexico and country of origin.

Learning Objective 2

Inflation Accounting Internationally

Netherlands Replacement Cost Accounting

Prior to the required use of IFRSs in 2005, Dutch companies could use replacement cost accounting. In 2003 only Heineken used this approach. Heineken presented inventories and fixed assets at replacement cost. Cost of sales and depreciation were also based on replacement costs. The entry accompanying the asset revaluation was reported in stockholders equity.

Learning Objective 2

Inflation Accounting Internationally

International Financial Reporting Standards

IAS 15, Information Reflecting the Effects of Changing Prices was issued in 1981. This standard has been withdrawn due to lack of support. The relevant standard now is IAS 29, Financial Reporting in Hyperinflationary Economies. IAS 29 is required for some companies located in environments experiencing very high levels of inflation.

Learning Objective 2

Inflation Accounting Internationally

International Financial Reporting Standards

IAS 29 includes guidelines for determining the environments where it must be used. Nonmonetary assets and liabilities and stockholders equity are restated using a general price index. Income statement items are restated using a general price index from the time of the transaction. Purchasing power gains and losses are included in net income.

Learning Objective 2

Business Combinations and Consolidated Financial Statements

Background and conceptual issues

Business combinations are the primary mechanism used by MNEs for expansion. Sometimes the acquiree ceases to exist. In other cases, the acquiree remains a separate legal entity as a subsidiary of the acquirer (parent). Accounting for the parent and one or more subsidiaries is often called group accounting.

Learning Objective 3

History of Group Accounting

For many years, there was no group accounting anywhere. In the 1920s, in the United States, and elsewhere, conglomerates formed, composed of many separate legal entities. Group accounting began to develop in these market-based economies. By the late 1960s (the peak of another boom), the topic had become quite controversial. A crucial issue was purchase versus pooling-ofinterests accounting. In the 1970s, the newly formed FASB issued a new standard making it much harder to use pooling-of-interests. Around the world, however, group accounting continued to be ignored.

In the late 1980s, Europe, through the 7th directive, adopted group accounting for multinational enterprises. Very recently, the IASB adopted group accounting. The accounting now part of international financial reporting standards (IFRS#3) is essentially identical to that used in USA!

Business Combinations and Consolidated Financial Statements

Group Accounting Determination of control

Control provides the basis for whether a parent and a subsidiary should be accounted for as a group. Legal control through majority ownership or legal contract is often used to determine control. Effective control can be achieved without majority ownership. IAS 27, Consolidated and Separate Financial Statements, uses the effective control definition.

Learning Objectives 3 and 4

Business Combinations and Consolidated Financial Statements

Group Accounting Full Consolidation

Full consolidation involves aggregation of 100 percent of the subsidiarys financial statement elements. When the subsidiary is not 100 percent owned, the nonowned portion is presented in a separate item called minority interest. Full consolidation is accomplished using one of two methods; purchase method or pooling of interests method.

Learning Objective 3

Business Combinations and Consolidated Financial Statements

Full Consolidation Purchase Method

When one company purchases a majority of the voting shares of another company, the purchased assets and liabilities are stated at fair value. The excess of the purchase price over the fair value of the net assets is goodwill. IFRS 3, Business Combinations, measures the minority interest as the minority percentage multiplied by the fair value of the purchased net assets.

Learning Objectives 3 and 4

Business Combinations and Consolidated Financial Statements

Full Consolidation Goodwill

Significant variation exists internationally in accounting for goodwill. U.S., IFRS, and most other countries require goodwill to be capitalized as an asset. Some countries require amortization over a period of up to 40 years. U.S., Canada, and IFRS do not require amortization but do require an annual impairment test. Japan allows immediate expensing of goodwill.

Learning Objectives 3 and 4

Business Combinations and Consolidated Financial Statements

Group Accounting Equity Method

When companies do not control, but have significant influence over an investee, the equity method is used. Twenty percent ownership is often used as the threshold for significant influence. The equity method is sometimes referred to as one-line consolidation. Some differences exist between countries regarding standard pertaining to the equity method.

Learning Objectives 3 and 4

Business Combinations and Consolidated Financial Statements

Group Accounting Other

Pooling of interests method is now prohibited by IFRS and in many countries. Pooling of interests was historically a popular method because it allowed for lower expense recognition compared to the purchase method. Proportionate consolidation method under IAS 31, Financial Reporting of Interests in Joint Ventures, but is prohibited by U.S. GAAP.

Learning Objectives 3 and 4

Segment Reporting
Background

MNEs typically have multiple types of businesses located around the world. Consolidated financial statements aggregate this information. Different types of business activity and location involve different growth prospects and risks. Financial statement users desire information to be disaggregated in order to facilitate its usefulness.

Learning Objective 5

Segment Reporting
Background

Beginning in the 1960s, standard setters began to require disclosures by segment. Segments are defined both by line-of-business and geographic area. The AICPA and Association of Investment Management and Research (AIMR) recommend segment reporting consistent with how a business is managed. A significant point of resistance to segment reporting is concerns about competitive disadvantage.

Learning Objective 5

Segment Reporting

IAS 14, Segment Reporting

Requires segment reporting both by line-of-business and geographic area. The company chooses one of these as a primary reporting format. Significantly more information is required for the primary reporting format. Generally, the primary reporting format will be consistent with internal reporting to upper management. Reportability of a segment is based on the significance of the segment.

Learning Objective 5

Segment Reporting
IAS 14, Segment Reporting Significance Test

Reportability of a segment is based on the significance of the segment. A segment is deemed reportable if it meets one of three significance tests. The significance tests are based on revenue, profit or loss, and assets. A segment is reportable if it equals or exceeds 10 percent on any one of these tests.

Learning Objective 5

Segment Reporting
SFAS 131, Disclosures about Segments of an Enterprise and Related Information

Requires reporting of significant operating segments which can be based on either line-of-business or geographic area. The significance tests and required disclosures are similar to IAS 14. SFAS 131 does not, however, require reporting of both line-of-business and geographic segments. If reporting is based on line-of-business, some additional information about foreign operations is required.

Learning Objective 5

Segment Reporting

Segment Reporting Internationally

There is a significant lack of convergence internationally in the area of segment reporting. In a number of countries, segment reporting is not required if deemed to be of competitive disadvantage by the company. The IASB-FASB short-term convergence project is looking at this area. IASB is planning to follow the SFAS 131 management approach to identifying segments.

Learning Objective 5