CHAPTER 5
Current Liabilities o Unavoidable costs of meeting the obligation exceed
IAS 1, Presentation of Financial Statements:
 Requires liabilities to be classified as current or
noncurrent
 Current:
1. Expects to settle in its normal business cycle
2. Holds primarily for the purpose of trading
3. Expects to settle within 12 months of the balance
sheet date
4. Does not have the right to defer until 12 months after
the balance sheet date
IFRS is similar but differences may relate to:
o Refinanced short-term debt– only long-term if
completed prior to balance sheet date vs. U.S. GAAP
which allows long-term if an agreement has been
reached prior to balance sheet date, even if not
completed by then.
o Accounts payable on demand due to violation of
debt covenants—must be current unless lender issues
waiver of at least 12 months by balance sheet date. The
waiver must be obtained, under U.S. GAAP, by annual
report issuance date.
o Bank overdrafts—netted against cash if an integral part
of cash management—otherwise current liabilities. U.S.
GAAP always treats as current liabilities.
o Liabilities and assets of uncertain timing, amount, or
existence.
o Onerous contracts and restructuring costs.
o Examples of environmental costs and nuclear
decommissioning costs.
Contingent Liabilities and Provisions
Contingent liability is either:
o Possible obligation from past events to be confirmed by
presence or absence of future event OR
o Present obligation not recognized because no probable
outflow of resources or amount can’t be measured
reliably
o Contingent liability is not recognized on balance sheet
while a provision is.
o Provision is a liability of uncertain timing or amount:
o Present legal or constructive obligation resulting from
past event (constructive—e.g. manufacturer announces
will honor defunct retailer rebates).
o Probable (more likely than not) outflow of resources.
o Can be estimated reliably.
Types of Differences Between IFRS and U.S. GAAP
o U.S. GAAP doesn’t recognize constructive obligations—
only legal.
o For contingencies U.S. GAAP does not define probable,
although research shows most accountants use 70%-
90% probability. IAS 37 uses “more likely than not”,
which implies a threshold of just over 50%.
Onerous Contract
economic benefits to be realized.
o Recognize lower of cost of fulfillment or penalty from
non-fulfillment.
o If onerous from entity's own action--no recognition until
that action happens.
Restructuring
o A program planned and controlled by management that
materially changes either scope of business or manner
in which business is conducted.
o Such as sale or termination of line of business, closure
of location, change in management structure, material
reorganization which changes nature and focus of
operations.
o U.S. GAAP doesn’t allow restructuring provision until
liability incurred, so may occur later than under IFRS.
Contingent Assets
o Probable asset arising from past events whose existence
will be confirmed by occurrence or non-occurrence of
future event.
o Don’t recognize—disclose when probable inflow of
economic benefits.
o Recognize as asset when virtually certain.
o Earlier recognition of contingent asset and related gain
than U.S. GAAP, which generally requires realization
before recognition.
Proposed Amendments to IAS 37
o Criterion of “probable outflow of resources” for provision
would be removed---i.e.—recognize as long as
reasonably measurable.
o “Best estimate” rule would be replaced with liability
measurement at what would be a rational expectation of
payment to relieve present obligation---in many cases
the present value of required resources.
IAS 19, Employee Benefits
o Covers all forms of employee compensation and benefits
other than share-based compensation (e.g. stock
options).
Four types:
1. Short-term (compensated absences and bonuses).
2. Post-employment ( pensions, medical benefits, etc.).
3. Other long-term benefits (deferred compensation and
disability).
4. Termination benefits (severance and early retirement).
IFRS 2, Share-based Payment
o IASB and FASB worked closely on standards.
o # of minor differences, but both standards
substantially similar
o IFRS 2 sets out measurement principles and specific
guidance for three types of transactions:
o Equity-settled—entity receives goods or services in
exchange for equity instruments (e.g. stock options).
o Cash-settled—entity receives goods or services by
incurring liability to supplier based on price or value of
shares or other equity instruments (e.g. share
appreciation rights).
o Choice of settlement of above two options.
Equity-settled
o Non-employees– if fair value of goods or services
can’t be determined—use fair value of the equity
instrument as of each date goods or services are
received vs. U.S. GAAP where fair value of instrument
used and measured at earlier of commitment for
performance or when performance completed.
o Employees—use fair value of instrument since fair
value of services not reliably measurable—value at date
of grant—need to estimate # of options expected to
vest multiplied by fair value to determine compensation
expense over vesting period (offset is paid-in capital).
o If single vesting date (cliff vesting)—straight-line over
service period.
o If installments (graded vesting)—amortize each
installment (tranche) over their vesting period.
o U.S. GAAP re: graded vesting—choice of accelerated or
straight-line recognition.
o Modification of stock option plans—length or price may
change—recognize, at minimum, original compensation
cost at grant date.
o If fair value reduced---no change in compensation
deduction.
o If fair value increased—increase compensation by the
like amount.
o U.S. GAAP—if modifications—fair value at modification
date determines compensation expense---no minimum
compensation as under IFRS.
Cash-settled
o Stock appreciation rights—recognize liability for future
cash outflow at fair value of appreciation rights using
an option pricing model.
o Remeasure at each balance sheet date until settled.
o U.S. GAAP—certain cash-settled payments classified as
equity, whereas liability under IFRS.
Choice-of-settlement
o Treat as cash-settled only if present obligation to
settle in cash— otherwise, treat as equity-settled.
o Remeasure at each balance sheet date until settled.
o If supplier can choose—entity has compound
instrument with debt and equity components:
o Debt component measured at each balance sheet
date (recognize change in value in income).
o Equity component remains in equity and if supplier
chooses debt settlement in equity—transfer debt
piece to equity.
IAS 12, Income Taxes
o Similar approach with U.S. GAAP.
o Both have deferred tax assets and liabilities re: timing
differences and operating loss and tax credit carryovers.
o March 2009 IASB exposure draft “Income Tax” intended
to eliminate differences with U.S. GAAP.
o Final standard replacing IAS 12 still not published as of
Spring 2011.
Tax Laws and Rates
o Current and deferred taxes based on rates enacted or
substantively enacted (when future steps can’t change
outcome) by balance sheet date.
o U.S. GAAP must use actually enacted rates.
o To minimize double taxation some countries apply lower
rate to distributed profits vs. retained profits.
Recognition of Deferred Tax Asset
o If future realization probable (undefined) vs. U.S. GAAP
where realization takes place if more likely than not --
-IAS 12 is more stringent if probability interpreted to
mean greater than “more likely than not”.
Disclosures
o IAS 12 requires extensive disclosures, including current
and deferred components of tax expense and
relationship between hypothetical expense based on
statutory vs. effective tax rates using 2 approaches
(statutory rate in home country or weighted average
statutory rate between jurisdictions).
IFRS vs. U.S. GAAP
o IFRS can cause temporary differences not existing
under U.S. GAAP (e.g. revaluation model for p, p & e
under IAS 16).
o Differences in impairment standards.
Financial Statement Presentation
o Under U.S. GAAP—deferred tax assets and liabilities
current or non-current based on underlying asset or
liability or, if for loss or credit carryforwards, timing of
expected realization.
o IAS 1, Presentation of Financial Statements”—only
noncurrent.
IAS 18, Revenue
o Single standard covering most revenues (sale of goods,
rendering of services, interest, royalties and dividends).
o U.S. GAAP has no single standard—instead over 200
different authoritative pronouncements, so difficult to
compare IAS 18 and U.S. GAAP .
o Revenue must be measured at fair value of
consideration received or receivable.
o May need to split transaction into multiple elements
(e.g. sale of software and maintenance contract) or
may need to combine multiple transactions into one for
true economic substance.
Sale of Goods—5 Criteria
o Transfer of significant risks and rewards to buyer (IAS
has various examples of how seller may retain risks).
o No effective control maintained or management
involvement.
o Can measure revenue reliably.
o Probable future economic benefits flow to seller.
o Selling costs can be measured reliably.
Rendering of Service
o Estimate reliably amount of revenue, costs incurred or to
be incurred, and stage of completion (see IAS 11,
Construction Contracts, which can also apply to service
contracts).
o Probable benefits will flow to enterprise.
o U.S. GAAP doesn’t allow percentage-of-completion for
service contracts.
o If outcome can’t be measured reliably, only estimate
revenue to extent expenses are probably recoverable—
otherwise, recognize only expense and not revenue.
Interest, Royalties and Dividends (if reliably
measurable)
o Interest recognized on effective yield basis.
o Royalties recognized on accrual basis based on relevant
agreement.
o Dividends recognized when shareholder’s right to
receive payment is established.
Exchange of Goods or Services—no gain or loss if
similar—if dissimilar—recognize fair value of what is
received adjusted for cash paid or received
IASB-FASB Revenue Recognition Project
o Both boards working since 2002.
o June 2010—joint Exposure Draft “Revenue from
Contracts with Customers”.
5 steps:
1. Identify the contract.
2. Identify separate performance obligations in the
contract.
3. Determine the transaction price.
4. Allocate the transaction price to the separate
performance obligations.
5. Recognize the revenue allocated to each performance
obligation when the entity satisfies each performance
obligation.
Financial Instruments
Three Standards
o IAS 32, Financial Instruments: Presentation.
o IAS 39, Financial Instruments: Recognition and
Measurement.
o IFRS 7, Financial Instruments: Disclosure.
Also—IFRS 9, Financial Instruments—issued in
November 2009 to replace IAS 39—effective
November 2013
Definitions
o IAS 32 says a financial instrument is any contract that
gives rise to both a financial asset of one entity and a
financial liability or equity instrument of another entity.
o Financial asset (e.g. cash, receivables, loans to others,
etc.):
o Cash
o Contractual right to:
a) Receive cash or other financial asset
b) Exchange financial assets or financial liabilities under
potentially favorable conditions
o An equity instrument of another entity
o A contract that will or may be settled in the equity’s own
equity instruments and is not classified as an equity
instrument of the entity
o Financial liability (e.g. payables, loans from other
entities, bonds, etc.):
o A contractual obligation to:
a) Deliver cash or another financial asset
b) Exchange financial assets or financial liabilities
under potentially unfavorable conditions
o A contract that will or may be settled in the equity’s own
equity instruments.
o Equity instrument—any contract that evidences a
residual interest in the assets of an entity after
deducting all its liabilities.
Compound Financial Instruments
o Both a liability and equity element (e.g. convertible
bond).
o Split accounting required using with and without
method.
Classification of Financial Assets and Liabilities
o Financial asset:
1. Fair value through profit or loss (FVPL)
2. Held-to-maturity investments
3. Loans and receivables
4. Available-for-sale financial assets
o Financial liabilities:
1. Fair value through profit or loss (FVPL)
2. Financial liabilities measured at amortized cost
Measurement of Financial Instruments
o Initial—fair value (normally = amount paid or
received).
o Subsequent—cost, amortized cost, or fair value.
CHAPTER 6
China: Background
o World’s largest country with population of over 1.3
billion.
o People’s Republic of China (PRC) established in 1949.
o Politically: Communist, one-party state.
o Economically: Until the 1980s, all firms state-owned.
o Currently in transformation to socialist market economy.
o World’s fourth largest economy and fastest growing
among large economies, and is largest recipient of FDI.
o China
o First securities regulations adopted in 1984.
o Two major stock exchanges, Shanghai and Shenzhen
established in 1
o 990 and 1991.
o Government controls capital market via Chinese Security
Regulatory Commission (CSRC) similar to SEC.
o Domestic companies list four types of shares: A, B, C, H.
o Market characterized by speculation, high share
turnover.
o First securities regulations adopted in 1984.
o Two major stock exchanges, Shanghai and Shenzhen
established in 1990 and 1991.
o Government controls capital market via Chinese Security
Regulatory Commission (CSRC) similar to SEC.
o Domestic companies list four types of shares: A, B, C, H.
o Market characterized by speculation, high share
turnover.
Accounting Profession
o In October 2007, the ICAEW (Institute of Chartered
Accountants in England and Wales) and CICPA launched
a joint project for cooperation between the professional
bodies in the two countries.
o Most domestic Chinese accounting firms are “hooked up”
to a government-sponsoring body, although the
government has encouraged independence.
o “Guanxi” or tight, close-knit networks, is common way of
doing business, but may collide ethically for accountants
Accounting Regulation
o Government continues to act as accounting regulator.
o Recent activity is focused on harmonizing variety of
domestic systems which vary by industry.
o Committed to converging with IFRS, spurred by desired
membership in World Trade Organization (WTO).
o Audits of financial statements widely required.
o Death penalty in an accounting fraud case suggests that
it is taken very seriously.
o Ministry of Finance (MoF) in similar role as FASB.
o MoF has issued several pronouncements to achieve
harmony.
Accounting Principles and Practice
o Computation of taxable income is of primary importance.
o Conservatism is criticized as a method by which owners
can understate income and justify low wages.
o Lack of conservatism is still a major difference with
IFRS.
o Lack of accounting infrastructure contributes to the
gap between accounting principles and practice.
o Accounting System for Business Enterprises (ASBE)
is followed by over 500,000 firms, including all listed
companies.
Differences with IFRS
o Property, plant, and equipment -- historical cost,
whereas IAS 16 permits revaluations.
o Asset impairments – Chinese standards are silent,
whereas IAS 36 requires impairment test and
recognition of loss.
o Pre-operating expenses – deferred, then
expensed when operations begin, whereas, under
IAS 38, expense immediately.
o Business combinations – no specific rules,
whereas IAS 22 specifically discusses accounting for
business combinations.
Germany: Background
 European Union’s largest country, population 83
million.
 West Germany and East Germany established in
1949, were reunified in 1990.
 Historically, banks have been primary source of
finance via both loans and equity.
 Since reunification, the economy has been
affected by internationalization.
 German companies increasingly listing on
foreign exchanges, e.g., New York Stock
Exchange.
 Most common business forms are
Aktiengesellschaft (AG) and Gesellschaft mit
beschrankter Haftung (GMBH).
 AG are publicly traded/GMBH are non-publicly
traded.
 Historically had significant influence on
accounting systems in a number of other
countries.
 Japan’s commercial code is modeled on
Germany’s.
Accounting Profession
 Profession has traditionally been less influential
than in U.S./U.K.
 Auditing is dominant part of profession and
certified auditors title of Wirtschaftprufer (WP)
was created in 1931.
 Institut der Wirtschaftprufer similar to the
AICPA.
 Obtaining WP title is extremely rigorous.
 Wirtschaftpruferkammer (WPK) is a state-
sponsored group that oversees auditing
profession.
Accounting Regulation
o Commercial code and tax laws are main sources of
accounting rules.
o Traditionally has not used a system of independent
institutional oversight.
o Stock exchange rules have less influence than in U.S.
o Prudence (conservatism) is fundamental--recognition of
revenues only when realized, losses when they appear
possible.
o Began change away from creditor orientation in 1960s
towards shareholder orientation.
o As of 2009 the German Accounting Standards Board
(GASB) worked on IASB projects relating to the financial
crisis.
Accounting Principles and Practices
o Historical cost attribute for measuring tangible assets is
strictly adhered to.
o Traditional focus on creditor protection is at odds with
the true and fair view concept.
o Importance of tax laws led to the reverse authoritative
principle which requires expenses to be deducted from
accounting income if they are to be tax deductible.
o Differences between accounting and tax income are
minimal, thereby reducing need for deferred taxes.
o In contrast to China, conservatism has been used to
resist labor’s wage demands.
o Standards allow for income smoothing, frequently
accomplished via early recognition of losses.
o EU fourth directive requires true and fair view, but
Germans have a unique interpretation of the concept.
o Commitment to globalization reflected in rule that allows
public companies to use IFRS for consolidated
statements.
o Main intention of German Accounting Law Modernization
Act is conformity with IFRS.
o In August 2010 only about 10 German companies were
listed on the NYSE due to NYSE overregulation.
Differences with IFRS
o Goodwill – deducted immediately against equity,
whereas, under IFRS 3, accounted for as an indefinite
life intangible asset.
o Internally generated intangibles – not recognized,
whereas, under IAS 38, recognized as an asset under
some conditions.
o Leases – accounting uses tax rules, with capitalization
rare, whereas IAS 17 criteria result in more frequent
capitalization.
o Accounting for subsidiaries – allow exclusion of
dissimilar subsidiaries, which are consolidated under IAS
27.
Japan: Background
o Population 127 million, world’s third largest economy.
o Banks are primary source of finance via both loans and
equity, and cross-corporate equity ownership is also
common.
o Keiretsu (and predecessor Zaibatsu) emphasize close
business ties and reflect cultural value of collectivism.
o 1990s recession led to an increase in Japanese firms’
attempts to obtain capital internationally.
Accounting Profession
o Certified Public Accountants Law (1948) established the
profession.
o JICPA is one of the nine founding members of the IASC.
o Profession is significantly less influential than in
U.S./U.K. and is also much smaller in numbers than U.S.
o Obtaining CPA title is extremely rigorous, as in Germany.
o Low status within Japanese society vs. engineers and
scientists.
o Collectivism leads to lack of trust of auditors.
o Tax advising is a much larger, separate, profession.
Accounting Regulation
o Government influences accounting via Commercial Code,
Corporate Income Tax Law and Securities and Exchange
Law.
o Similar to Germany, strong creditor orientation and
accounting rules closely tied to tax rules.
o Big Bang financial reforms are leading to harmonization
with international standards.
o These reforms included requirements for consolidation
and fair value accounting for tradable securities.
o Business Accounting Principles issued by Ministry of
Finance consist of 7 guidelines (the equivalent of a
conceptual framework).
o In December 2009 Japan Financial Services Agency
(FSA) permitted domestic use of IFRS and established
framework for voluntary adoption of IFRS starting with
fiscal years ending on or after March 31, 2010
Accounting Principles and Practices
o In contrast to U.S., net income is less a measure of
performance and seen more as funds available for
dividends.
o Since providers of financing tend to be close to the
firm, there has historically been little pressure for
disclosure.
o Lack of disclosure is apparent in segment reporting.
o 2007 Tokyo Agreement goal to eliminate all Japanese
GAAP and IFRS differences by June 2011 (except major
new IFRS developed after 2011.
Differences with IFRS
o Revaluation of Land – allowed, but updating not
required, whereas, under IFRS 16, revaluations require
regular updating.
o Pre-operating costs – capitalization is allowed,
whereas, under IAS 38, expensed immediately.
o Construction contracts – completed contract method
is allowed, whereas IAS 11 essentially requires
percentage-of-completion.
o Provisions – allows for provisions prior to actual
obligation, whereas IAS 37 only allows for present
obligations based on past transaction.
Mexico: Background
o History of significant inflation-- government control of
business is partially blamed for this.
o Significant changes in 1990s, including privatization of
state-owned firms and NAFTA.
o Historically, most businesses family-owned-- even the
very large—prefer to raise capital via debt vs. equity—but
gradually changing.
o Mexico’s one stock exchange, the Bolsa Mexicana de
Valores, is privately-owned.
o Represents one of the largest U.S. trading partners (75%
of Mexico’s imports, more than 80% of her exports, and
60% of all FDI).
Accounting Profession
o The Asociacion de Contadores Publicos, first professional
accountant organization, established in 1917.
o This group was succeeded by the Mexican Institute of
Public Accountants (MIPA) in 1964.
o MIPA establishes accounting and auditing principles.
o In order to practice public accounting in Mexico, one
needs a “professional diploma.”
o Contador Publico Certificado (CPC) is equivalent of U.S.
CPA and can have reciprocal privileges in U.S. and
Canada based on passing certain exams.
Accounting Principles and Practices
o Mexican GAAP heavily influenced by U.S. GAAP due to
NAFTA, geographical proximity, and comprehensiveness
of U.S. GAAP.
o Despite international influences, Mexico’s Bulletin B-10
on inflation accounting shows how harmonized
accounting may not be appropriate for all circumstances.
o In November 2008 the Mexico Securities and Exchange
Commission announced that all companies listed on the
Mexican Stock Exchange will be required to use IFRS in
2012
o Bulletin B-10, Recognition of the Effects of Inflation,
reflects a major difference to U.S. GAAP.
o Nonmonetary assets and liabilities to be restated for
purchasing power changes of the peso.
o Inventory can be restated using current replacement
costs.
o Recognition in income (generally) of the gain or loss
from the net monetary position, asset or liability.
o In line with IAS 29, Mexico has given up on inflation
accounting recently, due to low rate of inflation
Differences with IFRS
o Statement of cash flows – statement of changes in
financial position required, whereas IAS 7 requires a
statement of cash flows.
o Inflation Accounting – requires inflation adjustments
regardless of inflation rate, whereas IAS 29 required
only for hyperinflationary countries.
o Negative Goodwill – recorded as a deferred credit and
amortized over a period of up to five years, whereas
IFRS 3 requires immediate recognition of gain.
United Kingdom: Background
o Population of about 62 million, comprised of England,
Northern Ireland, Scotland, and Wales.
o Among the five countries in this chapter, its financial
structure is closest to the U.S.
o 15,000 Private Limited Companies (PLCs) with about
2,500 of these listed on the London Stock Exchange.
Accounting Profession
o World’s first association of professional accountants, The
Society of Accountants in Edinburgh, established in
1853.
o Six professional chartered bodies coordinated through
Consultative Committee of Accountancy Bodies (CCAB).
o The profession developed in response to the needs of
industry and has influenced the development of
professions in a number of other countries.
o Compared to the U.S. the certification requirements
focus more on work experience and less on university
education.
Accounting Regulation
o The Companies Act, accounting pronouncements, and
stock exchange rules comprise accounting regulation.
o Similar to the U.S., and unlike Germany and Japan, tax
rules do not significantly influence financial reporting.
o Standard-setters have historically taken a principles-
based approach using a statement of principles as a
conceptual framework.
o Has not historically had a strong, SEC type agency, but
recent scandals have led to increased regulation.
o The Financial Reporting Council (FRC) annual report for
2008/2009-- key themes for 2009/2010 would be to
influence:
o Market participants to high standards of reporting and
governance
o Legislators and standard-setters to encourage
proportionate and principles-based approach in
furtherance of the first goal
o International regulatory authorities to encourage
effective cooperation
Accounting Principles and Practices
o A primary objective of accounting is to support an
effective capital market.
o The true and fair view principle is paramount.
o True and fair view override requires that companies not
comply with standards that would result in misleading
financial statements.
o Professional judgment is essential additional component
to true and fair view.
o Financial Reporting Review Panel 2010 annual report
says there has been continuous improvement in the
general quality of IFRS financial reporting.
Differences with IFRS
o Goodwill – amortization allowed, whereas IFRS 3
prohibits amortization and requires an annual
impairment test.
o Related party disclosures – requires disclosure of
related party names, whereas IAS 24 requires disclosure
by type, not name, of related party.
o Revaluation gains/losses – generally not taken to
income statement, whereas IAS 40 requires gains and
losses to affect net income.

CHAPTER 7
Foreign exchange rate
o Purchase price of a foreign currency-- e.g., in February
2010 it cost about 0.08 U.S. dollars (eight cents) to
purchase one Mexican peso.
o From 1945 to 1973 countries had exchange rates fixed
to the U.S. dollar.
o U.S. dollar was fixed to gold at $35 per ounce.
o Balance-of-payments deficits in the U.S. during the
1960s doomed this system, so, by March 1973 most
currencies were allowed to float in value.
Exchange Rate Mechanisms
o Independent float – currency value allowed to move
freely with little government intervention.
o Pegged to another currency – currency value fixed
(pegged) in terms of a particular foreign currency (e.g.,
U.S. dollar), and central bank intervenes to maintain the
exchange rate.
o European Monetary System (Euro) – twelve
countries use a single currency, which floats against
other currencies such as the U.S. dollar.
Foreign Exchange Rates
o Exchange rates, to the U.S. dollar, are published in many
places on the internet and in newspapers.
o Exchange rates are reflected both as US $ equivalent
(direct quotes) and currency per US $ (indirect quotes).
Spot rates and Forward rates
o Spot rate – today’s price for purchasing or selling a
foreign currency.
o Forward rate – today’s price for purchasing or selling a
foreign currency for some future date.
o Premium -- when the forward rate is greater than the
spot rate for a particular day.
o Discount -- when the forward rate is less than the spot
rate for a particular day.
Option contracts
o Foreign currency option – gives the right, but not
the obligation, to trade foreign currency for some period.
o Put option – the option to sell the foreign currency.
o Call option – the option to buy the foreign currency.
o Strike price – the exchange rate at which currency will
be exchanged when option is exercised.
o Option premium – cost of purchasing the option,
which is a function of the option’s intrinsic value and
time value.
o Intrinsic value – is the gain that could be made by
immediate exercise of the option.
o Time value – the value that derives from the fact that
the currency value could increase during the remainder
of the option period.
Terminology
o Export sale – a company sells to a foreign customer
and later receives payment in the customer’s currency.
o Import purchase – a company purchases from a
foreign supplier and later pays in the supplier’s currency.
o Foreign exchange risk – the chance that the exporter
will receive less or that the importer will pay more than
anticipated as a result of a change in the exchange rate.
Accounting – sale transaction
One transaction perspective
o Treats sale and collection as one transaction.
o Transaction is complete when foreign currency is
received and converted, and sale is measured at
converted amount.
o This approach is not allowed under IAS or U.S. GAAP.
Two transaction perspective
o Treats sale and collection as two transactions
o Sale is one transaction and collection is a second
transaction.
o Sale is based on current exchange rate.
o If exchange rate changes, collection is for different
amount.
o Difference is considered foreign exchange gain or loss.
o Concepts are identical for purchase transaction.
Transaction types, exposure type and gain or loss
– export sales
o Export sale  asset exposure--if foreign currency
appreciates  foreign exchange gain.
o Export sale  asset exposure--if foreign currency
depreciates  foreign exchange loss.
o Import purchase  liability exposure -- if foreign
currency appreciates  foreign exchange loss.
o Import purchase  liability exposure -- if foreign
currency depreciates  foreign exchange gain.
o Hedging -- protecting against losses from exchange rate
fluctuations. Companies often use foreign currency
forward contracts and foreign currency options.
o Foreign currency forward contract – an agreement
to buy or sell foreign currency at a future date.
o Foreign currency option – the right to buy or sell
foreign currency for a period of time.
o Hedge accounting – an offsetting gain or loss from
the hedge is recognized in net income during the same
period as the gain or loss from the hedged item.
o Cash flow hedge – an accounting designation for
hedges that offset variability in cash flows of hedged
items.
o Fair value hedge – an accounting designation for
hedges that offset the variability in fair value of hedged
assets and liabilities.
CHAPTER 8
Translating Foreign Currency Financial Statements
– Conceptual Issues
o Foreign country operations usually prepare financial
statements using local currency as the monetary unit.
o These financial statements must be translated into home
country currency.
o These operations also typically use local GAAP.
o Financial statements must be translated into home
country GAAP.
Primary conceptual issues
o Each financial statement item must be translated using
the appropriate exchange rate.
o Choices include the current exchange rate, average
exchange rate, and the historical exchange rate.
o Current exchange rate is as of the balance sheet date,
while historical exchange rate is as of the date of the
transaction.
o The resulting translation adjustment can be recognized
in current income or included in an equity account on
the balance sheet.
Balance Sheet Exposure
o Assets and liabilities translated at the current exchange
rate are exposed to risk of a translation adjustment.
o When foreign currency appreciates, a net asset exposure
results in a positive translation adjustment.
o When foreign currency appreciates, a net liability
exposure results in a negative translation adjustment.
o Assets and liabilities translated at the historical exchange
rate are not exposed to a translation adjustment.
Translation Methods
o Current/Noncurrent Method
o Current assets and liabilities are translated at the current
exchange rate.
o Noncurrent assets and liabilities and stockholders’ equity
accounts are translated at historical exchange rates.
o There is no theoretical basis for this method.
o Method is seldom used in any countries and is not
allowed by U.S. GAAP or IFRS.
Monetary/Nonmonetary Method
o Monetary assets and liabilities are translated at the
current exchange rate.
o Nonmonetary assets and liabilities and stockholders’
equity accounts are translated at historical exchange
rates.
o The translation adjustment measures the net foreign
exchange gain or loss on current assets and liabilities as
if these items were carried on the parent’s books.
Temporal Method
o Objective is to translate financial statements as if the
subsidiary had been using the parent’s currency.
o Items carried on subsidiary’s books at historical cost,
including all stockholders’equity items, are translated at
historical exchange rates.
o Items carried on subsidiary’s books at current value are
translated at current exchange rates.
o Income statement items are translated at the exchange
rate in effect at the time of the transaction.
Current Rate Method
o Objective is to reflect that the parent’s entire investment
in a foreign subsidiary is exposed to exchange risk.
o All assets and liabilities are translated at the current
exchange rate.
o Stockholders’ equity accounts are translated at historical
exchange rates.
o Income statement items are translated at the exchange
rate in effect at the time of the transaction.
Translation methods illustrated – Summary
Current Rate Method
o All assets and liabilities translated at current rate.
o This results in net asset exposure.
o Net asset exposure and devaluing foreign currency
results in translation loss.
o Translation adjustment included in equity.
Temporal Method
o Primarily monetary assets and liabilities translated at
current rate.
o This results in net liability exposure.
o Net liability exposure and devaluing foreign currency
result in translation gain.
o Translation gain included in current income.
U.S. GAAP
o FASB ASC 830, Foreign Currency Matters( formerly SFAS
52, Foreign Currency Translation) is the relevant
accounting standard.
o Requires identification of functional currency.
o Functional currency is the primary currency of the
foreign subsidiary’s operating environment.
o The standard includes a list of indicators as guidance for
the foreign currency decision.
o When functional currency is U.S. Dollar, temporal
method is required.
o When functional currency is foreign currency, current
rate method is required.
IFRS
o IAS 21, The Effects of Changes in Foreign Exchange
Rates is the relevant accounting standard.
o Uses the functional currency approach developed by the
FASB.
o The standard includes a list, similar to the FASB list, of
indicators as guidance for the foreign currency decision.
o The standard’s requirements pertaining to
hyperinflationary economies are substantially different
from U.S. GAAP.
Highly Inflationary Economies – U.S. GAAP
o U.S. GAAP defines such economies as those with
cumulative 100% inflation over a period of three years
(with compounding—average of 26% per year for three
years in a row).
o Temporal method required—translation gains/losses
reported in income
Hyperinflationary Economies – IFRS
o IAS 21 and 29 use the term hyperinflationary economies.
o IAS 21 is not as specific in defining hyperinflationary
economies as is U.S. GAAP, but does suggest that a
cumulative three-year rate approaching or exceeding
100% is evidence.
o IAS 21 requires restatement of the foreign financial
statements for inflation per IAS 29, Financial Reporting in
Hyperinflationary Economies.
o IAS 21 then requires the use of the current exchange
rate to translate the restated financial statements,
including all balance sheet accounts as well as all
income statement
o Companies that have foreign subsidiaries with highly
integrated operations use the temporal method.
o The temporal method requires translation gains and
losses to be recognized in income.
o Losses negatively affect earnings, and both gains and
losses increase earnings volatility.
o t accounts.
o IAS approach is substantially different from U.S. GAAP.
o These gains and losses result from the combination of
balance sheet exposure and exchange rate fluctuations.
o Companies can also hedge to offset the effects of the
translation adjustment to equity under the current rate
method.
o Companies can hedge against gains and losses by using
foreign currency forward contracts, options, and
borrowings.
CHAPTER 9
Inflation Accounting – Conceptual Issues
Impact of inflation on financial statements
o Understated asset values.
o Overstated income and overpayment of taxes.
o Demands for higher dividends.
o Differing impacts across companies resulting in lack of
comparability.
Impact of inflation on financial statements
o Historical cost ignores purchasing power gains and
losses.
o Purchasing power losses result from holding monetary
assets, such as cash and accounts receivable.
o Purchasing power gains result from holding monetary
liabilities, such as accounts payable.
o The two most common approaches to inflation
accounting are general purchasing power accounting
and current cost accounting.
Net Income and Capital Maintenance
o Historical cost, general purchasing power and current
cost accounting all flow from different concepts of
capital maintenance.
o Net income represents the amount of dividends that
can be paid out while still maintaining the company’s
capital balance.
o Historical cost net income maintains a nominal, not
adjusted for inflation, amount of contributed capital.
o General purchasing power net income maintains the
purchasing power of contributed capital.
o Current cost net income maintains the productive
capacity of physical capital.
General Purchasing Power (GPP) Accounting
o Updates historical cost accounting for changes in the
general purchasing power of the monetary unit.
o Also referred to as General Price-Level-Adjusted
Historical Cost Accounting (GPLAHC).
o Nonmonetary assets and liabilities, stockholders’ equity
and income statement items are restated using the
General Price Index (GPI).
o Requires purchasing power gains and losses to be
included in net income.
Current Cost (CC) Accounting
o Updates historical cost of assets to the current cost to
replace those assets.
o Also referred to as Current Replacement Cost
Accounting (CRC).
o Nonmonetary assets are restated to current
replacement costs and expense items are based on
these restated costs.
o Holding gains and losses are included in equity.
United States and United Kingdom
o SFAS 33, Financial Reporting and Changing Prices
briefly required large U.S. companies to provide GPP
and CC accounting disclosures.
o This information is now optional (SFAS 89) and few
companies provide it.
o In the U.K., SSAP 16 required current cost information,
but this was later rescinded.
o Both countries have experienced low rates of inflation
since the 1980s, which is why the inflation accounting
requirements were lifted.
Latin America
o Latin America has a long history of significant inflation.
o Brazil, Chile, and Mexico have developed sophisticated
inflation accounting standards over time.
o Like the U.S. and U.K., Brazil has abandoned inflation
accounting.
o Mexico’s Bulletin B-10, Recognition of the Effects of
Inflation in Financial Information, is a well-known
example.
Mexico – Bulletin B-10
o Required restatement of nonmonetary assets and
liabilities using the central bank’s general price level
index.
o An exception was the option to use replacement cost for
inventory and related cost of goods sold.
o Another exception was imported machinery and
equipment.
o This exception allowed a combination of country of
origin price index and the exchange rate between
Mexico and country of origin.
o Based on inflation being held to under 5% for several
consecutive years, Bulletin B-10 was abandoned late in
2007.
o Companies no longer are required to use inflation
accounting.
Netherlands – Replacement Cost Accounting
o Prior to the required use of IFRS in 2005, Dutch
companies could use replacement cost accounting.
o In 2003 and 2004 only Heineken used this approach.
o Heineken presented inventories and fixed assets at
replacement cost.
o Cost of sales and depreciation were also based on
replacement costs.
o The entry accompanying the asset revaluation was
reported in stockholders’ equity.
International Financial Reporting Standards
o IAS 15, Information Reflecting the Effects of Changing
Prices was issued in 1981.
o This standard has been withdrawn due to lack of
support.
o The relevant standard now is IAS 29, Financial
Reporting in Hyperinflationary Economies.
IAS 29 is required for some companies located in
o o
environments experiencing very high levels of
inflation.
o IAS 29 includes guidelines for determining the
environments where it must be used.
o Nonmonetary assets and liabilities and stockholders’
equity are restated using a general price index.
o Income statement items are restated using a general
price index from the time of the transaction.
o Purchasing power gains and losses are included in net
income.
Background and conceptual issues
o Business combinations are the primary mechanism
used by MNEs for expansion.
o Sometimes the acquiree ceases to exist.
o In other cases, the acquiree remains a separate legal
entity as a subsidiary of the acquirer (parent).
o Accounting for the parent and one or more subsidiaries
is often called group accounting.
Group Accounting – Determination of control
o Control provides the basis for whether a parent and a
subsidiary should be accounted for as a group.
o Legal control through majority ownership or legal
contract is often used to determine control.
o Effective control can be achieved without majority
ownership.
o IAS 27, Consolidated and Separate Financial
Statements, uses the effective control definition.
Group Accounting – Full Consolidation
o Full consolidation involves aggregation of 100 percent
of the subsidiary’s financial statement elements.
o When the subsidiary is not 100 percent owned, the
non-owned portion is presented in a separate item
called minority interest.
o Full consolidation is accomplished using one of two
methods-- purchase method or pooling of interests
method.
o IFRS 3, issued in 2004, allows the use of the purchase
method only.
o Pooling of interests is no longer acceptable under IFRS,
or in the U.S., Canada, Brazil or Mexico.
Full Consolidation – Purchase Method
o When one company purchases a majority of the voting
shares of another company, the purchased assets and
liabilities are stated at fair value.
o The excess of the purchase price over the fair value of
the net assets is goodwill.
o IFRS 3, Business Combinations, measures the minority
interest as the minority percentage multiplied by the
fair value of the purchased net assets.
Full Consolidation – Goodwill
o Significant variation exists internationally in accounting
for goodwill.
U.S., IFRS, and most other countries require goodwill
to be capitalized as an asset.
o Some countries require amortization over a period of
up to 40 years.
o U.S., Canada, and IFRS do not require amortization but
do require an annual impairment test.
o Japan allows the option of immediate expensing of
goodwill.
Group Accounting – Equity Method
o When companies do not control, but have significant
influence over an investee, the equity method is used.
o Twenty percent ownership is often used as the
threshold for significant influence.
o The equity method is sometimes referred to as one-line
consolidation.
o Some differences exist between countries regarding
standards
o pertaining to the equity method.
Group Accounting – Other
o As stated previously, the pooling of interests method is
no longer permitted by IFRS and in many countries.
o Pooling of interests was historically a popular method
because it allowed for lower expense recognition
compared to the purchase method.
o The proportionate consolidation method is allowed
under IAS 31, Financial Reporting of Interests in Joint
 Ventures, but is prohibited by U.S. GAAP. The equity
method is used instead.
o The IASB issued an exposure draft in late 2007, ED 9,
Joint Arrangements, that proposes using the equity
method only in joint ventures, in an effort to converge
with U.S. GAAP. The transitional arrangements have not
yet been finalized.
Group Accounting – Further Convergence of U.S.
GAAP and IFRS
o In January 2008 IFRS 3 was revised. In addition, an
amended version of IAS 27, Consolidated and Separate
Financial Statements was issued, both of which become
effective July 1, 2009, with earlier adoption permitted.
o In December 2007 FASB issued SFAS 141 (R), Business
Combinations and SFAS 160, Noncontrolling Interests in
Consolidated Financial Statements.
o The major change in IFRS has the acquirer remeasuring
its investment in the acquiree at its fair value at the
date of control, with any gain or loss recognized in net
income.
o This replaces the step treatment, which measured the
fair value at each step of achieving control.
o The major change in U.S. GAAP includes requiring the
use of the acquisition method for business combinations
and classifying noncontrolling interests as equity.
Segment Reporting
Background
o MNEs typically have multiple types of businesses
located around the world.
o Consolidated financial statements aggregate this
information.
o Different types of business activity and location involve
different growth prospects and risks.
o Financial statement users desire information to be
disaggregated in order to facilitate its usefulness.
o Beginning in the 1960s, standard setters began to
require disclosures by segment.
o Segments are defined both by line-of-business and
geographic area.
o The AICPA and Association of Investment
Management and Research (AIMR) recommend
segment reporting consistent with how a business is
managed.
o A significant point of resistance to segment reporting
is concerns about competitive disadvantage.
IFRS 8, Operating Segments :
o Substantially converges IFRS with U.S. GAAP.
o Adopts the management approach to segment
reporting.
o Management disaggregates components to make
operating decisions.
o An operating segment is an enterprise component if:
1. It earns revenues and incurs expenses.
2. Its operating results are regularly reviewed for
performance and resource allocation.
3. Discrete financial information is available for it.
IFRS 8, Operating Segments – Significance
Tests to Justify Disclosure
Must meet any of the following tests:
o Revenue test—segment revenue (external and
intersegment) represents 10% or more of
combined internal and external revenue.
o Profit or loss test—segment profit or loss is
10% or more of the higher of the combined
reported profit of profitable segments or the
combined loss of all segments reporting a loss.
o Asset test—segment assets are 10% or more
of the combined assets of all operating
segments.
o Notwithstanding the tests above, segments must
be disclosed if less than 75% of total company
sales are to outsiders
U.S. GAAP
Only three substantive differences exist between
IFRS 8 and U.S. GAAP:
U.S. GAAP does not require disclosure of segment
liabilities.
IFRS 8 explicitly includes intangibles in the definition of
long-lived assets for geographic area disclosures.
When a company has a matrix form of organization, IFRS
8 allows operating segments to be based on either
products or services or geographic areas. U.S. GAAP
only allows the products or services basis.
Disclosures
o General information about the operating segment (how
identified and products and services).
o Segment profit or loss and the following line items:
a. Revenues from external customers
b. Intersegment revenues
c. Interest revenue and expense
d. Depreciation, depletion and amortization
e. Other significant noncash items in segment profit or
loss
f. Unusual items (e.g. discontinued operations and
extraordinary items)
g. Income tax expense or benefit
h. Total segment assets (and liabilities for IFRS).
i. Expenditures for additions to long-lived assets (U.S.
GAAP) and noncurrent assets (IFRS 8).
j. Information about products and services.
k. Information about major customers (if 10% or more
of total entity revenue).
l. Information about geographic areas.