Additional Financial Reporting Issues: Chapter Outline

CHAPTER 8
ADDITIONAL FINANCIAL REPORTING ISSUES

Chapter Outline
I. In addition to issues involving the accounting for foreign currency, three financial reporting
issues of international importance are: (a) accounting for changing prices (inflation
accounting), (b) accounting for business combinations and consolidated financial
statements, and (c) segment reporting.
II. Historical cost accounting in a period of inflation understates asset values (and related
expenses) and overstates income. Historical cost accounting also ignores the gains and
losses in purchasing power caused by inflation that arise from holding monetary assets
and liabilities.
III. Two methods of accounting for inflation have been used in different countries – general
purchasing power (GPP) accounting and current cost (CC) accounting.
A. Under GPP accounting, nonmonetary assets and stockholders’ equity accounts are
restated for changes in the general price level. Cost of goods sold and
depreciation/amortization are based on restated asset values and the net purchasing
power gain/loss on the net monetary liability/asset position is included in income. GPP
income is the amount that can be paid as a dividend while maintaining the purchasing
power of capital.
B. Under CC accounting, nonmonetary assets are revalued to current cost, and cost of
goods sold and depreciation/amortization are based on revalued amounts. CC
income is the amount that can be paid as a dividend while maintaining physical capital.
IV. IAS 29 requires the use of GPP accounting by firms that report in the currency of a
hyperinflationary economy. IAS 21 requires the financial statements of a foreign operation
located in a hyperinflationary economy to first be adjusted for inflation in accordance with
IAS 29 before translation into the parent company’s reporting currency.
V. Issues that must be resolved in accounting for a business combination relate to (a)
selection of an appropriate method, (b) recognition and measurement of goodwill, and (c)
measurement of minority interest.
A. IFRS 3 and US. GAAP both require the purchase method in accounting for business
combinations; the pooling of interests method is not allowed.
B. Goodwill is recognized on the consolidated balance sheet as an asset and tested
annually for impairment under both IFRS 3 and U.S. GAAP.
C. When less than 100% of a company is acquired, IFRS 3 requires the acquired assets
and liabilities to be recorded at full fair value and minority interest is initially measured
at the minority shareholders’ percentage ownership in the fair value of the acquired
company’s net assets. This is known as the economic unit or entity concept.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

Doupnik and Perera, International Accounting, 1/e 8-1
1. In addition to the economic unit or entity concept, U.S. GAAP also allows use of
the parent company concept in which the acquired assets and liabilities are initially
measured at book value plus the parent’s ownership percentage in the difference
between fair value and book value. Under this approach, minority interest is
initially measured at the minority shareholders’ percentage ownership in the book
value of the subsidiary’s net assets.
VI. IAS 28 and US. GAAP require use of the equity method when an investor has the ability to
exert significant influence over an investee; significant influence is presumed when the
investor owns 20% or more of the investee’s voting shares.
VII. In accounting for an investment in a joint venture, IAS 31 prefers the use of proportionate
consolidation, but also allows the equity method. The equity method is required under
U.S. GAAP.
VIII. Questions arise as to (a) when an investee should be considered a subsidiary and (b)
which subsidiaries should be consolidated when a parent company prepares consolidated
financial statements.
A. IAS 27 defines a subsidiary as an enterprise controlled by another enterprise known as
the parent. Control is defined as the power to govern the financial and operating
policies of an entity so as to obtain benefits from its activities. Control can exist
without owning a majority of shares of stock, for example, when one company has
power over more than half of the voting rights through agreements with other
shareholders.
1. Historically, U.S. companies have relied on majority stock ownership as evidence of
control.
B. IAS 27 requires a parent to consolidate all subsidiaries unless (a) the subsidiary was
acquired with the intent to dispose of it within 12 months and (b) management is
actively seeking a buyer.
1. U.S. GAAP requires all subsidiaries to be consolidated unless the parent has lost
control due to bankruptcy or severe restrictions imposed by a foreign government.
IX. The aggregation of all of a company’s activities into consolidated totals masks the
differences in risk and potential existing across different lines of business and in different
parts of the world. To provide information that can be used to evaluate these risks and
potentials, companies disaggregate consolidated totals and provide disclosures on a
segment basis. Segment reporting is an area in which considerable diversity exists
internationally.

X. IAS 14 requires companies to disclose disaggregated information by business segment
and geographic segment, one of which is designated as the primary reporting format.
A. A business segment or a geographic segment is reportable if a majority of its revenues
are generated from external customers and it meets one of three significance tests.
The segment must have: 10% or more of combined segment revenues, 10% or more
of combined segment profits, or 10% or more of combined segment assets.
B. A sufficient number of segments must be separately reported to disclose at least 75%
of consolidated revenues.
C. Disclosures to be provided for each primary reporting format reportable segment
include: revenue, profit or loss, assets, liabilities, capital expenditures, depreciation
and amortization, other significant noncash expenses, and equity method profit or loss.
D. Disclosures to be provided for each secondary reporting format reportable segment
include: revenue from external customers, assets, and capital expenditures.
XI. U.S. GAAP requires extensive disclosure to be made for operating segments, which can
be based either on product lines or geographic regions.
A. Disclosures should reflect what is reported internally to the chief operating officer, even
if this is on a non-GAAP basis.
B. If operating segments are not based on geography, revenues and long-lived assets
must be disclosed for (a) the domestic country, (b) all foreign countries in total, and (c)
for each foreign country in which a material amount of revenues or long-lived assets
are located. A quantitative threshold for determining materiality is not specified.

Answers to Questions
1. Historical cost accounting causes assets to be significantly understated in a country

experiencing high inflation. Understated assets, such as inventory and fixed assets, leads
to understated expenses, such as cost of goods sold and depreciation, which in turn leads
to overstated income and stockholders’ equity.
Understated asset values can have a negative impact on a company’s ability to borrow
because the collateral is understated. Understated asset values also can be an invitation for
a hostile takeover to the extent that the current market price of a company’s stock does not
reflect the current value of assets.
Overstated income results in more taxes being paid to the government than would otherwise
be paid, and could lead to stockholders demanding a higher level of dividend than would
otherwise be expected. Through the payment of taxes on inflated income and the payment
of dividends out of inflated net income, both of which result in cash outflows, a company
may find itself in a liquidity crisis.
To the extent that companies are exposed to different rates of inflation, the understatement
of assets and overstatement of income will differ across companies; this can distort
comparisons across companies. For example, a company with older fixed assets will report
a higher return on assets than a company with newer assets because income is more
overstated and assets are more understated than for the comparison company. Because
inflation rates tend to vary across countries, comparisons made by a parent company across
its subsidiaries located in different countries can be distorted.
2. Non-monetary assets and non-monetary liabilities are restated for changes in the general
purchasing power of the monetary unit. Most non-monetary items are carried at historical
cost. In these cases, the restated cost is determined by applying to the historical cost the
change in general price index from the date of acquisition to the balance sheet date. Some
non-monetary items are carried at revalued amounts, for example, property, plant and
equipment revalued according to the allowed alternative treatment in IAS 16, “Property,
Plant and Equipment.” These items are restated from the date of the revaluation.
All components of owners’ equity are restated by applying the change in the general price
index from the beginning of the period or the date of contribution, if later, to the balance
sheet date.
Monetary assets and monetary liabilities (cash, receivables, and payables) are not restated
because they are already expressed in terms of the monetary unit current at the balance
sheet date.
All income statement items are restated by applying the change in the general price index
from the dates when the items were originally recorded to the balance sheet date.
The gain or loss on net monetary position (purchasing power gain or loss) is included in net
income.
3. Monetary assets (cash and receivables) give rise to purchasing power losses and monetary
liabilities (payables) give rise to purchasing power gains.

4. Historical costs of nonmonetary assets (inventory, fixed assets, intangibles) are replaced
with current replacement cost and expenses (cost of goods sold, depreciation, amortization)
are based on these current costs. The amount by which nonmonetary assets are revalued
to replacement cost on the balance sheet is also reflected in stockholders’ equity as a
revaluation surplus (or reserve).
5. Current cost accounting generally results in a larger amount of nonmonetary assets, as well
as a larger amount of stockholders’ equity, being reported on the balance sheet. Expenses
based on the current cost of nonmonetary assets (carried at larger amounts) generally
results in a smaller amount of net income being reported under current cost accounting.
With smaller income and larger stockholders’ equity, return on equity measured under
current cost accounting is generally smaller than under historical cost accounting.
6. IAS 15, “Information Reflecting the Effects of Changing Prices,” required supplementary
disclosure of the following items reflecting the effects of changing prices:
1. the amount of adjustment to depreciation expense,
2. the amount of adjustment to cost of sales,
3. the amount of purchasing power gain or loss on monetary items,
4. the aggregate of all adjustments reflecting the effects of changing prices, and
5. if current cost accounting is used, the current cost of property, plant, and equipment.
The standard only applied to enterprises “whose levels of revenues, profits, assets or
employment are significant in the economic environment in which they operate,” and
allowed those enterprises to choose between making adjustments on a GPP or a CC basis.
Because of a lack of international support for inflation accounting disclosures, in 1989, the
IASC decided to make IAS 15 optional. However, the IASB encourages presentation of
inflation-adjusted information as required by IAS 15.
IAS 29, “Financial Reporting in Hyperinflationary Economies,” was issued in 1989 and
applies to the primary financial statements of any company that reports in a currency of a
hyperinflationary economy. IAS 29 requires the use of GPP accounting following
procedures outlined above in the answer to question 2.
IAS 21, “The Effects of Changes in Foreign Exchange Rates,” requires application of IAS 29
to restate the foreign operation’s financial statements to a GPP basis. The GPP adjusted
financial statements are then translated into the parent company’s reporting currency using
the current rate method of translation. This approach is referred to as the restate/translate
method.
7. IAS27, “Consolidated Financial Statements and Accounting for Investments in Subsidiaries,”

defines a group as a parent and all its subsidiaries, and requires parents to present
consolidated financial statements.
8. The concept of a group relates to a business combination in which one company obtains
control over another company but the acquired company continues its separate legal
existence.

9. IAS 27 states that control exists when the investor owns more than 50 of the stock of
another company. However, control also can exist for an investor owning less than 50% of
the stock of another company when the investor has power:
 Over more than half of the voting rights through agreements with other shareholders,
 To set the company’s financial and operating policies because of existing statutes or
agreements,
 To appoint or remove majority of the members of the governing body (board of directors
or equivalent group), or
 To cast the majority of votes at meetings of the company’s governing body.
10. Because of their extensive cross-ownership of companies, identifying the legal ownership
patterns of Japanese company groups (Keiretsu) can be extremely difficult.
11. IAS 27 requires a parent to consolidate all subsidiaries, foreign and domestic, unless (a)
control of the subsidiary is temporary because it is held with a view to its disposal in the near
future, or (b) the subsidiary operates under severe long-term restrictions that significantly
affect its ability to send funds to its parent. IAS 27 does not allow a subsidiary to be
excluded from consolidated financial statements solely because its operations are dissimilar
to those of the other companies that comprise the group. U.S. GAAP requires all
subsidiaries to be consolidated unless the parent has lost control due to bankruptcy or
severe restrictions imposed by a foreign government.
12. In some cases, two companies will jointly control another entity as a joint venture. IAS 31,
“Financial Reporting of Interests in Joint Ventures,” prefers proportional consolidation for
joint ventures (benchmark treatment), while equity accounting is allowed as an alternative.
The effect of the proportional consolidation method is to remove the “investment in joint
venture” account from the investor’s balance sheet and replace it with the proportion of all
the individual items that it represents. In contrast, the full consolidation method replaces the
“investment in subsidiary” account on the parent’s balance sheet with 100% of the value of
the subsidiary’s balance sheet items. If the parent owns less than 100% of the subsidiary, a
minority interest account is reflected on the parent’s consolidated balance sheet. There is
no minority interest reported under proportional consolidation.
Proportional consolidation is prohibited in the U.S. and the U.K., except for unincorporated
joint ventures. Instead, the equity method is used to account for investments in joint
ventures. In Germany, proportional consolidation was not allowed before the
implementation of the Seventh Directive, which permits its use for joint ventures. On the
other hand, proportional consolidation has been relatively common in both France and in the
Netherlands.

13. IAS 14 defines a business segment as a distinguishable component of a company that is
engaged in providing an individual product or service or groups of related products or
services and that is subject to risks and returns that are different from those of other
business segments. A geographical segment is a distinguishable component of a company
that is engaged in providing products or services within a particular economic environment
and is subject to risks and returns that differ from those of components operating in other
economic environments. Geographical segments can be a single country or groups of
countries. Factors to consider in identifying geographical segments include:
 similarity of economic and political conditions,
 geographical proximity,
 special risk associated with operations in a particular area,
 exchange control regulations, and
 currency risks.
A business segment or a geographical segment is a reportable segment if (1) a majority of
its revenues are generated from external customers and (2) it meets any one of the
following three significance tests:
 Revenue test. Segment revenues, both external and intersegment, are 10% or more of
the combined revenue, internal and external, of all segments.
 Profit or loss test. Segment result (profit or loss) is 10% or more of the greater (in
absolute value terms) of the combined profit of segments with a profit or combined loss
of segments with a loss.
 Asset test. Segment assets are 10% or more of the combined assets of all segments.
In applying these tests, segment result is defined as segment revenue less segment
expense. Segment revenue includes revenue directly attributable to a segment and a
portion of enterprise revenue that can be allocated on a reasonable basis to a segment.
Segment expense includes expenses directly attributable to a segment and a portion of
enterprise expense that can be allocated on a reasonable basis to a segment. IAS 14
defines segment assets as those operating assets that are employed by a segment in its
operating activities and that either are directly attributable to the segment or can be
allocated to the segment on a reasonable basis.
If total external revenue attributable to reportable segments constitutes less than 75% of the
total consolidated revenue, additional segments should be reported even if they do not meet
the 10% threshold. All segments that are neither separately reported nor combined should
be included in the segment reporting disclosures as an unallocated reconciliation item or in
an “all other” category.

14. The information required to be reported by geographic area under IAS 14 depends on
whether geographic segments represent the primary reporting format or the secondary
reporting format. The following information must be provided for each reportable primary
reporting format segment, whether business segment or geographic segment:
 segment revenue,
 segment profit or loss,
 carrying amount of segment assets,
 segment liabilities,
 cost during the period to acquire property, plant, and equipment, and intangible assets
(capital expenditures),
 depreciation and amortization,
 significant noncash expenses, other than depreciation and amortization, and aggregate
share of profit or loss and aggregate investment in equity method associates and joint
ventures.
When business segments are the primary reporting format, the following geographical
segment information also should be provided:
 revenue from external customers for each geographical segment whose revenue from
sales to external customers is 10% or more of total external revenue,
 carrying amount of segment assets for each geographical segment whose assets are
10% or more of total assets of all geographical segments, and
 capital expenditures for each geographical segment whose assets are 10% or more of
total assets of all geographical segments.
Under IAS 14, geographical segments can be a single country or groups of countries.
Under SFAS 131, companies must identify operating segments based on its internal
reporting system. Operating segments can be based on geography. Items disclosed by
operating segment under U.S. GAAP are the same as those items required to be disclosed
for the primary reporting format under IAS 14, with a few exceptions. U.S. GAAP does not
require disclosure of liabilities by segment, but does require disclosure of interest, taxes,
and unusual items (discontinued operations and extraordinary items). Whereas IAS 14
requires segment information to be presented in accordance with the company’s accounting
policies, SFAS 131 requires segment disclosures to be the same as what is reported
internally even if this is on a non-GAAP basis.
If operating segments are not based on geography, then companies must also
provide information about their foreign operations. Companies must disclose revenues and
long-lived assets for:
1. the domestic country,
2. all foreign countries in which the company derives revenues or holds assets, and
3. each foreign country in which a material amount of revenues is derived or long-lived
assets are held.
The SFAS 131 requirement to provide disclosures by individual foreign country is a
significant difference from IAS 14.

15. The major concern of some companies with respect to segment disclosures is that it could
provide information that competitors can use to better compete with the company.
Information about the revenues and profits earned in specific lines of business and/or
geographic areas that otherwise would be undisclosed, could be of interest to competing
firms as they are looking for lines of business and/or geographic areas in which to expand.

Solutions to Exercises and Problems
1. Sorocaba Company
December 31, Year 1

Original Restated
Purchase Historical Restatement Historical
Date Item Cost Ratio Cost
1/15/Y1 Machine X $ 20,000 140/100 $ 28,000
3/20/Y1 Machine Y 55,000 140/110 70,000
10/10/Y1 Machine Z 130,000 140/130 140,000
$205,000
$238,000
December 31, Year 2

Original Restated
Purchase Historical Restatement Historical
Date Item Cost Ratio Cost
3/20/Y1 Machine Y $ 55,000 180/110 $ 90,000
10/10/Y1 Machine Z 130,000 180/130 180,000
$185,000
$270,000
Alternatively, the restated historical cost at December 31, Year 2 could be determined as
follows:
December 31, Year 2

Restated Restated
Historical Historical
Purchase Cost Restatement Cost
Date Item (12/31/Y1) Ratio (12/31/Y2)
3/20/Y1 Machine Y $ 70,000 180/140 $ 90,000
10/10/Y1 Machine Z 140,000 180/140 180,000
$210,000
$270,000
Ignoring depreciation, machinery and equipment would be reported on the balance sheet at:
12/31/Y1 $238,000
12/31/Y2 $270,000
2. Antalya Company

a. The nominal interest expense is TL 600,000 (TL 1,000,000 x 60% x 1 year).
b. The purchasing power gain is TL 550,000 (TL 1,000,000 x 387.5/250 = TL 1,550,000 –
1,000,000).
c. The real interest expense is TL 5,000, which equates to a real interest rate of 0.5% (TL
5,000/ TL 1,000,000)

3. Doner Company
Calculation of Purchasing Power Loss

Net monetary assets, 1/1/Y1 $5,000 x 150/100 = $ 7,500
Plus: Increase in net monetary assets 15,000 x 150/120 = 18,750
Net monetary assts, 12/31/Y1 $20,000 $26,250
20,000
Purchasing power loss $ 6,250
GPP Income Statement

Year 1
Revenues $50,000 x 150/120 = $ 62,500
Depreciation (5,000) x 150/100 = (7,500)
Other expenses (incl. income taxes) (35,000) x 150/120 = (43,750)
Purchasing power loss (6,250)
Net income $ 5,000

4. Petrodat Company
Subsidiary in Mexico
GPI
1/1/Y1 100
Average 105
12/31/Y1 110
a.
Balance Sheet, 1/1/Y1 Historical Restatement Restated to

Cost Factor 12/31/Y1 GPP
Machinery and equipment 1,000,000.00 110/100 1,100,000.00
Total assets 1,000,000.00 1,100,000.00
Contributed capital 1,000,000.00 110/100 1,100,000.00

Total stockholders’ equity 1,000,000.00 1,100,000.00
Income Statement, Year 1

Historical Restatement Restated to
Revenues 400,000.00 110/105 419,047.62
Depreciation expense (200,000.00) 110/100 (220,000.00)
Other expenses (150,000.00) 110/105 (157,142.86)
Purchasing power loss (11,904.76)
Income 50,000.00 30,000.00

Net monetary assets, 1/1 0.00 110/100 0.00
plus: Increase in NMA, Y1* 250,000.00 110/105 261,904.76
Net monetary assets, 12/31 250,000.00 261,904.76
250,000.00
Purchasing power loss (11,904.76)
* Revenues less other expenses

Cash 250,000.00 none 250,000.00
Less: accumulated depreciation (200,000.00) 110/100 (220,000.00)
Total assets 1,050,000.00 1,130,000.00

Retained earnings 50,000.00 above 30,000.00
Total stockholders' equity 1,050,000.00 1,130,000.00
Calculation of Average Stockholders' Equity

January 1, Year 1 (restated) 1,100,000.00
December 31, Year 1 1,130,000.00
2,230,000.00
Average stockholders’ equity 1,115,000.00
b. Calculation of profit margin and return on equity on an inflation-adjusted basis

Profit margin 30,000.00 7.16%
419,047.62
Return on Equity 30,000.00 2.69%

1,115,000.00

Subsidiary in Venezuela
GPI
1/1/Y1 100
Average 115
12/31/Y1 130
a.

Total assets 150,000,000.00 195,000,000.00

Total stockholders’ equity 150,000,000.00 195,000,000.00
Income Statement, Year 1

Historical Restatement Restated to
Revenues 60,000,000.00 130/115 67,826,086.96
Depreciation expense (30,000,000.00) 130/100 (39,000,000.00)
Other expenses (22,500,000.00) 130/115 (25,434,782.61)
Purchasing power loss (4,891,304.35)
Income 7,500,000.00 (1,500,000.00)

Net monetary assets, 1/1 0.00 130/100 0.00
plus: Increase in NMA, Y1* 37,500,000.00 130/115 42,391,304.35
Net monetary assets, 12/31 37,500,000.00 42,391,304.35
37,500,000.00
Purchasing power loss (4,891,304.35)
* Revenues less other expenses

Cash 37,500,000.00 none 37,500,000.00
Less: accumulated deprec (30,000,000.00) 130/100 (39,000,000.00)
Total assets 157,500,000.00 193,500,000.00

Retained earnings 7,500,000.00 above (1,500,000.00)
Total stockholders' equity 157,500,000.00 193,500,000.00
Calculation of Average Stockholders' Equity

January 1, Year 1 (restated) 195,000,000.00
December 31, Year 1 193,500,000.00
388,500,000.00
Average stockholders’ equity 194,250,000.00
b. Calculation of profit margin and return on equity on an inflation-adjusted basis

Profit margin (1,500,000.00) -2.21%
67,826,086.96
Return on Equity (1,500,000.00) -0.77%

194,250,000.00
c. Both subsidiaries had the same profit margin and return on equity when these ratios were
calculated from unadjusted historical cost information. After adjusting for inflation, the
Mexican subsidiary appears to be substantially more profitable than the Venezuelan
subsidiary.

5. Auroral Company
Name of % Voting
Company Rights IFRSs U.S. GAAP
Accurcast 100% Full consolidation Full consolidation
Bonello 45% Equity method – unless there is Equity method
evidence that Auroral exercises
effective control
Cromos 30% Equity method Equity method
Fidelis 100% Do not consolidate – fair value Do not consolidate – fair
method value method
Jenna 100% Full consolidation Full consolidation
Marek 40% Full consolidation Equity method
Phenix 90% Full consolidation Full consolidation
Regulus 50% Proportional consolidation or Equity method
equity method
Synkron 15% Fair value method Fair value method
Tiksed 70% Full consolidation Full consolidation
Ypsilon 51% Full consolidation Full consolidation

6. Sandestino Company
a. Restated financial statements:
1. Proportionate Consolidation Method
Sandestino Company
Income Statement
Year 1
Revenues $840,000
Expenses 475,000
Income before tax 365,000
Tax expense 105,000
Net income $260,000
Sandestino Company
Balance Sheet
December 31, Year 1
Cash $150,000 Liabilities $280,000

Inventory 230,000 Common stock 600,000
Property, plant, & equipment (net) 810,000 Retained earnings 310,000
Total $1,190,000 Total $1,190,000
2. Equity Method
Sandestino Company
Income Statement
Year 1
Revenues $800,000
Expenses (450,000)
Equity in Grand Sand’s net income 10,000
Income before tax 360,000
Tax expense (100,000)
Net income $260,000
Sandestino Company
Balance Sheet
December 31, Year 1
Cash $130,000 Liabilities $250,000

Inventory 200,000 Common stock 600,000
Property, plant, & equipment (net) 650,000 Retained earnings 310,000
Investment in Grand Sand 180,000 Total $1,160,000
Total $1,160,000

b. Calculation of ratios:
Proportionate Consolidation Equity Method

Profit margin 260,000/840,000 = 0.3095 260,000/800,000 = 0.325
Debt/equity 280,000/910,000 = 0.3077 250,000/910,000 = 0.275
Sandestino’s profit margin would be higher and its debt-to-equity ratio would be lower if it used
the equity method to account for its investment in Grand Sand.

7. Horace Jones Company
The first step in determining which business segments must be reported separately is to
determine whether a majority of revenues are generated from external customers. As shown
below, this criterion is met by all segments other than C. Therefore, segment C will not be
reported separately.
Majority of Revenues Test A B C D E F

Revenues:
External sales revenue 1,030 350 20 140 130 120
Intersegment sales revenue 30 20 200 10 0 0
Total revenues 1,060 370 220 150 130 120
External revenues as % of
total revenues 97% 95% 9% 93% 100% 100%
The next step is to apply the three significance tests to determine whether the second criterion
for a reportable segment is met.
Revenue Test Total Percentage

Segment Revenues of Total
A 1,060 52% reportable
B 370 18% reportable
C 220 11%
D 150 7%
E 130 6%
F 120 6%
Total 2,050 100%
Profit or Loss Test Segment Segment Segment Result

Segment Revenues Expenses Profit Loss
A 1,060 824 236 reportable
B 370 560 (190) reportable
C 220 158 62
D 150 144 6
E 130 73 57 reportable
F 120 101 19
Total 2,050 1,860 380 (190)

Asset Test Total Percentage
Segment Assets of Total
A 1,650 47% reportable
B 650 19% reportable
C 500 14%
D 280 8%
E 300 9%
F 120 3%
Total 3,500 100%
Of the five business segments that meet the criterion of having a majority of revenues from
external sources, only three segments meet at least one of the significance tests. Segments A,
B, and E will be reported separately; segments C, D, and F will be combined into Other
Segments. However, if total external revenues attributable to separately reportable segments is
less than 75% of total consolidated revenue, additional segments must be reported even if they
do not meet any of the significance tests.
75% Test External Percentage of

Segment Revenues Consolidated Revenues
A 1,030 58%
B 350 20%
C 20 n/a
D 140 n/a
E 130 7%
F 120 n/a
Total consolidated
revenues 1,790 84%
Because A, B, and E collectively comprise more than 75% of total consolidated revenues,
segments C, D, and F will be combined.

The schedule below provides a suggestion for how the information items required to be
presented for primary format segments might be presented. A reconciliation is provided for the
amounts that appear in the consolidated income statement.
Segment Segment Segment Other Corp- Elimin- Consoli-

A B E Segments orate ations dated
Total revenues 1,060 370 130 490 - (260) 1,790

(200 1,06
Cost of goods sold 600 300 60 300 - ) 0
Depreciation and 1 23
amortization 80 100 5 35 0 0
Other operating 5 38
expenses 120 150 5 55 0 0
Allocated corporate (50
expense 24 10 3 13 - ) -
Segment profit or 12
loss 236 (190) 57 87 0
3
Interest expense 0
Income taxes 30
Net income 60
Other information:
10 3,60
Segment assets 1,650 650 300 900 0 0
1,70
Segment liabilities 750 300 140 510 - 0
Capital 1 38
expenditures 200 50 20 105 0 5
Depreciation and 8 1
amortization 0 100 5 35 0 230

8. Schering AG
Schering’s Primary Reporting Format is geographic. The following table indicates the heading
used by Schering to report information required by IAS 14 for each reportable primary reporting
format segment:
IAS 14 Requirement Schering heading

Segment revenue Segment net sales
Segment profit or loss Segment result
Carrying amount of segment assets Segment assets
Segment liabilities Segment liabilities
Cost during the period to acquire property, Investments in intangibles and property,
plant, and equipment, and intangible assets plant and equipment
Depreciation and amortization Depreciation
Significant noncash expenses, other than Other significant non-cash expenses
depreciation and amortization
Aggregate share of profit or loss and Not found, might not be applicable
aggregate investment in equity method
associates and joint ventures.
IAS 14 also requires a reconciliation between the information disclosed for primary segments
and the aggregate information in the consolidated financial statements. Schering provides this
reconciliation; consolidated amounts are referred to as “Schering AG Group.”
When the primary reporting format is geographical segments, three items of information as
shown below should be provided for each business segment whose external revenues are 10%
of total external revenues or whose segment assets are 10% or more of total segment assets.
IAS 14 Requirement Schering heading

Revenue from external customers External net sales
Carrying amount of segment assets Segment assets
Capital expenditures Investments in intangibles and property,
plant and equipment
Geographical segments can be determined on the basis of where assets are located or on the
basis of where customers are located. If the primary reporting format is geographical segments
based on location of assets and customer location is different from asset location, the company
should disclose revenues from external customers for each customer-based geographical
segment that has 10% or more of total external revenues. If the primary reporting format
instead is geographical segments based on customer location and assets are located in
geographical areas different from customers, the company should disclose:
 the carrying amount of segment assets for each asset-based geographical segment that
has 10% or more of total external revenues, and
 capital expenditures during the period for each asset-based geographical segment that
has 10% or more of total capital expenditures.

Schering’s geographic segments are based on customer location. The company complies with
the above requirements by reporting “Segment assets by geographic location” and “Investments
by geographic location.”
In conclusion, Schering AG complies fully with the primary and secondary reporting format
requirements of IAS 14.

9. IBM, Johnson & Johnson, and General Motors
a. A commonly used measure of multinationality is the percentage of total sales that are
generated in countries other than the United States: Foreign Sales/Total Sales. This
ratio can be calculated for each company by subtracting U.S. sales from total sales and
then dividing by total sales:
IBM ($96,293 - $35,637) / $96,293 = 63.0%
Johnson & Johnson ($47,348 - $27,770) / $47,348 = 41.3%
General Motors ($193,517 - $134,380) / $193,517 = 30.6%
Based on this measure, IBM is the most multinational company among the three in
Exhibit 8.8.
b. International diversification refers to the extent to which a company’s operations are

spread across different countries and regions of the world. General Motors appears to
be concentrated in a relatively small number of countries, and is therefore not very
diversified internationally. Almost 90% of GM’s sales are generated from operations in
only eight countries (U.S., Canada and Mexico, France, Germany, Spain, U.K., and
Brazil). From Johnson & Johnson’s segment disclosure, it is impossible to know the
number of countries in which the company has operations. For example, “Europe” could
imply operations in anywhere from one to 30+ countries. One can determine that about
50% of IBM’s revenues are generated in only two countries (U.S. and Japan), but it is
impossible to know where in the world the remaining 40% of its sales are generated.
We do know that there are no other countries in which IBM believes it has a material
amount of revenues, because it would be required to disclose this country separately.
This exercise demonstrates the difficulty in assessing international diversification given
current segment reporting practices.

10. BMW and Volkswagen
a. A commonly used measure of multinationality is the percentage of total sales that are
generated in countries other than the home country: Foreign Sales/Total Sales. This
ratio can be calculated for each company by subtracting sales in Germany from total
sales and then dividing by total sales:
BMW (€44,335 – €11,961) / €44,335 = 73.0%
Volkswagen (€88,963 – €24,504) / €88,963 = 72.5%
Based on this measure, BMW is slightly more multinational than Volkswagen. Both
companies rely very heavily on sales made outside of Germany.
Note that the internationality of the two companies can be directly compared by
collapsing VW’s North America and South America segments into one region – America
– and by collapsing its Africa and Asia/Oceania segments into one region – Africa, Asia,
Oceania.
b. One way to measure international diversification is the extent to which sales are spread
out over different regions of the world. Column B in the table below shows that BMW’s
sales are more evenly spread over the four segments than are VW’s. Whereas VW
generates 72% of its sales in Europe including Germany, BMW generates only 63% of
its sale in Europe.
External Sales Col. A Col. B Col. C Col. D Col. E

Year-to-year
BMW 2004 % 2003 % % change
Germany 11,961 27.0% 10,590 25.5% 12.9%
Rest of Europe 15,823 35.7% 13,389 32.2% 18.2%
America 10,648 24.0% 11,620 28.0% -8.4%
Africa, Asia, Oceania 5,903 13.3% 5,926 14.3% -0.4%
44,335 100.0% 41,525 100.0% 6.8%
Volkswagen
Germany 24,504 27.5% 23,298 27.5% 5.2%
Rest of Europe 39,755 44.7% 35,723 42.1% 11.3%
America 17,257 19.4% 18,084 21.3% -4.6%
Africa, Asia, Oceania 7,447 8.4% 7,708 9.1% -3.4%
88,963 100.0% 84,813 100.0% 4.9%
c. BMW experienced a growth in 2004 revenues of 6.8% (Col. E in table above).

Revenues grew in Germany and the Rest of Europe only. The greatest decrease in
revenues incurred in America.
Volkswagen experienced an overall increase in sales in 2004 of 4.9% (Col. E). The
pattern of revenue growth for Volkswagen is similar to that for BMW. Sales for VW also
grew in Germany and the Rest of Europe, with a decline in America and
Africa/Asia/Oceania. The largest year-to-year % decline was in America (Col. E).


Additional Financial Reporting Issues: Chapter Outline

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CHAPTER 8

ADDITIONAL FINANCIAL REPORTING ISSUES

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

1. Historical cost accounting causes assets to be significantly understated in a country

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

7. IAS27, “Consolidated Financial Statements and Accounting for Investments in Subsidiaries,”

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

December 31, Year 1

December 31, Year 2

December 31, Year 2

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

Calculation of Purchasing Power Loss

GPP Income Statement

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

Balance Sheet, 1/1/Y1 Historical Restatement Restated to

Contributed capital 1,000,000.00 110/100 1,100,000.00

Income Statement, Year 1

Calculation of Purchasing Power Loss

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

Contributed capital 1,000,000.00 110/100 1,100,000.00

Calculation of Average Stockholders' Equity

b. Calculation of profit margin and return on equity on an inflation-adjusted basis

Return on Equity 30,000.00 2.69%

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

Balance Sheet, 1/1/Y1 Historical Restatement Restated to

Contributed capital 150,000,000.00 130/100 195,000,000.00

Income Statement, Year 1

Calculation of Purchasing Power Loss

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

Contributed capital 150,000,000.00 130/100 195,000,000.00

Calculation of Average Stockholders' Equity

b. Calculation of profit margin and return on equity on an inflation-adjusted basis

Return on Equity (1,500,000.00) -0.77%

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

a. Restated financial statements:

1. Proportionate Consolidation Method

Cash $150,000 Liabilities $280,000

Cash $130,000 Liabilities $250,000

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

Proportionate Consolidation Equity Method

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

Majority of Revenues Test A B C D E F

Revenue Test Total Percentage

Profit or Loss Test Segment Segment Segment Result

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

75% Test External Percentage of

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

Segment Segment Segment Other Corp- Elimin- Consoli-

Total revenues 1,060 370 130 490 - (260) 1,790

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

IAS 14 Requirement Schering heading

IAS 14 Requirement Schering heading

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

b. International diversification refers to the extent to which a company’s operations are