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 company’s 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. • Mexico’s 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 bank’s 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-of-interests 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 subsidiary’s financial statement elements. • When the subsidiary is not 100 percent owned, the non-owned 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