Additional Financial Reporting Issues

1
Additional Financial Reporting Issues

• Inflation
• Business Combinations
• Segment Reporting

2
Additional International Financial Reporting
Issues

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

3
Inflation

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

4
Inflation

• Inflation distorts, or eradicates, the meaning of
  financial statement numbers.
• The more the inflation, the greater the need for
  adjustment so that financial reports remain
  useful.

5
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 cause problems
  with comparability.

6
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.

7
Inflation Accounting Conceptual Issues

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

8
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.

9
Inflation Accounting Conceptual Issues

• Net Income and Capital Maintenance
• General purchasing power net income maintains the
  purchasing power of contributed capital.
• Current cost net income maintains the productive
  capacity of physical capital.

10
A major question

• How do you measure inflation?

11
The CPI

• Measures a very specific basket of goods and
  services a very specific way.
• Does this basket truly detect the degree of
  inflation impacting an economic system?
• Note The CPI, for more than a decade, has
  measured aggregate changes in the price level of
  the economy at well below 5 (annualized).

12
Corn- Monthly price changes
13
Wheat-Monthly changes in price
14
Pork Bellies-monthly changes in price
15
Lumber-monthly changes in price
16
Orange Juice-monthly changes in price
17
Copper-monthly changes in price
18
Cocoa-monthly changes in price
19
Service costs

• Medical Insurance
• gt60 since 2000 gt10 per year on average.
• Labor costs
• lt4 per year, on average
• College tuitions
• 10-12 per year since 2000.
• Magazines, media
• lt5 per year, on average

20
The Problem of Hidden Inflation

• What if an economy enters recession and the price
  index, in response, declines by 10?
• Or, what if a foreign producer exports goods at a
  cost 10 below current prices, and
• What if the money supply is then increased such
  than the supply of currency increases 12 faster
  than economic growth would suggest?
• CPI-measured inflation 12- 10 2.

21
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.

22
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.

23
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.

24
Inflation Accounting Internationally

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

25
Inflation Accounting Internationally

• Mexico Bulletin B-10
• Requires restatement of nonmonetary assets and
  liabilities using the central banks general
  price level index.
• An exception is the option to use replacement
  cost for inventory and related cost of goods
  sold.
• Another exception is imported machinery and
  equipment.
• This exception allows a combination of country of
  origin price index and the exchange rate between
  Mexico and country of origin.

26
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.

27
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.

28
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.

29
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.

30
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.

31

• 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 (IFRS3) is
  essentially identical to that used in USA!

32
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.

33
Business Combinations and Consolidated Financial
Statements

• Group Accounting Full Consolidation
• Full consolidation involves aggregation of 100
  percent of the subsidiarys financial statement
  elements.
• When the subsidiary is not 100 percent owned, the
  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.

34
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.

35
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.

36
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.

37
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.

38
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.

39
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.

40
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.

41
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.

42
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.

43
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.