Ias-reviewer.docx

CHAPTER 5 Current Liabilities 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

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IFRS is similar but differences may relate to: 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. o

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Contingent Liabilities and Provisions Contingent liability is either: Possible obligation from past events to be confirmed by presence or absence of future event OR Present obligation not recognized because no probable outflow of resources or amount can’t be measured reliably Contingent liability is not recognized on balance sheet while a provision is. Provision is a liability of uncertain timing or amount: Present legal or constructive obligation resulting from past event (constructive—e.g. manufacturer announces will honor defunct retailer rebates). Probable (more likely than not) outflow of resources. Can be estimated reliably. Types of Differences Between IFRS and U.S. GAAP U.S. GAAP doesn’t recognize constructive obligations— only legal. 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%.

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Onerous Contract Unavoidable costs of meeting the obligation exceed economic benefits to be realized. Recognize lower of cost of fulfillment or penalty from non-fulfillment. If onerous from entity's own action--no recognition until that action happens. Restructuring A program planned and controlled by management that materially changes either scope of business or manner in which business is conducted. 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. U.S. GAAP doesn’t allow restructuring provision until liability incurred, so may occur later than under IFRS. Contingent Assets Probable asset arising from past events whose existence will be confirmed by occurrence or non-occurrence of future event. Don’t recognize—disclose when probable inflow of economic benefits. Recognize as asset when virtually certain. Earlier recognition of contingent asset and related gain than U.S. GAAP, which generally requires realization before recognition. Proposed Amendments to IAS 37 Criterion of “probable outflow of resources” for provision would be removed---i.e.—recognize as long as reasonably measurable. “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 Covers all forms of employee compensation and benefits other than share-based compensation (e.g. stock options). Four types: Short-term (compensated absences and bonuses). Post-employment ( pensions, medical benefits, etc.). Other long-term benefits (deferred compensation and disability). Termination benefits (severance and early retirement). IFRS 2, Share-based Payment IASB and FASB worked closely on standards. # of minor differences, but both standards substantially similar IFRS 2 sets out measurement principles and specific guidance for three types of transactions: Equity-settled—entity receives goods or services in exchange for equity instruments (e.g. stock options).

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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). Choice of settlement of above two options. Equity-settled 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. 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). If single vesting date (cliff vesting)—straight-line over service period. If installments (graded vesting)—amortize each installment (tranche) over their vesting period. U.S. GAAP re: graded vesting—choice of accelerated or straight-line recognition. Modification of stock option plans—length or price may change—recognize, at minimum, original compensation cost at grant date. If fair value reduced---no change in compensation deduction. If fair value increased—increase compensation by the like amount. U.S. GAAP—if modifications—fair value at modification date determines compensation expense---no minimum compensation as under IFRS. Cash-settled Stock appreciation rights—recognize liability for future cash outflow at fair value of appreciation rights using an option pricing model. Remeasure at each balance sheet date until settled. 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.

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Both have deferred tax assets and liabilities re: timing differences and operating loss and tax credit carryovers. March 2009 IASB exposure draft “Income Tax” intended to eliminate differences with U.S. GAAP. Final standard replacing IAS 12 still not published as of Spring 2011. Tax Laws and Rates Current and deferred taxes based on rates enacted or substantively enacted (when future steps can’t change outcome) by balance sheet date. U.S. GAAP must use actually enacted rates. To minimize double taxation some countries apply lower rate to distributed profits vs. retained profits. Recognition of Deferred Tax Asset 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 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 IFRS can cause temporary differences not existing under U.S. GAAP (e.g. revaluation model for p, p & e under IAS 16). Differences in impairment standards. Financial Statement Presentation 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. IAS 1, Presentation of Financial Statements”—only noncurrent. IAS 18, Revenue Single standard covering most revenues (sale of goods, rendering of services, interest, royalties and dividends). U.S. GAAP has no single standard—instead over 200 different authoritative pronouncements, so difficult to compare IAS 18 and U.S. GAAP . Revenue must be measured at fair value of consideration received or receivable. 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 Transfer of significant risks and rewards to buyer (IAS has various examples of how seller may retain risks). No effective control maintained or management involvement.

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Can measure revenue reliably. Probable future economic benefits flow to seller. Selling costs can be measured reliably. Rendering of Service 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). Probable benefits will flow to enterprise. U.S. GAAP doesn’t allow percentage-of-completion for service contracts. 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) Interest recognized on effective yield basis. Royalties recognized on accrual basis based on relevant agreement. 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 Both boards working since 2002. June 2010—joint Exposure Draft “Revenue from

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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

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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. Financial asset (e.g. cash, receivables, loans to others, etc.): Cash

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Contractual right to: a) Receive cash or other financial asset b) Exchange financial assets or financial liabilities under potentially favorable conditions An equity instrument of another entity 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 Financial liability (e.g. payables, loans from other entities, bonds, etc.): A contractual obligation to: a) Deliver cash or another financial asset b) Exchange financial assets or financial liabilities under potentially unfavorable conditions A contract that will or may be settled in the equity’s own equity instruments. Equity instrument—any contract that evidences a residual interest in the assets of an entity after deducting all its liabilities. Compound Financial Instruments Both a liability and equity element (e.g. convertible bond). 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 Initial—fair value (normally = amount paid or received). Subsequent—cost, amortized cost, or fair value. CHAPTER 6 China: Background World’s largest country with population of over 1.3 billion. People’s Republic of China (PRC) established in 1949. Politically: Communist, one-party state. Economically: Until the 1980s, all firms state-owned. Currently in transformation to socialist market economy. World’s fourth largest economy and fastest growing among large economies, and is largest recipient of FDI. China First securities regulations adopted in 1984. Two major stock exchanges, Shanghai and Shenzhen established in 1 990 and 1991.

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

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Pre-operating expenses – deferred, then expensed when operations begin, whereas, under IAS 38, expense immediately. 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 statesponsored group that oversees auditing profession. Accounting Regulation Commercial code and tax laws are main sources of accounting rules. Traditionally has not used a system of independent institutional oversight. Stock exchange rules have less influence than in U.S. Prudence (conservatism) is fundamental--recognition of revenues only when realized, losses when they appear possible. Began change away from creditor orientation in 1960s towards shareholder orientation.

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As of 2009 the German Accounting Standards Board (GASB) worked on IASB projects relating to the financial crisis. Accounting Principles and Practices Historical cost attribute for measuring tangible assets is strictly adhered to. Traditional focus on creditor protection is at odds with the true and fair view concept. 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. Differences between accounting and tax income are minimal, thereby reducing need for deferred taxes. In contrast to China, conservatism has been used to resist labor’s wage demands. Standards allow for income smoothing, frequently accomplished via early recognition of losses. EU fourth directive requires true and fair view, but Germans have a unique interpretation of the concept. Commitment to globalization reflected in rule that allows public companies to use IFRS for consolidated statements. Main intention of German Accounting Law Modernization Act is conformity with IFRS. In August 2010 only about 10 German companies were listed on the NYSE due to NYSE overregulation. Differences with IFRS Goodwill – deducted immediately against equity, whereas, under IFRS 3, accounted for as an indefinite life intangible asset. Internally generated intangibles – not recognized, whereas, under IAS 38, recognized as an asset under some conditions. Leases – accounting uses tax rules, with capitalization rare, whereas IAS 17 criteria result in more frequent capitalization. Accounting for subsidiaries – allow exclusion of dissimilar subsidiaries, which are consolidated under IAS 27. Japan: Background Population 127 million, world’s third largest economy. Banks are primary source of finance via both loans and equity, and cross-corporate equity ownership is also common. Keiretsu (and predecessor Zaibatsu) emphasize close business ties and reflect cultural value of collectivism. 1990s recession led to an increase in Japanese firms’ attempts to obtain capital internationally. Accounting Profession Certified Public Accountants Law (1948) established the profession. JICPA is one of the nine founding members of the IASC. Profession is significantly less influential than in U.S./U.K. and is also much smaller in numbers than U.S.

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Obtaining CPA title is extremely rigorous, as in Germany. Low status within Japanese society vs. engineers and scientists. Collectivism leads to lack of trust of auditors. Tax advising is a much larger, separate, profession. Accounting Regulation Government influences accounting via Commercial Code, Corporate Income Tax Law and Securities and Exchange Law. Similar to Germany, strong creditor orientation and accounting rules closely tied to tax rules. Big Bang financial reforms are leading to harmonization with international standards. These reforms included requirements for consolidation and fair value accounting for tradable securities. Business Accounting Principles issued by Ministry of Finance consist of 7 guidelines (the equivalent of a conceptual framework). 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 In contrast to U.S., net income is less a measure of performance and seen more as funds available for dividends. Since providers of financing tend to be close to the firm, there has historically been little pressure for disclosure. Lack of disclosure is apparent in segment reporting. 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 Revaluation of Land – allowed, but updating not required, whereas, under IFRS 16, revaluations require regular updating. Pre-operating costs – capitalization is allowed, whereas, under IAS 38, expensed immediately. Construction contracts – completed contract method is allowed, whereas IAS 11 essentially requires percentage-of-completion. Provisions – allows for provisions prior to actual obligation, whereas IAS 37 only allows for present obligations based on past transaction. Mexico: Background History of significant inflation-- government control of business is partially blamed for this. Significant changes in 1990s, including privatization of state-owned firms and NAFTA. Historically, most businesses family-owned-- even the very large—prefer to raise capital via debt vs. equity—but gradually changing.

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Mexico’s one stock exchange, the Bolsa Mexicana de Valores, is privately-owned. 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 The Asociacion de Contadores Publicos, first professional accountant organization, established in 1917. This group was succeeded by the Mexican Institute of Public Accountants (MIPA) in 1964. MIPA establishes accounting and auditing principles. In order to practice public accounting in Mexico, one needs a “professional diploma.” 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 Mexican GAAP heavily influenced by U.S. GAAP due to NAFTA, geographical proximity, and comprehensiveness of U.S. GAAP. Despite international influences, Mexico’s Bulletin B-10 on inflation accounting shows how harmonized accounting may not be appropriate for all circumstances. 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 Bulletin B-10, Recognition of the Effects of Inflation, reflects a major difference to U.S. GAAP. Nonmonetary assets and liabilities to be restated for purchasing power changes of the peso. Inventory can be restated using current replacement costs. Recognition in income (generally) of the gain or loss from the net monetary position, asset or liability. In line with IAS 29, Mexico has given up on inflation accounting recently, due to low rate of inflation Differences with IFRS Statement of cash flows – statement of changes in financial position required, whereas IAS 7 requires a statement of cash flows. Inflation Accounting – requires inflation adjustments regardless of inflation rate, whereas IAS 29 required only for hyperinflationary countries. 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 Population of about 62 million, comprised of England, Northern Ireland, Scotland, and Wales. Among the five countries in this chapter, its financial structure is closest to the U.S. 15,000 Private Limited Companies (PLCs) with about 2,500 of these listed on the London Stock Exchange.

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Accounting Profession World’s first association of professional accountants, The Society of Accountants in Edinburgh, established in 1853. Six professional chartered bodies coordinated through Consultative Committee of Accountancy Bodies (CCAB). The profession developed in response to the needs of industry and has influenced the development of professions in a number of other countries. Compared to the U.S. the certification requirements focus more on work experience and less on university education. Accounting Regulation The Companies Act, accounting pronouncements, and stock exchange rules comprise accounting regulation. Similar to the U.S., and unlike Germany and Japan, tax rules do not significantly influence financial reporting. Standard-setters have historically taken a principlesbased approach using a statement of principles as a conceptual framework. Has not historically had a strong, SEC type agency, but recent scandals have led to increased regulation. The Financial Reporting Council (FRC) annual report for 2008/2009-- key themes for 2009/2010 would be to influence: Market participants to high standards of reporting and governance Legislators and standard-setters to encourage proportionate and principles-based approach in furtherance of the first goal International regulatory authorities to encourage effective cooperation Accounting Principles and Practices A primary objective of accounting is to support an effective capital market. The true and fair view principle is paramount. True and fair view override requires that companies not comply with standards that would result in misleading financial statements. Professional judgment is essential additional component to true and fair view. Financial Reporting Review Panel 2010 annual report says there has been continuous improvement in the general quality of IFRS financial reporting. Differences with IFRS Goodwill – amortization allowed, whereas IFRS 3 prohibits amortization and requires an annual impairment test. Related party disclosures – requires disclosure of related party names, whereas IAS 24 requires disclosure by type, not name, of related party. Revaluation gains/losses – generally not taken to income statement, whereas IAS 40 requires gains and losses to affect net income.

Import purchase – a company purchases from a foreign supplier and later pays in the supplier’s currency. 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

o 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.

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One transaction perspective Treats sale and collection as one transaction. Transaction is complete when foreign currency is received and converted, and sale is measured at converted amount. This approach is not allowed under IAS or U.S. GAAP.

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Treats sale and collection as two transactions Sale is one transaction and collection is a second transaction. Sale is based on current exchange rate. If exchange rate changes, collection is for different amount. Difference is considered foreign exchange gain or loss. Concepts are identical for purchase transaction. Transaction types, exposure type and gain or loss – export sales Export sale  asset exposure--if foreign currency appreciates  foreign exchange gain. Export sale  asset exposure--if foreign currency depreciates  foreign exchange loss. Import purchase  liability exposure -- if foreign currency appreciates  foreign exchange loss. Import purchase  liability exposure -- if foreign currency depreciates  foreign exchange gain.

Hedging -- protecting against losses from exchange rate fluctuations. Companies often use foreign currency forward contracts and foreign currency options. Foreign currency forward contract – an agreement to buy or sell foreign currency at a future date. Foreign currency option – the right to buy or sell foreign currency for a period of time. 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. Cash flow hedge – an accounting designation for hedges that offset variability in cash flows of hedged items. 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

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Foreign country operations usually prepare financial statements using local currency as the monetary unit. These financial statements must be translated into home country currency. These operations also typically use local GAAP. Financial statements must be translated into home country GAAP. Primary conceptual issues Each financial statement item must be translated using the appropriate exchange rate. Choices include the current exchange rate, average exchange rate, and the historical exchange rate. Current exchange rate is as of the balance sheet date, while historical exchange rate is as of the date of the transaction. The resulting translation adjustment can be recognized in current income or included in an equity account on the balance sheet. Balance Sheet Exposure Assets and liabilities translated at the current exchange rate are exposed to risk of a translation adjustment. When foreign currency appreciates, a net asset exposure results in a positive translation adjustment. When foreign currency appreciates, a net liability exposure results in a negative translation adjustment. Assets and liabilities translated at the historical exchange rate are not exposed to a translation adjustment. Translation Methods Current/Noncurrent Method Current assets and liabilities are translated at the current exchange rate. Noncurrent assets and liabilities and stockholders’ equity accounts are translated at historical exchange rates. There is no theoretical basis for this method. Method is seldom used in any countries and is not allowed by U.S. GAAP or IFRS. Monetary/Nonmonetary Method Monetary assets and liabilities are translated at the current exchange rate. Nonmonetary assets and liabilities and stockholders’ equity accounts are translated at historical exchange rates. 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 Objective is to translate financial statements as if the subsidiary had been using the parent’s currency. Items carried on subsidiary’s books at historical cost, including all stockholders’equity items, are translated at historical exchange rates. Items carried on subsidiary’s books at current value are translated at current exchange rates.

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Income statement items are translated at the exchange rate in effect at the time of the transaction. Current Rate Method Objective is to reflect that the parent’s entire investment in a foreign subsidiary is exposed to exchange risk. All assets and liabilities are translated at the current exchange rate. Stockholders’ equity accounts are translated at historical exchange rates. Income statement items are translated at the exchange rate in effect at the time of the transaction. Translation methods illustrated – Summary Current Rate Method All assets and liabilities translated at current rate. This results in net asset exposure. Net asset exposure and devaluing foreign currency results in translation loss. Translation adjustment included in equity. Temporal Method Primarily monetary assets and liabilities translated at current rate. This results in net liability exposure. Net liability exposure and devaluing foreign currency result in translation gain. Translation gain included in current income. U.S. GAAP FASB ASC 830, Foreign Currency Matters( formerly SFAS 52, Foreign Currency Translation) is the relevant accounting standard. Requires identification of functional currency. Functional currency is the primary currency of the foreign subsidiary’s operating environment. The standard includes a list of indicators as guidance for the foreign currency decision. When functional currency is U.S. Dollar, temporal method is required. When functional currency is foreign currency, current rate method is required. IFRS IAS 21, The Effects of Changes in Foreign Exchange Rates is the relevant accounting standard. Uses the functional currency approach developed by the FASB. The standard includes a list, similar to the FASB list, of indicators as guidance for the foreign currency decision. The standard’s requirements pertaining to hyperinflationary economies are substantially different from U.S. GAAP. Highly Inflationary Economies – U.S. GAAP 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).

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Temporal method required—translation gains/losses reported in income Hyperinflationary Economies – IFRS IAS 21 and 29 use the term hyperinflationary economies. 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. IAS 21 requires restatement of the foreign financial statements for inflation per IAS 29, Financial Reporting in Hyperinflationary Economies. 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 Companies that have foreign subsidiaries with highly integrated operations use the temporal method. The temporal method requires translation gains and losses to be recognized in income. Losses negatively affect earnings, and both gains and losses increase earnings volatility. t accounts. IAS approach is substantially different from U.S. GAAP. These gains and losses result from the combination of balance sheet exposure and exchange rate fluctuations. Companies can also hedge to offset the effects of the translation adjustment to equity under the current rate method. 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 Understated asset values. Overstated income and overpayment of taxes. Demands for higher dividends. Differing impacts across companies resulting in lack of comparability. 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. Net Income and Capital Maintenance Historical cost, general purchasing power and current cost accounting all flow from different concepts of capital maintenance.

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Net income represents the amount of dividends that can be paid out while still maintaining the company’s capital balance. 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. 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. 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 (CRC). Nonmonetary assets are restated to current replacement costs and expense items are based on these restated costs. Holding gains and losses are included in equity. United States and United Kingdom SFAS 33, Financial Reporting and Changing Prices briefly required large U.S. companies to provide GPP and CC accounting disclosures. This information is now optional (SFAS 89) and few companies provide it. In the U.K., SSAP 16 required current cost information, but this was later rescinded. Both countries have experienced low rates of inflation since the 1980s, which is why the inflation accounting requirements were lifted. 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 U.K., Brazil has abandoned inflation accounting. Mexico’s Bulletin B-10, Recognition of the Effects of Inflation in Financial Information, is a well-known example. Mexico – Bulletin B-10 Required restatement of nonmonetary assets and liabilities using the central bank’s general price level index. An exception was the option to use replacement cost for inventory and related cost of goods sold.

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 o

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Reporting in Hyperinflationary Economies. IAS 29 is required for some companies located in 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

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IAS 27, Consolidated and Separate Financial Statements, uses the effective control definition. 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. IFRS 3, issued in 2004, allows the use of the purchase method only. Pooling of interests is no longer acceptable under IFRS, or in the U.S., Canada, Brazil or Mexico. 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. 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 the option of immediate expensing of goodwill. 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 standards pertaining to the equity method. Group Accounting – Other As stated previously, the pooling of interests method is no longer permitted 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. 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.