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