Electronic Presentations in Microsoft ® PowerPoint ® Prepared by Peter Secord Saint Mary’s University © 2003 McGraw-Hill Ryerson Limited

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 2 Chapter 10 Other Consolidation Reporting Issues

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 3 Other Consolidation Reporting Issues Chapter Outline –Joint Ventures and Proportionate Consolidation –Future Income Taxes and Business Combinations –Segmented Disclosures –Examples –International Views

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 4 Joint Ventures

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 5 Joint Ventures Joint Ventures are a common mechanism where two or more companies with common interests (but perhaps different geographic or technical scope) arrange to do business together, generally on a project or “venture” basis –Generally, a separate business entity is formed, which may or may not be incorporated –The venturers continue in their own businesses; the venture tends to carry on a “new” business under the control of the venturers, such as entering a new market or developing a new oil well

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 6 Joint Ventures and Proportionate Consolidation Joint ventures are very common in certain industries, including oil and gas exploration and development and in food, beverages and hospitality

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 7 Joint Ventures In terms of definitions, the CICA Handbook notes: –A joint venture is an “economic activity” resulting from a contractual arrangement whereby two or more venturers jointly control the economic activity This activity is typically a business venture –Joint control of an economic activity is the contractually agreed sharing of the continuing power to determine its strategic operating, investing and financing policies The venture tends to be governed by a board of directors appointed by the venturers

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 8 Joint Ventures The venturers are the parties to the joint venture, have joint control over that joint venture, have the right and ability to obtain future economic benefits from the resources of the joint venture and are exposed to the related risks The combination of the joint right and ability to obtain future economic benefits and exposure to the related risks suggests that neither accounting model, full consolidation or the equity method, is fully appropriate

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 9 Joint Ventures The venturers are bound by contractual arrangements which establish that the venturers have joint control over the joint venture, regardless of the difference that may exist in their ownership interest –Although they each have “significant influence”, none of the individual venturers is in a position to exercise unilateral control over the joint venture –Decisions in all areas essential to the accomplishment of the joint venture require the consent of the venturers in such manner as defined in the terms of the contractual arrangement

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 10 Joint Ventures Joint ventures are unique: –The characteristic of joint control distinguishes interests in joint ventures from investments in other activities where an investor may exercise control or significant influence A contract is generally required, but not in all cases: –Activities conducted with no formal contractual arrangements which are jointly controlled in substance are joint ventures The unique aspects of joint ventures require a unique accounting treatment

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 11 Joint Ventures and Proportionate Consolidation Proportionate consolidation is the appropriate accounting treatment in Canada for external financial reporting by venturers of their investments in joint ventures Proportionate consolidation is an application of the proprietary concept of reporting

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 12 Proportionate Consolidation The proprietary approach incorporates the amounts recorded by the subsidiary into the consolidated financial statements at fair value at the date of acquisition, but only to the extent of the proportion acquired The basis of the inclusion in this manner is that the investor shares in the risks and rewards of ownership in direct proportion to the shareholding percentage With a joint venture, joint control makes this treatment appropriate

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 13 Joint Ventures: International View Under US GAAP, proportionate consolidation is not permitted Net income will be the same under the equity method, as the venturer’s share of net income of the venture is recognized

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 14 Joint Ventures: International View Proportionate consolidation is often used by companies reporting under International Accounting Standards

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 15 Joint Ventures: International View IAS 31 recommends proportionate consolidation, allows use of the equity method for joint ventures 2000 annual report

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 16 Joint Ventures: International View Exercise Caution: –The term “joint venture” is frequently used in the “international context” in a manner which is less restrictive than the definitions of the CICA Handbook, and (for some companies) refers to any intercorporate partnership, regardless of the control structure. –Proportionate consolidation is not necessarily applied in all cases which would qualify for this method in Canada –Further, proportionate consolidation can be, and often is, applied in cases that would not qualify in Canada

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 17 Future Income Taxes and Business Combinations

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 18 Future Income Taxes and Business Combinations The liability method is GAAP for tax allocation in Canada, in common with the US and IAS

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 19 Future Income Taxes and Business Combinations In earlier chapters, we recognized the income tax effects and accounted for future income taxes when we eliminated unrealized profits We did this when we had asset and liability values for tax purposes which differed from values for financial reporting purposes –Gains realized for tax purposes were unrealized in the consolidated financial statements There are other intercorporate investment situations where income tax effects, including future income taxes, must be recognized

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 20 Future Income Taxes and Business Combinations At any point in time, there may be a difference between the tax basis of an asset or liability and its carrying amount This difference can occur when the purchase discrepancy is recognized and allocated in a business combination accounted for as a purchase The difference in carrying value (new book value in consolidation, as compared to tax basis) gives rise to future income taxes which must be recognized in the financial statements

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 21 Future Income Taxes and Business Combinations Basic principles –The premise is that an enterprise should recognize a future income tax liability whenever recovery or settlement of the carrying amount of an asset or liability would result in future income tax outflows –Similarly, an enterprise should recognize a future income tax asset whenever recovery or settlement of the carrying amount of an asset or liability would generate future income tax reductions These situations arises whenever the values in consolidation differ from the tax values as recorded by the individual companies

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 22 Future Income Taxes and Business Combinations There are two essential provisions of the Handbook which apply in the context of business combinations: –“Old” future income taxes recorded by the subsidiary company are not carried forward into the consolidated financial statements –“New” future income taxes are recognized on any temporary differences arising in consolidation between the reported values (consolidated) and the tax basis of the asset on the books of the individual enterprise (the subsidiary)

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 23 Future Income Taxes and Business Combinations Example –In a business combination, the carrying amount of a particular asset is stated at its fair value of $20,000. In the books of the acquired company the asset had a book value of $12,000 and a tax basis of $9,000, which does not change. Assume a tax rate of 40% –The “old” future tax liability of (12, ,000) * 40% = $1,200 must be eliminated –A “new” future tax liability must be reported in the consolidated financial statements in the amount of (20, ,000) * 40% = $4,400 –Such allocations change the reported goodwill

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 24 Future Income Taxes and Business Combinations A business combination may increase the likelihood that loss carry forwards or other tax deductible amounts may be claimed –Other previously unrecognized future income tax assets (of either parent or subsidiary) may be recognized at the time of a business combination, providing that it is more likely than not that the benefits will be realized –These future income tax assets are identifiable assets in the allocation of the purchase price

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 25 Segmented Reporting

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 26 Segmented Reporting When consolidated financial statements are prepared, a significant amount of detail is lost –This lost detail could be very useful for analysts and other users of the financial statements –Yet, individual financial statements of subsidiaries may provide so much information as to overload –Managers do not wish competitors to have confidential or sensitive data An efficient method of communicating just enough pertinent detail is necessary The mechanism of segmented reporting provides this vehicle

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 27 Segmented Reporting Segments may be defined in various ways; there are fundamental issues associated with segment definition: –The CICA Handbook recommends a management approach, based on the way segments are organized within the enterprise for making operating decisions and assessing performance –As a result: Segments are based on defined organizational structure in a transparent manner Preparers can provide the required information in a cost-effective and timely manner.

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 28 Segmented Reporting To employ the management approach, an operating segment is defined as a component of an enterprise: –that engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same enterprise)

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 29 Segmented Reporting To employ the management approach, an operating segment is defined as a component of an enterprise: –that engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same enterprise) –whose operating results are regularly reviewed by the enterprise's chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance, and

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 30 Segmented Reporting To employ the management approach, an operating segment is defined as a component of an enterprise: –that engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same enterprise) –whose operating results are regularly reviewed by the enterprise's chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance, and –for which discrete financial information is available

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 31 Segmented Reporting Separate disclosure is required for segments when one or more of these thresholds is met: –Reported revenue, both external and intersegment, is 10 percent or more of the combined revenue, internal and external, of all segments

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 32 Segmented Reporting Separate disclosure is required for segments when one or more of these thresholds is met: –Reported revenue, both external and intersegment, is 10 percent or more of the combined revenue, internal and external, of all segments –The absolute amount of reported profit or loss is 10 percent or more of the greater, in absolute amount, of: the combined reported profit of all operating segments that did not report a loss, or the combined reported loss of all operating segments that did report a loss.

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 33 Segmented Reporting Separate disclosure is required for segments when one or more of these thresholds is met: –Reported revenue, both external and intersegment, is 10 percent or more of the combined revenue, internal and external, of all segments –The absolute amount of reported profit or loss is 10 percent or more of the greater, in absolute amount, of: the combined reported profit of all operating segments that did not report a loss, or the combined reported loss of all operating segments that did report a loss. –Its assets are 10 percent or more of the combined assets of all operating segments.

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 34 Segmented Reporting General information is required: –Factors used to identify the enterprise's reportable segments, including the basis of organization whether management has chosen to organize the enterprise around differences in products and services, geographic areas, regulatory environments, or a combination of factors and whether operating segments have been aggregated –Types of products and services from which each reportable segment derives its revenues Note that the prior approach of geographic and industrial segmentation has been superceded

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 35 Segmented Reporting Segment information is provided for the following items, until 75% of the total revenue is reached: –A measure of profit or loss and total assets for each reportable segment, including detail of Revenues, separating internal and external Interest revenue and interest expense (separately) Amortization and other significant non-cash items Unusual items and extraordinary items (separately) Equity in the net income of investees Income tax expense or benefit Investments subject to significant influence Expenditure on capital assets and goodwill

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 36 Segmented Reporting Comprehensive reconciliation to consolidated amounts is required: –The total of the reportable segments' revenues to the enterprise's total revenues. –The total of the reportable segments' measures of profit or loss to the enterprise's corresponding measure of profit or loss –The total of the reportable segments' assets to the enterprise's total assets. –For all other significant items, in a like manner All significant reconciling items should be separately identified and described

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 37 Segmented Reporting Segmented disclosure is generally in the notes, but can also be on the face of the financial statements

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 38 Segmented Reporting Segmented disclosure is potentially minimal

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 39 Segmented Reporting Segmented disclosure may also be highly detailed, with full explanation, definitions and justification of the approach used and disclosure provided Which approach provides more assistance to the user of the financial statements?

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 40 Segmented Reporting

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 41 Segmented Reporting

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 42 International View Under US GAAP, the management approach to segment disclosure is also required, and provides similar results Under IAS, definitions, thresholds and reporting criteria are similar, but disclosure is provided in a matrix format, with geographic or industry segments defined and identified as primary or secondary –For example, this means that if the geographic areas are identified as primary segments, secondary segments (industrial) would also be reported

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 43 International View Graphical depiction can be very effective

Chapter 10 © 2003 McGraw-Hill Ryerson Limited 44 International View These graphs illustrate the two layer (matrix) approach recommended under IAS