1. McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Nine Additional Financial Reporting Issues Copyright © 2012 The McGraw-Hill Companies, All Rights Reserved

2. 9-2 Chapter Topics Inflation accounting – general purchasing power and current cost accounting approaches. Inflation accounting – differences in standards worldwide. Business combinations and consolidated financial statements (group accounting). International approaches to group accounting. International approaches to segment reporting.

3. 9-3 Learning Objectives 1. Explain the concepts underlying two methods of accounting for changing prices (inflation)—general purchasing power accounting and current cost accounting. 2. Describe attempts to account for inflation in different countries, as well as the rules found in International Financial Reporting Standards (IFRS) related to this issue. 3. Discuss the various issues related to the accounting for business combinations and the preparation of consolidated financial statements (group accounting). 4. Present the approaches used internationally to address the issues related to group accounting, focusing on IFRS. 5. Describe IFRS segment reporting requirements.

4. 9-4 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

5. 9-5 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

6. 9-6 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

7. 9-7 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

8. 9-8 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

9. 9-9 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. Learning Objective 1

10. 9-10 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. Learning Objective 2

11. 9-11 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. Learning Objective 2

12. 9-12 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. This exception allowed a combination of country of origin price index and the exchange rate between Mexico and country of origin. Based on inflation being held to under 5% for several consecutive years, Bulletin B-10 was abandoned late in 2007. Companies no longer are required to use inflation accounting. Learning Objective 2

13. 9-13 Netherlands – Replacement Cost Accounting Prior to the required use of IFRS in 2005, Dutch companies could use replacement cost accounting. In 2003 and 2004 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

14. 9-14 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

15. 9-15 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

16. 9-16 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

17. 9-17 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

18. 9-18 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. Learning Objective 3

19. 9-19 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

20. 9-20 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 goodwil l. Learning Objectives 3 and 4

21. 9-21 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. Learning Objectives 3 and 4

22. 9-22 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. 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. Learning Objectives 3 and 4

23. 9-23 Group Accounting – Further Convergence of U.S. GAAP and IFRS 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. In December 2007 FASB issued SFAS 141 (R), Business Combinations and SFAS 160, Noncontrolling Interests in Consolidated Financial Statements. 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. This replaces the step treatment, which measured the fair value at each step of achieving control. The major change in U.S. GAAP includes requiring the use of the acquisition method for business combinations and classifying noncontrolling interests as equity. Learning Objectives 3 and 4

24. 9-24 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

25. 9-25 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

26. 9-26 IFRS 8, Operating Segments : Substantially converges IFRS with U.S. GAAP. Adopts the management approach to segment reporting. Management disaggregates components to make operating decisions. An operating segment is an enterprise component if:  It earns revenues and incurs expenses.  Its operating results are regularly reviewed for performance and resource allocation.  Discrete financial information is available for it. Learning Objective 5

27. 9-27 IFRS 8, Operating Segments – Significance Tests to Justify Disclosure Must meet any of the following tests: Revenue test—segment revenue (external and intersegment) represents 10% or more of combined internal and external revenue. 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. Asset test—segment assets are 10% or more of the combined assets of all operating segments. Notwithstanding the tests above, segments must be disclosed if less than 75% of total company sales are to outsiders. Learning Objective 5

28. 9-28 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. Learning Objective 5

29. 9-29 Disclosures General information about the operating segment (how identified and products and services). Segment profit or loss and the following line items:  Revenues from external customers  Intersegment revenues  Interest revenue and expense  Depreciation, depletion and amortization  Other significant noncash items in segment profit or loss  Unusual items (e.g. discontinued operations and extraordinary items)  Income tax expense or benefit Learning Objective 5

30. 9-30 Disclosures Total segment assets (and liabilities for IFRS). Expenditures for additions to long-lived assets (U.S. GAAP) and noncurrent assets (IFRS 8). Learning Objective 5

31. 9-31 Disclosures Information about products and services. Information about major customers (if 10% or more of total entity revenue). Information about geographic areas.