Chapter 8 additional financial reporting issues



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CHAPTER 8


ADDITIONAL FINANCIAL REPORTING ISSUES

Chapter Outline
I. In addition to issues involving the accounting for foreign currency, three financial reporting issues of international importance are: (a) accounting for changing prices (inflation accounting), (b) accounting for business combinations and consolidated financial statements, and (c) segment reporting.
II. Historical cost accounting in a period of inflation understates asset values (and related expenses) and overstates income. Historical cost accounting also ignores the gains and losses in purchasing power caused by inflation that arise from holding monetary assets and liabilities.
III. Two methods of accounting for inflation have been used in different countries – general purchasing power (GPP) accounting and current cost (CC) accounting.

A. Under GPP accounting, nonmonetary assets and stockholders’ equity accounts are restated for changes in the general price level. Cost of goods sold and depreciation/amortization are based on restated asset values and the net purchasing power gain/loss on the net monetary liability/asset position is included in income. GPP income is the amount that can be paid as a dividend while maintaining the purchasing power of capital.

B. Under CC accounting, nonmonetary assets are revalued to current cost, and cost of goods sold and depreciation/amortization are based on revalued amounts. CC income is the amount that can be paid as a dividend while maintaining physical capital.
IV. IAS 29 requires the use of GPP accounting by firms that report in the currency of a hyperinflationary economy. IAS 21 requires the financial statements of a foreign operation located in a hyperinflationary economy to first be adjusted for inflation in accordance with IAS 29 before translation into the parent company’s reporting currency.
V. Issues that must be resolved in accounting for a business combination relate to (a) selection of an appropriate method, (b) recognition and measurement of goodwill, and (c) measurement of minority interest.

A. IFRS 3 and US. GAAP both require the purchase method in accounting for business combinations; the pooling of interests method is not allowed.

B. Goodwill is recognized on the consolidated balance sheet as an asset and tested annually for impairment under both IFRS 3 and U.S. GAAP.

C. When less than 100% of a company is acquired, IFRS 3 requires the acquired assets and liabilities to be recorded at full fair value and minority interest is initially measured at the minority shareholders’ percentage ownership in the fair value of the acquired company’s net assets. This is known as the economic unit or entity concept.


1. In addition to the economic unit or entity concept, U.S. GAAP also allows use of the parent company concept in which the acquired assets and liabilities are initially measured at book value plus the parent’s ownership percentage in the difference between fair value and book value. Under this approach, minority interest is initially measured at the minority shareholders’ percentage ownership in the book value of the subsidiary’s net assets.
VI. IAS 28 and US. GAAP require use of the equity method when an investor has the ability to exert significant influence over an investee; significant influence is presumed when the investor owns 20% or more of the investee’s voting shares.
VII. In accounting for an investment in a joint venture, IAS 31 prefers the use of proportionate consolidation, but also allows the equity method. The equity method is required under U.S. GAAP.
VIII. Questions arise as to (a) when an investee should be considered a subsidiary and (b) which subsidiaries should be consolidated when a parent company prepares consolidated financial statements.

A. IAS 27 defines a subsidiary as an enterprise controlled by another enterprise known as the parent. Control is defined as the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. Control can exist without owning a majority of shares of stock, for example, when one company has power over more than half of the voting rights through agreements with other shareholders.

1. Historically, U.S. companies have relied on majority stock ownership as evidence of control.

B. IAS 27 requires a parent to consolidate all subsidiaries unless (a) the subsidiary was acquired with the intent to dispose of it within 12 months and (b) management is actively seeking a buyer.

1. U.S. GAAP requires all subsidiaries to be consolidated unless the parent has lost control due to bankruptcy or severe restrictions imposed by a foreign government.
IX. The aggregation of all of a company’s activities into consolidated totals masks the differences in risk and potential existing across different lines of business and in different parts of the world. To provide information that can be used to evaluate these risks and potentials, companies disaggregate consolidated totals and provide disclosures on a segment basis. Segment reporting is an area in which considerable diversity exists internationally.
X. IAS 14 requires companies to disclose disaggregated information by business segment and geographic segment, one of which is designated as the primary reporting format.

A. A business segment or a geographic segment is reportable if a majority of its revenues are generated from external customers and it meets one of three significance tests. The segment must have: 10% or more of combined segment revenues, 10% or more of combined segment profits, or 10% or more of combined segment assets.

B. A sufficient number of segments must be separately reported to disclose at least 75% of consolidated revenues.

C. Disclosures to be provided for each primary reporting format reportable segment include: revenue, profit or loss, assets, liabilities, capital expenditures, depreciation and amortization, other significant noncash expenses, and equity method profit or loss.

D. Disclosures to be provided for each secondary reporting format reportable segment include: revenue from external customers, assets, and capital expenditures.
XI. U.S. GAAP requires extensive disclosure to be made for operating segments, which can be based either on product lines or geographic regions.

A. Disclosures should reflect what is reported internally to the chief operating officer, even if this is on a non-GAAP basis.

B. If operating segments are not based on geography, revenues and long-lived assets must be disclosed for (a) the domestic country, (b) all foreign countries in total, and (c) for each foreign country in which a material amount of revenues or long-lived assets are located. A quantitative threshold for determining materiality is not specified.
Answers to Questions
1. Historical cost accounting causes assets to be significantly understated in a country experiencing high inflation. Understated assets, such as inventory and fixed assets, leads to understated expenses, such as cost of goods sold and depreciation, which in turn leads to overstated income and stockholders’ equity.

Understated asset values can have a negative impact on a company’s ability to borrow because the collateral is understated. Understated asset values also can be an invitation for a hostile takeover to the extent that the current market price of a company’s stock does not reflect the current value of assets.

Overstated income results in more taxes being paid to the government than would otherwise be paid, and could lead to stockholders demanding a higher level of dividend than would otherwise be expected. Through the payment of taxes on inflated income and the payment of dividends out of inflated net income, both of which result in cash outflows, a company may find itself in a liquidity crisis.

To the extent that companies are exposed to different rates of inflation, the understatement of assets and overstatement of income will differ across companies; this can distort comparisons across companies. For example, a company with older fixed assets will report a higher return on assets than a company with newer assets because income is more overstated and assets are more understated than for the comparison company. Because inflation rates tend to vary across countries, comparisons made by a parent company across its subsidiaries located in different countries can be distorted.


2. Non-monetary assets and non-monetary liabilities are restated for changes in the general purchasing power of the monetary unit. Most non-monetary items are carried at historical cost. In these cases, the restated cost is determined by applying to the historical cost the change in general price index from the date of acquisition to the balance sheet date. Some non-monetary items are carried at revalued amounts, for example, property, plant and equipment revalued according to the allowed alternative treatment in IAS 16, “Property, Plant and Equipment.” These items are restated from the date of the revaluation.

All components of owners’ equity are restated by applying the change in the general price index from the beginning of the period or the date of contribution, if later, to the balance sheet date.

Monetary assets and monetary liabilities (cash, receivables, and payables) are not restated because they are already expressed in terms of the monetary unit current at the balance sheet date.

All income statement items are restated by applying the change in the general price index from the dates when the items were originally recorded to the balance sheet date.

The gain or loss on net monetary position (purchasing power gain or loss) is included in net income.
3. Monetary assets (cash and receivables) give rise to purchasing power losses and monetary liabilities (payables) give rise to purchasing power gains.
4. Historical costs of nonmonetary assets (inventory, fixed assets, intangibles) are replaced with current replacement cost and expenses (cost of goods sold, depreciation, amortization) are based on these current costs. The amount by which nonmonetary assets are revalued to replacement cost on the balance sheet is also reflected in stockholders’ equity as a revaluation surplus (or reserve).
5. Current cost accounting generally results in a larger amount of nonmonetary assets, as well as a larger amount of stockholders’ equity, being reported on the balance sheet. Expenses based on the current cost of nonmonetary assets (carried at larger amounts) generally results in a smaller amount of net income being reported under current cost accounting. With smaller income and larger stockholders’ equity, return on equity measured under current cost accounting is generally smaller than under historical cost accounting.
6. IAS 15, “Information Reflecting the Effects of Changing Prices,” required supplementary disclosure of the following items reflecting the effects of changing prices:

1. the amount of adjustment to depreciation expense,

2. the amount of adjustment to cost of sales,

3. the amount of purchasing power gain or loss on monetary items,

4. the aggregate of all adjustments reflecting the effects of changing prices, and

5. if current cost accounting is used, the current cost of property, plant, and equipment.

The standard only applied to enterprises “whose levels of revenues, profits, assets or employment are significant in the economic environment in which they operate,” and allowed those enterprises to choose between making adjustments on a GPP or a CC basis. Because of a lack of international support for inflation accounting disclosures, in 1989, the IASC decided to make IAS 15 optional. However, the IASB encourages presentation of inflation-adjusted information as required by IAS 15.

IAS 29, “Financial Reporting in Hyperinflationary Economies,” was issued in 1989 and applies to the primary financial statements of any company that reports in a currency of a hyperinflationary economy. IAS 29 requires the use of GPP accounting following procedures outlined above in the answer to question 2.

IAS 21, “The Effects of Changes in Foreign Exchange Rates,” requires application of IAS 29 to restate the foreign operation’s financial statements to a GPP basis. The GPP adjusted financial statements are then translated into the parent company’s reporting currency using the current rate method of translation. This approach is referred to as the restate/translate method.
7. IAS27, “Consolidated Financial Statements and Accounting for Investments in Subsidiaries,” defines a group as a parent and all its subsidiaries, and requires parents to present consolidated financial statements.
8. The concept of a group relates to a business combination in which one company obtains control over another company but the acquired company continues its separate legal existence.
9. IAS 27 states that control exists when the investor owns more than 50 of the stock of another company. However, control also can exist for an investor owning less than 50% of the stock of another company when the investor has power:


  • Over more than half of the voting rights through agreements with other shareholders,

  • To set the company’s financial and operating policies because of existing statutes or agreements,

  • To appoint or remove majority of the members of the governing body (board of directors or equivalent group), or

  • To cast the majority of votes at meetings of the company’s governing body.

10. Because of their extensive cross-ownership of companies, identifying the legal ownership patterns of Japanese company groups (Keiretsu) can be extremely difficult.


11. IAS 27 requires a parent to consolidate all subsidiaries, foreign and domestic, unless (a) control of the subsidiary is temporary because it is held with a view to its disposal in the near future, or (b) the subsidiary operates under severe long-term restrictions that significantly affect its ability to send funds to its parent. IAS 27 does not allow a subsidiary to be excluded from consolidated financial statements solely because its operations are dissimilar to those of the other companies that comprise the group. U.S. GAAP requires all subsidiaries to be consolidated unless the parent has lost control due to bankruptcy or severe restrictions imposed by a foreign government.
12. In some cases, two companies will jointly control another entity as a joint venture. IAS 31, “Financial Reporting of Interests in Joint Ventures,” prefers proportional consolidation for joint ventures (benchmark treatment), while equity accounting is allowed as an alternative. The effect of the proportional consolidation method is to remove the “investment in joint venture” account from the investor’s balance sheet and replace it with the proportion of all the individual items that it represents. In contrast, the full consolidation method replaces the “investment in subsidiary” account on the parent’s balance sheet with 100% of the value of the subsidiary’s balance sheet items. If the parent owns less than 100% of the subsidiary, a minority interest account is reflected on the parent’s consolidated balance sheet. There is no minority interest reported under proportional consolidation.

Proportional consolidation is prohibited in the U.S. and the U.K., except for unincorporated joint ventures. Instead, the equity method is used to account for investments in joint ventures. In Germany, proportional consolidation was not allowed before the implementation of the Seventh Directive, which permits its use for joint ventures. On the other hand, proportional consolidation has been relatively common in both France and in the Netherlands.


13. IAS 14 defines a business segment as a distinguishable component of a company that is engaged in providing an individual product or service or groups of related products or services and that is subject to risks and returns that are different from those of other business segments. A geographical segment is a distinguishable component of a company that is engaged in providing products or services within a particular economic environment and is subject to risks and returns that differ from those of components operating in other economic environments. Geographical segments can be a single country or groups of countries. Factors to consider in identifying geographical segments include:

  • similarity of economic and political conditions,

  • geographical proximity,

  • special risk associated with operations in a particular area,

  • exchange control regulations, and

  • currency risks.

A business segment or a geographical segment is a reportable segment if (1) a majority of its revenues are generated from external customers and (2) it meets any one of the following three significance tests:

  • Revenue test. Segment revenues, both external and intersegment, are 10% or more of the combined revenue, internal and external, of all segments.

  • Profit or loss test. Segment result (profit or loss) is 10% or more of the greater (in absolute value terms) of the combined profit of segments with a profit or combined loss of segments with a loss.

  • Asset test. Segment assets are 10% or more of the combined assets of all segments.

In applying these tests, segment result is defined as segment revenue less segment expense. Segment revenue includes revenue directly attributable to a segment and a portion of enterprise revenue that can be allocated on a reasonable basis to a segment. Segment expense includes expenses directly attributable to a segment and a portion of enterprise expense that can be allocated on a reasonable basis to a segment. IAS 14 defines segment assets as those operating assets that are employed by a segment in its operating activities and that either are directly attributable to the segment or can be allocated to the segment on a reasonable basis.

If total external revenue attributable to reportable segments constitutes less than 75% of the total consolidated revenue, additional segments should be reported even if they do not meet the 10% threshold. All segments that are neither separately reported nor combined should be included in the segment reporting disclosures as an unallocated reconciliation item or in an “all other” category.


14. The information required to be reported by geographic area under IAS 14 depends on whether geographic segments represent the primary reporting format or the secondary reporting format. The following information must be provided for each reportable primary reporting format segment, whether business segment or geographic segment:

  • segment revenue,

  • segment profit or loss,

  • carrying amount of segment assets,

  • segment liabilities,

  • cost during the period to acquire property, plant, and equipment, and intangible assets (capital expenditures),

  • depreciation and amortization,

  • significant noncash expenses, other than depreciation and amortization, and aggregate share of profit or loss and aggregate investment in equity method associates and joint ventures.

When business segments are the primary reporting format, the following geographical segment information also should be provided:

  • revenue from external customers for each geographical segment whose revenue from sales to external customers is 10% or more of total external revenue,

  • carrying amount of segment assets for each geographical segment whose assets are 10% or more of total assets of all geographical segments, and

  • capital expenditures for each geographical segment whose assets are 10% or more of total assets of all geographical segments.

Under IAS 14, geographical segments can be a single country or groups of countries.
Under SFAS 131, companies must identify operating segments based on its internal reporting system. Operating segments can be based on geography. Items disclosed by operating segment under U.S. GAAP are the same as those items required to be disclosed for the primary reporting format under IAS 14, with a few exceptions. U.S. GAAP does not require disclosure of liabilities by segment, but does require disclosure of interest, taxes, and unusual items (discontinued operations and extraordinary items). Whereas IAS 14 requires segment information to be presented in accordance with the company’s accounting policies, SFAS 131 requires segment disclosures to be the same as what is reported internally even if this is on a non-GAAP basis.

If operating segments are not based on geography, then companies must also provide information about their foreign operations. Companies must disclose revenues and long-lived assets for:

1. the domestic country,

2. all foreign countries in which the company derives revenues or holds assets, and

3. each foreign country in which a material amount of revenues is derived or long-lived assets are held.

The SFAS 131 requirement to provide disclosures by individual foreign country is a significant difference from IAS 14.


15. The major concern of some companies with respect to segment disclosures is that it could provide information that competitors can use to better compete with the company. Information about the revenues and profits earned in specific lines of business and/or geographic areas that otherwise would be undisclosed, could be of interest to competing firms as they are looking for lines of business and/or geographic areas in which to expand.
Solutions to Exercises and Problems
1. Sorocaba Company
December 31, Year 1

Original Restated



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