Transcript RCJ Sample Template - California State University, San

Overview of
International Financial
Reporting Differences
and Inflation
Revsine/Collins/Johnson: Chapter 18
Learning objectives
1. Why financial reporting philosophies and detailed GAAP
procedures have differed across countries in the past.
2. How globalization has relaxed cross-border barriers and
prompted convergence of reporting standards across countries.
3. Why the International Accounting Standards Board (IASB) has
become important.
4. Efforts by the FASB and IASB to converge their respective
standards and facilitate cross-border securities transactions.
5. How to cope with reporting differences that persist.
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Learning objectives:
Concluded
6. Whether or not the SEC will ease rules that require foreign
companies listed on U.S. exchanges to reconcile their reporting
methods to U.S. GAAP.
7. Whether compliance with GAAP is carefully monitored in different
companies.
8. That companies in foreign countries with high inflation rates
depart from the historical cost reporting model.
9. The two major approaches for adjusting financial reports for
changing prices—current cost accounting and general price level
accounting.
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Overview:
Growth in cross-border securities transactions
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Overview:
Growth in international investment
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Overview:
Largest companies
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Overview:
Why international accounting is important
 U.S. companies do not dominate the global economy.
 The growth in global investing has been fueled by several factors:

Relaxed security market regulatory rules have made it easier for
foreign firms to meet listing requirements.

Improvements in telecommunications and computer technology have
given investors access to information on a global scale.

Investors understand that portfolios based on a global investment
strategy are less risky than are those composed exclusively of
domestic companies.
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International financial reporting:
Two approaches
 Before the early 1990s, two widely divergent financial reporting
approaches existed.
Economic
performance approach
Commercial and
tax law approach
• Intended to capture the underlying economic
performance of the business entity.
• Examples include the United Kingdom and U.S.
• Intended to conform to mandated laws or detailed
tax rules.
• Examples include France, Italy and Belgium.
 Differences in financial reporting standards have been greatly
reduced in recent years.
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International financial reporting:
Why reporting philosophies differ
 Financial reporting objectives evolve from the specific legal,
political, and financial institutions within a country, as well as from
social customs and systems.

Germany developed ultraconservative accounting rules and dividend
guidelines to protect companies’ survival prospects and protect jobs.

Canada and the United Kingdom developed financial reporting rules
intended to help the many outside debt and equity investors make
informed decisions (the economic performance approach).

In Japan, financial reporting standards conformed to income tax rules
and other commercial laws (an arbitrary legal format) because
outside investors were unimportant to how Japanese companies
were financed.
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International financial reporting:
Convergence of standards across countries
 The “relaxation” of cross-border barriers in markets for goods,
labor, and capital has increased international competitiveness.
 Many companies in countries that used the commercial and tax
law approach felt compelled to provide supplemental U.S. GAAP
or IFRS financial statements. Daimler-Benz began issuing U.S.
GAAP reports in 1996.
 A two-tiered financial reporting system emerged:
Parent Company
“Group”
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• Tax-paying and statutory entities comprising the firm.
• Statements conform to tax or commercial law.
• Consolidated statements directed at investors.
• Statements conform to U.S. GAAP or IFRS
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International Financial Reporting:
The IASC and the IASB
International Accounting
Standards Committee
(IASC)
International Accounting
Standards Board
(IASB)
• Formed in 1973.
• Included professional accounting organizations in
10 countries.
• Establishes high quality, understandable and enforceable
global accounting standards.
• Works to achieve convergence throughout the world.
• Includes more than 121 countries.
• Has issued 41 International Financial Reporting
Standards (IFRS).
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International Financial Reporting:
U.S. GAAP vs. IFRS
 Compared to U.S. GAAP, IASB standards allow firms more latitude.
 IFRS often permit different accounting treatments for similar
economic events.
Benchmark
treatment
Allowed
treatment
Preferred
May be used
 IFRS frequently follow a more “broad brush” approach than does
U.S. GAAP.
 Existing differences between U.S. GAAP and IFRS will be narrowed
in the future.
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International Financial Reporting:
Some difference between U.S. GAAP and IFRS
U.S. GAAP
IFRS
Historical cost minus
depreciation and
impairment loss
Permits upward revaluation
when replacement cost is
above original cost
Prohibited
Permitted
Joint ventures
Equity method when
ownership is not more
than 50%
Proportionate consolidation
Research &
development
Expensed as incurred
Separate rules for
“research” phase and
“development” phase
Requires capitalization in
certain instances
Benchmark treatment is to
expense all interest
Long-lived assets
Reversal of impairment
losses
Capitalized interest
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International Financial Reporting:
Coping with differences that persist
 There are at least four different approaches that regulatory
commissions in a country can use to deal with foreign issuers of
securities:
1. Compel the use of the host country’s reporting rules.
2. Create a bilateral arrangement that allows the host to accept
statements prepared under the foreign country’s reporting rules.
3. Allow every foreign issuer to use it home country reporting rules
without a requirement to reconcile to host country GAAP.
4. Require the use of International Financial Reporting Standards.
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International Financial Reporting:
Compel the use of host country GAAP
 The U.S. SEC requires foreign companies that wish to have
securities traded on U.S. exchanges to reconcile their own
reporting methods to U.S. GAAP.
 The reconciliation is called a Form 20-F.
 There are two reasons this approach is controversial:


Competitive disadvantages that reconciliation may impose on U.S.
capital markets.
Concerns that the reconciliation may not really overcome differences
between U.S. and foreign GAAP.
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International Financial Reporting:
Form 20-F example
Home company GAAP
U.S. GAAP
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International Financial Reporting:
Making bilateral agreements
 The U.S. and Canada allow each other’s companies to use
foreign GAAP when seeking to issue debt or preferred stock.
 The company avoids the cost of reformulating its financial
statements.
 However, this cost is tempered by the fact that U.S. and
Canadian GAAP are somewhat similar.
 A reconciliation to host country GAAP is required when the
company seeks to issue common stock.
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International Financial Reporting:
Allowing foreign GAAP
 This approach imposes no costs on the reporting company.
 However, it does impose burdens on analysts in the host country
who need to be knowledgeable about a wide range of foreign
financial reporting practices.
 It is the practice on the London Stock Exchange where foreign
listed companies from other EU countries may use their national
GAAP, or IFRS, or U.S. GAAP.
 The London Stock Exchange does not require a reconciliation to
U.K. GAAP.
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International Financial Reporting:
Using international financial reporting standards
 The IOSCO has given a “qualified acceptance” to IASB standards.
International Organization Of
Securities Commissions (IOSCO)
 Individual countries’ securities commissions may choose to:




Accept statements prepared under IASB standards without
adjustment.
Require a reconciliation between IASB statements and local GAAP.
Require supplemental disclosures that contain more information than
the IASB standards must provide.
Disallow certain IASB accounting treatments.
 The U.S. SEC appears willing to consider dropping the Form 20-F
reconciliation procedure for firms using improved IFRS.
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International Financial Reporting:
Monitoring compliance
 Not only do financial reporting rules differ across countries, but
also do the mechanisms for monitoring compliance with those
rules.
 Different countries have different structures for determining
whether the stated principles are actually being followed.
External
auditor
• Competence
• Independence
Securities
commission
Accounting
court
• SEC can challenge
financial reports
• Enterprise chartered
in the Netherlands
• Adequate staff and
budget remains an
issue
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Inflation accounting
 Inflation—a decline in the purchasing power of a country’s currency—
complicates the analysis of international financial reports.
 Financial reporting standards in countries with high rates of inflation (e.g.,
Mexico) mandate some form of inflation accounting for both tax and
financial statement reporting.
 Two forms of inflation accounting are required by Mexican GAAP:
Specific price-change
adjustments
• Rate of price change for specific items like electronic
components, coffee beans, or natural gas.
• Current cost accounting approach.
General price-level
adjustments
• General rate of inflation for the economy as a whole.
• General price-level accounting approach
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Inflation accounting:
Current cost approach
 Current cost refers to the market price that an individual firm
would have to pay in order to replace the specific assets it owns.
 Current cost accounting is designed to accomplish two things:
1. Reflect all nonmonetary assets (inventory, buildings, and equipment)
at their current replacement cost as of the balance sheet date.
2. Differentiate between:
(a) current cost income from continuing operations, and
(b) increases or decreases in current cost amounts (holding gains or
losses).
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Inflation accounting:
Current cost example
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Inflation accounting:
Current cost example—journal entries
 One unit of inventory is purchased for $100:
DR Inventory
$100
CR Cash
$100
 Current cost increases by $15:
DR Inventory
$15
CR Owners’ equity
Inventory is now shown
at current cost
$15
 The inventory is sold for $180
DR Cash
$180
DR Cost of goods sold
115
CR Sales
$180
CR Inventory
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Now shown at
current cost
115
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Inflation accounting:
A representative current cost disclosure
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Inflation accounting:
SFAS No. 33
 Only nonmonetary assets like inventory, buildings, and equipment were
adjusted.
 Actual market replacement costs were used where available.
 Price-level indices were used if replacement costs were not available.
 All monetary assets and liabilities (e.g., cash, receivables, accounts
payable) were reported at their face value without adjustment.
 Stockholders’ equity was increased as a balancing item:
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Inflation accounting:
SFAS No. 33 (continued)
 Current cost adjustments on the income statement were limited to
cost of goods sold and depreciation.
 Here’s an example:
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Inflation accounting:
Union Carbide’s realized holding gains
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Inflation accounting:
Historical cost income can overstate true profits
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Inflation accounting:
Teléfonos de México’s Form 20-F note
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Inflation accounting:
General price-level accounting
 The real amount of goods and services that can be acquired at
any moment is what determines the purchasing power of a
currency like the U.S. dollar.
 General price-level accounting measures changes in purchasing
power using a price index for a broad market basket of goods and
services.
Current cost
accounting
• Purchasing powers changes linked to special
nonmonetary assets (e.g. computer chips inventory).
General price-level
accounting
• Purchasing powers changes linked to general price
index and broad market basket.
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Inflation accounting:
General price-level accounting illustration
 The goal is to adjust all historical amounts into common
purchasing power units.
 Here’s an example:
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Inflation accounting:
General price-level accounting
 To restate historical amounts into current purchasing power units, the
nominal dollar amount is multiplied by a restatement factor:
 General price-level accounting is not intended to reflect current market
values of assets and liabilities.
 SFAS No. 33 required firms to use the “Consumer Price Index (CPI) for
all urban consumers” as the price-level index.
Nonmonetary items
Monetary items
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• Cash, receivables, notes payable are fixed dollar claims
• Unaffected by price-level changes
• Inventory, buildings, and equipment
• Price will change with price-level changes
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Inflation accounting:
GPLA for nonmonetary items
 Suppose a firm’s only asset is land, which was purchased for
$1,000 on January 1, 2005:
 Assume that the general level of prices rose by 4% during 2005.
The constant dollar basic accounting equation would look like:
The upward
adjustment to
owners’ equity is
not considered to
be income
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Inflation accounting:
GPLA for monetary items
 Suppose a firm’s only asset is cash of $1,000 on January 1, 2005
and that the general level of prices again rose by 4% during 2005.
 At the end of 2005, the constant dollar basic accounting equation
would look like:
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Summary
 The financial reporting rules in some countries like the United
States, Canada, and the United Kingdom strive to reflect firms’
underlying economic performance.
 But reporting rules in many other countries—Germany, France,
and Japan—merely complied with taxation or other statutory
requirements.
 “Globalization” forced many countries using a commercial or tax
law approach to seek foreign capital, and to move toward an
economic performance approach to reporting.
 International reporting differences have narrowed, but differences
still exist.
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Summary concluded
 Various mechanisms for coping with cross-border reporting diversity have
evolved—reconciliation to host country GAAP, required use of IASB
standards, and so on.
 Mechanisms for monitoring compliance with GAAP also differ significantly
from one country to another—both in terms of the form of monitoring and
in its effectiveness.
 When inflation is a serious problem, historical cost accounting becomes
less meaningful and inflation accounting is used.
 Current cost accounting measures changes in specific purchasing power.
 By contrast, general price-level accounting strives to reflect overall,
average changes in purchasing power.
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