International Accounting 5140

Impact of Inflation on Financial Statements

- understated asset values - Overstated income and over-payment of taxes. - Demand for higher dividends - Differing impacts across companies resulting in lack of comparability.

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 % multiplied by the fair value of the purchased net assets.

Capital Budgeting 3 steps

1. Project identification and definition 2. Evaluation and selection 3. Monitoring and review

Foreight Corrupt Practices Act

1977, requires companies to maintain effective internal controls and not pay bribes. The logic is that effective internal controls over financial reporting will mitigate the risk of bribe payments. This legislation was a reaction to the discovery , in the 1970s, that many US companies did pay bribes. Enforcement of the FCPA has resulted in large fines against major US companies.

Import Purchase

A company purchases from a foreign supplier and later pays in the suppliers currency.

Audit Committees - Internationally

Audit committees are increasingly being seen as an important component of corporate governance. There is a wide acceptance globally that the auditor works for the audit committee Australia, for example, requires listed companies to have audit committees composed completely of outside directors. Audit committees are also now required for listed companies in Malaysia and Singapore.

Auditor Liability - Background

Auditors are subject to civil liability, criminal liability, and professional sanctions. Civil liability can result from breach of contract or civil duty (e.g. negligence) Criminal Liability can result from criminal court (fraud) Professional sanctions can result from violation of the rules of a professional body. The potential for legal liability varies internationally and is highly significant in some countries (US)

Step one mechanics - Reformatting

Begin with four column worksheet in US GAAP format. Columns are Local GAAP, debits, credits, and US GAAP. Amounts are presented in the original currency. Prepare worksheets for income statements, statement of retained earnings, and balance sheet. Line items in the worksheet are presented in the terminology of US account titles.

Budgeting

Budgeting is the primary use of accounting information in strategy formulation Budgeting assists in strategy formulation by providing managers with information about short-term and long-term planning responbilities. Budgeting also provides expectations against which future results can be judged.

Differences in Accounting Principles

Differences in accounting principles often result in significantly different income and other financial statement amounts. Some of the biggest problem areas are consolidations, fixed asset valuation and depreciation, and goodwill. These differences cause some investors to limit the scope of their investments!!!

Performance Evaluation Measures

Financial measures are based directly on financial statement data. Examples include net profit, return on investment, and comparison of budgeted to actual profit. Non-financial measures are based on data non obtained directly from financial statements. Examples include market share, relationship with host country government, and labor turnover.

Form 20-F

Foreign companies listed on the US Stock Exchange are required to provide a reconciliation of net income and stockholders' equity to US GAAP in the form 20-F Most ratios cannot be computed as if under US GAAP

International Diversity in External Auditing - Background

Globalization is leading to increased importance of auditing internationally. Significant international diversity exists in various aspects of auditing. The purpose of external audits varies between countries. The environment in which auditing takes place varies. Regulation of the audit function varies. The content of audit reports varies.

Auditor Liability - Possible reforms

Several solutions to limiting auditor liability exist in order to limit potential damage to firms. Change in ownership structure to limit or eliminate joint and several liability. Proportionate liability that limits auditor liability to the proportion for which they are deemed responsible. Statutory caps to limit damages. Disclaimer to liability to avoid unintended liability. Some UK auditors use these, ut the US SEC rejects them as invalid.

IFRS 8, Operating Segments

Substantially converges IFRS with US GAAP. Adopts a Management Approach to segment reporting. 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 by Chief operating decision makers. - Discrete financial information is available for it.

Expropriation

The act of taking a privately owned property by the government to be used for the benefit of the public. In the United States,, the government has the right to take property through eminent domain.

Audit Committees - United States

The audit committee is a committee of the board of directors responsible for financial reporting oversight. Beginning in the 1990s, increased attention has been paid to this topic. In the US the blue ribbon committee made a series of recommendations to enhance the role of the audit committee. Sarbanes-Oxley includes specific provisions related to audit committees.

Timeliness

This varies significantly internationally since filing deadlines differ from country to country. US and Canada are most timely. Continental Europe is the least. Requirements about the frequency of information also vary internationally from quarterly to annual reporting. Not much you can do about this, It's up to the regulators.

Capital Budgeting in international context

Three factors primarily related to the risk associated with future cash flows: 1. Political risk 2. Economic risk 3. Financial risk

Two Transaction Perspective

Treats sale and collection as two transactions. Sale is one transaction and collection is a 2nd transaction. Sale is based on Current Exchange Rate. If exchange rate changes, collection if for different amount. Difference is considered foreign exchange gain or loss. Concepts are identical for purchase transaction

International Diversity in External Auditing - Purpose of Auditing

In the US and UK, the purpose of the external audits is to provide assurance that the financial statements are fairly represented. In the US, Sarbanes-Oxley also requires audits of internal controls. Such a report provides assurance about the process of financial statement preparation. In Germany, auditors are also responsible for evaluating the report of management.

Auditor Independence

Independence is a fundamental principle in auditing Auditors in the US are required to adhere to a detailed set of independence rules The SEC had additional rules for auditors of public companies. An SEC report in 2000 cited numerous violations by big 5 auditors. Auditor independence is a subject of intense debate internationally as well as in the US.

Economic Risk

Refers to the likelihood that changes in the host country economy will impact cash flows. Inflation is the most significant of economic risk. Inflation affects the ability of the local population to purchase goods and also impacts the overall cost structure of a business.

Financial Risk

Refers to the likelihood that changes is currency values, interest rates, and other financial factors will impact cash flows. Foreign exchange risk is also a component of financial risk.

Political Risk

Refers to the likelihood that political events will impact cash flows. Terrorism, enforced regime chagne and resource nationalism. Nationalism and expropriation of assets is the most extreme form of political risk. Also, changes is: foreign exchange controls, repatriation restrictions, tax rules, and labor laws.

Nationalization

Refers to the process of government taking control of a company or industry, which can occur for a variety of reasons. Former owners of companies may or may not be compensated for their loss in net worth and potential income.

Restatement - Step One

Reformatting - involves tranforming the financial statements into US format. Transforming terminology differences. Presentation differences are also transformed. Item definitions and classifications are transformed.

Data Accessibility - 10

Relative to the US, financial information is difficult to obtain in many countries. While databases of foreign financial statements do exist, these can contain errors and present information in a variety of formats. These databases do not contain complete disclosures. Another approach is to obtain a copy of the foreign company's annual report.

Group Accounting - Full Considation

- full consolidation involves aggregation of 100% of the subsidiary's financial statement elements. - when the subsidiary is not 100% owned, the non-owned portion is presented in a separate item called minority interest. - Full consolidation is accomplished using one method - purchase method (IFRS 3) allows the use of the purcahse method - same as US.

Financial Analysis - chapter 10

Involves the use of adjusted financial statement information to conduct: - cash flow analysis - the analysis of how a company generates and uses cash - Profitability Analysis: with a focus on return on capital investment. - Risk Analysis: including an evaluation of liquidity and solvency to assess a company's ability to meet its obligations.

Capital Budgeting

Large, long-term investments are referred to as capital investments.

Currency - 10

Many international companies produce their financial statements in a currency other than the US dollar.

Return on Investment

Represents the average annual return on the initial investment. Average net income / initial investment The project will be accepted if the return on investment exceeds a predetermined rate (required rate of return) Ignores: time value of money, possibility cash outlays subsequent to initial investment.

Restatement - Step Two

Restating the foreign GAAP amounts to US GAAP amounts - Process is made easier when companies file a form 20-f - sometimes, companies will present a similar reconciliation without actually filing the form 20-f - in any case, notes to the financial statements are very useful in completing this step.

Sarbanes-Oxley and the Future of Accounting

Sarbanes-Oxley is the most significant legislation pertaining to financial reporting and auditing since the establishment of the SEC in the 1930s. The act has had an observable impact on business, one example of which is the increase in financial expertise on audit committees. Companies have spent significant resources enhancing internal controls. on a more negative note, may financial executives are experiencing increased stress due to Sarbanes-Oxley.

Prospective Analysis

Using accounting analysis and financial analysis along with business environment analysis and company strategy, to forecast future cash flow and income.

Export Sale

a company sells to a foreign customer and later receives payment in the Customer's Currency.

Like US and UK, Brazil has also

abandoned inflation accounting.

Cash Flow Hedge

an 'accounting designation' for hedges that offset variability in cash flows of hedged items. this type of hedge would be used to offset the risk associated with a recognized asset or liability such as future interest payments on variable rate debt. Cash flow hedges try to protect against this risk

Fair Value Hedgw

an accounting designation for hedges that offset the variability in fair value of hedged assets and liabilities. This specific hedge is used for an asset that has fixed value but its value fluctuates due to supply and demand.

Foreign currency forward contract

an agreement to buy or sell foreign currency at a future date.

Accounting Analysis - Chapter 10

an evaluation of the extent to which company's financial statements reflect economic reality. Three common distortions: 1. Accounting standards that are inconsistent with economic reality (all R&D expenses expensed immediately with no possibility of recognizing an asset is an example. 2. Estimation errors made by managers (The estimation of the cost of pension) 3. The intentional manipulation of financial statements by managers often known as earnings management.

Hedge Accounting

an offsetting gain or loss from the hedge is recognized in net income during the same period as the gain or loss from the hedged item.

Option Premium

cost of purchasing the option, which is a function of the option's intrinsic value and time value.

Pegged to another currency

currency value fixed (pegged) in terms of a particular foreign currency (e.g., U.S. Dollar), and central bank intervenes to maintain the exchange rate.

Export Sale -> Asset Exposure

if foreign currency appreciates -> foreign exchange gain if foreign currency depreciates -> foreign exchange loss

Import Purchase -> liability exposure

if foreign currency appreciates -> foreign exchange loss if foreign currency depreciates -> foreign exchange gain

Evaluation and selection

involves identifying cash flows and then using one or more capital budgeting methods to evaluate the project. How do we select one capital project from another?

Monitoring and review

involves updating the analysis and project plan during the implementation stage.

Intrinsic value

is the gain that could be made by immediate exercise of the option.

Current Exchange Rate

is the rate of the balance sheet date.

Historical exchange rate

is the rate of the date of transactions.

Project Identification and Definition

provides a clear basis for understanding the project and predicting the associated cash flows.

Payback period

represents the length of time it takes to recoup the initial investment. The decision makers typically choose the shortest payback period time frame. Ignores the time value of money and ignores the total profitability of the project.

Purchasing power losses

results from holding monetary assets, such as cash and accounts receivable.

Purchasing power gains

results from holding monetary liabilities, such as accounts payable.

Translation to parent currency - performance evaluation

since the translation is for internal purposes, financial accounting standards need not be followed. Likewise, the inclusion of the translation adjustment in the profit measure is based on the internal needs rather than the accounting needs. 1 factor: the decision is whether the adjustment reflects the impact of exchange rates on parent currency cash flows. 2 factor: whether the local manager has the authority to hedge against exchange rate changes.

Foreign currency Option

the Right to buy or sell foreign currency for a period of time. Gives you the right, but not the obligation, to trade foreign currency for some period.

Strike Price

the exchange rate at which currency will be exchanged when option is exercised.

Time value

the value that derives from the fact that the currency value could increase during the remainder of the option period.

Spot Rate

today's price for purchasing or selling (bid or ask) a foreign currency.

Forward Rate

today's price for purchasing or selling a foreign currency for some future date.

European Monetary System (Euro)

twelve countries use a single currency, which floats against other currencies such as the U.S. Dollar.

Current Exchange Rate - Balance Sheet Exposure

when foreign currency appreciates, a net asset exposure results in a positive translation adjustment. When foreign currency appreciates, a net liability exposure results in a negative translation adjustment. Assets and Liabilities are translated at the historical exchange rate are not exposed to translation adjustment.

Premium

when the forward rate is greater than the spot rate for a particular day.

Discount

when the forward rate is less than the spot rate for a particular day.

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 - Non-monetary assets are restated to current replacement costs and expense items are based on these restated costs. - Holding gains and losses are included in equity.

Effective Control

"the power to govern with financial and operating policies of an entity so as to obtain benefits from its activities" - It recognized that an investor owning less than 50% of the stock of another company nevertheless may have control 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 the majority of the members of the governing body. --- to cast the majority of votes at meetings of the company's governing body

Business Combinations and Consolidated Financial Statements.

- Business combinations are the primary mechanism use by MNE (Multi-National Entities). - 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.

Group Accounting - Determination of Control

- Control provides 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 effected control definition.

IFRS Inflation Accounting

- Non-monetary assets and liabilities and stockholders' equity are restated using the GPI. - Income statements are restated using a general price index from the time of the transaction. - Purchasing power gains and losses are included in net income. - IAS 29 includes guidelines for determining the environment where it must be used.

Disclosures for Profit or Loss and the following line items

- Revenues from external customers - Intersegment revenues - Intersect 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.

Full Consolidation - Goodwill

- Significant variation exists internationally in accounting for goodwill - US, IFRS, and most countries will require goodwill to be capitalized as an asset. - Some countries require amortization over a period of up to 40 years (Mexico, Brazil, Japan, etc.) - US, Canada, and IFRS do not require amortization but do require an annual impairment test. - Japan allows the option of immediate expensing of goodwill.

Disclosures

- Total segment assets (and liabilities for IFRS) - Expenditures for additions to long live assets (US GAAP) and non-current assets (IFRS 8) - Information about products and services. - Information about major customers (if 10% or more of total entity revenue) - Information about geographic areas.

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). - Non-monetary assets and liabilities, stockholders' equity and income statement items are restated using the General Price Index (GPI also referred to as the CPI - Consumer Price Index). - Requires purchasing power gains and losses to be included in net income.

Recommended Segment Reporting

Consistent with how a business is Managed.

International Diversity in External Auditing - Environment of auditing

Countries with less developed financial infrastructure would need less sophisticated auditing. When banks or families are the primary source of financing, there is less demand for auditing. Audit quality and independence are likely to be influenced by level of rigor to join the profession and by the extent of legal liability assigned to auditors.

Independent float

Currency value allowed to move freely with little government intervention.

Business Environment Differences

Differences in culture and economic environments have an impact on the relevance of ratios. A study of companies in Japan, Korea, and the U.S. found significant differences due to business environment. For example, Japanese and Korean companies borrow much more on a short-term basis than U.S. companies, leading to lower current ratios. Debt ratios also tend to be higher in Japan and Korea because of the sources of financing. Lower profit margins in Japan in the late 1970s, relative to the U.S., can be partly explained by the Japanese companies having their focus on market share as opposed to profits.

Terminology - 10

Differences in terminology exist between countries using the same language. For example, "inventory" in the U.S. can be called "stocks" in the U.K. Much of the U.S. and U.K. differences were removed in 2005 when the U.K. adopted IFRS.

Cash Flow Exposure

Exists if changes in exchange rates can affect the amount of cash flow to be realized from a transaction, with changes in cash flow reflected in net income. A cash flow exposure exists for 1) recognized foreign currency assets and liabilities, 2) Foreign currency firm commitments, 3) Forecasted foreign currency transations.

International Harmonization of Auditing Standards

International auditing has historically received less attention than international accounting. Recently, globalization has increased the importance of cross national understanding of audit reports. Harmonization of international auditing standards will help increase consistency of auditing worldwide. The increased level of assurance on financial statements should result in more efficient global capital markets. The International Federation of Accountants (IFAC) develops international auditing standards.

Purpose of Auditing

International variation in the purpose of audits seems to be related to differences in corporate governance structure. The supervisory board in Germany has essentially equivalent responsibilities to the US board of directors. German law includes specific regulations about the composition of the supervisory board. German supervisory boards are more broadly representative that their US equivalent

Proposals to strengthen auditor independence

Involvement of stockholders in auditor appointments. Restrictions or prohibitions of certain consulting activities. Increased regulatory oversight Increased involvement by the board of directors and audit committee. Mandatory rotation of audit firms or engagement parties.

Language - 10

Many international companies do not produce financial statements in English - could hire a translator or develop foreign language capability - Since English is the language of business, companies in may foreign countries produce "convenience translations" of their financial statements in English

Format

Most major format problems is because information is not provided. it is common in Europe to not provide cost of goods sold.

IFRS 8, Operating Segments - Significance Tests to Justify Disclosure

Must meet ANY of the following Tests: - Revenue Test: Segment revenue (external and inter segment) 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.

Current Rate Method

Objective: is to reflect that the parent's entire investment in a foreign subsidiary is exposed to exchange risk. Current Rate: all assets and liabilities. Historical Rate: all stockholders' equity accounts Income statement items are translated at the exchange rate in effect at the time of the transaction.

Temporal Method

Objective: to translate financial statements as if the subsidiary had been using the parent's currency. Historical Exchange Rate: Items carried on subsidiary's books at historical cost, including all stockholder's equity items. Current Exchange Rates: Items carried on subsidiary's books at current value. Income Statement Items are translated at the exchange rate in effect at the time of transaction.

U.S. GAAP Segment Reporting

Only three substantive differences exist between IFRS 8 and US GAAP: 1. US GAAP does not require disclosure of segment liabilities. 2. IFRS 8 explicitly includes intangibles in the definition of long-lived assets fro geographic area disclosures.

Capital budgeting techniques

Payback period Return on Investment Net present value Internal rate of return

Functional Currency

Primary currency of the foreign subsidiary's operating environment. When functional currency is U.S. Dollar, temporal method is required. When functional currency is foreign currency, current rate method is required.

Choice of currency in measuring profit

Profit can be measured in either the local currency or the parent currency. Local currency is Appropriate if the subsidiary is not expected to pay parent company dividends. Otherwise, parent currency is appropriate. When parent currency is used, the company also must choose a translation method. Further, a decision must be made about whether to include a translation adjustment in the profit measure.

Hedging

Protecting against losses from exchange rate fluctuating.

Choice of currency in operational budgeting

The international context adds an element of complexity due to exchange rate fluctuations. Three available exchange rates: 1. actual at time of budget 2. projected at time of budget 3. actual at end of budget period.

Step Two mechanics - Reformatting

The work in this step affects the debit and credit columns of the worksheet. The nature of these entries is essentially adjusting and reclassification entries. Some entries affect current net income or beginning retained earnings, while other affect both. Each entry reflects the adjustment needed to reconcile to US GAAP from local GAAP.