WEEK 5 LECTURE NOTES

Analysis of Financial Statements & Other Reporting Issues

This week we will conclude with the following specific financial reporting topics:

· Inflation – accounting for changing prices.

· Business combinations and consolidated financials.

· Segment reporting.

Historical cost accounting in a period of inflation understates asset values (and related expenses) and overstates income. It ignores the gains and losses in purchasing power caused by inflation that arise from holding monetary assets and liabilities.

Methods of accounting for inflation are

· general purchasing power (GPP) accounting, and

· current cost (CC) accounting.

General Purchasing Power 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.

· Income is the amount that can be paid as a dividend while maintaining the purchasing power of capital.

Current Cost Accounting

· Nonmonetary assets are revalued to current cost.

· Cost of goods sold and depreciation/amortization are based on revalued amounts.

· Income is the amount that can be paid as a dividend while maintaining physical capital.

IAS 29

IAS 29 Financial Reporting in Hyperinflationary Economies applies where an entity’s functional currency is that of a hyperinflationary economy. The standard does not prescribe when hyperinflation arises but requires the financial statements (and corresponding figures for previous periods) of an entity with a functional currency that is hyperinflationary to be restated for the changes in the general pricing power of the functional currency.

IAS 29 was issued in July 1989 and is operative for periods beginning on or after 1 January 1990.

https://www.iasplus.com/en/standards/ias/ias29

IAS 21

IAS 21 The Effects of Changes in Foreign Exchange Rates outlines how to account for foreign currency transactions and operations in financial statements and how to translate financial statements into a presentation currency. An entity is required to determine a functional currency (for each of its operations if necessary) based on the primary economic environment in which it operates and generally records foreign currency transactions using the spot conversion rate to that functional currency on the date of the transaction.

IAS 21 was reissued in December 2003 and applies to annual periods beginning on or after 1 January 2005.

https://www.iasplus.com/en/standards/ias/ias21

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.

IFRS 3

IFRS 3 Business Combinations outlines the accounting when an acquirer obtains control of a business (e.g. an acquisition or merger). Such business combinations are accounted for using the ‘acquisition method’, which generally requires assets acquired and liabilities assumed to be measured at their fair values at the acquisition date.

A revised version of IFRS 3 was issued in January 2008 and applies to business combinations occurring in an entity’s first annual period beginning on or after 1 July 2009.

https://www.iasplus.com/en/standards/ifrs/ifrs3

The core principle of IFRS 3 is that an acquirer of a business recognizes the assets acquired and liabilities assumed at their acquisition-date fair values and discloses information that enables users to evaluate the nature and financial effects of the acquisition.

The objective of IFRS 3 is to improve the relevance, reliability, and comparability of the information that a reporting entity provides in its financial statements about a business combination and its effects. To accomplish this, IFRS 3 establishes principles and requirements for how the acquirer:

· recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquiree;

· recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and

· determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination.

Issues that must be resolved in accounting for a business combination:

A. Selection of an appropriate method

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

B. Recognition and measurement of goodwill

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. Measurement of minority interest.

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.

Note: 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.

IAS 28

IAS 28 Investments in Associates and Joint Ventures (as amended in 2011) outlines the accounting for investments in associates. An associate is an entity over which an investor has significant influence, being the power to participate in the financial and operating policy decisions of the investee (but not control or joint control), and investments in associates are, with limited exceptions, required to be accounted for using the equity method.

IAS 28 was reissued in December 2003, applies to annual periods beginning on or after 1 January 2005, and is superseded by  IAS 28  Investments in Associates and Joint Ventures and  IFRS 12  Disclosure of Interests in Other Entities with effect from annual periods beginning on or after 1 January 2013.

https://www.iasplus.com/en/standards/ias/ias28

Also reference Week 3 lecture notes for details and a chart that should help you to visualize how IAS28 and

IFRS 11 relate.

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. It is also defined as the power to participate in the financial and operating policy decisions of the investee, but is not control or joint control over those policies

IAS 31

IAS 31 Interests in Joint Ventures sets out the accounting for an entity’s interests in various forms of joint ventures: jointly controlled operations, jointly controlled assets, and jointly controlled entities. The standard permits jointly controlled entities to be accounted for using either the equity method or by proportionate consolidation.

IAS 31 was reissued in December 2003, applies to annual periods beginning on or after 1 January 2005, and is superseded by  IFRS 11  Joint Arrangements and  IFRS 12  Disclosure of Interests in Other Entities with effect from annual periods beginning on or after 1 January 2013.

https://www.iasplus.com/en/standards/ias/ias31

IAS 27

IAS 27 Consolidated and Separate Financial Statements outlines when an entity must consolidate another entity, how to

account for a change in ownership interest, how to prepare separate financial statements, and related disclosures.

Consolidation is based on the concept of ‘control’ and changes in ownership interests while control is maintained are

accounted for as transactions between owners as owners in equity.

IAS 27 was reissued in January 2008 and applies to annual periods beginning on or after 1 July 2009, and is superseded by

IAS 27  Separate Financial Statements and  IFRS 10  Consolidated Financial Statements with effect from annual periods

beginning on or after 1 January 2013.

https://www.iasplus.com/en/standards/ias/ias27

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.

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

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.

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.

The aggregation of all 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.

IFRS 8

IFRS 8 Operating Segments requires particular classes of entities (essentially those with publicly traded securities) to disclose information about their operating segments, products and services, the geographical areas in which they operate, and their major customers. Information is based on internal management reports, both in the identification of operating segments and measurement of disclosed segment information.

IFRS 8 was issued in November 2006 and applies to annual periods beginning on or after 1 January 2009.

https://www.iasplus.com/en/standards/ifrs/ifrs8

IFRS 8 was issued in 2006 to converge with U.S. GAAP. Both IFRS and U.S. GAAP follow the so-called management approach in determining operating segments, which are components of a business that:

· Engage in activities from which they earn revenues and incurs expenses.

· Are regularly reviewed by the chief operating decision maker to assess performance and make resource allocation decisions.

· Have discrete financial information available.

IFRS and U.S. GAAP also require enterprise-wide disclosures related to:

I. Major customers – any customer from which the enterprise generates 10% or more of revenues.

The existence of major customers must be disclosed along with the operating segment generating the revenues, but the identity of the customer need not be revealed.

II. Products and services – if operating segments are not organized along these lines.

External revenues derived from each major product or service line must be disclosed when the company has only one operating segment or operating segments are based on something other than products/services.

III. Geographic areas – if operating segments are not organized geographically.

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.

Analysis of Foreign Financial Statements

Reasons to analyze financials whether the company is US based or foreign are for the most part the same:

· Portfolio investment decisions

· Merger and acquisition decisions

· Credit decisions about foreign customers

· Evaluation of suppliers

· Benchmarking against competitors

Potential problems or differences when analyzing US-based vs foreign companies’ financials:

· finding and obtaining financial information about a foreign company (data accessibility),

· understanding the language in which the financial statements are presented,

· the currency used in presenting monetary amounts,

· terminology differences that result in uncertainty as to the information provided,

· differences in format that lead to confusion and missing information,

· lack of adequate disclosures,

· financial statements are not made available on a timely basis (timeliness),

· accounting differences that hinder cross-country comparisons, and

· differences in business environments that might make ratio comparisons or analysis meaningless even if accounting differences are eliminated.

Solutions:

· Some of the potential problems can be removed by companies through their preparation of convenience translations in which language, currency, and perhaps even accounting principles have been restated for the convenience of foreign readers

OR

· The analyst can restate foreign financials in terms of a preferred GAAP through the use of a reconciliation worksheet in which debit/credit entries summarizing the differences in GAAP are used to adjust the original reported amounts.

· All income differences also affect stockholders’ equity through retained earnings.

· In addition to adjustments resulting from differences in GAAP, an adjustment also will be needed for the deferred tax effect of the aggregate difference in pre-tax income.

Another Perspective on the Challenges and Opportunities in Cross-Border Analysis

Cross border analysis involves multiple jurisdictions.

Challenges

Nations vary dramatically in ….

· Accounting practices

· Disclosure quality

· Legal and regulatory systems

· Nature and extent of business risk

· Modes of conducting business

· Providing credible information

· Vast differences in financial reporting

· Government continuing to publish highly suspect information

Positives

· Accounting harmonization of standards allows for comparability

· Companies worldwide are disclosing more information

· Improving availability and quality of that information

· Impact of the worldwide web and accessibility to information

· Globalization of capital markets

· Increased competition

· Inter-dependencies are growing

Business Analysis Framework

Four stages of analysis….

1. business strategy analysis

2. accounting analysis

3. financial analysis (ratio and cash flow)

4. prospective analysis

1. Business Strategy Analysis

Provides a qualitative understanding of a company and its competitors

in relation to its economic environment.

Ensures analysis is performed using a holistic perspective.

By identifying key profit drivers and business risks, forecasts are realistic.

2. Accounting Analysis

The purpose is to assess the extent to which a firm’s report results reflect economic reality.

Need: evaluate the firm’s accounting policies and estimates, and

Assess the nature and extent of a firm’s accounting flexibility

Six Steps in Accounting Analysis

> Identify key accounting policies

> Assess accounting flexibility

> Evaluate accounting strategy

> Evaluate the quality of disclosure

> Identify potential red flags

> Adjust for accounting distortions

3. International Financial Analysis

Goal: evaluate a firm’s current and past performance, and

to judge whether its performance can be sustained.

Ratio and cash flow analysis are important tools.

Ratio analysis

1st – do cross-country differences in accounting principles cause significant variation in financial statement amounts of companies from different countries?

2nd – how do differences in local culture and economic and competitive conditions affect the interpretation of accounting measures in financial ratios, even if account measurements from different countries are restated to achieve “accounting comparability”?

Cash flow analysis

Cash-flow related measures are especially useful in international analysis because they are less affected by accounting principle differences than are earnings-based measures.

4. International Prospective Analysis

Two steps:

1. Forecasting – analysts make explicit forecasts of a firm’s prospects based on its business strategy.

2. Valuation – analysts convert quantitative forecasts into an estimate of a firm’s value.

All four stages of business analysis (business strategy, accounting, financial and prospective analysis may be affected by the following:

· Information access

· More widely available due to the world wide web

· Timeliness of information

· Varies dramatically by country

· In the U.S. quarterly financial reporting is generally accepted; this is seldom the case elsewhere.

· Financial reporting lags can also be estimated by comparing a company’s fiscal year end with its audit report date, an indication of when financial information becomes public.

· Language and terminology barriers

· Language and accounting terminology differences can cause difficulty.

· Foreign currency issues

· Reader convenience: i.e., financials presented in dollars vs foreign currency

· Information content

· Differences in types and formats of financial statements

· Balance sheet and income statement format varies from country to country

· Classification differences abound internationally.

Homework Assignment:

The week’s discussion covered the following International Accounting Standards (IAS):

#21 The Effects of Changes in Foreign Exchange Rates

#27 Separate Financial Statements

#28 Investments in Associates and Joint Ventures

#29 Financial Reporting in Hyperinflationary Economies

#31 Interests in Joint Ventures (superseded by IFRS 11 Joint Arrangements and IFRS 12

Disclosures of Interests in Other Entities)

and

IFRS 3 Business Combinations

IFRS 8 Operating Segments

This part of the homework is twofold. First research your MNC and report which, if any, of these standards are applicable for your MNC. Second, select one of those standards and explain how your MNC handles it.

Part II of the homework assignment, you are required to read at least one other posting and make a substantive comment. If someone asks a question of you, please take the time to also respond to those questions.

Part III of the homework….

Question: What companies might your MNC include in a benchmarking study and in which countries are those companies located. Your answer should include, at least, four other companies for the comparison. As an example of the response for this assignment, consider Ford Motor Company.

Ford might want to include the following companies in a benchmarking study:

U.S. – General Motors, Chrysler

Japan – Honda, Toyota, Subaru

Germany – BMW, Volkswagen, Audi

Korea – Hyundai, Kia

France – Renault, Peugeot

Your homework for Parts I and III must be posted by nlt Saturday evening. It will give everyone time to read and respond to the various posts.

I would also suggest, when reading and responding to the benchmarking studies component, if you have any other companies you would include, please mention them in your response….especially those of you who are located outside of the U.S.

Homework is to be posted in this week’s discussion.