Accounting paper

International Accounting Fourth Edition

Timothy Doupnik University of South Carolina

Hector Perera Macquarie University

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INTERNATIONAL ACCOUNTING, FOURTH EDITION

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2015 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2012, 2010, and 2005. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

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ISBN 978-0-07-786220-6 MHID 0-07-786220-1

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Library of Congress Cataloging-in-Publication Data

Doupnik, Timothy S. International accounting / Timothy Doupnik, University of South Carolina, Hector Perera, Macquarie University.—Fourth Edition. pages cm Includes bibliographical references and index. ISBN 978-0-07-786220-6 (alk. paper) 1. Accounting. 2. International business enterprises—Accounting. 3. Foreign exchange—

Accounting. I. Perera, M. H. B. II. Title. HF5636.D68 2014 657'.96—dc23 2013039346

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.

www.mhhe.com

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To my wife, Birgit, and children, Stephanie and Alexander —TSD To my wife, Sujatha, and daughter, Hasanka —HBP

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iv

About the Authors Timothy S. Doupnik University of South Carolina Timothy S. Doupnik is a Professor of Accounting at the University of South Carolina, where he has been on the faculty since 1982, and primarily teaches ! nancial and international accounting. He served as director of the School of Accounting from 2003 until 2010, and then as Vice Provost for international affairs until 2013. He has an undergraduate degree from California State University–Fullerton, and received his master’s and Ph.D. from the University of Illinois.

Professor Doupnik has published exclusively in the area of international account- ing in various journals, including The Accounting Review; Accounting, Organizations, and Society; Abacus; Journal of International Accounting Research; Journal of Accounting Lit- erature; International Journal of Accounting; and Journal of International Business Studies.

Professor Doupnik is a past president of the International Accounting Section of the American Accounting Association, and he received the section’s Outstanding International Accounting Educator Award in 2008. He has taught or conducted re- search in the area of international accounting at universities in a number of coun- tries around the world, including Brazil, China, Dominican Republic, Finland, Germany, and Mexico.

Hector B. Perera Macquarie University Hector Perera is an Emeritus Professor at Massey University, New Zealand, and an Adjunct Professor at Macquarie University, Australia. Prior to joining Macquarie University in January 2007, he was at Massey University for 20 years. He has an undergraduate degree from the University of Peradeniya, Sri Lanka, and a Ph.D. from the University of Sydney, Australia.

Professor Perera’s research has dealt mainly with international accounting issues and has been published in a number of scholarly journals, including Journal of International Accounting Research; Critical Perspectives on Accounting; Journal of Accounting Literature; International Journal of Accounting; Advances in Accounting, incorporating Advances in International Accounting; Journal of International Financial Management and Accounting; Abacus; Accounting and Business Research; Accounting Historians Journal; Accounting, Auditing and Accountability Journal; Journal of Con- temporary Asia; British Accounting Review; Accounting Education—An International Journal; Australian Accounting Review; International Journal of Management Education; and Paci! c Accounting Review. In an article appearing in a 1999 issue of the Interna- tional Journal of Accounting, he was ranked fourth equal in authorship of interna- tional accounting research in U.S. journals over the period 1980–1996.

Professor Perera served as chair of the International Relations Committee of the American Accounting Association’s International Accounting Section in 2003 and 2004. He was an associate editor for the Journal of International Accounting Research and on the editorial boards of Accounting Horizons and Paci! c Accounting Review. Currently, he is on the editorial boards of Review of Accounting and Finance; Inter- national Journal of Accounting, Auditing and Performance Evaluation; and Qualitative Research in Accounting and Management.

Professor Perera has been a visiting professor at a number of universities, including the University of Glasgow in Scotland; New South Wales University, Wollongong University, and Charles Darwin University in Australia; Turku School of Economics and Business Administration and Åbo Akademi University in Finland; Unversiti Teknologi Mara, Malaysia; and University of Sharjah, UAE.

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v

Preface ORIENTATION AND UNIQUE FEATURES

International accounting can be viewed in terms of the accounting issues uniquely confronted by companies involved in international business. It also can be viewed more broadly as the study of how accounting is practiced in each and every coun- try around the world, learning about and comparing the differences in ! nancial reporting, taxation, and other accounting practices that exist across countries. More recently, international accounting has come to be viewed as the study of rules and regulations issued by international organizations—most notably International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB). This book is designed to be used in a course that attempts to provide an overview of the broadly de! ned area of international accounting, but that focuses on the accounting issues related to international busi- ness activities and foreign operations and provides substantial coverage of the IASB and IFRS.

The unique bene! ts of this textbook include its up-to-date coverage of relevant material; extensive numerical examples provided in most chapters; two chapters devoted to the application of International Financial Reporting Standards (IFRS); and coverage of nontraditional but important topics such as strategic account- ing issues of multinational companies, international corporate governance, and corporate social reporting. This book contains several important distinguishing features:

Numerous excerpts from recent annual reports to demonstrate differences in ! nancial reporting practices across countries and to demonstrate ! nancial reporting issues especially relevant for multinational corporations.

Incorporation of research ! ndings into the discussion on many issues. Extensive end-of-chapter assignments that help students develop their analyti-

cal, communication, and research skills. Detailed discussion on the most recent developments in the area of interna-

tional harmonization/convergence of ! nancial reporting standards. Two chapters on International Financial Reporting Standards that provide

detailed coverage of a wide range of standards and topics. One chapter focuses on the ! nancial reporting of assets, and the second chapter focuses on liabilities, ! nancial instruments, and revenue recognition. (IFRS related to topics such as business combinations, foreign currency, and segment reporting are covered in other chapters.) The IFRS chapters also include numerical examples demon- strating major differences between IFRS and U.S. GAAP and their implications for ! nancial statements.

Separate chapters for foreign currency transactions and hedging foreign exchange risk and translation of foreign currency ! nancial statements. The ! rst of these chapters includes detailed examples demonstrating the accounting for foreign currency derivatives used to hedge a variety of types of foreign cur- rency exposure.

Separate chapters for international taxation and international transfer pricing, with detailed examples based on provisions in U.S. tax law.

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vi Preface

A chapter devoted to a discussion of the strategic accounting issues facing mul- tinational corporations, with a focus on the role accounting plays in strategy formulation and implementation.

Use of a corporate governance framework to cover external and internal audit- ing issues in an international context, with substantial coverage of the Sarbanes- Oxley Act of 2002.

A chapter on corporate social responsibility reporting, which is becoming increasingly more common among global enterprises.

CHAPTER-BY-CHAPTER CONTENT Chapter 1 introduces the accounting issues related to international business by following the evolution of a ! ctional company as it grows from a domestic com- pany to a global enterprise. This chapter provides the context into which the topics covered in the remaining chapters can be placed.

Chapters 2 and 3 focus on differences in ! nancial reporting across countries and the international convergence of accounting standards.

Chapter 2 presents evidence of the diversity in ! nancial reporting that exists around the world, explores the reasons for that diversity, and describes the problems that are created by differences in accounting practice across countries. In this chapter, we also describe and compare several major models of account- ing used internationally. We discuss the potential impact that culture has on the development of national accounting systems and present a simpli! ed model of the reasons for international differences in ! nancial reporting. The ! nal section of this chapter uses excerpts from recent annual reports to present additional examples of some of the differences in accounting that exist across countries.

Chapter 3 focuses on the major efforts worldwide to converge ! nancial report- ing practices, with an emphasis on the activities of the International Accounting Standards Board (IASB). We explain the meaning of convergence, identify the arguments for and against convergence, and discuss the use of the IASB’s In- ternational Financial Reporting Standards (IFRS), including national efforts to converge with those standards.

The almost universal recognition of IFRS as a high-quality set of global account- ing standards is arguably the most important development in the world of inter- national accounting. Chapters 4 and 5 introduce ! nancial reporting under IFRS for a wide range of accounting issues.

Chapter 4 summarizes the major differences between IFRS and U.S. GAAP. It provides detailed information on selected IFRS, concentrating on standards that relate to the recognition and measurement of assets—including inventories; property, plant, and equipment; intangible assets; and leased assets. Numeri- cal examples demonstrate the application of IFRS, differences between IFRS and U.S. GAAP, and the implications for ! nancial statements. This chapter also describes the requirements of IFRS in a variety of disclosure and presentation standards.

Chapter 5 focuses on current liabilities, provisions, employee bene! ts, share- based payment, income taxes, revenue, and ! nancial instruments, including major differences between IFRS and U.S. GAAP.

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Preface vii

Chapter 6 describes the accounting environment in ! ve economically signi! - cant countries—China, Germany, Japan, Mexico, and the United Kingdom—that are representative of major clusters of accounting systems. The discussion related to each country’s accounting system is organized into four parts: background, accounting profession, accounting regulation, and accounting principles and prac- tices. Exhibits throughout the chapter provide detailed information on differences between each country’s GAAP and IFRS, as well as reconciliations from local GAAP to U.S. GAAP.

Chapters 7, 8, and 9 deal with ! nancial reporting issues that are of particu- lar importance to multinational corporations. Two different surveys of business executives indicate that the most important topics that should be covered in an international accounting course are related to the accounting for foreign currency. 1 Because of its importance, this topic is covered in two separate chapters (Chapters 7 and 8). Chapter 9 covers three additional ! nancial reporting topics of particular importance to multinational corporations—in" ation accounting, business combi- nations and consolidated ! nancial statements, and segment reporting. Emphasis is placed on understanding IFRS related to these topics.

Chapter 7 begins with a description of the foreign exchange market and then demonstrates the accounting for foreign currency transactions. Much of this chapter deals with the accounting for derivatives used in foreign currency hedging activities. We ! rst describe how foreign currency forward contracts and foreign currency options can be used to hedge foreign exchange risk. We then explain the concepts of cash " ow hedges, fair value hedges, and hedge accounting. Finally, we demonstrate the accounting for forward contracts and options used as cash " ow hedges and fair value hedges to hedge foreign cur- rency assets and liabilities, foreign currency ! rm commitments, and forecasted foreign currency transactions.

Chapter 8 focuses on the translation of foreign currency ! nancial statements for the purpose of preparing consolidated ! nancial statements. We begin by examining the conceptual issues related to translation, focusing on the concept of balance sheet exposure and the economic interpretability of the translation adjustment. Only after a thorough discussion of the concepts and issues do we then describe the manner in which these issues have been addressed by the IASB and by the U.S. FASB. We then illustrate application of the two methods prescribed by both standard-setters and compare the results. We discuss the hedging of balance sheet exposure and provide examples of disclosures related to translation.

Chapter 9 covers three additional ! nancial reporting issues. The section on in" ation accounting begins with a conceptual discussion of asset valuation and capital maintenance through the use of a simple numerical example and then summarizes the in" ation accounting methods used in different countries. The second section focuses on International Financial Reporting Standards related to business combinations and consolidations, covering issues such as

1 T. Conover, S. Salter, and J. Price, “International Accounting Education: A Comparison of Course Syllabi and CFO Preferences,” Issues in Accounting Education, Volume 9, Issue 2, Fall 1994; and T. Foroughi and B. Reed, “A Survey of the Present and Desirable International Accounting Topics in Accounting Educa- tion,” International Journal of Accounting, Volume 23, Number 1, Fall 1987, pp. 64–82.

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viii Preface

the determination of control, the acquisition method, proportionate consolida- tion, and the equity method. The ! nal section of this chapter focuses on Inter- national Financial Reporting Standard 8, Operating Segments.

Chapter 10 introduces issues related to the analysis of foreign ! nancial state- ments. We explore potential problems (and possible solutions to those problems) associated with using the ! nancial statements of foreign companies for decision- making purposes. This chapter also provides an example of how an analyst would reformat and restate ! nancial statements from one set of GAAP to another.

Business executives rank international taxation second only to foreign currency in importance as a topic to be covered in an international accounting course. 2 International taxation and tax issues related to international transfer pricing are covered in Chapters 11 and 12.

Chapter 11 focuses on the taxation of foreign operation income by the home- country government. Much of this chapter deals with foreign tax credits, the most important mechanism available to companies to reduce double taxation. This chapter provides a comprehensive example demonstrating the major issues involved in U.S. taxation of foreign operation income. We also discuss bene! ts of tax treaties, translation of foreign currency amounts for tax purposes, and tax incentives provided to attract foreign investment.

Chapter 12 covers the topic of international transfer pricing, focusing on tax implications. We explain how discretionary transfer pricing can be used to achieve speci! c cost minimization objectives and how the objectives of per- formance evaluation and cost minimization can con" ict in determining inter- national transfer prices. We also describe government reactions to the use of discretionary transfer pricing by multinational companies, focusing on the U.S. rules governing intercompany pricing.

Chapter 13 covers strategic accounting issues of particular relevance to multi- national corporations. This chapter discusses multinational capital budgeting as a vital component of strategy formulation and operational budgeting as a key in- gredient in strategy implementation. Chapter 13 also deals with issues that must be addressed in designing a process for evaluating the performance of foreign operations.

Chapter 14 covers comparative international auditing and corporate gover- nance. This chapter discusses both external and internal auditing issues as they re- late to corporate governance in an international context. Chapter 14 also describes international diversity in external auditing and the international harmonization of auditing standards.

Chapter 15 introduces the current trend toward corporate social reporting (CSR) by multinational corporations (MNCs). We describe theories often used to explain CSR practices by companies and the motivations for them to engage in CSR practices. We also examine the implications of climate change for CSR. Fur- ther, we discuss some issues associated with regulation of CSR at the international level and identify international organizations that promote CSR, such as Global Reporting Initiative (GRI). Finally, we provide examples of actual CSR practices by MNCs.

2 Ibid.

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Preface ix

CHANGES IN THE FOURTH EDITION

Chapter 1

Updated statistics provided in the section titled “The Global Economy” Updated End-of-Chapter (EOC) assignments based on annual reports and other dated

material to the most current information available

Chapter 2

Noted that inflation is no longer as important in explaining accounting diversity as it once was and that European accountants need to develop an expertise in both local GAAP and IFRS

Chapter 3

Updated exhibits on excerpts from annual reports of various companies Added two new sections at the end of the chapter titled “Challenges to International

Convergence of Financial Reporting Standards” and “New Direction to the IASB” Added three new Exercises and Problems to the EOC material

Chapter 4

Noted that the discussion in the section on “Leases” is based on guidance in effect at the time of publication, and that a revised IASB-FASB exposure draft issued in 2013 was likely to substantially change and converge lease accounting at some unknown future date

Chapter 5

Deleted the subsection on “Proposed Amendments to IAS 37” Rewrote the subsection on “Post-Employment Benefits” to reflect the new guidance

provided in IAS 19 (Revised), which was issued in 2011 Rewrote several Exercises and Problems in the EOC material related to post-

employment benefits to reflect the changes in IAS 19 (Revised) Deleted the subsection on “Termination Benefits” Removed reference to a 2009 IASB Exposure Draft from the section on “Income Taxes” In the subsection titled “IASB-FASB Revenue Recognition Project,” removed some of

the specific discussion and an example based upon the 2011 IASB-FASB joint Expo- sure Draft, and noted that a new standard, if approved, would not become effective any earlier than 2017

Chapter 6

Updated annual report excerpts Added new material incorporating the latest developments with regard to financial

reporting in China, Germany, Japan, Mexico, and the United Kingdom Added three new Questions and one new Exercise and Problem to the EOC material

Chapter 7

Updated annual report excerpts and the related discussion Updated Exhibit 7.1 to provide recent exchange rates and the related discussion

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x Preface

Enhanced explanation of several journal entries related to the accounting for a “Forward Contract Designated as Cash Flow Hedge”

Deleted the subsection titled “The Euro” Updated Case 7-2 to be based on more recent exchange rates

Chapter 8

Updated annual report excerpts and the related discussion Updated the U.S dollar-to-euro exchange rates used in the example provided in

“Translation Process Illustrated” to more current levels

Chapter 9

Updated annual report excerpts and the related discussion Added a subsection on “Identification of Highly Inflationary Countries” Deleted the subsection on “Proportionate Consolidation” and removed the require-

ments in EOC Exercise and Problem 6 related to proportionate consolidation Added discussion of IFRS 11 in the section titled “Equity Method” Updated EOC Exercise and Problem 10 to be based on the most current annual report

disclosures available

Chapter 10

Deleted the discussion related to leases in the subsection titled “Extent of Disclosure”

Chapter 11

Updated information in several Exhibits providing income, withholding, and treaty tax rates and updated Case 11-1 to reflect changes in these rates

Chapter 12

Updated statistics related to the extent of international intercompany transfers, the use of various transfer pricing methods, the use of advance pricing agreements, and the enforcement of transfer pricing regulations

Chapter 13

Replaced Exhibit 13.14, “Rockwater’s Balanced Scorecard,” with “Use of Balanced Scorecard at Veolia Water”

Revamped Case 13-2, Lion Nathan Limited, in the EOC material

Chapter 14

Updated Exhibits 14.5 and 14.6, and “Appendix to Chapter 14” on excerpts from annual reports of various companies.

Chapter 15

Added new material incorporating GRI’s fourth-generation guidelines issued in 2013 Updated Exhibits 15.4, 15.5, and 15.6 Added a new Case 15-1, Modco Inc., to the EOC material

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Preface xi

SUPPLEMENTARY MATERIAL International Accounting is accompanied by supplementary items for both students and instructors. The Online Learning Center ( www.mhhe.com/doupnik4e ) is a book-speci! c website that includes the following supplementary materials.

For Students: PowerPoint Presentation

For Instructors: Access to all supplementary materials for students Instructor’s Manual PowerPoint Presentation Test Bank

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xii

Acknowledgments We want to thank the many people who participated in the review process and offered their helpful comments and suggestions:

Wagdy Abdallah Seton Hall University Kristine Brands Regis University Bradley Childs Belmont University Teresa Conover University of North Texas Orapin Duangploy University of Houston–Downtown Gertrude Eguae-Obazee Albright College Emmanuel Emmenyonu Southern Connecticut State University Charles Fazzi Saint Vincent College Mark Finn Northwestern University Leslie B. Fletcher Georgia Southern University Paul Foote California State University–Fullerton Mohamed Gaber State University of New York at Plattsburgh Giorgio Gotti University of Massachusetts–Boston Shiv Goyal University of Maryland University College Robert Gruber University of Wisconsin

Marianne James California State University–Los Angeles Cynthia Jeffrey Iowa State University Craig Keller Missouri State University Victoria Krivogorsky San Diego State University Britton McKay Georgia Southern University Jamshed Mistry Suffolk University Gregory Naples Marquette University Cynthia Nye Bellevue University Randon C. Otte Clarion University Obeua Persons Rider University Felix Pomeranz Florida International University Grace Pownall Emory University Juan Rivera University of Notre Dame Kurt Schulzke Kennesaw State University Mary Sykes University of Houston–Downtown

We are also thankful to Gary Blumenthal, chief ! nancial of! cer of The Forbes Consulting Group and instructor at Stonehill College, who revised the PowerPoint slides and Test Bank to accompany the third edition of the text.

We also pass along many thanks to all the McGraw-Hill Education who partici- pated in the creation of this book. In particular, Executive Brand Manager James Heine, Development Editor Gail Korosa, and Senior Marketing Manager Kathleen Klehr.

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xiii

8 Translation of Foreign Currency Financial Statements 403

9 Additional Financial Reporting Issues 448

10 Analysis of Foreign Financial Statements 492

11 International Taxation 541

12 International Transfer Pricing 586

13 Strategic Accounting Issues in Multinational Corporations 621

14 Comparative International Auditing and Corporate Governance 674

15 International Corporate Social Reporting 739

About the Authors iv

Preface v

Chapter

1 Introduction to International Accounting 1

2 Worldwide Accounting Diversity 23

3 International Convergence of Financial Reporting 65

4 International Financial Reporting Standards: Part I 118

5 International Financial Reporting Standards: Part II 179

6 Comparative Accounting 232

7 Foreign Currency Transactions and Hedging Foreign Exchange Risk 339

Brief Contents

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xiv

Access to Foreign Capital Markets 31 Comparability of Financial Statements 32 Lack of High-Quality Accounting Information 33

Accounting Clusters 33 A Judgmental Classi! cation of Financial Reporting Systems 34

An Empirical Test of the Judgmental Classi! cation 35 The In" uence of Culture on Financial Reporting 37

Hofstede’s Cultural Dimensions 37 Gray’s Accounting Values 37 Religion and Accounting 39

A Simpli! ed Model of the Reasons for International Differences in Financial Reporting 41

Examples of Countries with Class A Accounting 42 Recent Changes in Europe 42

Further Evidence of Accounting Diversity 43 Financial Statements 43 Format of Financial Statements 43 Level of Detail 47 Terminology 47 Disclosure 49 Recognition and Measurement 53

Summary 54 Appendix to Chapter 2 The Case of Daimler-Benz 55 Questions 57 Exercises and Problems 58 Case 2-1: The Impact of Culture on Conservatism 60 Case 2-2: SKD Limited 62 References 63

Chapter 3 International Convergence of

Financial Reporting 65

Introduction 65 International Accounting Standard- Setting 66 Harmonization Efforts 68

International Organization of Securities Commissions 68 International Federation of Accountants 69 European Union 69

About the Authors iv Preface v

Chapter 1 Introduction to International

Accounting 1

What Is International Accounting? 1 Evolution of a Multinational Corporation 2

Sales to Foreign Customers 2 Hedges of Foreign Exchange Risk 4 Foreign Direct Investment 4 Financial Reporting for Foreign Operations 6 International Income Taxation 7 International Transfer Pricing 7 Performance Evaluation of Foreign Operations 8 International Auditing 8 Cross-Listing on Foreign Stock Exchanges 9 Global Accounting Standards 10

The Global Economy 10 International Trade 10 Foreign Direct Investment 11 Multinational Corporations 12 International Capital Markets 14

Outline of the Book 14 Summary 15 Questions 16 Exercises and Problems 17 Case 1-1: Besserbrau AG 19 Case 1-2: Vanguard International Growth Fund 20 References 22

Chapter 2 Worldwide Accounting Diversity 23

Introduction 23 Evidence of Accounting Diversity 24 Reasons for Accounting Diversity 28

Legal System 28 Taxation 29 Providers of Financing 29 In" ation 30 Political and Economic Ties 30 Correlation of Factors 30

Problems Caused by Accounting Diversity 31 Preparation of Consolidated Financial Statements 31

Contents

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Contents xv

The International Forum on Accountancy Development (IFAD) 72 The International Accounting Standards Committee (IASC) 72

Creation of the IASB 75 The Structure of the IASB 77

Arguments for and against International Convergence of Financial Reporting Standards 82

Arguments for Convergence 82 Arguments against Convergence 82

A Principles-Based Approach to International Financial Reporting Standards 83 The IASB Framework 84

The Need for a Framework 84 Objective of Financial Statements and Underlying Assumptions 84 Qualitative Characteristics of Financial Statements 85 Elements of Financial Statements: De! nition, Recognition, and Measurement 85 Concepts of Capital Maintenance 86

International Financial Reporting Standards 86 Presentation of Financial Statements (IAS 1) 86 First-Time Adoption of International Financial Reporting Standards (IFRS 1) 90 International Convergence toward IFRS 92 The Adoption of International Financial Reporting Standards 94 IFRS in the European Union 96 IFRS in the United States 98

Support for a Principles-Based Approach 98 The SEC and IFRS Convergence 99 Challenges to International Convergence 100 New Direction for the IASB 102 The FASB and IFRS Convergence 103 The Norwalk Agreement 103 AICPA and IFRS Convergence 105 Revision of the Conceptual Framework 106

Some Concluding Remarks 108 Summary 109 Appendix to Chapter 3 What Is This Thing Called Anglo- Saxon Accounting? 110 Questions 112 Exercises and Problems 113 Case 3-1: Jardine Matheson Group (Part 1) 115 References 116

Chapter 4 International Financial Reporting

Standards: Part I 118

Introduction 118 Types of Differences between IFRS and U.S. GAAP 119 Inventories 120

Lower of Cost or Net Realizable Value 121 Property, Plant, and Equipment 122

Recognition of Initial and Subsequent Costs 123 Measurement at Initial Recognition 123 Measurement Subsequent to Initial Recognition 124 Depreciation 130 Derecognition 130

Investment Property 131 Impairment of Assets 131

De! nition of Impairment 131 Measurement of Impairment Loss 132 Reversal of Impairment Losses 133

Intangible Assets 134 Purchased Intangibles 135 Intangibles Acquired in a Business Combination 136 Internally Generated Intangibles 136 Revaluation Model 141 Impairment of Intangible Assets 141

Goodwill 141 Impairment of Goodwill 142 Goodwill Not Allocable to Cash-Generating Unit under Review 144

Borrowing Costs 146 Leases 147

Lease Classi! cation 147 Finance Leases 149 Operating Leases 150 Sale–Leaseback Transaction 150 Disclosure 151 IASB/FASB Convergence Project 153 Other Recognition and Measurement Standards 153

Disclosure and Presentation Standards 154 Statement of Cash Flows 154 Events after the Reporting Period 155 Accounting Policies, Changes in Accounting Estimates, and Errors 156 Related Party Disclosures 157 Earnings per Share 157 Interim Financial Reporting 158 Noncurrent Assets Held for Sale and Discontinued Operations 158 Operating Segments 158

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xvi Contents

Classi! cation of Financial Assets and Financial Liabilities 206 Measurement of Financial Instruments 208 Available-for-Sale Financial Asset Denominated in a Foreign Currency 210 Impairment 211 Derecognition 211 Derivatives 213 Receivables 213

Summary 215 Questions 217 Exercises and Problems 218 Case 5-1: S. A. Harrington Company 230

Chapter 6 Comparative Accounting 232

Introduction 232 People’s Republic of China (PRC) 234

Background 234 Accounting Profession 236 Accounting Regulation 241 Accounting Principles and Practices 246

Germany 257 Background 257 Accounting Profession 258 Accounting Regulation 259 Accounting Principles and Practices 263 Issues Related to the Adoption of IFRS in Germany 267

Japan 277 Background 277 Accounting Profession 278 Accounting Regulation 281 Accounting Principles and Practices 284

Mexico 291 Background 291 Accounting Profession 293 Accounting Regulation 294 Accounting Principles and Practices 297

United Kingdom 303 Background 303 Accounting Profession 303 Accounting Regulation 305 Accounting Principles and Practices 309

Summary 325 Questions 327 Exercises and Problems 328 Case 6-1: China Petroleum and Chemical Corporation 329 References 336

Summary 159 Questions 161 Exercises and Problems 162 Case 4-1: Bessrawl Corporation 177 References 178

Chapter 5 International Financial Reporting

Standards: Part II 179

Introduction 179 Current Liabilities 179 Provisions, Contingent Liabilities, and Contingent Assets 180

Contingent Liabilities and Provisions 180 Onerous Contract 182 Restructuring 183 Contingent Assets 183 Additional Guidance 184

Employee Bene! ts 185 Short-Term Bene! ts 185 Post-employment Bene! ts 185 Other Long-Term Employee Bene! ts 188

Share-Based Payment 188 Equity-Settled Share-Based Payment Transactions 189 Cash-Settled Share-Based Payment Transactions 190 Choice-of-Settlement Share-Based Payment Transactions 191

Income Taxes 193 Tax Laws and Rates 193 Recognition of Deferred Tax Asset 194 Disclosures 195 IFRS versus U.S. GAAP 195 Financial Statement Presentation 196

Revenue Recognition 197 General Measurement Principle 197 Identi! cation of the Transaction Generating Revenue 197 Sale of Goods 197 Rendering of Services 199 Interest, Royalties, and Dividends 200 Exchanges of Goods or Services 200 IAS 18, Part B 200 Customer Loyalty Programs 201 Construction Contracts 202 IASB–FASB Revenue Recognition Project 203

Financial Instruments 204 De! nitions 204 Liability or Equity 205 Compound Financial Instruments 205

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Contents xvii

Use of Hedging Instruments 375 Foreign Currency Borrowing 377

Foreign Currency Loan 379 Summary 379 Appendix to Chapter 7 Illustration of the Accounting for Foreign Currency Transactions and Hedging Activities by an Importer 380 Questions 392 Exercises and Problems 393 Case 7-1: Zorba Company 401 Case 7-2: Porto! no Company 402 Case 7-3: Better Food Corporation 402 References 402

Chapter 8 Translation of Foreign Currency Financial

Statements 403

Introduction 403 Two Conceptual Issues 404

Example 404 Balance Sheet Exposure 407

Translation Methods 408 Current/Noncurrent Method 408 Monetary/Nonmonetary Method 408 Temporal Method 409 Current Rate Method 410 Translation of Retained Earnings 411 Complicating Aspects of the Temporal Method 413

Disposition of Translation Adjustment 414 U.S. GAAP 415

FASB ASC 830 416 Functional Currency 416 Highly In" ationary Economies 417

International Financial Reporting Standards 418 The Translation Process Illustrated 420 Translation of Financial Statements: Current Rate Method 421

Translation of the Balance Sheet 422 Computation of Translation Adjustment 424

Remeasurement of Financial Statements: Temporal Method 424

Remeasurement of Income Statement 424 Computation of Remeasurement Gain 426

Nonlocal Currency Balances 427 Comparison of the Results from Applying the Two Different Methods 428

Underlying Valuation Method 428 Underlying Relationships 429

Chapter 7 Foreign Currency Transactions

and Hedging Foreign Exchange Risk 339

Introduction 339 Foreign Exchange Markets 340

Exchange Rate Mechanisms 340 Foreign Exchange Rates 341 Spot and Forward Rates 343 Option Contracts 344

Foreign Currency Transactions 344 Accounting Issue 345 Accounting Alternatives 345 Balance Sheet Date before Date of Payment 347

Hedging Foreign Exchange Risk 349 Accounting for Derivatives 350

Fundamental Requirement of Derivatives Accounting 351 Determining the Fair Value of Derivatives 351 Accounting for Changes in the Fair Value of Derivatives 351

Hedge Accounting 352 Nature of the Hedged Risk 352 Hedge Effectiveness 353 Hedge Documentation 353

Hedging Combinations 353 Hedges of Foreign-Currency-Denominated Assets and Liabilities 354 Forward Contract Used to Hedge a Recognized Foreign-Currency-Denominated Asset 355

Forward Contract Designated as Cash Flow Hedge 357 Forward Contract Designated as Fair Value Hedge 361

Foreign Currency Option Used to Hedge a Recognized Foreign-Currency-Denominated Asset 363

Option Designated as Cash Flow Hedge 365 Spot Rate Exceeds Strike Price 367 Option Designated as Fair Value Hedge 368

Hedges of Unrecognized Foreign Currency Firm Commitments 368

Forward Contract Used as Fair Value Hedge of a Firm Commitment 368 Option Used as Fair Value Hedge of Firm Commitment 371

Hedge of Forecasted Foreign-Currency- Denominated Transaction 373

Option Designated as a Cash Flow Hedge of a Forecasted Transaction 374

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xviii Contents

Foreign Portfolio Investment 494 International Mergers and Acquisitions 494 Other Reasons 495

Potential Problems in Analyzing Foreign Financial Statements 495

Data Accessibility 495 Language 496 Currency 498 Terminology 499 Format 500 Extent of Disclosure 500 Timeliness 502 Differences in Accounting Principles 503 International Ratio Analysis 506

Restating Financial Statements 508 Explanation of Reconciling Adjustments 513 Comparison of Local GAAP and U.S. GAAP Amounts 518

Summary 519 Appendix to Chapter 10 Morgan Stanley Dean Witter: Apples to Apples 520 Questions 523 Exercises and Problems 523 Case 10-1: Swisscom AG 535 References 539

Chapter 11 International Taxation 541

Introduction 541 Investment Location Decision 541 Legal Form of Operation 542 Method of Financing 542

Types of Taxes and Tax Rates 542 Income Taxes 542 Tax Havens 544 Withholding Taxes 546 Tax-Planning Strategy 547 Value-Added Tax 547

Tax Jurisdiction 548 Worldwide versus Territorial Approach 548 Source, Citizenship, and Residence 549 Double Taxation 550

Foreign Tax Credits 551 Credit versus Deduction 551 Calculation of Foreign Tax Credit 552 Excess Foreign Tax Credits 553 FTC Baskets 555 Indirect Foreign Tax Credit (FTC for Subsidiaries) 556

Hedging Balance Sheet Exposure 429 Disclosures Related to Translation 432 Summary 434 Questions 435 Exercises and Problems 436 Case 8-1: Columbia Corporation 443 Case 8-2: Palmerstown Company 445 References 447

Chapter 9 Additional Financial Reporting

Issues 448

Introduction 448 Accounting for Changing Prices (In" ation Accounting) 449

Impact of In" ation on Financial Statements 449 Purchasing Power Gains and Losses 450 Methods of Accounting for Changing Prices 450 General Purchasing Power (GPP) Accounting 452 Current Cost (CC) Accounting 453 In" ation Accounting Internationally 454 International Financial Reporting Standards 457 Translation of Foreign Currency Financial Statements in Hyperin" ationary Economies 460 Identi! cation of High In" ation Countries 463

Business Combinations and Consolidated Financial Statements 463

Determination of Control 464 Scope of Consolidation 467 Full Consolidation 467 Equity Method 472

Segment Reporting 474 Operating Segments—The Management Approach 475 Example: Application of Signi! cance Tests 476 Operating Segment Disclosures 478 Entity-Wide Disclosures 478

Summary 482 Questions 483 Exercises and Problems 483 References 491

Chapter 10 Analysis of Foreign Financial

Statements 492

Introduction 492 Overview of Financial Statement Analysis 492 Reasons to Analyze Foreign Financial Statements 494

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Contents xix

Advance Pricing Agreements 607 Enforcement of Transfer Pricing Regulations 609

Worldwide Enforcement 610 Summary 611 Questions 612 Exercises and Problems 613 Case 12-1: Litch! eld Corporation 618 Case 12-2: Global Electronics Company 619 References 620

Chapter 13 Strategic Accounting Issues in

Multinational Corporations 621

Introduction 621 Strategy Formulation 622

Capital Budgeting 622 Capital Budgeting Techniques 626 Multinational Capital Budgeting 629 Illustration: Global Paper Company 631

Strategy Implementation 637 Management Control 637 Operational Budgeting 640

Evaluating the Performance of Foreign Operations 641

Designing an Effective Performance Evaluation System for a Foreign Subsidiary 642 Performance Measures 643 Financial Measures 643 Non! nancial Measures 643 Financial versus Non! nancial Measures 644 The Balanced Scorecard (BSC): Increased Importance of Non! nancial Measures 646 Responsibility Centers 648 Foreign Operating Unit as a Pro! t Center 649 Separating Managerial and Unit Performance 650 Uncontrollable Items 650 Choice of Currency in Measuring Pro! t 652 Foreign Currency Translation 652 Choice of Currency in Operational Budgeting 653 Incorporating Economic Exposure into the Budget Process 656 Implementing a Performance Evaluation System 659

Culture and Management Control 660 Summary 661 Questions 663 Exercises and Problems 663 Case 13-1: Canyon Power Company 665 Case 13-2: Lion Nathan Limited 667 References 672

Tax Treaties 557 Model Treaties 558 U.S. Tax Treaties 558 Treaty Shopping 560

Controlled Foreign Corporations 561 Subpart F Income 561 Determination of the Amount of CFC Income Currently Taxable 562 Safe Harbor Rule 562

Summary of U.S. Tax Treatment of Foreign Source Income 562

Example: U.S. Taxation of Foreign Source Income 562 Translation of Foreign Operation Income 565

Translation of Foreign Branch Income 566 Translation of Foreign Subsidiary Income 567 Foreign Currency Transactions 568

Tax Incentives 568 Tax Holidays 569 U.S. Export Incentives 570

Summary 572 Appendix to Chapter 11 U.S. Taxation of Expatriates 573 Questions 576 Exercises and Problems 576 Case 11-1: U.S. International Corporation 584 References 585

Chapter 12 International Transfer Pricing 586

Introduction 586 Decentralization and Goal Congruence 587 Transfer Pricing Methods 588 Objectives of International Transfer Pricing 589

Performance Evaluation 589 Cost Minimization 591 Other Cost-Minimization Objectives 591 Survey Results 593 Interaction of Transfer Pricing Method and Objectives 594

Government Reactions 595 U.S. Transfer Pricing Rules 595

Sale of Tangible Property 596 Licenses of Intangible Property 601 Intercompany Loans 603 Intercompany Services 604 Arm’s-Length Range 604 Correlative Relief 604 Penalties 606 Contemporaneous Documentation 606 Reporting Requirements 607

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xx Contents

Auditing No Longer Only the Domain of the External Auditor 713 Different Corporate Governance Models 713

Summary 713 Appendix to Chapter 14 Examples of Audit Reports from Multinational Corporations 714 Questions 722 Exercises and Problems 723 Case 14-1: Honda Motor Company 725 Case 14-2: Daimler AG 732 References 736

Chapter 15 International Corporate Social

Reporting 739

Introduction 739 Theories to Explain CSR Practices 741 Drivers of CSR Practices by Companies 741 Implications of Climate Change for CSR 743

Climate Change at a Glance 743 Some Related Key Concepts 744

Regulating CSR Practices 745 Regulation of CSR in the United States 746 Regulation of CSR in Other Countries and Regions 748 International Arrangements to Regulate CSR 748 Global Reporting Initiative (GRI) 749

CSR Practices by MNCs 754 Concluding Remarks 764 Summary 766 Questions 767 Exercises and Problems 767 Case 15-1: The Case of Modco Inc. 767 References 769 Index 772

Chapter 14 Comparative International Auditing

and Corporate Governance 674

Introduction 674 International Auditing and Corporate Governance 676 International Diversity in External Auditing 680

Purpose of Auditing 680 Audit Environments 682 Regulation of Auditors and Audit Firms 684 Audit Reports 687

International Harmonization of Auditing Standards 688 Ethics and International Auditing 693

A More Communitarian View of Professional Ethics 694

Additional International Auditing Issues 695 Auditor’s Liability 695 Limiting Auditor’s Liability 695 Auditor Independence 697 Audit Committees 701

Internal Auditing 702 The Demand for Internal Auditing in MNCs 704 U.S. Legislation against Foreign Corrupt Practices 705 Legislation in Other Jurisdictions 708

Future Directions 710 Consumer Demand 711 Reporting on the Internet 711 Increased Competition in the Audit Market 712 Continued High Interest in the Audit Market 712 Increased Exposure of the International Auditing Firms 712 Tendency toward a Checklist Approach 713

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1

Chapter One

Introduction to International Accounting Learning Objectives

After reading this chapter, you should be able to

• Discuss the nature and scope of international accounting. • Describe accounting issues confronted by companies involved in international

trade (import and export transactions). • Explain the reasons for, and the accounting issues associated with, foreign direct

investment. • Describe the practice of cross-listing on foreign stock exchanges. • Explain the notion of global accounting standards. • Examine the importance of international trade, foreign direct investment, and

multinational corporations in the global economy.

WHAT IS INTERNATIONAL ACCOUNTING?

Most accounting students are familiar with ! nancial accounting and managerial accounting, but many have only a vague idea of what international accounting is. De! ned broadly, the accounting in international accounting encompasses the functional areas of ! nancial accounting, managerial accounting, auditing, taxa- tion, and accounting information systems.

The word international in international accounting can be de! ned at three dif- ferent levels. 1 The ! rst level is supranational accounting, which denotes standards, guidelines, and rules of accounting, auditing, and taxation issued by supranational organizations. Such organizations include the United Nations, the Organization for Economic Cooperation and Development, and the International Federation of Accountants.

1 This framework for defi ning international accounting was developed by Professor Konrad Kubin in the preface to International Accounting Bibliography 1982–1994, distributed by the International Accounting Section of the American Accounting Association (Sarasota, FL: AAA, 1997).

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2 Chapter One

At the second level, the company level, international accounting can be viewed in terms of the standards, guidelines, and practices that a company follows related to its international business activities and foreign investments. These would in- clude standards for accounting for transactions denominated in a foreign currency and techniques for evaluating the performance of foreign operations.

At the third and broadest level, international accounting can be viewed as the study of the standards, guidelines, and rules of accounting, auditing, and taxa- tion that exist within each country as well as comparison of those items across countries. Examples would be cross-country comparisons of (1) rules related to the ! nancial reporting of plant, property, and equipment; (2) income and other tax rates; and (3) the requirements for becoming a member of the national accounting profession.

Clearly, international accounting encompasses an enormous amount of territory—both geographically and topically. It is not feasible or desirable to cover the entire discipline in one course, so an instructor must determine the scope of an international accounting course. This book is designed to be used in a course that attempts to provide an overview of the broadly de! ned area of international accounting, but that also focuses on the accounting issues related to international business activities and foreign operations.

EVOLUTION OF A MULTINATIONAL CORPORATION

To gain an appreciation for the accounting issues related to international business, let us follow the evolution of Magnum Corporation, a ! ctional auto parts manu- facturer headquartered in Detroit, Michigan. 2 Magnum was founded in the early 1950s to produce and sell rearview mirrors to automakers in the United States. For the ! rst several decades, all of Magnum’s transactions occurred in the United States. Raw materials and machinery and equipment were purchased from suppli- ers located across the United States, ! nished products were sold to U.S. automak- ers, loans were obtained from banks in Michigan and Illinois, and the common stock was sold on the New York Stock Exchange. At this stage, all of Magnum’s business activities were carried out in U.S. dollars, its ! nancial reporting was done in compliance with U.S. generally accepted accounting principles (GAAP), and taxes were paid to the U.S. federal government and the state of Michigan.

Sales to Foreign Customers In the 1980s, one of Magnum’s major customers, Normal Motors Inc., acquired a production facility in the United Kingdom, and Magnum was asked to supply this operation with rearview mirrors. The most feasible means of supplying Normal Motors UK (NMUK) was to manufacture the mirrors in Michigan and then ship them to the United Kingdom, thus making export sales to a foreign customer. If the sales had been invoiced in U.S. dollars, accounting for the export sales would have been no different from accounting for domestic sales. However, Normal Motors required Magnum to bill the sales to NMUK in British pounds (£), thus creating foreign currency sales for Magnum. The ! rst shipment of mirrors to NMUK was

2 The description of Magnum’s evolution is developed from a U.S. perspective. However, the international accounting issues that Magnum is forced to address would be equally applicable to a company head- quartered in any other country in the world.

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Introduction to International Accounting 3

invoiced at £100,000 with credit terms of 2/10, net 30. If Magnum were a British company, the journal entry to record this sale would have been:

Dr. Accounts Receivable (1 Assets) . . . . . . . . . . . . . . . . . . . . . . . . . . . £100,000

          Cr. Sales Revenue (1 Equity) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     £100,000

However, Magnum is a U.S.-based company that keeps its accounting records in U.S. dollars (US$). To account for this export sale, the British pound sale and re- ceivable must be translated into US$. Assuming that the exchange rate between the £ and the US$ at the time of this transaction was £1 5 US$1.60, the journal entry would have been:

Dr. Accounts Receivable (£) (1 Assets) . . . . . . . . . . . . . . . . . . . . . . US$160,000

          Cr. Sales Revenue (1 Equity) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   US$160,000

This was the ! rst time since its formation that Magnum had found it necessary to account for a transaction denominated (invoiced) in a currency other than the U.S. dollar. The company added to its chart of accounts a new account indicating that the receivable was in a foreign currency, “Accounts Receivable (£),” and the accoun- tant had to determine the appropriate exchange rate to translate £ into US$.

As luck would have it, by the time NMUK paid its account to Magnum, the value of the £ had fallen to £1 5 US$1.50, and the £100,000 received by Magnum was converted into US$150,000. The partial journal entry to record this would have been:

Dr. Cash (1 Asset) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . US$150,000

          Cr. Accounts Receivable (£) (− Asset) . . . . . . . . . . . . . . . . . . . . . . .    US$160,000

This journal entry is obviously incomplete because the debit and the credit are not equal and the balance sheet will be out of balance. A question arises: How should the difference of US$10,000 between the original US$ value of the receivable and the actual number of US$ received be re" ected in the accounting records? Two possible answers would be (1) to treat the difference as a reduction in sales rev- enue or (2) to record the difference as a separate loss resulting from a change in the foreign exchange rate. This is an accounting issue that Magnum was not required to deal with until it became involved in export sales. Speci! c rules for accounting for foreign currency transactions exist in the United States, and Magnum’s accoun- tants had to develop an ability to apply those rules.

Through the British-pound account receivable, Magnum became exposed to foreign exchange risk—the risk that the foreign currency will decrease in US$ value over the life of the receivable. The obvious way to avoid this risk is to require foreign customers to pay for their purchases in US$. Sometimes foreign customers will not or cannot pay in the seller’s currency, and to make the sale, the seller will be obliged to accept payment in the foreign currency. Thus, foreign exchange risk will arise.

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4 Chapter One

Hedges of Foreign Exchange Risk Companies can use a variety of techniques to manage, or hedge, their exposure to foreign exchange risk. A popular way to hedge foreign exchange risk is through the purchase of a foreign currency option that gives the option owner the right, but not the obligation, to sell foreign currency at a predetermined exchange rate known as the strike price. Magnum purchased such an option for US$200 and was able to sell the £100,000 it received for a total of US$155,000 because of the option’s strike price. The foreign currency option was an asset that Magnum was required to account for over its 30-day life. Options are a type of derivative ! nancial instru- ment, 3 the accounting for which can be quite complicated. Foreign currency for- ward contracts are another example of derivative ! nancial instruments commonly used to hedge foreign exchange risk. Magnum never had to worry about how to account for hedging instruments such as options and forward contracts until it became involved in international trade.

Foreign Direct Investment Although the managers at Magnum at ! rst were apprehensive about international business transactions, they soon discovered that foreign sales were a good way to grow revenues and, with careful management of foreign currency risk, would allow the company to earn adequate pro! t. Over time, Magnum became known through- out Europe for its quality products. The company entered into negotiations and eventually landed supplier contracts with several European automakers, ! lling or- ders through export sales from its factory in the United States. Because of the com- bination of increased shipping costs and its European customers’ desire to move toward just-in-time inventory systems, Magnum began thinking about investing in a production facility somewhere in Europe. The ownership and control of for- eign assets, such as a manufacturing plant, is known as foreign direct investment. Exhibit 1.1 summarizes some of the major reasons for foreign direct investment.

Two ways for Magnum to establish a manufacturing presence in Europe were to purchase an existing mirror manufacturer (acquisition) or to construct a brand- new plant (green! eld investment). In either case, the company needed to calculate the net present value (NPV) from the potential investment to make sure that the return on investment would be adequate. Determination of NPV involves fore- casting future pro! ts and cash " ows, discounting those cash " ows back to their present value, and comparing this with the amount of the investment. NPV calcu- lations inherently involve a great deal of uncertainty.

In the early 1990s, Magnum identi! ed a company in Portugal (Espelho Ltda.) as a potential acquisition candidate. In determining NPV, Magnum needed to fore- cast future cash " ows and determine a fair price to pay for Espelho. Magnum had to deal with several complications in making a foreign investment decision that would not have come into play in a domestic situation.

First, to assist in determining a fair price to offer for the company, Magnum asked for Espelho’s ! nancial statements for the past ! ve years. The ! nancial state- ments had been prepared in accordance with Portuguese accounting rules, which were much different from the accounting rules Magnum’s managers were familiar with. The balance sheet did not provide a clear picture of the company’s assets,

3 A derivative is a fi nancial instrument whose value is based on (or derived from) a traditional security (such as a stock or bond), an asset (such as foreign currency or a commodity like gold), or a market index (such as the S&P 500 index). In this example, the value of the British-pound option is based on the price of the British pound.

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Introduction to International Accounting 5

EXHIBIT 1.1 Reasons for Foreign Direct Investment

Source: Alan M. Rugman and Simon Collinson, International Business, 4th ed. (Essex, England: Pearson Education Limited, 2006), pp. 70–77.

Increase Sales and Profi ts

International sales may be a source of higher profi t margins or of additional profi ts through additional sales. Unique products or technological advantages may provide a comparative advantage that a company wishes to exploit by expanding sales in foreign countries.

Enter Rapidly Growing or Emerging Markets

Some international markets are growing much faster than others. Foreign direct investment is a means for gaining a foothold in a rapidly growing or emerging market. The ultimate objective is to increase sales and profi ts.

Reduce Costs

A company sometimes can reduce the cost of providing goods and services to its customers through foreign direct investment. Signifi cantly lower labor costs in some countries provide an opportunity to reduce the cost of production. If materials are in short supply or must be moved a long distance, it might be less expensive to locate production close to the source of supply rather than to import the materials. Transportation costs associated with making export sales to foreign customers can be reduced by locating production close to the customer.

Gain a Foothold in Economic Blocs

To be able to sell its products within a region without being burdened by import taxes or other restrictions, a company might establish a foothold in a country situated in a major economic bloc. The three major economic blocs are the North American Free Trade Association (NAFTA), the European Union, and an Asian bloc that includes countries such as China, India, Indonesia, Malaysia, the Philippines, South Korea, Taiwan, and Thailand.

Protect Domestic Markets

To weaken a potential international competitor and protect its domestic market, a company might enter the competitor’s home market. The rationale is that a potential competitor is less likely to enter a foreign market if it is preoccupied with protecting its own domestic market.

Protect Foreign Markets

Additional investment in a foreign country is sometimes motivated by a need to protect that market from local competitors. Companies generating sales through exports to a particular country sometimes fi nd it necessary to establish a stronger presence in that country over time to protect their market.

Acquire Technological and Managerial Know-How

In addition to conducting research and development at home, another way to acquire technological and managerial know-how is to set up an operation close to leading competitors. Through geographical proximity, companies fi nd it easier to more closely monitor and learn from industry leaders and even hire experienced employees from the competition.

and many liabilities appeared to be kept off-balance-sheet. Footnote disclosure was limited, and cash " ow information was not provided. This was the ! rst time that Magnum’s management became aware of the signi! cant differences in ac- counting between countries. Magnum’s accountants spent much time and effort restating Espelho’s ! nancial statements to a basis that Magnum felt it could use for valuing the company.

Second, in determining NPV, cash " ows should be measured on an after-tax basis. To adequately incorporate tax effects into the analysis, Magnum’s manage- ment had to learn a great deal about the Portuguese income tax system and the taxes and restrictions imposed on dividend payments made to foreign parent com- panies. These and other complications make the analysis of a foreign investment much more challenging than the analysis of a domestic investment.

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6 Chapter One

Magnum determined that the purchase of Espelho Ltda. would satisfy its Euro- pean production needs and also generate an adequate return on investment. Mag- num acquired all of the company’s outstanding common stock, and Espelho Ltda. continued as a Portuguese corporation. The investment in a subsidiary located in a foreign country created several new accounting challenges that Magnum previ- ously had not been required to address.

Financial Reporting for Foreign Operations As a publicly traded company in the United States, Magnum Corporation is re- quired to prepare consolidated ! nancial statements in which the assets, liabilities, and income of its subsidiaries (domestic and foreign) are combined with those of the parent company. The consolidated ! nancial statements must be presented in U.S. dollars and prepared using U.S. GAAP. Espelho Ltda., being a Portuguese corporation, keeps its accounting records in euros (€) in accordance with Portu- guese GAAP. 4 To consolidate the results of its Portuguese subsidiary, two proce- dures must be completed.

First, for all those accounting issues for which Portuguese accounting rules differ from U.S. GAAP, amounts calculated under Portuguese GAAP must be converted to a U.S. GAAP basis. To do this, Magnum needs someone who has expertise in both U.S. and Portuguese GAAP and can reconcile the differences between them. Magnum’s ! nancial reporting system was altered to accommodate this conversion process. Magnum relied heavily on its external auditing ! rm (one of the so-called Big Four ! rms) in developing procedures to restate Espelho’s ! nancial statements to U.S. GAAP.

Second, after the account balances have been converted to a U.S. GAAP basis, they then must be translated from the foreign currency (€) into US$. Several meth- ods exist for translating foreign currency ! nancial statements into the parent’s re- porting currency. All the methods involve the use of both the current exchange rate at the balance sheet date and historical exchange rates. By translating some ! nancial statement items at the current exchange rate and other items at historical exchange rates, the resulting translated balance sheet no longer balances, as can be seen in the following example:

Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . € 1,000 × $1.35 US$1,350

Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 × 1.35 810 Stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 × 1.00 400

€ 1,000 US$1,210

To get the US$ ! nancial statements back into balance, a translation adjustment of US$140 must be added to stockholders’ equity. One of the major debates in translating foreign currency ! nancial statements is whether the translation ad- justment should be reported in consolidated net income as a gain or whether it should simply be added to equity with no effect on income. Each country has developed rules regarding the appropriate exchange rate to be used for the vari- ous ! nancial statement items and the disposition of the translation adjustment. Magnum’s accountants needed to learn and be able to apply the rules in force in the United States.

4 Note that in 2005 Portugal adopted International Financial Reporting Standards for publicly traded com- panies, in compliance with European Union regulations. However, as a wholly owned subsidiary, Espelho Ltda. continues to use Portuguese GAAP in keeping its books.

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Introduction to International Accounting 7

International Income Taxation The existence of a foreign subsidiary raises two kinds of questions with respect to taxation:

1. What are the income taxes that Espelho Ltda. has to pay in Portugal, and how can those taxes legally be minimized?

2. What are the taxes, if any, that Magnum Corporation has to pay in the United States related to the income earned by Espelho in Portugal, and how can those taxes legally be minimized?

All else being equal, Magnum wants to minimize the total amount of taxes it pays worldwide because doing so will maximize its after-tax cash " ows. To achieve this objective, Magnum must have expertise in the tax systems in each of the countries in which it operates. Just as every country has its own unique set of ! nancial accounting rules, each country also has a unique set of tax regulations.

As a Portuguese corporation doing business in Portugal, Espelho Ltda. will have to pay income tax to the Portuguese government on its Portuguese source income. Magnum’s management began to understand the Portuguese tax system in the process of determining after-tax net present value when deciding to acquire Espelho. The United States taxes corporate pro! ts on a worldwide basis, which means that Magnum will also have to pay tax to the U.S. government on the in- come earned by its Portuguese subsidiary. However, because Espelho is legally incorporated in Portugal (as a subsidiary), U.S. tax generally is not owed until Espelho’s income is repatriated to the parent in the United States as a dividend. (If Espelho were registered with the Portuguese government as a branch, its income would be taxed currently in the United States regardless of when the income is remitted to Magnum.) Thus, income earned by the foreign operations of U.S. com- panies is subject to double taxation.

Most countries, including the United States, provide companies relief from double taxation through a credit for the amount of taxes already paid to the for- eign government. Tax treaties between two countries might also provide some relief from double taxation. Magnum’s tax accountants must be very conversant in U.S. tax law as it pertains to foreign source income to make sure that the company is not paying more taxes to the U.S. government than is necessary.

International Transfer Pricing Some companies with foreign operations attempt to minimize the amount of worldwide taxes they pay through the use of discretionary transfer pricing. Auto mirrors consist of three major components: mirrored glass, a plastic housing, and a steel bracket. The injection-molding machinery for producing the plastic housing is expensive, and Espelho Ltda. does not own such equipment. The plastic parts that Espelho requires are produced by Magnum in the United States and then shipped to Espelho as an intercompany sale. Prices must be established for these intercompany transfers. The transfer price generates sales revenue for Magnum and is a component of cost of goods sold for Espelho. If the transfer were being made within the United States, Magnum’s management would allow the buyer and the seller to negotiate a price that both would be willing to accept.

This intercompany sale is being made from one country to another. Because the income tax rate in Portugal is higher than that in the United States, Magnum requires these parts to be sold to Espelho at as high a price as possible. Transfer- ring parts to Portugal at high prices shifts gross pro! t to the United States that

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8 Chapter One

otherwise would be earned in Portugal, thus reducing the total taxes paid to both countries. Most governments are aware that multinational companies have the ability to shift pro! ts between countries through discretionary transfer pricing. To make sure that companies pay their fair share of local taxes, most countries have laws that regulate international transfer pricing. Magnum Corporation must be careful that, in transferring parts from the United States to Portugal, the transfer price is acceptable to tax authorities in both countries. The United States, espe- cially, has become aggressive in enforcing its transfer pricing regulations.

Performance Evaluation of Foreign Operations To ensure that operations in both the United States and Portugal are achieving their objectives, Magnum’s top management requests that the managers of the various operating units submit periodic reports to headquarters detailing their unit’s per- formance. Headquarters management is interested in evaluating the performance of the operating unit as well as the performance of the individuals responsible for managing those units. The process for evaluating performance that Magnum has used in the past for its U.S. operations is not directly transferable to evaluating the performance of Espelho Ltda. Several issues unique to foreign operations must be considered in designing the evaluation system. For example, Magnum has to decide whether to evaluate Espelho’s performance on the basis of euros or U.S. dollars. Translation from one currency to another can affect return-on-investment ratios that are often used as performance measures. Magnum must also decide whether reported results should be adjusted to factor out those items over which Espelho’s managers had no control, such as the in" ated price paid for plastic parts imported from Magnum. There is no universally correct solution to the various is- sues that Magnum must address, and the company is likely to ! nd it necessary to make periodic adjustments to its evaluation process for foreign operations.

International Auditing The primary objective of Magnum’s performance evaluation system is to main- tain control over its decentralized operations. Another important component of the management control process is internal auditing. The internal auditor must (1) make sure that the company’s policies and procedures are being followed and (2) uncover errors, inef! ciencies, and, unfortunately, at times fraud. There are sev- eral issues that make the internal audit of a foreign operation more complicated than domestic audits.

Perhaps the most obvious obstacle to performing an effective internal audit is language. To be able to communicate with Espelho’s managers and employees— asking the questions that need to be asked and understanding the answers— Magnum’s internal auditors need to speak Portuguese. The auditors also need to be familiar with the local culture and customs, because these may affect the amount of work necessary in the audit. This familiarity can help to explain some of the behavior encountered and perhaps can be useful in planning the audit. Another important function of the internal auditor is to make sure that the com- pany is in compliance with the Foreign Corrupt Practices Act, which prohibits a U.S. company from paying bribes to foreign government of! cials to obtain busi- ness. Magnum needs to make sure that internal controls are in place to provide reasonable assurance that illegal payments are not made.

External auditors encounter the same problems as internal auditors in dealing with the foreign operations of their clients. External auditors with multinational company clients must have expertise in the various sets of ! nancial accounting

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Introduction to International Accounting 9

rules as well as the auditing standards in the various jurisdictions in which their clients operate. Magnum’s external auditors, for example, must be capable of ap- plying Portuguese auditing standards to attest that Espelho’s ! nancial statements present a true and fair view in accordance with Portuguese GAAP. In addition, they must apply U.S. auditing standards to verify that the reconciliation of Espelho’s ! nancial statements for consolidation purposes brings the ! nancial statements into compliance with U.S. GAAP.

As ! rms have become more multinational, so have their external auditors. Today, the Big Four international accounting ! rms are among the most multina- tional organizations in the world. Indeed, one of the Big Four accounting ! rms, KPMG, is the result of a merger of four different accounting ! rms that originated in four different countries (see Exhibit 1.2 ) and currently has of! ces in more than 150 jurisdictions around the world.

Cross-Listing on Foreign Stock Exchanges Magnum’s investment in Portugal turned out to be extremely pro! table, and over time the company established operations in other countries around the world. As each new country was added to the increasingly international company, Magnum had to address new problems associated with foreign GAAP conversion, foreign currency translation, international taxation and transfer pricing, and management control.

By the beginning of the 21st century, Magnum had become a truly global enterprise, with more than 10,000 employees spread across 16 different countries. Although the United States remained its major market, the company generated less than half of its revenues in its home country. Magnum eventually decided that in addition to its stock being listed on the New York Stock Exchange (NYSE), there would be advantages to having the stock listed and traded on several foreign stock exchanges. Most stock exchanges require companies to ! le an annual re- port and specify the accounting rules that must be followed in preparing ! nancial

EXHIBIT 1.2 The History of KPMG

Source: KPMG Campus, www.kpmgcampus.com/ kpmg-family/kpmg-history .shtml , accessed February 1, 2013.

KPMG was formed in 1987 through the merger of Peat Marwick International (PMI) and Klynveld Main Goerdeler (KMG). KPMG’s history can be traced through the names of its principal founding members—whose initials form the name “K.P.M.G.”

• K stands for Klynveld. Piet Klynveld founded the accounting fi rm Klynveld Kraayenhof & Co. in Amsterdam in 1917.

• P is for Peat. William Barclay Peat founded the accounting fi rm William Barclay Peat & Co. in London in 1870.

• M stands for Marwick. James Marwick founded the accounting fi rm Marwick, Mitchell & Co. with Roger Mitchell in New York City in 1897.

• G is for Goerdeler. Dr. Reinhard Goerdeler was for many years chairman of the German accounting fi rm Deutsche Treuhand-Gesellschaft.

In 1911, William Barclay Peat & Co. and Marwick Mitchell & Co. joined forces to form what would later be known as Peat Marwick International (PMI), a worldwide network of accounting and consulting fi rms.

In 1979, Klynveld joined forces with Deutsche Treuhand-Gesellschaft and the international professional services fi rm McLintock Main Lafrentz to form Klynveld Main Goerdeler (KMG).

In 1987, PMI and KMG and their member fi rms joined forces. Today, all member fi rms throughout the world carry the KPMG name exclusively or include it in their national fi rm names.

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10 Chapter One

statements. Regulations pertaining to foreign companies can differ from those for domestic companies. For example, in the United States, the Securities and Exchange Commission requires all U.S. companies to use U.S. GAAP in prepar- ing their ! nancial statements. Foreign companies listed on U.S. stock exchanges may use foreign GAAP in preparing their ! nancial statements but must provide a reconciliation of net income and stockholders’ equity to U.S. GAAP. In 2007 the U.S. Securities and Exchange Commission relaxed this requirement for those com- panies that use International Financial Reporting Standards to prepare ! nancial statements.

Many stock exchanges around the world now allow foreign companies to be listed on those exchanges by using standards developed by the International Ac- counting Standards Board (IASB). Magnum determined that by preparing a set of ! nancial statements based on the IASB’s International Financial Reporting Stan- dards (IFRS), it could gain access to most of the stock exchanges it might possibly want to, including London’s and Frankfurt’s. With the help of its external audit- ing ! rm, Magnum’s accountants developed a second set of ! nancial statements prepared in accordance with IFRS, and the company was able to obtain stock exchange listings in several foreign countries.

Global Accounting Standards Through their experiences in analyzing the ! nancial statements of potential ac- quisitions and in cross-listing the company’s stock, Magnum’s managers began to wonder whether the differences that exist in GAAP across countries were really nec- essary. There would be signi! cant advantages if all countries, including the United States, were to adopt a common set of accounting rules. In that case, Magnum could use one set of accounting standards as the local GAAP in each of the countries in which it has operations and thus avoid the GAAP conversion that it currently must perform in preparing consolidated ! nancial statements. A single set of accounting rules used worldwide also would signi! cantly reduce the problems the company had experienced over the years in evaluating foreign investment opportunities based on ! nancial statements prepared in compliance with a variety of local GAAP. Magnum Corporation became a strong proponent of global accounting standards.

THE GLOBAL ECONOMY

Although Magnum is a ! ctitious company, its evolution into a multinational cor- poration is not unrealistic. Most companies begin by selling their products in the domestic market. As foreign demand for the company’s product arises, this de- mand is met initially through making export sales. Exporting is the entry point for most companies into the world of international business.

International Trade International trade (imports and exports) constitutes a signi! cant portion of the world economy. In 2011, companies worldwide exported more than $18.3 trillion worth of merchandise. 5 The three largest exporters were China, the United States, and Germany, in that order. The United States, Germany, and China, in that order, were the three largest importers. Although international trade has existed for thousands of years, recent growth in trade has been phenomenal. Over the period

5 World Trade Organization, International Trade Statistics 2012, Table I.7, Leading Exporters and Importers in World Merchandise Trade, 2011.

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Introduction to International Accounting 11

1996–2011, U.S. exports increased from $625 billion to $1,480 billion per year, a 137 percent increase. During the same period, Chinese exports increased eightfold to $1,898 billion in 2011. Manufactured products account for 64.6 percent of world trade, followed by fuel and mining products (22.5 percent) and agricultural prod- ucts (9.3 percent). 6

The number of companies involved in trade also has grown substantially. The number of U.S. companies making export sales rose by 233 percent from 1987 to 1999, when the number stood at 231,420. 7 Boeing is a U.S.-based company with billions of dollars of annual export sales. In 2011, 49 percent of the company’s sales were outside of the United States. In addition, some of the company’s key suppli- ers and subcontractors are located in Europe and Japan. However, not only large companies are involved in exporting. Companies with fewer than 500 workers comprise more than 90 percent of U.S. exporters.

Foreign Direct Investment The product cycle theory suggests that, as time passes, exporters may feel the only way to retain their advantage over their competition in foreign markets is to produce locally, thereby reducing transportation costs. Companies often acquire existing operations in foreign countries as a way to establish a local production capability. Alternatively, companies can establish a local presence by founding a new company speci! cally tailored to the company’s needs. Sometimes this is done through a joint venture with a local partner.

The acquisition of existing foreign companies and the creation of new foreign subsidiaries are the two most common forms of what is known as foreign direct investment (FDI). The growth in FDI can be seen in Exhibit 1.3 . The tremendous increase in the " ow of FDI from 1990 to 2011 is partially attributable to the liberal- ization of investment laws in many countries speci! cally aimed at attracting FDI. Of 244 changes in national FDI laws in 2003, 220 were more favorable for foreign investors. 8

FDI plays a large and important role in the world economy. Global sales of for- eign af! liates were about 1.5 times as high as global exports in 2011, compared to almost parity in 1982. Global sales of foreign af! liates comprise about 40 percent of worldwide gross domestic product.

In 2011, there were 66 cross-border acquisitions of existing companies in which the purchase price exceeded $3 billion. The largest deal was the acquisition of International Power PLC, a British company, by GDF Suez SA, a French electric services ! rm, for a reported $25.1 billion. More than 15,000 FDI green! eld and expansion projects were announced in 2011. 9 The United States was the leading location of these projects, followed by China and the United Kingdom.

In" ows of FDI within the countries of the Organization for Economic Coop- eration and Development (OECD) reached a peak of $1.4 trillion in 2007, drop- ping to $849 billion in 2011. 10 The most popular locations for inbound FDI in 2011 among OECD countries were, in order of importance, the United States, Bel- gium, Australia, the United Kingdom, and France. The countries with the largest

6 Ibid., Table II.1, World Merchandise Exports by Major Product Group, 2011. 7 U.S. Department of Commerce, International Trade Administration, “Small and Medium-Sized Enterprises Play an Important Role,” Export America, September 2001, pp. 26–29. 8 United Nations, World Investment Report 2004, p. xvii. 9 United Nations, World Investment Report 2012 , Annex Tables I.7, I.8, and I.9. 10 Organization for Economic Cooperation and Development, “FDI in Figures,” October 2012, p. 2.

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12 Chapter One

dollar amounts of outbound FDI in 2011 were the United States, Japan, the United Kingdom, France, and Belgium.

The extent of foreign corporate presence in a country can be viewed by looking at the cumulative amount of inward FDI. Over the period 1990–2011, the United States received more FDI ($3.5 trillion) than any other OECD country. The United States also had the largest amount of outbound FDI ($4.5 trillion) during this period. 11

Multinational Corporations A multinational corporation is a company that is headquartered in one country but has operations in other countries. 12 In 2009, the United Nations estimated that there were more than 82,000 multinational companies in the world, with more than 810,000 foreign af! liates. 13 The 100 largest multinational companies accounted for approximately 4 percent of the world’s GDP. 14

Companies located in a relatively small number of countries conduct a large proportion of international trade and investment. These countries—collectively known as the triad—are the United States, Japan, and members of the European Union. As Exhibit 1.4 shows, 74 of the 100 largest companies in the world are located in the triad.

The largest companies are not necessarily the most multinational. Of the 500 largest companies in the United States in 2000, for example, 36 percent had no foreign operations. 15 In 2011 the United Nations measured the multinationality of companies by averaging three factors: the ratio of foreign sales to total sales, the ratio of foreign assets to total assets, and the ratio of foreign employees to total

EXHIBIT 1.3 Growth in Foreign Direct Investment, 1990–2011

Source: United Nations, World Investment Report 2012, Table I.8.

(Billions of dollars)

Item 1990

2005–2007 precrisis average 2009 2010 2011

FDI infl ows . . . . . . . . . . . . . . . . $ 207 $ 1,473 $ 1,198 $ 1,309 $ 1,524 FDI outfl ows . . . . . . . . . . . . . . . 241 1,501 1,175 1,451 1,694 FDI inward stock . . . . . . . . . . . . 1,081 14,588 18,041 19,907 20,438 FDI outward stock . . . . . . . . . . . 2,093 15,812 19,326 20,865 21,168 Sales of foreign affi liates . . . . . . 5,102 20,656 23,866 25,622 27,877 Total assets of foreign affi liates . . 4,599 43,623 74,910 75,609 82,131

Employment by foreign affi liates (thousands) . . . . . . . . . 21,458 51,593 59,877 63,903 69,065

11 United Nations, World Investment Report 2012 , Web Tables 3 and 4. 12 There is no universally accepted defi nition of a multinational corporation. The defi nition used here comes from Alan M. Rugman and Simon Collinson, International Business, 4th ed. (Essex, England: Pearson Education Limited, 2006), p. 5. Similarly, the United Nations defi nes multinational corporations as “enterprises which own or control production or service facilities outside the country in which they are based” (United Nations, Multinational Corporations in World Development, 1973, p. 23), and defi nes transnational corporations as “enterprises comprising parent companies and their foreign affi liates” (United Nations, World Investment Report 2001, p. 275). 13 United Nations, World Investment Report 2009, p. 17. 14 Ibid. 15 T. Doupnik and L. Seese, “Geographic Area Disclosures under SFAS 131: Materiality and Fineness,” Journal of International Accounting, Auditing & Taxation, 2001, pp. 117–38.

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Introduction to International Accounting 13

employees. Exhibit 1.5 lists the top 10 companies according to this measure. Nestlé SA was the most multinational company in the world, with more than 96 percent of its assets, sales, and employees located outside its home country of Switzerland. Sixty percent of the companies on this list come from Switzerland or the United Kingdom. The ! ve most multinational U.S. companies in 2011, in order, were Lib- erty Global Inc., AES Corporation, ExxonMobil, Schlumberger, and Kraft Foods.

Many companies have established a worldwide presence. Nike Inc., the world’s largest manufacturer of athletic footwear, apparel, and equipment, has branch of- ! ces and subsidiaries in 52 countries, sells products in more than 190 countries, and has more than 44,000 employees around the globe. Virtually all of Nike’s footwear and apparel products are manufactured outside of the United States. The company generates approximately 58 percent of its sales outside of North America. 16

EXHIBIT 1.4 Home Country of Largest 100 Companies by Sales

Source: Fortune, “The 2011 Global 500,” July 23, 2011.

United States ................................... 29 Other Japan ............................................... 12 China .............................................. 10

European Union Brazil .............................................. 2 Germany ......................................... 11 India ............................................... 2 France ............................................. 9 Korea .............................................. 2 Italy ................................................. 4 Russia ............................................. 2 Spain ............................................... 3 Switzerland ..................................... 2 United Kingdom .............................. 3 Malaysia ......................................... 1 Netherlands ..................................... 2 Mexico ............................................ 1 Luxembourg .................................... 1 Norway ........................................... 1 33 Thailand .......................................... 1 Taiwan ............................................ 1 Venezuela ....................................... 1 26

16 Nike Inc., 2011 Form 10-K, various pages.

EXHIBIT 1.5 The World’s Top 10 Non! nancial Companies in Terms of Multinationality, 2011

Source: United Nations, World Investment Report 2012, Web Table 28.

Corporation Country Industry MNI * Nestlé SA Switzerland Food, beverages, and tobacco 96.9 Anglo American Plc United Kingdom Mining and quarrying 93.9 Xstrata Plc Switzerland Mining and quarrying 93.5 Anheuser-Busch InBev NV Belgium Food, beverages, and tobacco 92.4 British American Tobacco Plc United Kingdom Food, beverages, and tobacco 91.7 Nokia OYJ Finland Electrical and electronic equipment 91.4 ABB Ltd. Switzerland Engineering services 91.2 ArcelorMittal Luxembourg Metal and metal products 90.5 Linde AG Germany Chemicals 90.2 Vodafone Group Plc United Kingdom Telecommunications 90.2

*Multinationality index (MNI) is calculated as the average of three ratios: foreign assets/total assets, foreign sales/total sales, and foreign employment/ total employment.

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14 Chapter One

Nokia, the Finnish cellular telephone manufacturer, has eight manufacturing facilities in seven different countries around the world, including Brazil, China, Hungary, and India. Because these subsidiaries are outside of the euro zone, Nokia must translate the ! nancial statements from these operations into euros for con- solidation purposes. Nokia’s management states that, from time to time, it uses forward contracts and foreign currency loans to hedge the foreign exchange risk created by foreign net investments. 17

International Capital Markets Many multinational corporations have found it necessary, for one reason or an- other, to have their stock cross-listed on foreign stock exchanges. Large companies in small countries, such as Finland’s Nokia, might ! nd this necessary to obtain suf! cient capital at a reasonable cost. Nokia’s shares are listed on the Helsinki, Stockholm, Frankfurt, and New York stock exchanges. Other companies obtain a listing on a foreign exchange to have an “acquisition currency” for acquiring ! rms in that country through stock swaps. Not long after obtaining a New York Stock Exchange (NYSE) listing, Germany’s Daimler-Benz acquired Chrysler in the United States through an exchange of shares.

As of December 31, 2012, there were 525 foreign companies from 46 countries cross-listed on the NYSE. 18 A signi! cant number of these companies were required to reconcile their local GAAP ! nancial statements to a U.S. GAAP basis.

Many U.S. companies are similarly cross-listed on non-U.S. stock exchanges. For example, more than 40 U.S. companies are listed on the London Stock Exchange, including Abbott Labs, Boeing, and P! zer. U.S. companies such as Caterpillar, DuPont, and Procter & Gamble are listed on NYSE Euronext.

OUTLINE OF THE BOOK

The evolution of the ! ctitious Magnum Corporation presented earlier in this chap- ter highlights many of the major accounting issues that a multinational corpora- tion must address and that form the focus for this book. The remainder of this book is organized as follows.

Chapters 2 and 3 focus on differences in ! nancial reporting across countries and the international convergence of accounting standards. Chapter 2 provides evidence of the diversity in ! nancial reporting that has existed internationally, ex- plores the reasons for that diversity, and describes the various attempts to classify countries by accounting system. Chapter 3 describes and evaluates the major ef- forts to converge accounting internationally. The most important player in the de- velopment of global ! nancial reporting standards is the International Accounting Standards Board (IASB). Chapter 3 describes the work of the IASB and introduces International Financial Reporting Standards (IFRS).

Chapters 4 and 5 describe and demonstrate the requirements of selected IASB standards through numerical examples. In addition to describing the guidance provided by IFRS, these chapters provide comparisons with U.S. GAAP to indi- cate the differences and similarities between the two sets of standards. Chapter 4 focuses on IFRS related to the recognition and measurement of assets, speci! - cally inventories; property, plant, and equipment; intangibles and goodwill; and

17 Nokia Corporation, 2012 Form 20-F, various pages. 18 New York Stock Exchange, NYSE Current List of All Non-U.S. Issuers as of December 31, 2012, accessed at www.nyse.com/pdfs/CurListofallStocks%2012-31-12.pdf on February 1, 2013.

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Introduction to International Accounting 15

leased assets. IFRS that deal exclusively with disclosure and presentation issues also are brie" y summarized. Chapter 5 covers IFRS related to current liabilities, provisions, employee bene! ts, share-based payment, income taxes, revenue, and ! nancial instruments.

Chapter 6 describes the accounting environment in ! ve economically signi! - cant countries—China, Germany, Japan, Mexico, and the United Kingdom—that are representative of major clusters of accounting systems. In this chapter, the latest developments in the accounting profession, accounting regulation, and ac- counting principles and practices in each of these countries are explained.

Chapters 7–9 focus on ! nancial reporting issues that are of international signi! - cance, either because they relate to international business operations or because there is considerable diversity in how they are handled worldwide. Chapters 7 and 8 deal with issues related to foreign currency translation. Chapter 7 covers the accounting for foreign currency transactions and hedging activities, and Chapter 8 demonstrates the translation of foreign currency ! nancial statements. Chapter 9 covers several other important ! nancial reporting issues, speci! cally in" ation accounting, business combinations and consolidated ! nancial statements, and segment reporting. This chapter focuses on IFRS related to these topics.

Chapter 10 introduces issues related to the analysis of foreign ! nancial state- ments and explores potential problems (and potential solutions) associated with using the ! nancial statements of foreign companies in decision making. This chap- ter also provides an example of how an analyst would reformat and restate ! nan- cial statements from one set of GAAP to another.

International taxation and international transfer pricing are covered in Chap- ters 11 and 12. Chapter 11 focuses on the taxation of foreign operation income by the home country government. Much of this chapter deals with foreign tax credits, the most important mechanism available to companies to reduce double taxation. Chapter 12 covers the topic of international transfer pricing, focusing on tax implications.

Strategic accounting issues of particular relevance to multinational corporations are covered in Chapter 13. This chapter covers multinational capital budgeting as a vital component of strategy formulation and operational budgeting as a key ingredient in strategy implementation. Chapter 13 also deals with issues that must be addressed in designing a process for evaluating the performance of foreign operations.

Chapter 14 covers comparative international auditing and corporate governance. This chapter discusses both external and internal auditing issues as they relate to corporate governance in an international context. Chapter 14 also describes interna- tional diversity in external auditing and the international harmonization of auditing standards. In addition to ! nancial reports, more than 1,000 multinational companies worldwide publish a separate sustainability report, which provides environmental, social responsibility, and related disclosures. Chapter 15 introduces corporate social responsibility (CSR) and sustainability reporting, and it explains the latest efforts at the international level, for example by the Global Reporting Initiative (GRI), to encourage companies to adopt CSR practices.

Summary 1. International accounting is an extremely broad topic. At a minimum, it focuses on the accounting issues unique to multinational corporations. At the other extreme, it includes the study of the various functional areas of accounting (! nancial, managerial, auditing, tax, information systems) in all countries of

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16 Chapter One

the world, as well as a comparison across countries. This book provides an overview of the broadly de! ned area of international accounting, with a focus on the accounting issues encountered by multinational companies engaged in international trade and making foreign direct investments.

2. The world economy is becoming increasingly more integrated. International trade (imports and exports) has grown substantially in recent years and is even becoming a normal part of business for relatively small companies. The number of U.S. exporting companies more than doubled in the 1990s.

3. The tremendous growth in foreign direct investment (FDI) over the last two decades is partially attributable to the liberalization of investment laws in many countries speci! cally aimed at attracting FDI. The aggregate revenues gener- ated by foreign operations outstrip the revenues generated through exporting by a two-to-one margin.

4. There are more than 82,000 multinational companies in the world, and their 810,000 foreign subsidiaries generate approximately 10 percent of global gross domestic product (GDP). A disproportionate number of multinational corpora- tions are headquartered in the triad: the United States, Japan, and the European Union.

5. The largest companies in the world are not necessarily the most multinational. Indeed, many large U.S. companies have no foreign operations. According to the United Nations, the two most multinational companies in the world in 2011 were headquartered in Switzerland and the United Kingdom.

6. In addition to establishing operations overseas, many companies also cross-list their shares on stock exchanges outside of their home country. There are a num- ber of reasons for doing this, including gaining access to a larger pool of capital.

7. The remainder of this book consists of 14 chapters. Nine chapters (Chapters 2–10) deal primarily with ! nancial accounting and reporting issues, including the analysis of foreign ! nancial statements. Chapters 11 and 12 focus on interna- tional taxation and transfer pricing. Chapter 13 deals with the management accounting issues relevant to multinational corporations in formulating and implementing strategy. Chapter 14 covers comparative international auditing and corporate governance. The ! nal chapter, Chapter 15, provides an introduc- tion to social responsibility reporting at the international level.

Questions 1. How important is international trade (imports and exports) to the world economy?

2. What accounting issues arise for a company as a result of engaging in interna- tional trade (imports and exports)?

3. Why might a company be interested in investing in an operation in a foreign country (foreign direct investment)?

4. How important is foreign direct investment to the world economy? 5. What ! nancial reporting issues arise as a result of making a foreign direct

investment? 6. What taxation issues arise as a result of making a foreign direct investment? 7. What are some of the issues that arise in evaluating and maintaining control

over foreign operations?

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8. Why might a company want its stock listed on a stock exchange outside of its home country?

9. Where might one ! nd information that could be used to measure the “multi- nationality” of a company?

10. What would be the advantages of having a single set of accounting standards used worldwide?

Exercises and Problems

1. Sony Corporation reported the following in the summary of Signi! cant Accounting Policies included in the company’s 2012 annual report on Form 20-F (p. F-16):

Translation of Foreign Currencies

All asset and liability accounts of foreign subsidiaries and af! liates are translated into Japanese yen at appropriate ! scal year end current exchange rates and all income and expense accounts are translated at exchange rates that approximate those rates prevailing at the time of the transactions. The resulting translation adjustments are accumulated as a component of accumulated other comprehensive income.

Receivables and payables denominated in foreign currency are translated at appro- priate ! scal year end exchange rates and the resulting translation gains or losses are taken into income.

Required: Explain in your own words the policies that Sony uses in re" ecting in the ! - nancial statements the impact of changes in foreign exchange rates.

2. Sony Corporation reported the following in the Notes to Consolidated Finan- cial Statements included in the company’s 2012 annual report on Form 20-F (p. F-49):

Foreign Exchange Forward Contracts and Foreign Currency Option Contracts

Foreign exchange forward contracts and purchased and written foreign currency option contracts are utilized primarily to limit the exposure affected by changes in foreign cur- rency exchange rates on cash " ows generated by anticipated intercompany transactions and intercompany accounts receivable and payable denominated in foreign currencies.

Sony also enters into foreign exchange forward contracts, which effectively ! x the cash " ows from foreign currency denominated debt.

Required: Explain in your own words why Sony has entered into foreign exchange for- ward contracts and foreign currency option contracts.

3. Cooper Grant is the president of Acme Brush of Brazil, the wholly owned Brazilian subsidiary of U.S.-based Acme Brush Inc. Cooper Grant’s compensa- tion package consists of a combination of salary and bonus. His annual bonus is calculated as a predetermined percentage of the pre-tax annual income earned by Acme Brush of Brazil. A condensed income statement for Acme Brush of Brazil for the most recent year is as follows (amounts in thousands of Brazilian reals [BRL]):

Sales . . . . . . . . . . . . . . . . . . . . . BRL 10,000 Expenses . . . . . . . . . . . . . . . . . . 9,500 Pre-tax income . . . . . . . . . . . . . . BRL 500

Introduction to International Accounting 17

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After translating the Brazilian real income statement into U.S. dollars, the con- densed income statement for Acme Brush of Brazil appears as follows (amounts in thousands of U.S. dollars [US$]):

Sales . . . . . . . . . . . . . . . . . . . . . . . . US$3,000 Expenses . . . . . . . . . . . . . . . . . . . . . 3,300 Pre-tax income (loss) . . . . . . . . . . . . US$ (300)

Required: a. Explain how Acme Brush of Brazil’s pretax income (in BRL) became a U.S.-

dollar pretax loss. b. Discuss whether Cooper Grant should be paid a bonus or not.

4. The New York Stock Exchange (NYSE) provides a list of non-U.S. companies listed on the exchange on its Web site ( www.nyse.com ). (Hint: Search the Inter- net for “NYSE List of Non-U.S. Listed Issuers.”)

Required: a. Determine the number of foreign companies listed on the NYSE and the

number of countries they represent. b. Determine the ! ve countries with the largest number of foreign companies

listed on the NYSE. c. Speculate as to why non-U.S. companies have gone to the effort to have their

shares listed on the NYSE.

5. The London Stock Exchange (LSE) provides a list of companies listed on the exchange on its Web site ( www.londonstockexchange.com ) under “Statistics” and “List of Companies.”

Required: a. Determine the number of foreign companies listed on the LSE and the num-

ber of countries they represent. b. Determine the number of companies listed on the LSE from these countries:

Australia, Brazil, Canada, France, Germany, Mexico, and the United States. Speculate as to why there are more companies listed on the LSE from Austra- lia and Canada than from France and Germany.

6. Astra Zeneca PLC, based in the United Kingdom, and Abbott Laboratories, based in the United States, are two of the largest pharmaceutical ! rms in the world. The following information was provided in each company’s 2012 annual report.

ASTRAZENECA 2012 Annual Report

(£ in millions) Revenues Noncurrent Assets

United Kingdom £ 8,782 £ 2,743 Continental Europe 11,264 3,673 The Americas 15,822 25,767 Asia, Africa, Australasia 6,534 803 £42,402 £32,986

18 Chapter One

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Case 1-1

Besserbrau AG Besserbrau AG is a German beer producer headquartered in Ergersheim, Bavaria. The company, which was founded in 1842 by brothers Hans and Franz Besser, is publicly traded, with shares listed on the Frankfurt Stock Exchange. Manufactur- ing in strict accordance with the almost 500-year-old German Beer Purity Law, Besserbrau uses only four ingredients in making its products: malt, hops, yeast, and water. While the other ingredients are obtained locally, Besserbrau imports hops from a company located in the Czech Republic. Czech hops are considered to be among the world’s ! nest. Historically, Besserbrau’s products were marketed exclusively in Germany. To take advantage of a potentially enormous market for its products and expand sales, Besserbrau began making sales in the People’s Republic of China three years ago. The company established a wholly owned sub- sidiary in China (BB Pijio) to handle the distribution of Besserbrau products in that country. In the most recent year, sales to BB Pijio accounted for 20 percent of Besserbrau’s sales, and BB Pijio’s sales to customers in China accounted for 10 per- cent of the Besserbrau Group’s total pro! ts. In fact, sales of Besserbrau products in China have expanded so rapidly and the potential for continued sales growth is so great that the company recently broke ground on the construction of a brewery in Shanghai, China. To ! nance construction of the new facility, Besserbrau negotiated a listing of its shares on the London Stock Exchange to facilitate an initial public offering of new shares of stock.

Required: Discuss the various international accounting issues confronted by Besserbrau AG.

ABBOTT LABORATORIES 2012 Annual Report

($ in millions) Net Sales to External

Customers Long-Term Assets

United States $16,784 $15,244 Japan 2,441 1,169 Germany 1,740 6,173 The Netherlands 1,883 532 Italy 1,127 222 Canada 1,253 352 France 1,167 220 Spain 942 314 United Kingdom 1,049 1,345 India 933 3,467 All Other Countries 10,555 6,874 Consolidated $39,874 $35,912

Required: Calculate an index of multinationality based upon the geographical distribu- tion of Sales and Assets (employee information is not available) to determine which of these two companies is more multinational.

Introduction to International Accounting 19

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20 Chapter One

Case 1-2

Vanguard International Growth Fund The Vanguard Group is an investment ! rm with more than 50 different mutual funds in which the public may invest. Among these funds are 13 international funds that concentrate on investments in non-U.S. stocks and bonds. One of these is the International Growth Fund. The following information about this fund was provided in the fund’s prospectus, dated December 27, 2012.

VANGUARD INTERNATIONAL GROWTH FUND

Excerpts from Prospectus December 27, 2012

Vanguard Fund Summary

Investment Objective

The Fund seeks to provide long-term capital appreciation.

Primary Investment Strategies

The Fund invests predominantly in the stocks of companies located outside the United States and is expected to diversify its assets across developed and emerging markets in Europe, the Far East, and Latin America. In selecting stocks, the Fund’s advisors evaluate foreign markets around the world and choose large-, mid-, and small-capitalization companies considered to have above-average growth potential. The Fund uses multiple investment advisors.

Market Exposure

The Fund invests mainly in common stocks of non-U.S. companies that are considered to have above- average potential for growth. The asset-weighted median market capitalization of the Fund as of August 31, 2012, was $32 billion. The Fund is subject to investment style risk, which is the chance that returns from non-U.S. growth stocks and, to the extent that the Fund is invested in them, small- and mid-cap stocks, will trail returns from the overall domestic stock market. Historically, small- and mid-cap stocks have been more volatile in price than the large-cap stocks that dominate the overall market, and they often perform quite differently. The Fund is subject to stock market risk, which is the chance that stock prices overall will decline. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices. In addition, investments in foreign stock markets can be riskier than U.S. stock investments. The prices of foreign stocks and the prices of U.S. stocks have, at times, moved in opposite directions. The Fund is subject to country/regional risk and currency risk. Country/regional risk is the chance that world events—such as political upheaval, fi nancial troubles, or natural disasters—will adversely affect the value of securities issued by companies in foreign countries or regions. Because the Fund may invest a large portion of its assets in securities of companies located in any one country or region, including emerging markets, the Fund’s performance may be hurt disproportionately by the poor performance of its investments in that area. Currency risk is the chance that the value of a foreign investment, measured in U.S. dollars, will decrease because of unfavorable changes in currency exchange rates. Country/regional risk and currency risk are especially high in emerging markets. The Fund is subject to manager risk, which is the chance that poor security selection or focus on securities in a particular sector, category, or group of companies will cause the Fund to underperform relevant benchmarks or other funds with a similar investment objective.

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Introduction to International Accounting 21

The International Growth Fund’s annual report for the year ended August 31, 2012, indicated that 97 percent of the fund’s portfolio was invested in 186 non-U.S. stocks and 3 percent was in temporary cash investments. The allocation of fund net assets by region was as follows: Europe 55 percent, Paci! c 17 percent, Emerg- ing Markets 23 percent, North America 4 percent, and Middle East 1 percent. The sectors and individual countries in which the fund was invested are presented in the following tables:

PLAIN TALK ABOUT International Investing

U.S. investors who invest abroad will encounter risks not typically associated with U.S. companies, because foreign stock and bond markets operate differently from the U.S. markets. For instance, foreign companies are not subject to the same accounting, auditing, and fi nancial-reporting standards and practices as U.S. companies, and their stocks may not be as liquid as those of similar U.S. fi rms. In addition, foreign stock exchanges, brokers, and companies generally have less government supervision and regulation than their counterparts in the United States. These factors, among others, could negatively affect the returns U.S. investors receive from foreign investments.

Market Diversifi cation (% of equity exposure)

Europe Pacifi c United Kingdom . . . . 20.0% Japan . . . . . . . . . . . 8.9% Switzerland . . . . . . . . 7.8 Australia . . . . . . . . 4.3 France . . . . . . . . . . . . 7.6 Hong Kong . . . . . . 3.4 Germany . . . . . . . . . . 5.6 Other . . . . . . . . . . . 0.4 Sweden . . . . . . . . . . . 4.7     Subtotal . . . . . . . 17.0% Spain . . . . . . . . . . . . . 2.9 Emerging Markets Denmark . . . . . . . . . . 1.6 China . . . . . . . . . . . 8.1% Norway . . . . . . . . . . . 1.4 Brazil . . . . . . . . . . . 5.3 Italy . . . . . . . . . . . . . . 1.3 South Korea . . . . . . 3.7 Other . . . . . . . . . . . . . 2.0 India . . . . . . . . . . . 1.4     Subtotal . . . . . . . . . 54.9% Turkey . . . . . . . . . . 1.2 Other . . . . . . . . . . . 3.3     Subtotal . . . . . . . 23.0% North America Canada . . . . . . . . . 2.3% United States . . . . . 1.5    Subtotal . . . . . . . 3.8% Middle East     Israel . . . . . . . . . 1.3%

Source: Annual report, p. 14.

Source: Vanguard International Growth Fund Prospectus, pp. 1–13.

Sector Diversifi cation (% of equity exposure)

Consumer discretionary . . . . . . . . . . . . 16.6% Consumer staples . . . . . . . . . . . . . . . . 10.4 Energy . . . . . . . . . . . . . . . . . . . . . . . . . 6.6 Financials . . . . . . . . . . . . . . . . . . . . . . . 19.6 Health care . . . . . . . . . . . . . . . . . . . . . 7.5 Industrials . . . . . . . . . . . . . . . . . . . . . . 14.1 Information technology . . . . . . . . . . . . 13.1 Materials . . . . . . . . . . . . . . . . . . . . . . . 9.2 Telecommunication services . . . . . . . . . 2.0 Utilities . . . . . . . . . . . . . . . . . . . . . . . . 0.9

Source: Annual report, p. 13.

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22 Chapter One

Required: 1. Explain why an individual investor might want to invest in an international

growth fund. 2. Describe the risks associated with making an investment in an international

growth fund. Identify the risks that would be common to domestic and interna- tional funds, and those risks that would be unique to an international fund.

3. Discuss how the fact that foreign companies are not subject to the same account- ing, auditing, and ! nancial reporting standards and practices as U.S. compa- nies poses a risk not typically encountered when investing in the stock of U.S. companies.

4. Consider the allocation of fund assets by region. Speculate as to why the pro- portions of fund assets are distributed in this manner.

5. Consider the country diversi! cation of fund assets. Identify the countries in which the fund is most heavily invested. Speculate as to why this might be the case. Are there any countries in which you would have expected the fund to be more heavily invested than it is? Are there any countries in which you would have expected the fund to be invested and it is not?

6. Consider the sector diversi! cation of fund assets. Identify the sectors in which the fund is most heavily invested. Speculate as to why this might be the case.

References Do upnik , T. , and L. Seese . “Geographic Area Disclosures under SFAS 131: Materi- ality and Fineness.” Journal of International Accounting, Auditing & Taxation 2001, pp. 117–38 .

Kubin, Konrad. Preface, International Accounting Bibliography 1982–1994. Sarasota, FL: International Accounting Section of the American Accounting Association, 1997 .

Organization for Economic Cooperation and Development. “Trends and Recent Developments in Foreign Direct Investment.” International Investment Perspec- tives, 2006 .

Rugman , Alan M. , and Simon Collinson. International Business, 4th ed. Essex, England: Pearson Education Limited, 2006 .

“The 2009 Global 500.” Fortune, July 20, 2009 . United Nations. Multinational Corporations in World Development, 1973 . ———. World Investment Report 2004 . ———. World Investment Report 2001 . ———. World Investment Report 2009 . ———. World Investment Report 2012 . U.S. Department of Commerce. “Small and Medium-Sized Enterprises Play an

Important Role.” Export America, September 2001 . World Trade Organization. International Trade Statistics 2012 .

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23

Chapter Two

Worldwide Accounting Diversity Learning Objectives

After reading this chapter, you should be able to

• Provide evidence of the diversity that exists in accounting internationally. • Explain the problems caused by accounting diversity. • Describe the major environmental factors that infl uence national accounting

systems and lead to accounting diversity. • Describe a judgmental classifi cation of countries by fi nancial reporting system. • Discuss the infl uence that culture is thought to have on fi nancial reporting. • Describe a simplifi ed model of the reasons for international differences in fi nancial

reporting. • Categorize accounting differences internationally and provide examples of each

type of difference.

INTRODUCTION

Considerable differences exist across countries in the accounting treatment of many items. For example, companies in the United States are not allowed to report property, plant, and equipment at amounts greater than historical cost. In contrast, companies in the European Union are allowed to report their assets on the balance sheet at market values. Research and development costs must be expensed as incurred in Japan, but development costs may be capitalized as an asset in Canada and France. Chinese companies are required to use the direct method in preparing the statement of cash ! ows, whereas most companies in the United States and Europe use the indirect method.

Differences in accounting can result in signi" cantly different amounts being re- ported on the balance sheet and income statement. In its 2009 annual report, the South Korean telecommunications " rm SK Telecom Company Ltd. described 15 signi" cant differences between South Korean and U.S. accounting rules. Under South Korean generally accepted accounting principles (GAAP), SK Telecom re- ported 2009 net income of 1,056 billion South Korean won (KRW). If SK Telecom had used U.S. GAAP in 2009, its net income would have been KRW 1,357 bil- lion, approximately 28 percent larger. 1 Shareholders’ equity as stated under South

1 The largest adjustments related to “retroactive application of equity method on business combination” and the recognition of gains on “currency and interest rate swap.”

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24 Chapter Two

Korean GAAP was KRW 12,345 billion but would have been KRW 14,261 billion under U.S. GAAP, a 16 percent difference. Braskem SA, a Brazilian chemical com- pany, made 13 adjustments in 2009 to its Brazilian GAAP net income to report net income on a U.S. GAAP basis. These adjustments caused Brazilian GAAP income of 767.8 million Brazilian reais (BRL) to decrease by 70 percent, to 232.7 million reais under U.S. GAAP. Similarly, stockholders’ equity of BRL 4,592.5 million on a Brazilian GAAP basis decreased to only BRL 4,379.4 million under U.S. GAAP. 2

This chapter presents evidence of accounting diversity, explores the reasons for that diversity, and describes the problems that are created by differences in ac- counting practice across countries. Historically, several major models of account- ing have been used internationally, with clusters of countries following them. These also are described and compared in this chapter. We describe the poten- tial impact that culture has had on the development of national accounting sys- tems and present a simpli" ed model of the reasons for international differences in " nancial reporting.

The " nal section of this chapter uses excerpts from annual reports to present ad- ditional examples of some of the differences in accounting that exist across coun- tries. It should be noted that much of the accounting diversity that existed in the past has been eliminated as countries have abandoned their local GAAP in favor of International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB). This chapter provides a historical perspec- tive on accounting diversity that should allow readers to more fully appreciate the harmonization and convergence efforts described in the next chapter.

EVIDENCE OF ACCOUNTING DIVERSITY

Exhibits 2.1 and 2.2 present consolidated balance sheets for the British company Vodafone Group PLC and its U.S. competitor Verizon Communications Inc. A quick examination of these statements shows several differences in format and ter- minology between the United Kingdom and the United States. Perhaps the most obvious difference is the order in which assets are presented. Whereas Verizon presents assets in order of liquidity, beginning with cash and cash equivalents, Vodafone presents assets in reverse order of liquidity, starting with goodwill. On the other side of the balance sheet, Vodafone presents its equity accounts before liabilities. In the equity section, “Called-up share capital” is the equivalent of the common stock account on a U.S. balance sheet, and “Share premium account” is the contributed capital in excess of par value. Vodafone uses a “Capital redemp- tion reserve” to indicate an appropriation of retained earnings. Reserves are un- known in the United States. Vodafone includes “Provisions,” which represent estimated liabilities related to restructurings, legal disputes, and asset retirements, in both current and noncurrent liabilities. This line item does not appear in the U.S. balance sheet.

Common for U.S. companies, Verizon includes only consolidated " nancial statements in its annual report. In addition to consolidated " nancial statements, Vodafone also includes the parent company’s separate balance sheet in its an- nual report. This is shown in Exhibit 2.3 . In the parent company balance sheet, investments in subsidiaries are not consolidated, but instead are reported as

2 The largest difference in stockholders’ equity stems from a difference in the accounting treatment for distributions to shareholders.

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Worldwide Accounting Diversity 25

VODAFONE GROUP PLC Consolidated Balance Sheets

Consolidated Balance Sheet at 31 March

2009 2008 Note £m £m

Noncurrent assets Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 53,958 51,336 Other intangible assets. . . . . . . . . . . . . . . . . . . . . . . . . . 9 20,980 18,995 Property, plant and equipment . . . . . . . . . . . . . . . . . . . . 11 19,250 16,735 Investments in associated undertakings . . . . . . . . . . . . . 14 34,715 22,545 Other investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 7,060 7,367 Deferred tax assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 630 436 Postemployment benefi ts. . . . . . . . . . . . . . . . . . . . . . . . 26 8 65 Trade and other receivables . . . . . . . . . . . . . . . . . . . . . . 17 3,069 1,067 139,670 118,546 Current assets Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 412 417 Taxation recoverable . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 57 Trade and other receivables . . . . . . . . . . . . . . . . . . . . . . 17 7,662 6,551 Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . 18 4,878 1,699 13,029 8,724 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152,699 127,270

Equity Called-up share capital. . . . . . . . . . . . . . . . . . . . . . . . . . 19 4,153 4,182 Share premium account . . . . . . . . . . . . . . . . . . . . . . . . . 21 43,008 42,934 Own shares held . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 (8,036) (7,856) Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . 21 100,239 100,151 Capital redemption reserve . . . . . . . . . . . . . . . . . . . . . . 21 10,101 10,054 Accumulated other recognised income and expense . . . 22 20,517 10,558 Retained losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 (83,820) (81,980) Total equity shareholders’ funds . . . . . . . . . . . . . . . . 86,162 78,043 Minority interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,787 1,168 Written put options over minority interests. . . . . . . . . . . (3,172) (2,740) Total minority interests . . . . . . . . . . . . . . . . . . . . . . . (1,385) (1,572) Total equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84,777 76,471 Noncurrent liabilities Long-term borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . 25 31,749 22,662 Deferred tax liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . 6 6,642 5,109 Postemployment benefi ts. . . . . . . . . . . . . . . . . . . . . . . . 26 240 104 Provisions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 533 306 Trade and other payables . . . . . . . . . . . . . . . . . . . . . . . . 28 811 645 39,975 28,826 Current liabilities Short-term borrowings. . . . . . . . . . . . . . . . . . . . . . . . . . 25, 35 9,624 4,532 Current taxation liabilities . . . . . . . . . . . . . . . . . . . . . . . 4,552 5,123 Provisions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 373 356 Trade and other payables . . . . . . . . . . . . . . . . . . . . . . . . 28 13,398 11,962 27,947 21,973 Total equity and liabilities . . . . . . . . . . . . . . . . . . . . . 152,699 127,270

EXHIBIT 2.1

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26 Chapter Two

EXHIBIT 2.2 VERIZON COMMUNICATIONS, INC.

Consolidated Balance Sheets

At December 31 (Dollars in Millions, Except per Share Amounts) . . . . . . . . . . . . . . . . . . . . . . . 2009 2008 Assets Current assets Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,009 $ 9,782 Short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 490 509 Accounts receivable, net of allowances of $976 and $941 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,573 11,703 Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,289 2,092 Prepaid expenses and other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,247 1,989

Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,608 26,075

Plant, property, and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228,518 215,605 Less accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137,052 129,059 91,466 86,546 Investments in unconsolidated businesses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,535 3,393 Wireless licenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72,067 61,974 Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,472 6,035 Other intangible assets, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,764 5,199 Other investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — 4,781 Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,339 8,349

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $227,251 $202,352

Liabilities and Shareowners’ Investment Current liabilities Debt maturing within one year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,205 $ 4,993 Accounts payable and accrued liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,223 13,814 Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,708 7,099

Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29,136 25,906 Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,051 46,959 Employee benefi t obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,622 32,512 Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,310 11,769 Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,765 6,301 Equity Series preferred stock ($.10 par value; none issued) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — — Common stock ($.10 par value; 2,967,610,119 shares issued in both periods) . . . . . . . . . . . . . 297 297 Contributed capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,108 40,291 Reinvested earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,592 19,250 Accumulated other comprehensive loss (11,479) (13,372) Common stock in treasury, at cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (5,000) (4,839) Deferred compensation—employee stock ownership plans and other . . . . . . . . . . . . . . . . . . . 88 79 Noncontrolling interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,761 37,199

Total equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84,367 78,905

Total liabilities and equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $227,251 $202,352

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Worldwide Accounting Diversity 27

“Shares in group undertakings” in the “Fixed assets” section. Liabilities are called “Creditors,” and receivables are “Debtors.” From the perspective of U.S. " nancial reporting, the UK parent company balance sheet has an unusual structure. Rather than the U.S. norm of Assets 5 Liabilities 1 Shareholders’ equity, Vodafone’s parent company balance sheet is presented as Assets − Liabilities 5 Shareholders’ equity. Closer inspection shows that the balance sheet presents the left-hand side of the equa- tion as Noncurrent assets 1 Net current assets (or Working capital) − Noncurrent liabilities 5 Shareholders’ equity.

All of these super" cial differences would probably cause a " nancial analyst little problem in analyzing the company’s " nancial statements. More important than the format and terminology differences are the differences in recognition and measurement rules employed to value assets and liabilities and to calculate in- come. As was noted in the introduction to this chapter, very different amounts of net income and stockholders’ equity can be reported by a company depending on the accounting rules that it uses. For example, SK Telecom’s 2009 net income was 28 percent larger under U.S. GAAP than under South Korean GAAP; Braskem’s 2009 net income was 70 percent smaller under U.S. GAAP than under Brazilian GAAP.

VODAFONE GROUP PLC Company Balance Sheets

Company Balance Sheet at 31 March

2009 2008 Note £m £m

Fixed assets

Shares in group undertakings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 64,937 64,922

Current assets

Debtors: amounts falling due after more than one year . . . . . . . . . 4 2,352 821

Debtors: amounts falling due within one year . . . . . . . . . . . . . . . . 4 126,334 126,099

128,797 126,920

Cash at bank and in hand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111 —

Creditors: amounts falling due within one year . . . . . . . . . . . 5 (92,339) (98,784)

Net current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,458 28,136

Total assets less current liabilities . . . . . . . . . . . . . . . . . . . . . . . 101,395 93,058

Creditors: amounts falling due after more than one year . . . . 5 (21,970) (14,582)

79,425 78,476

Capital and reserves

Called-up share capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 4,153 4,182

Share premium account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 43,008 42,934

Capital redemption reserve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 10,101 10,054

Capital reserve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 88 88

Other reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 957 942

Own shares held . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 (8,053) (7,867)

Profi t and loss account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 29,171 28,143

Equity shareholders’ funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79,425 78,476

EXHIBIT 2.3

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28 Chapter Two

REASONS FOR ACCOUNTING DIVERSITY

Why do " nancial reporting practices differ across countries? Accounting schol- ars have hypothesized numerous in! uences on a country’s accounting system, including factors as varied as the nature of the political system, the stage of eco- nomic development, and the state of accounting education and research. A survey of the relevant literature has identi" ed the following " ve items as being commonly accepted as factors in! uencing a country’s " nancial reporting practices: (1) legal system, (2) taxation, (3) providers of " nancing, (4) in! ation, and (5) political and economic ties. 3

Legal System There are two major types of legal systems used around the world: common law and codi" ed Roman law. Common law began in England and is primarily found in the English-speaking countries of the world. Common law countries rely on a limited amount of statute law, which is then interpreted by the courts. Court decisions establish precedents, thereby developing case law that supplements the statutes. A system of code law, followed in most non-English-speaking countries, originated in the Roman jus civile and was developed further in European univer- sities during the Middle Ages. Code law countries tend to have relatively more statute or codi" ed law governing a wider range of human activity.

What does a country’s legal system have to do with accounting? Code law countries generally have corporation law (sometimes called a commercial code or companies act) that establishes the basic legal parameters governing business enterprises. The corporation law often stipulates which " nancial statements must be published in accordance with a prescribed format. Additional accounting mea- surement and disclosure rules are included in an accounting law debated and passed by the national legislature. In countries where accounting rules are legis- lated, the accounting profession tends to have little in! uence on the development of accounting standards. In countries with a tradition of common law, although a corporation law laying the basic framework for accounting might exist (such as in the United Kingdom), speci" c accounting rules are established by the profession or by an independent nongovernmental body representing a variety of constitu- encies. Thus, the type of legal system in a country tends to determine whether the primary source of accounting rules is the government or a nongovernmental organization.

In code law countries, the accounting law tends to be rather general, does not provide much detail regarding speci" c accounting practices, and may provide no guidance at all in certain areas. Germany is a good example of this type of coun- try. The German accounting law passed in 1985 is only 47 pages long and is silent with regard to issues such as leases, foreign currency translation, and cash ! ow statements. 4 When no guidance is provided in the law, German companies refer to other sources, including tax law, opinions of the German auditing profession, and standards issued by the German Accounting Standards Committee, to decide how to do their accounting. Interestingly enough, important sources of accounting practice in Germany have been textbooks and commentaries written by account- ing academicians.

3 Gary K. Meek and Sharokh M. Saudagaran, “A Survey of Research on Financial Reporting in a Transna- tional Context,” Journal of Accounting Literature, 1990, pp. 145–82. 4 Jermyn Paul Brooks and Dietz Mertin, Neues Deutsches Bilanzrecht (Düsseldorf: IDW-Verlag, 1986).

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Worldwide Accounting Diversity 29

In common law countries, where there is likely to be a nonlegislative organiza- tion developing accounting standards, much more detailed rules are developed. The extreme case might be the Financial Accounting Standards Board (FASB) in the United States, which provides a substantial amount of implementation guid- ance in its accounting standards codi" cation (ASC) and updates and has been accused of producing a “standards overload.”

To illustrate this point, consider the rules related to accounting for leases es- tablished by the FASB in the United States and in German accounting law. In the United States, leases must be capitalized if any one of four very speci" c criteria is met. Additional guidance establishes rules for speci" c situations, such as sales with leasebacks, sales-type leases of real estate, and changes in leases resulting from refundings of tax-exempt debt. In contrast, the German accounting law is si- lent with regard to leases. The only guidance in the law can be found in paragraph 285, which simply states that all liabilities must be recorded. 5

Taxation In some countries, published " nancial statements form the basis for taxation, whereas in other countries, " nancial statements are adjusted for tax purposes and submitted to the government separately from the reports sent to stockholders. Continuing to focus on Germany, the so-called congruency principle (Massgeblich- keitsprinzip) in that country stipulates that the published " nancial statements serve as the basis for taxable income. 6 In most cases, for an expense to be deductible for tax purposes, it must also be used in the calculation of " nancial statement income. Well-managed German companies attempt to minimize income for tax purposes, for example, through the use of accelerated depreciation, so as to reduce their tax liability. As a result of the congruency principle, accelerated depreciation must also be taken in the calculation of accounting income.

In the United States, in contrast, conformity between the tax statement and the " nancial statements is required only with regard to the use of the last-in, " rst-out (LIFO) inventory cost ! ow assumption. U.S. companies are allowed to use acceler- ated depreciation for tax purposes and straight-line depreciation in the " nancial statements. All else being equal, because of the in! uence of the congruency prin- ciple, a German company is likely to report lower income than its U.S. counterpart.

The difference between tax and accounting income gives rise to the necessity to account for deferred income taxes, a major issue in the United States in recent years. Deferred income taxes are much less of an issue in Germany; for many German companies, they do not exist at all. This is also true in other code law countries such as France and Japan.

Providers of Financing The major providers of " nancing for business enterprises are family members, banks, governments, and shareholders. In those countries in which company " nancing is dominated by families, banks, or the state, there will be less pressure for public accountability and information disclosure. Banks and the state will often

5 In compliance with European Union regulations, Germany requires publicly traded companies to use International Financial Reporting Standards (IFRS) to prepare their consolidated fi nancial statements. German accounting law continues to be used by privately held companies and by publicly traded companies in preparing parent company fi nancial statements. 6 German taxable income is computed by comparing an opening and closing tax balance sheet, the Steuerbilanz. The tax balance sheet is based on the published balance sheet, the Handelsbilanz.

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30 Chapter Two

be represented on the board of directors and will therefore be able to obtain infor- mation necessary for decision making from inside the company. As companies become more dependent on " nancing from the general populace through the pub- lic offering of shares of stock, the demand for more information made available outside the company becomes greater. It simply is not feasible for the company to allow the hundreds, thousands, or hundreds of thousands of shareholders access to internal accounting records. The information needs of those " nancial statement users can be satis" ed only through extensive disclosures in accounting reports.

There can also be a difference in " nancial statement orientation, with stockhold- ers being more interested in pro" t (emphasis on the income statement) and banks more interested in solvency and liquidity (emphasis on the balance sheet). Bankers tend to prefer companies to practice rather conservative accounting with regard to assets and liabilities.

Infl ation Countries experiencing chronic high rates of in! ation have found it necessary to adopt accounting rules that required the in! ation adjustment of historical cost amounts. This has been especially true in Latin America, which as a region has had more in! ation than any other part of the world. For example, throughout the 1980s and 1990s, the average annual rate of in! ation rate in Mexico was approximately 50 percent, with a high of 159 percent in 1987. 7 Double- and triple-digit in! ation rates render historical costs meaningless. Throughout most of the latter half of the 20th century, this factor primarily distinguished Latin America from the rest of the world with regard to accounting. 8 However, in! ation has been successfully brought under control in most countries, and this factor is no longer as important in explaining accounting diversity as it once was.

Adjusting accounting records for in! ation results in a write-up of assets and therefore related depreciation and amortization expenses. Adjusting income for in! ation is especially important in those countries in which accounting state- ments serve as the basis for taxation; otherwise, companies will be paying taxes on " ctitious pro" ts.

Political and Economic Ties Accounting is a technology that can be relatively easily borrowed from or imposed on another country. Through political and economic links, accounting rules have been conveyed from one country to another. For example, through previous colo- nialism, both England and France have transferred their accounting frameworks to a variety of countries around the world. British-style accounting systems can be found in countries as far-! ung as Australia and Zimbabwe. French accounting is prevalent in the former French colonies of western Africa. More recently, it is thought that economic ties with the United States have had an impact on account- ing in Canada, Mexico, and Israel.

Correlation of Factors Whether by coincidence or not, there is a high degree of correlation between legal system, tax conformity, and source of " nancing. As Exhibit 2.4 shows, common law countries tend to have greater numbers of domestic listed companies, relying more heavily on equity as a source of capital. Code law countries tend to link taxa- tion to accounting statements and rely less on " nancing provided by shareholders.

7 Joseph B. Lipscomb and Harold Hunt, “Mexican Mortgages: Structure and Default Incentives, Historical Simulation 1982–1998,” Journal of Housing Research 10, no. 2 (1999), pp. 235–65. 8 Mexico continued its use of infl ation accounting until 2007.

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Worldwide Accounting Diversity 31

PROBLEMS CAUSED BY ACCOUNTING DIVERSITY

Preparation of Consolidated Financial Statements The diversity in accounting practice across countries causes problems that can be quite serious for some parties. One problem relates to the preparation of consoli- dated " nancial statements by companies with foreign operations. Consider Gen- eral Motors Corporation, which has subsidiaries in more than 50 countries around the world. Each subsidiary incorporated in the country in which it is located is required to prepare " nancial statements in accordance with local regulations. These regulations usually require companies to keep books in local currency using local accounting principles. Thus, General Motors de Mexico prepares " nancial statements in Mexican pesos using Mexican accounting rules, and General Motors Japan Ltd. prepares " nancial statements in Japanese yen using Japanese standards. To prepare consolidated " nancial statements in the United States, in addition to translating the foreign currency " nancial statements into U.S. dollars, the parent company must also convert the " nancial statements of its foreign operations into U.S. GAAP. Either each foreign operation must maintain two sets of books prepared in accordance with both local and U.S. GAAP or, as is more common, reconciliations from local GAAP to U.S. GAAP must be made at the balance sheet date. In either case, considerable effort and cost are involved; company personnel must develop an expertise in more than one country’s accounting standards.

Access to Foreign Capital Markets A second problem caused by accounting diversity relates to companies gain- ing access to foreign capital markets. If a company desires to obtain capital by selling stock or borrowing money in a foreign country, it might be required to present a set of " nancial statements prepared in accordance with the accounting standards in the country in which the capital is being obtained. Consider the case of the semiconductor manufacturer STMicroelectronics, which is based in Geneva, Switzerland. The equity market in Switzerland is so small (there are fewer than 8 million Swiss) and ST’s capital needs are so great that the company has found it necessary to have its common shares listed on the Euronext-Paris and Borsa Italiana stock exchanges in Europe and on the New York Stock Exchange (NYSE) in the United States. To have stock traded in the United States, foreign companies must either prepare " nancial statements using U.S. accounting standards or provide a reconciliation of local GAAP net income and stockholders’ equity to U.S. GAAP.

EXHIBIT 2.4 Relationship between Several Factors In! uencing Accounting Diversity

Sources: Number of domes- tic listed companies obtained from World Federation of Exchanges (2009), www .world-exchanges.org . Country populations obtained from CIA World Fact Book (2010).

Domestic Listed Companies

Country Legal System Number Per Million of

Population Tax

Conformity Italy Code    296 5.1 Yes Germany Code    783 9.5 Yes Japan Code 2,335 18.4 Yes United Kingdom Common 2,792 45.6 No   Australia Common 1,966 91.4 No   Canada Common 3,700 109.6 No  

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32 Chapter Two

This can be quite costly. In preparing for a New York Stock Exchange listing in 1993, the German automaker Daimler-Benz estimated it spent $60 million to ini- tially prepare U.S. GAAP " nancial statements; it expected to spend $15 million to $20 million each year thereafter. 9 The appendix to this chapter describes the case of Daimler-Benz in becoming the " rst German company to list on the NYSE. As noted in Chapter 1, the U.S. SEC eliminated the U.S. GAAP reconciliation requirement for those foreign companies using IFRS to prepare their " nancial statements. However, foreign companies not using IFRS continue to need to provide U.S. GAAP information.

Comparability of Financial Statements A third problem relates to the lack of comparability of " nancial statements be- tween companies from different countries. This can signi" cantly affect the analy- sis of foreign " nancial statements for making investment and lending decisions. In 2003 alone, U.S. investors bought and sold nearly $3 trillion worth of foreign stocks, while foreign investors traded over $6 trillion in U.S. equity securities. 10 In recent years there has been an explosion in mutual funds that invest in the stock of foreign companies. As an example, the number of international stock funds in- creased from 123 in 1989 to 534 by the end of 1995. 11 T. Rowe Price’s New Asia Fund, for example, invests exclusively in stocks and bonds of companies located in Asian countries other than Japan. The job of deciding which foreign companies to invest in is complicated by the fact that foreign companies use accounting rules different from those used in the United States, and that those rules differ from country to country. It is very dif" cult if not impossible for a potential investor to directly compare the " nancial position and performance of an automobile manu- facturer in Germany (Volkswagen), Japan (Nissan), and the United States (Ford) because these three countries have different " nancial accounting and reporting standards. According to Ralph E. Walters, former chairman of the steering com- mittee of the International Accounting Standards Committee, “either international investors have to be extremely knowledgeable about multiple reporting methods or they have to be willing to take greater risk.” 12

A lack of comparability of " nancial statements also can have an adverse effect on corporations when making foreign acquisition decisions. As a case in point, consider the experience of foreign investors in Eastern Europe. After the fall of the Berlin Wall in 1989, Western companies were invited to acquire newly privatized companies in Poland, Hungary, and other countries in the former communist bloc. The concepts of pro" t and accounting for assets in those countries under com- munism were so different from accounting practice in the West that most Western investors found " nancial statements useless in helping to determine which enter- prises were the most attractive acquisition targets. In many cases, the international public accounting " rms were called on to convert " nancial statements to a Western basis before acquisition of a company could be seriously considered.

9 Allan B. Afterman, International Accounting, Financial Reporting, and Analysis (New York: Warren, Gorham & Lamont, 1995), pp. C1–17, C1–22. 10 U.S. Department of Commerce, Bureau of Economic Analysis, “U.S. International Transactions,” Survey of Current Business, January 2005, pp. 45–76, Table 7a. 11 James L. Cochrane, James E. Shapiro, and Jean E. Tobin, “Foreign Equities and U.S. Investors: Breaking Down the Barriers Separating Supply and Demand,” NYSE Working Paper 95–04, 1995. 12 Stephen H. Collins, “The Move to Globalization,” Journal of Accountancy, March 1989, p. 82.

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Worldwide Accounting Diversity 33

There was a very good reason why accounting in the communist countries of Eastern Europe and the Soviet Union was so much different from accounting in capitalist countries. Financial statements were not prepared for the bene" t of investors and creditors to be used in making investment and lending decisions. Instead, " nancial statements were prepared to provide the government with in- formation to determine whether the central economic plan was being ful" lled. Financial statements prepared for central planning purposes have limited value in making investment decisions.

Lack of High-Quality Accounting Information A fourth problem associated with accounting diversity is the lack of high-quality accounting standards in some parts of the world. There is general agreement that the failure of many banks in the 1997 East Asian " nancial crisis was due to three factors: a highly leveraged corporate sector, the private sector’s reliance on foreign currency debt, and a lack of accounting transparency. 13 To be sure, inadequate dis- closure did not create the East Asian meltdown, but it did contribute to the depth and breadth of the crisis. As Rahman explains: “It is a known fact that the very threat of disclosure in! uences behavior and improves management, particularly risk management. It seems that the lack of appropriate disclosure requirements indirectly contributed to the de" cient internal controls and imprudent risk man- agement practices of the corporations and banks in the crisis-hit countries.” 14 In- ternational investors and creditors were unable to adequately assess risk because " nancial statements did not re! ect the extent of risk exposure due to the following disclosure de" ciencies:

• The actual magnitude of debt was hidden by undisclosed related-party transac- tions and off-balance-sheet " nancing.

• High levels of exposure to foreign exchange risk were not evident. • Information on the extent to which investments and loans were made in highly

speculative assets (such as real estate) was not available. • Contingent liabilities for guaranteeing loans, often foreign currency loans, were

not reported. • Appropriate disclosures regarding loan loss provisions were not made.

Because of the problems associated with worldwide accounting diversity, attempts to reduce the accounting differences across countries have been ongoing for over three decades. This process is known as harmonization. The ultimate goal of harmonization is to have one set of international accounting standards that are followed by all companies around the world. Harmonization is the major topic of Chapter 3.

ACCOUNTING CLUSTERS

Given the discussion regarding factors in! uencing accounting practice worldwide, it should not be surprising to learn that there are clusters of countries that share a common accounting orientation and practices. One classi" cation scheme identi" es three major accounting models: the Fair Presentation/Full Disclosure Model, the

13 M. Zubaidur Rahman, “The Role of Accounting in the East Asian Financial Crisis: Lessons Learned?,” Transnational Corporations 7, no. 3 (December 1998), pp. 1–52. 14 Ibid., p. 7.

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34 Chapter Two

Legal Compliance Model, and the In! ation-Adjusted Model. 15 The Fair Presenta- tion/Full Disclosure Model (also known as the Anglo-Saxon or Anglo-American model) is used to describe the approach used in the United Kingdom and the United States, where accounting is oriented toward the decision needs of large numbers of investors and creditors. This model is used in most English-speaking countries and other countries heavily in! uenced by the United Kingdom or the United States. Most of these countries follow a common law legal system. The Legal Compliance Model originated in the code law countries of Continental Europe; it is also known as the Continental European model. It is used by most of Europe, Japan, and other code law countries. Companies in this group usually are tied quite closely to banks that serve as the primary suppliers of " nancing. Because these are code law coun- tries, accounting is legalistic and is designed to provide information for taxation or government-planning purposes. The In! ation-Adjusted Model was found primar- ily in South America. It resembles the Continental European model in its legalistic, tax, and government-planning orientation. It distinguishes itself, however, through the extensive use of adjustments for in! ation.

A Judgmental Classifi cation of Financial Reporting Systems Concentrating on the Anglo-Saxon and Continental European model countries, Nobes developed a more re" ned classi" cation scheme that attempts to show how the " nancial reporting systems in 14 developed countries relate to one another. 16 Exhibit 2.5 presents an adaptation of Nobes’s classi" cation.

EXHIBIT 2.5 Nobes’s Judgmental Classi" cation of Financial Reporting Systems Source: Christopher W. Nobes, “A Judgemental International Classi" cation of Financial Reporting Practices,” Journal of Business Finance and Accounting, Spring 1983, p. 7.

Class

Macro-uniform

Developed Western countries

Micro-based

Law-based

Tax-based

U.S. influence

Canada United States

Ireland United Kingdom New Zealand Australia

UK influence

Subclass

Government, economics

Continental: government, tax, legal

Business practice, pragmatic, British origin

Business economics, theory

Netherlands

Sweden

Japan Germany

Spain Belgium France Italy

Family Species

15 Helen Gernon and Gary Meek, Accounting: An International Perspective, 5th ed. (Burr Ridge, IL: Irwin/ McGraw-Hill, 2001), pp. 10–11. 16 Christopher W. Nobes, “A Judgemental International Classifi cation of Financial Reporting Practices,” Journal of Business Finance and Accounting, Spring 1983.

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Worldwide Accounting Diversity 35

The terms micro-based and macro-uniform describe the Anglo-Saxon and Con- tinental European models, respectively. Each of these classes is divided into two subclasses that are further divided into families. Within the micro-based class of accounting systems, there is a subclass heavily in! uenced by business econom- ics and accounting theory. The Netherlands is the only country in this subclass. One manifestation of the in! uence of theory is that Dutch companies may use current replacement cost accounting to value assets in their primary " nancial statements. The other micro-based subclass, of British origin, is more pragmatic and is oriented toward business practice, relying less on economic theory in the development of accounting rules. The British-origin subclass is further split into two families, one dominated by the United Kingdom and one dominated by the United States. Nobes does not indicate how these two families differ.

On the macro-uniform side of the classi" cation, a “government, economics” subclass has only one country, Sweden. Swedish accounting distinguishes itself from the other macro-uniform countries in being closely aligned with national eco- nomic policies. For example, income smoothing is allowed to promote economic stability, and social accounting has developed to meet macroeconomic concerns. The “continental: government, tax, legal” subclass primarily has Continental European countries. This subclass is further divided into two families. Led by Germany, the law-based family includes Japan. The tax-based family consists of several Romance-language countries. The major difference between these families is that the accounting law is the primary determinant of accounting practice in Germany, whereas the tax law dominates in the Southern European countries.

The importance of this hierarchical model is that it shows the comparative dis- tances between countries and could be used as a blueprint for determining where " nancial statement comparability is likely to be greater. For example, comparisons of " nancial statements between the United States and Canada (which are in the same family) are likely to be more valid than comparisons between the United States and the United Kingdom (which are not in the same family). However, the United States and the United Kingdom (which are in the same subclass) are more comparable than are the United States and the Netherlands (which are in different subclasses). Finally, comparisons between the United States and the Netherlands (which are in the same class) might be more meaningful than comparisons between the United States and any of the macro-uniform countries.

AN EMPIRICAL TEST OF THE JUDGMENTAL CLASSIFICATION

The judgmental classi" cation in Exhibit 2.5 was empirically tested in 1990. 17 Data gathered on 100 " nancial reporting practices in 50 countries (including the 14 countries in Exhibit 2.5 ) were analyzed using the statistical procedure of hierar- chical cluster analysis. The signi" cant clusters arising from the statistical analysis are in Exhibit 2.6 . Clusters are analogous to the families in Nobes’s classi" cation.

The results reported in Exhibit 2.6 clearly indicate the existence of two signi" - cantly different classes of accounting systems being used across these countries and are generally consistent with the classes, subclasses, and families of Nobes’s classi- " cation. The major deviations from Nobes’s classi" cation are that the Netherlands

17 Timothy S. Doupnik and Stephen B. Salter, “An Empirical Test of a Judgemental International Classifi cation of Financial Reporting Practices,” Journal of International Business Studies , First Quarter 1993, pp. 41–60.

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36 Chapter Two

is located in the UK-in! uence cluster (Cluster 1) rather than in a subclass by itself; Japanese accounting (Cluster 9) is not as similar to German accounting (Cluster 8) as hypothesized; and Belgium (located in Cluster 6) is not in the group with France, Spain, and Italy (Cluster 5). Indeed, there appears to be more diversity among the macro countries (as evidenced by the greater number of clusters) than among the countries comprising the micro class.

The large size of the UK-in! uence cluster (Cluster 1) shows the in! uence of British colonialism on accounting development. In contrast, Cluster 2, which in- cludes the United States, is quite small. The emergence of Cluster 4, which includes several Latin American countries, is evidence of the importance of in! ation as a factor affecting accounting practice.

The two classes of accounting re! ected in Exhibit 2.6 differ signi" cantly on 66 of the 100 " nancial reporting practices examined. Differences exist for 41 of the 56 disclosure practices studied. In all but one case, the micro class of countries pro- vided a higher level of disclosure than the macro class of countries. There were also signi" cant differences for 25 of the 44 practices examined affecting income mea- surement. Of particular importance is the item asking whether accounting practice adhered to tax requirements. The mean level of agreement with this statement among macro countries was 72 percent, whereas it was only 45 percent among micro countries. To summarize, companies in the micro-based countries provide more extensive disclosure than do companies in the macro-uniform countries, and companies in the macro countries are more heavily in! uenced by taxation than are companies in the micro countries. These results are consistent with the relative importance of equity " nance and the relatively weak link between accounting and taxation in the micro countries.

EXHIBIT 2.6 Results of Hierarchical Cluster Analysis on 100 Financial Reporting Practices in 1990

Source: Timothy S. Doupnik and Stephen B. Salter, “An Empirical Test of a Judgemental International Classi" cation of Financial Reporting Practices,” Journal of International Business Studies, First Quarter 1993, p. 53.

Cluster 1

Australia Botswana Hong Kong Ireland Jamaica Luxembourg Malaysia Namibia Netherlands Netherlands Antilles Nigeria New Zealand Philippines Papua New Guinea South Africa Singapore Sri Lanka Taiwan Trinidad and Tobago United Kingdom Zambia Zimbabwe

Micro Class Macro Class

Cluster 2

Bermuda Canada Israel United States

Cluster 3

Costa Rica

Cluster 4

Argentina Brazil Chile Mexico

Cluster 5

Colombia Denmark France Italy Norway Portugal Spain

Cluster 6

Belgium Egypt Liberia Panama Saudi Arabia Thailand United Arab Emirates

Cluster 7

Finland Sweden

Cluster 8

Germany

Cluster 9

Japan

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Worldwide Accounting Diversity 37

THE INFLUENCE OF CULTURE ON FINANCIAL REPORTING

In addition to economic and institutional determinants, national culture has long been considered a factor that affects the accounting system of a country. 18

Hofstede’s Cultural Dimensions Using responses to an attitude survey of IBM employees worldwide, Hofstede identi" ed four cultural dimensions that can be used to describe general similari- ties and differences in cultures around the world: (1) individualism, (2) power distance, (3) uncertainty avoidance, and (4) masculinity. 19 More recently, a " fth di- mension, long-term orientation, was identi" ed. Individualism refers to a preference for a loosely knit social fabric rather than a tightly knit social fabric (collectivism). Power distance refers to the extent to which hierarchy and unequal power distribu- tion in institutions and organizations are accepted. Uncertainty avoidance refers to the degree to which individuals feel uncomfortable with uncertainty and ambi- guity. Masculinity refers to an emphasis on traditional masculine values of per- formance and achievement rather than feminine values of relationships, caring, and nurturing. Long-term orientation stands for the “fostering of virtues oriented towards future rewards, in particular perseverance and thrift.” 20

Gray’s Accounting Values From a review of accounting literature and practice, Gray identi" ed four widely recognized accounting values that can be used to de" ne a country’s accounting sub- culture: professionalism, uniformity, conservatism, and secrecy. 21 Gray describes these accounting values as follows: 22

Professionalism versus Statutory Control —a preference for the exercise of individual professional judgment and the maintenance of professional self- regulation as opposed to compliance with prescriptive legal requirements and statutory control. Uniformity versus Flexibility —a preference for the enforcement of uniform accounting practices between companies and for the consistent use of such practices over time as opposed to ! exibility in accordance with the perceived circumstances of individual companies. Conservatism versus Optimism —a preference for a cautious approach to measurement so as to cope with the uncertainty of future events as opposed to a more optimistic, laissez-faire, risk-taking approach. Secrecy versus Transparency —a preference for con" dentiality and the restriction of disclosure of information about the business only to those who are closely involved with its management and " nancing as opposed to a more transpar- ent, open, and publicly accountable approach.

18 One of the fi rst to argue that accounting is determined by culture was W. J. Violet in “The Develop- ment of International Accounting Standards: An Anthropological Perspective,” International Journal of Accounting , 1983, pp. 1–12. 19 G. Hofstede, Culture’s Consequences: International Differences in Work-Related Values (London: Sage, 1980). 20 G. Hofstede, Culture’s Consequences: Comparing Values, Behaviors, Institutions, and Organizations across Nations , 2nd ed. (Thousand Oaks, CA: Sage, 2001), p. 359. 21 S. J. Gray, “Towards a Theory of Cultural Infl uence on the Development of Accounting Systems Internationally,” Abacus , March 1988, pp. 1–15. 22 Ibid., p. 8.

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38 Chapter Two

Gray argues that national cultural values affect accounting values, as shown in Exhibit 2.7 . The accounting values of conservatism and secrecy have the greatest relevance for the information content of a set of " nancial statements. The rela- tionship between culture and each of these two accounting values is explained as follows:

Conservatism can be linked perhaps most closely with the uncertainty-avoidance dimension and the short-term versus long-term orientations. A preference for more conservative measures of pro" ts and assets is consistent with strong uncertainty avoidance following from a concern with security and a perceived need to adopt a cautious approach to cope with uncertainty of future events. A less conservative approach to measurement is also consistent with a short-term orientation where quick results are expected and hence a more optimistic approach is adopted relative to conserving resources and investing for long-term trends. There also seems to be a link, if less strong, between high levels of individualism and masculinity, on the one hand, and weak uncertainty avoidance on the other, to the extent that an emphasis on individual achievement and performance is likely to foster a less conservative approach to measurement. 23

A preference for secrecy is consistent with strong uncertainty avoidance following from a need to restrict information disclosures so as to avoid con! ict and competi- tion and to preserve security. . . . [H]igh power-distance societies are likely to be characterized by the restriction of information to preserve power inequalities. Secrecy is also consistent with a preference for collectivism, as opposed to individu- alism, in that its concern is for the interests of those closely involved with the " rm rather than external parties. A long-term orientation also suggests a preference for secrecy that is consistent with the need to conserve resources within the " rm and ensure that funds are available for investment relative to the demands of sharehold- ers and employees for higher payments. A signi" cant but possibly less important link with masculinity also seems likely to the extent that in societies where there is more emphasis on achievement and material success there will be a greater ten- dency to publicize such achievements and material success. 24

Gray extended Hofstede’s model of cultural patterns to develop a framework that identi" es the mechanism through which culture in! uences the development of corporate reporting systems on a national level. According to this framework (shown in Exhibit 2.8 ), the particular way in which a country’s accounting system

Accounting Values Cultural Dimension Professionalism Uniformity Conservatism Secrecy Power distance Neg. Pos. n/a   Pos. Uncertainty avoidance Neg. Pos. Pos. Pos. Individualism Pos. Neg. Neg. Neg. Masculinity Pos. n/a   Neg. Neg. Long-term orientation Neg. n/a   Pos. Pos.

Pos. 5 Positive relationship hypothesized between cultural dimension and accounting value. Neg. 5 Negative relationship hypothesized between cultural dimension and accounting value. n/a 5 No relationship hypothesized.

EXHIBIT 2.7 Relationships between Accounting Values and Cultural Dimensions

Source: Lee H. Radebaugh and Sidney J. Gray, Inter- national Accounting and Multinational Enterprises, 5th ed. (New York: Wiley, 2002), p. 49.

23 Lee H. Radebaugh and Sidney J. Gray, International Accounting and Multinational Enterprises, 5th ed. (New York: Wiley, 2001), p. 47. 24 Ibid., p. 48.

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Worldwide Accounting Diversity 39

develops is in! uenced by accountants’ accounting values and by the country’s institutional framework, both of which are in! uenced by cultural values. Thus, culture is viewed as affecting accounting systems indirectly in two ways: through its in! uence on accounting values and through its institutional consequences.

Using measures of each of the cultural values for a group of 40 countries, Hofstede classi" ed countries into 10 different cultural areas. The Anglo cultural area, for example, is characterized by high individualism, low uncertainty avoidance, low power distance, and moderate masculinity. Given this pattern of cultural values, Gray hypothesized that Anglo countries (which include Australia, Canada, New Zealand, the United States, and the United Kingdom) would rank relatively low on the accounting values of conservatism and secrecy (or high on optimism and high on transparency). Exhibiting the opposite pattern of cultural values, the countries of the less developed Latin cultural area (which includes countries like Colombia and Mexico) are expected to rank relatively high in conservatism and secrecy. On a scale of 1 (low secrecy) to 7 (high secrecy) and a scale of 1 (low conservatism) to 5 (high conservatism), the different cultural areas were ranked as follows:

Cultural Area Secrecy Conservatism

Anglo 1 1 Nordic 2 2 Asian-Colonial 2 3 African 3 4 More developed Latin 3 5 Less developed Asian 4 4 Japan 5 5 Near Eastern 5 5 Germanic 6 4 Less developed Latin 7 5

These rankings show the strong positive relationship expected to exist between secrecy and conservatism. Countries that require limited disclosures in " nancial statements (high secrecy) are expected to more strictly adhere to the notion of con- servatism (high conservatism) in the measurement of assets and liabilities.

A number of studies have empirically examined the relationship between Hofstede’s cultural values and national accounting systems. 25 Although the results of this research are mixed, most studies " nd a relationship between cultural val- ues and disclosure consistent with Gray’s hypothesis. However, these studies are unable to determine whether culture in! uences disclosure through its effect on accounting values or through its effect on institutional consequences. Research results on the relationship between culture and conservatism are less conclusive.

Religion and Accounting Religion plays an important role in de" ning national culture in many parts of the world and can have a signi" cant effect on business practice. Under Islam, for example, the Koran provides guidance with respect to issues such as making charitable contributions and charging interest on loans. In some Islamic countries,

25 For a comprehensive review of this literature, see T. S. Doupnik and G. T. Tsakumis, “A Review of Empirical Tests of Gray’s Framework and Suggestions for Future Research,” Journal of Accounting Literature, 2004, pp. 1–48.

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40 Chapter Two

banking companies operate under Shariah, the Islamic law of human conduct de- rived from the Koran. Because traditional accounting rules do not cover many of the transactions carried out by Islamic " nancial institutions (IFIs), the Account- ing and Auditing Organization for Islamic Financial Institutions (AAOIFI), a standard-setting body based in Bahrain, has been active in developing and pro- moting Islamic accounting standards.

Based on the AAOIFI’s work, the Malaysian Accounting Standards Board (MASB) developed MASB i-1, Presentation of Financial Statements of Islamic Financial Institutions, in 2001. MASB i-1 states:

The general purpose of " nancial statements is to provide information about the " nancial position, performance and cash ! ows of IFIs, which are useful to a wide range of users in making economic decisions. It also portrays aspects of the manage- ment’s stewardship of the resources entrusted to it. All this information, along with other information in the notes to " nancial statements, allows users in assessing the degree of compliance of the IFIs with the prescribed Shariah requirements (para. 10).

In developing MASB i-1, the MASB consulted with the Malaysian Central Bank’s National Shariah Council on issues relating to Shariah. In April 2004, the MASB announced that it would introduce four new Islamic accounting standards related to ijarah (leasing), zakat (income tax), takaful (insurance), and mudarabah (deferred payments).

EXHIBIT 2.8 Framework for the Development of Accounting Systems Source: Adapted from S. J. Gray, “Towards a Theory of Cultural In! uence on the Development of Accounting Systems Internationally,” Abacus, March 1988, p. 7.

Institutional Consequences Legal system Corporate ownership Capital markets Professional associations Education Religion

Cultural Dimensions Individualism Power distance Uncertainty avoidance Masculinity

Ecological Influences Geographic Demographic Genetic/hygienic Historical Technological Urbanization

External Influences Forces of nature Trade Investment Conquest

Accounting Values Professionalism Uniformity Conservatism Secrecy

Accounting Systems Authority Enforcement Measurement Disclosure

Reinforcement

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Worldwide Accounting Diversity 41

A SIMPLIFIED MODEL OF THE REASONS FOR INTERNATIONAL DIFFERENCES IN FINANCIAL REPORTING

Sifting through the many reasons that have been hypothesized to affect interna- tional differences in " nancial reporting, Nobes developed a model with two ex- planatory factors: culture and the nature of the " nancing system. 26 Nobes argues that the major reason for international differences in " nancial reporting is different purposes for that reporting. A country’s " nancing system is seen as the most rele- vant factor in determining the purpose of " nancial reporting. Speci" cally, whether or not a country has a strong equity " nancing system with large numbers of out- side shareholders will determine the nature of " nancial reporting in a country.

Nobes divides " nancial reporting systems into two classes, labeled A and B. Class A accounting systems are found in countries with strong equity–outside shareholder " nancing. In Class A accounting systems, measurement practices are less conservative, disclosure is extensive, and accounting practice differs from tax rules. Class A corresponds to what may be called Anglo-Saxon accounting. Class B accounting systems are found in countries with weak equity–outside shareholder " nancing systems. Measurement is more conservative, disclosure is not as exten- sive, and accounting practice more closely follows tax rules. Class B corresponds to Continental European accounting.

Nobes posits that culture, including institutional structures, determines the na- ture of a country’s " nancing system. Although not explicitly de" ned, Nobes’s no- tion of culture appears to go beyond the rather narrow de" nition used in Gray’s framework, which relies on Hofstede’s cultural dimensions. Nobes assumes (with- out explaining how) that some cultures lead to strong equity-outsider " nancing systems and other cultures lead to weak equity-outsider " nancing systems. His simpli" ed model of reasons for international accounting differences is as follows:

26 Christopher W. Nobes, “Towards a General Model of the Reasons for International Differences in Financial Reporting,” Abacus , September 1998, p. 166.

Strength of equity- outsider financing system

Culture, including institutional structures

External environment

Class of accounting

Class A Accounting for outside shareholders

Strong equity- outsider financing

Self-sufficient Type 1 culture

Class of AccountingType of Financing SystemNature of Culture

Class B Accounting for tax and creditors

Weak equity- outsider financing

Self-sufficient Type 2 culture

Most countries in the developed world have a self-suf" cient culture. For these countries, Nobes applies his model as follows:

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42 Chapter Two

Many countries in the developing world are culturally dominated by another country, often as a result of European colonialism. Nobes argues that culturally dominated countries use the accounting system of their dominating country regardless of the nature of the equity " nancing system. Thus, countries with a Type 1 culture as well as countries historically dominated by a Type 1 country use Class A accounting systems.

Examples of Countries with Class A Accounting The United Kingdom is a culturally self-suf" cient Type 1 country with a strong equity-outsider system. It has an outside shareholder–oriented Class A account- ing system. New Zealand is culturally dominated by the United Kingdom. It also has a strong equity-outsider " nancing system, probably because of the in! uence of British culture. New Zealand also has a Class A accounting system. According to Nobes’s model, this can be the result of New Zealand’s being culturally domi- nated by the United Kingdom (a Type 1 culture country), having a strong equity- outsider " nancing system, or both. The African nation of Malawi has a weak equity-outsider " nancing system, but as a former British colony (culturally domi- nated by the United Kingdom), it has adopted a Class A accounting system even though it has a weak equity-outsider " nancing system.

Nobes further suggests that as the " nancing system in a country evolves from weak equity to strong equity, the accounting system will also evolve in the direc- tion of Class A accounting. He cites China as an example. Finally, Nobes argues that companies with strong equity-outsider " nancing will attempt to use Class A accounting even if they are located in a Class B accounting system country. He cites the German " rms Deutsche Bank and Bayer and the Swiss company Nestlé as examples.

Recent Changes in Europe The simpli" ed model developed by Nobes appears to explain accounting develop- ments that occurred in Europe over the past three decades. Because of the desire for companies to be competitive in attracting international equity investment, sev- eral European countries (with Class B accounting systems) developed a two-tiered " nancial reporting system in the late 1990s. Austria, France, Germany, Italy, and Switzerland gave stock-exchange-listed companies the option to use International Financial Reporting Standards (IFRS), a Class A accounting system, in preparing their consolidated " nancial statements. 27 The parent company statements, which serve as the basis for taxation, continued to be prepared using local accounting rules. Large numbers of German and Swiss companies (including Deutsche Bank, Bayer, and Nestlé), in particular, availed themselves of this opportunity to use IFRS.

This desire for companies to be competitive in the international capital market ultimately led the European Commission in 2005 to require all publicly traded companies within the European Union to use IFRS in preparing consolidated " nancial statements. Thus, it is no longer appropriate to think in terms of all German (or all French, all Italian, etc.) companies following the traditional Conti- nental European model of accounting. Publicly traded companies in the EU now use a set of accounting standards based upon the Anglo-Saxon model of account- ing in preparing their consolidated statements. However, in most cases, privately held companies in the EU continue to use local GAAP, as do public companies in

27 International Financial Reporting Standards are issued by the International Accounting Standards Board and are discussed in more detail in Chapters 4 and 5.

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Worldwide Accounting Diversity 43

preparing parent company " nancial statements. In these countries, accountants need to develop an expertise in both local GAAP and IFRS; the vast majority of companies, which are not publicly traded, continue to use local GAAP.

FURTHER EVIDENCE OF ACCOUNTING DIVERSITY

In the remainder of this chapter, we provide additional evidence of some of the differences in accounting that exist across countries. We categorize accounting dif- ferences in the following manner and provide examples of each of these types of difference:

1. Differences in the " nancial statements included in an annual report. 2. Differences in the format used to present individual " nancial statements. 3. Differences in the level of detail provided in the " nancial statements. 4. Terminology differences. 5. Disclosure differences. 6. Recognition and measurement differences.

We illustrate these differences by considering a typical set of U.S. " nancial state- ments as a point of reference.

Financial Statements U.S. companies are required to include a balance sheet, income statement, and statement of cash ! ows in a set of " nancial statements. In addition, schedules ex- plaining the changes in retained earnings and accumulated other comprehensive income must be presented. Many U.S. companies provide this information in a separate statement of stockholders’ equity.

Virtually all companies worldwide provide a balance sheet and an income state- ment in a set of " nancial statements. Although this is not universal, most countries now also require presentation of a statement of cash ! ows. Mexico, for example, implemented such a requirement in 2008. In addition to a balance sheet, income statement, and statement of cash ! ows, the Austrian " rm Strabag SE includes a statement of changes in " xed assets as one of its primary " nancial statements. This statement provides detail on the change during the year in the historical cost of noncurrent intangible assets, tangible assets, and investment property. A state- ment of changes in noncurrent assets often also is found in " nancial statements prepared by German companies.

Format of Financial Statements U.S. companies list assets and liabilities on the balance sheet in order of liquidity, from most liquid (cash) to least liquid (often intangible assets). The same is true in Canada, Mexico, and Japan. Companies in many other countries (including most of Europe) list assets and liabilities in reverse order of liquidity. An example was presented in Exhibit 2.1 for a British company.

In the income statement format commonly used by U.S. companies, sales reve- nue and cost of goods sold are generally reported as separate line items, the differ- ence being gross pro" t. Cost of goods sold includes manufacturing costs (materials, labor, and overhead) related to those items sold during the year. In addition to cost of goods sold, selling expense, administrative expense, research and development costs, and other operating expenses are subtracted to calculate operating income. Each of these line items includes costs related to materials (including supplies),

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44 Chapter Two

labor, and overhead. Callaway Golf Company’s income statement, presented in Exhibit 2.9, illustrates the format typically used by U.S.-based companies.

In contrast to the operational format income statement commonly found in the United States, many European companies present their income statement using a type of expenditure format. An example is presented in Exhibit 2.10 for Südzucker AG, a German sugar manufacturer. Rather than presenting cost of goods sold as a single line item, Südzucker presents separate line items for cost of materials, personnel expenses, and depreciation. The line item Personnel expenses aggregates the total amount of personnel cost incurred by the company. In contrast, Callaway Golf allocates these expenses to the various categories of operating expense (man- ufacturing, selling, administrative, research and development). Similarly, the line item Depreciation includes depreciation on manufacturing assets, as well as assets used in administration, marketing, and other departments. The second line in Südzucker’s income statement, Change in work in progress and ! nished goods inven- tories and internal costs capitalised, adjusts for the manufacturing costs included in Cost of materials, Personnel expenses, Depreciation, and Other operating expenses that are not part of cost of goods sold in the current year. As a result of this adjustment, the amount related to the cost of goods sold subtracted in calculating operating income is the same as if cost of goods sold had been reported as a separate line

EXHIBIT 2.9

CALLAWAY GOLF COMPANY Consolidated Statements of Operations

(In Thousands, Except per Share Data)

Year Ended December 31,

2009 2008 2007

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $950,799 $1,117,204 $1,124,591 Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 607,036 630,371 631,368 Gross profi t . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343,763 486,833 493,223 Selling expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260,597 287,802 281,960 General and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . 81,487 85,473 89,060 Research and development expenses . . . . . . . . . . . . . . . . . . . . . . . 32,213 29,370 32,020 Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374,297 402,645 403,040 Income (loss) from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . (30,534) 84,188 90,183 Interest and other income, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,685 1,863 3,455 Interest expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,754) (4,666) (5,363) Change in energy derivative valuation account (Note 10) . . . . . . . . — 19,922 — Income (loss) before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . (29,603) 101,307 88,275 Income tax provision (benefi t) . . . . . . . . . . . . . . . . . . . . . . . . . . . . (14,343) 35,131 33,688 Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (15,260) 66,176 54,587 Dividends on convertible preferred stock . . . . . . . . . . . . . . . . . . . . 5,688 — — Net income (loss) allocable to common stockholders . . . . . . . . . . . $ (20,948) $ 66,176 $ 54,587 Earnings (loss) per common share: . . . . . . . . . . . . . . . . . . . . . . . . . Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (0.33) $ 1.05 $ 0.82 Diluted. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (0.33) $ 1.04 $ 0.81 Weighted-average common shares outstanding. . . . . . . . . . . . . . . Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63,176 63,055 66,371 Diluted. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63,176 63,798 67,484

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Worldwide Accounting Diversity 45

item. Although much different in appearance, the format Südzucker uses to report income from operations does not affect the amount reported. The amount is the same regardless of whether the company uses the type of expenditure format or the cost of goods sold format.

The income statement prepared by Mexican companies includes a section gen- erally not found in other countries. Exhibit 2.11 presents the income statement for Cemex S.A.B. de C.V., the world’s largest supplier of building materials. After reporting Operating income, Cemex provides a calculation of Comprehensive ! nanc- ing result that includes interest income and expense, gains and losses on " nancial instruments, foreign currency gains and losses, and the Monetary position result, which is a measure of the purchasing power gain or loss associated with holding monetary assets and liabilities during a period of in! ation.

Most companies present operating pro" t, pretax income, and net income as measures of performance in their income statement. Exhibit 2.12 shows the in- come statement for Sol Meliá SA, a Spanish hotel chain, which provides several other and different measures of performance. The " rst performance measure re! ected in Sol Meliá’s income statement is EBITDAR (earnings before interest, tax, depreciation, amortization, and rent expenses), which is then followed by EBITDA (EBITDAR minus rent expense), and then EBIT (EBITDA minus deprecia- tion and amortization expense).

EXHIBIT 2.10

SÜDZUCKER AG Consolidated Income Statement

1 March 2009 to 28 February 2010 € million Note 2009/10 2008/09 Income statement

Revenues 6 5,718.2 5,871.3 Change in work in progress and fi nished goods inventories and internal costs capitalised . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 −256.1 −277.0 Other operating income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 157.9 238.5 Cost of materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 −3,445.1 −3,449.1 Personnel expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 −671.8 −662.8 Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 −256.7 −249.7 Other operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 −854.0 −1,125.9

Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 392.4 345.3 Income from associated companies . . . . . . . . . . . . . . . . . . . . . . . . 14 2.0 21.6 Financial income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 115.8 67.2 Financial expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 −161.8 −202.2

Earnings before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . 348.4 231.9 Taxes on income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 −72.0 −48.7

Net earnings for the year. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 276.4 183.2 of which attributable to Südzucker AG shareholders . . . . . . . . . 200.1 162.2 of which attributable to hybrid capital . . . . . . . . . . . . . . . . . . . . 26.2 26.2 of which attributable to minority interests . . . . . . . . . . . . . . . . . 50.1 −5.2

Earnings per share (€). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 1.06 0.86 Undiluted. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . −0.02 0.00 Diluted. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.04 0.86

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46

EXHIBIT 2.11

CEMEX S.A.B. DE C.V. Consolidated Income Statements

(Millions of Mexican Pesos, Except for Earnings per Share)

YEARS ENDED DECEMBER 31

Notes 2009 2008 2007

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3P $ 197,801 225,665 228,152 Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3Q (139,672) (153,965) (151,439)

Gross profi t . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58,129 71,700 76,713 Administrative and selling expenses . . . . . . . . . . . . . . . . . . . . . . . . (28,611) (32,262) (32,031) Distribution expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (13,678) (13,350) (13,072)

Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3Q (42,289) (45,612) (45,103)

Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,840 26,088 31,610 Other expenses, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3S (5,529) (21,403) (2,884)

Operating income after other expenses, net . . . . . . . . . . . . 10,311 4,685 28,626 Comprehensive fi nancing result . . . . . . . . . . . . . . . . . . . . . . . . . . . Financial expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 (13,513) (10,199) (8,808) Financial income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 385 513 823 Results from fi nancial instruments . . . . . . . . . . . . . . . . . . . . . . . 13 (2,127) (15,172) 2,387 Foreign exchange results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (266) (3,886) (274) Monetary position result. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3R 415 418 6,890

Comprehensive fi nancing result . . . . . . . . . . . . . . . . . . . . . . . (15,106) (28,326) 1,018 Equity in income of associates . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154 869 1,487

Income (loss) before income tax . . . . . . . . . . . . . . . . . . . . . . (4,641) (22,772) 31,131 Income tax. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 10,566 22,998 (4,474)

Income before discontinued operations . . . . . . . . . . . . . . . . 5,925 226 26,657 Discontinued operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4B (4,276) 2,097 288 Consolidated net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,649 2,323 26,945 Non-controlling interest net income . . . . . . . . . . . . . . . . . . . . . . 240 45 837

Controlling Interest Net Income . . . . . . . . . . . . . . . . . . . . . . . $ 1,409 2,278 26,108

Basic earnings per share of continuing operations . . . . . . . . . 19 $ 0.22 0.01 1.16

Basic earnings per share of discontinued operations . . . . . . . 19 $ (0.16) 0.09 0.01

Diluted earnings per share of continuing operations . . . . . . . 19 $ 0.22 0.01 1.16

Diluted earnings per share of discontinued operations . . . . . 19 $ (0.16) 0.09 0.01

EXHIBIT 2.12

SOL MELIÁ SA Consolidated Income Statements

Million Euros 12/09 12/08 Percent

Hotels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 876.5 1034.0 Leisure real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77.6 17.1 Vacation club. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66.5 97.4 Other revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128.1 130.6

Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,148.7 1,279.0 −10.2 Raw materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (138.0) (155.8) Personnel expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (390.8) (414.3) Other operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (338.4) (375.0)

Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (867.2) (945.1) −8.2

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Worldwide Accounting Diversity 47

EBITDAR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281.5 333.9 −15.7 Rental expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (79.4) (77.2) EBITDA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202.1 256.7 −21.3 Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . (96.9) (97.5) EBIT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105.2 159.2 −34.0 Net interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (27.7) (71.0) Exchange rate differences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.1 (9.1) Other interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (11.8) (11.7) Total fi nancial profi t/(Ioss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (38.5) (91.8) 58.1 Profi t/(Ioss) from equity investments. . . . . . . . . . . . . . . . . . . . . . . . (12.8) (6.6)

Continuing earnings before taxes . . . . . . . . . . . . . . . . . . . . . . . 53.9 (98.3) −154.8

Discontinuing operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.0 0.0

Profi t before taxes and minorities. . . . . . . . . . . . . . . . . . . . . . . 53.9 60.9 −11.5

Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (10.4) (6.3)

Group net profi t/(Ioss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43.5 54.6 −20.4

Minorities (P)/L . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (5.4) (3.4)

Profi t/loss of the parent company. . . . . . . . . . . . . . . . . . . . . . . 38.1 51.2 −25.6

Level of Detail Differences exist in the level of detail provided in the individual " nancial state- ments. U.S. companies tend to provide relatively few line items on the face of the " nancial statements and then supplement these with additional detail in the notes. Callaway Golf’s income statement presented in Exhibit 2.9 is a case in point. The level of detail provided by U.S.-based companies can be contrasted with the ex- tremely detailed income statement provided by Thai Airways International Public Company Limited, as shown in Exhibit 2.13 . Instead of reporting operating ex- penses in only three line items, as does Callaway Golf, Thai Airways presents 15 separate categories of operating expense. Even though considerable detail is pro- vided on the face of the income statement, additional information is included in the notes to provide further detail on those line items labeled as Other. For example, Note 8.23, on Other Income—Others, indicates that this line on the income state- ment includes gains on sales of assets, revenue from airport fees collected from passengers, and compensation revenue from the delayed delivery of aircraft.

Terminology The examination of Vodafone PLC’s balance sheet earlier in this chapter revealed a number of differences in the terminology used by Vodafone and a typical U.S. company. New Zealand–based Fletcher Building Group includes the following current assets on its balance sheet: Cash and liquid deposits, Current tax asset, Debtors, and Stocks. A “translation” of these terms into terminology commonly used in the United States would be: Cash and cash equivalents, Taxes receivable, Accounts receivable, and Inventories. Many non-English-language companies translate their annual reports into English for the convenience of English speak- ers. These companies typically choose between the British and the American for- mats and terminology in preparing convenience translations. Occasionally terms unfamiliar to both British and U.S. accounting are found in English-language re- ports to re! ect business, legal, or accounting practice unique to a speci" c country. For example, the Brazilian petrochemical " rm Braskem SA includes the line item

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48

EXHIBIT 2.13

THAI AIRWAYS INTERNATIONAL PUBLIC COMPANY LIMITED Consolidated Income Statements

For the years ended December 31, 2009 and 2008 Units: Baht

CONSOLIDATED

Notes 2009 2008

Revenues Revenues from sale or revenues from services Passenger and excess baggage. . . . . . . . . . . . . . . . . . . . . . . . . . . . 134,479,296,254 164,318,701,819 Freight . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,525,307,811 25,840,755,700 Mail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 822,754,186 912,990,339 Other activities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,775,384,234 9,045,532,774

Total revenues from sale or revenues from services . . . . . . . . 161,602,742,485 200,117,980,632

Other income Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178,067,252 493,287,861 Others . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.23 2,093,717,478 1,994,352,142

Total other income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,271,784,730 2,487,640,003

Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163,874,527,215 202,605,620,635

Expenses Fuel and oil . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47,014,753,162 89,459,872,853 Personnel. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,191,239,889 30,534,030,465 Management benefi t expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.22 60,916,443 93,395,719 Flight service expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,691,615,362 19,938,599,141 Crew expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,243,530,868 6,542,134,756 Aircraft maintenance and overhaul costs . . . . . . . . . . . . . . . . . . . . 10,320,750,374 10,847,783,197 Depreciation and amortisation expenses . . . . . . . . . . . . . . . . . . . . 21,023,460,156 20,281,081,576 Lease of aircraft and spare parts. . . . . . . . . . . . . . . . . . . . . . . . . . . 1,531,697,470 3,650,964,476 Inventories and supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,496,583,764 8,826,777,548 Selling and advertising expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 6,221,182,125 6,932,244,544 Insurance expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 760,064,787 751,270,159 Damages arising from Antitrust / Competition Law . . . . . . . . . . . . . 8.18.5 — 4,290,169,870 Impairment losses of assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 529,056,765 4,749,840,736 Other expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.24 8,103,657,883 9,285,303,024 Losses (gains) on foreign currency exchange. . . . . . . . . . . . . . . . . . (3,167,360,443) 4,471,388,154

Total expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,021,148,605 220,654,856,218

Share of losses (profi ts) of investments by the equity method. . . . . 8,562,792 65,137,572

Profi ts (losses) before fi nance costs and income tax expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,844,815,818 (18,114,373,155) Finance costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,737,562,830 5,485,264,531 Profi ts (losses) before income tax expenses . . . . . . . . . . . . . . . 8,107,252,988 (23,599,637,686) Net tax expenses (tax income) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.25 691,425,974 (2,285,253,584)

Net profi ts (losses) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,415,827,014 (21,314,384,102) Profi ts (losses) attributable to: Equity holders of the parent . . . . . . . . . . . . . . . . . . . . . . . . . 7,343,578,865 (21,379,451,415) Minority interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72,248,149 65,067,313

7,415,827,014 (21,314,384,102)

Basic earnings per share. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.27 Net profi ts (losses) per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.32 (12.58)

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Worldwide Accounting Diversity 49

Judicial deposits and compulsory loan as an asset on its balance sheet. Note 11 dis- closes that the judicial deposits relate to Tax contingencies and Labor and other claims, but provides no further information with regard to this asset. SK Telecom includes a noncurrent asset on its balance sheet called Guarantee deposits, which represents the amount of cash that customers have paid as a deposit to initiate telephone ser- vice. Among its current liabilities, SK Telecom reports the line item Withholdings, with no further explanation as to what this might be.

Disclosure Numerous differences exist across countries in the amount and types of informa- tion disclosed in a set of " nancial statements. Many of the disclosures provided by companies are required by law or other regulations. In addition, many compa- nies around the world provide additional, voluntary disclosures, often to better compete in obtaining " nance in the international capital markets. The disclosures required to be made by publicly traded companies in the United States generally are considered to be the most extensive in the world. Saudagaran and Biddle de- veloped a ranking of the level of disclosure required by stock exchanges in eight major countries (see Exhibit 2.14 ). Consistent with Gray’s expectations with respect to secrecy, the Anglo countries rank 1, 2, and 3 in the amount of disclosure pro- vided, whereas the Germanic countries rank 7 and 8.

One must be careful in generalizing these disclosure rankings to all companies within a country. For example, the Swiss banking " rm UBS AG provides extensive notes (108 pages in length) to its consolidated " nancial statements that are similar in scope and content to what is found in the annual reports of Anglo companies. The same can be said for other Swiss multinational corporations as well as for many multinationals in other non-Anglo countries.

There are an in" nite number of differences that can exist in the disclosures provided by companies. To illustrate the wide diversity, we provide several ex- amples of disclosures uncommon in the United States and most other countries. The Swedish appliance manufacturer AB Electrolux includes a note in its " nancial statements titled Employees and Remuneration (see Exhibit 2.15 ). This note reports the number of employees, their gender, and their total remuneration by geograph- ical area. By splitting total remuneration into the amount paid to boards and senior managers and the amount paid to other employees, the statement allows inter- ested readers to see that it is the latter group that receives the vast majority of compensation.

The Brazilian mining company Vale includes a social report in the notes to its " nancial statements (see Exhibit 2.16 ). The report is based on a model developed by the Federal Accounting Board of Brazil (CFC) and highlights the investments

Country Overall Disclosure Level Rank

United States . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.28 1 Canada. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.41 2 United Kingdom . . . . . . . . . . . . . . . . . . . . . . . . . 6.02 3 Netherlands . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.75 4 France . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.17 5 Japan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.83 6 Germany . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.81 7 Switzerland. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.17 8

EXHIBIT 2.14 Stock Market Disclosure Levels

Source: S. M. Saudagaran and G. C. Biddle, “Foreign Listing Location: A Study of MNCS and Stock Exchanges in Eight Countries,” Journal of International Business Stud- ies, Second Quarter 1995, p. 331.

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50 Chapter Two

Salaries and remuneration by geographical area for Board members, senior managers and other employees

2009 2008

Board members and senior managers

Other employees Total

Board members and senior managers

Other employees Total

Sweden Parent Company . . . . . . . . . . 48 716 764 47 779 826 Other. . . . . . . . . . . . . . . . . . . 8 201 209 5 230 235

Total Sweden. . . . . . . . . . . . 56 917 973 52 1,009 1,061

EU, excluding Sweden . . . . . . 99 5,797 5,896 88 5,765 5,853 Rest of Europe . . . . . . . . . . . . 10 768 778 10 700 710 North America . . . . . . . . . . . . 18 3,360 3,378 21 3,070 3,091 Latin America. . . . . . . . . . . . . 35 1,094 1,129 38 951 989 Asia . . . . . . . . . . . . . . . . . . . . 14 326 340 12 428 440 Pacifi c . . . . . . . . . . . . . . . . . . 4 641 645 1 498 499 Africa. . . . . . . . . . . . . . . . . . . 2 21 23 3 16 19

Total outside Sweden . . . . . 182 12,007 12,189 173 11,428 12,843

Group total . . . . . . . . . . . . . 238 12,924 13,162 225 12,437 13,987

Of the Board members in the Group, 77 were men and 12 were women, of whom 7 men and 4 women were in the Parent Company. Senior managers in the Group consisted of 186 men and 40 women, of whom 9 men and 3 women were in the Parent Company. The total pension cost for Board members and senior managers in the Group amounted to 37m (48) in 2009.

Salaries, other remuneration and employer contributions

2009 2008

Salaries and remuneration

Employer contributions Total

Salaries and remuneration

Employer contributions Total

Parent Company . . . . . . . . . . 764 562 1,326 826 657 1,483 (whereof pension costs) . . . . . . . . . . . . . . . (159)1) (159)1) (259)1) (259)1)

Subsidiaries . . . . . . . . . . . . . . 12,398 3,477 15,875 11,836 3,695 15,531 (whereof pension costs) . . . . . . . . . . . . . . . (718) (718) (687) (687)

Group total . . . . . . . . . . . . . 13,162 4,039 17,201 12,662 4,352 17,014 (whereof pension costs). . . . . . . . . . . . . . . (877) (877) (946) (946)

1) Includes SEK 14m (20), referring to the President and his predecessors.

EXHIBIT 2.15

AB ELECTROLUX Excerpt from Note 27, Employees and Remuneration

Notes, all amounts in SEKm, unless otherwise stated

In 2009, the average number of employees for continuing operations was 50,633 (55,177), of whom 32,955 (35,562) were men and 17,678 (19,615) were women.

Average number of employees, by geographical area

Group

2009 2008

Europe. . . . . . . . . . . . . . . 25,292 28,138 North America . . . . . . . . . 10,384 11,398 Rest of world . . . . . . . . . . 14,957 15,641 Total . . . . . . . . . . . . . . . . 50,633 55,177

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Worldwide Accounting Diversity 51

EXHIBIT 2.16

VALE SA Social Report

Consolidated

Basis of Calculation 2009 2008 Gross revenue . . . . . . . . . . . 49,812 72,766 Operating income before fi nancial results and equity results . . . . . . . 13,181 27,400 Gross payroll . . . . . . . . . . . . 2,549 4,422

% of % of

Labor indicators Amount Payroll Operating

income Amount Payroll Operating

income

Nutrition . . . . . . . . . . . . . . . 295 12% 2% 307 7% 1% Compulsory payroll charges. . . . . . . . . . . . . . . 792 31% 6% 892 20% 3% Transportation . . . . . . . . . . . 159 6% 1% 152 3% 1% Pension plan. . . . . . . . . . . . . 208 8% 2% 431 10% 2% Health . . . . . . . . . . . . . . . . . 339 13% 3% 297 7% 1% Education. . . . . . . . . . . . . . . 105 4% 1% 174 4% 1% Nursery . . . . . . . . . . . . . . . . 3 — — 2 — — Employee profi t sharing plan . . . . . . . . . . . 868 34% 7% 548 12% 2% Other . . . . . . . . . . . . . . . . . . 82 3% 1% 124 3% —

Total—Labor Indicators 2,855 112% 22% 2,927 66% 11%

% of % of

Social Indicators Amount Operating

income Net Operating

revenue Amount Operating

income Net Operating

revenue

Taxes (excluding payroll charges) . . . . . . . . 5,810 44% 12% 5,274 19% 7% Taxes paid recover . . . . . . . . (571) −4% −1% (1,955) −7% −3% Citizenship investments . . . . . . . . . . . — — — 409 1% 1% Social actions and projects. . . . . . . . . . . . . 370 3% 1% 390 1% 1%

Culture . . . . . . . . . . . . . . . 100 3% 1% 102 — — Native community. . . . . . . 19 — — 19 — —

Environmental investments . . . . . . . . . . . 1,397 11% 3% 808 3% 1%

Total—Social indicators 7,207 55% 14% 6,491 24% 9%

Workforce indicators . . . . . . Number of employees at the end of the period . . 60,036 62,490 Number of admittances during the period . . . . . 2,633 7,673

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52 Chapter Two

made by the company with respect to human resources, the environment, and social projects. In its Brazilian GAAP " nancial statements, Vale also presents a statement of added value (see Exhibit 2.17 ) that provides insight into the groups that bene" t most from the company’s existence. Employees and the government received the largest distributions of added value by the company in 2009. The social report indicates, among other things, the costs in addition to gross payroll the company incurs related to its labor force. These include costs related to food, health, education, and pro" t sharing. In 2009, these costs amounted to 112 percent of gross payroll, with the largest amounts going to compulsory payroll charges and pro" t sharing.

VALE SA Statement of Added Value

Period Ended In Millions of Reals

Consolidated

2009 2008 Generation of added value Gross revenue Revenue from products and services. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49,812 72,766 Revenue from the construction of own assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,919 17,706 Allowance for doubtful accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (23) (32) Less: Acquisition of products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,219) (2,805) Outsourced services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (6,242) (8,244) Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (20,653) (23,958) Fuel oil and gas. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,777) (3,761) Energy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,776) (2,052) Impairment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — (2,447) Other costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (6,920) (6,829)

Gross added value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,121 40,344 Depreciation, amortization and depletion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (5,447) (5,112)

Net added value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,674 35,232 Received from third parties Financial revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 866 1,221 Equity results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116 (1,325)

Total added value to be distributed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,656 35,128 Personnel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,086 5,046 Taxes, rates and contribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,810 5,267 Taxes paid recover . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (571) (1,955) Remuneration on third party’s capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,433 4,157 Infl ation and exchange rate variation, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (4,519) 902 Remuneration on stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stockholders. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,373 5,640 Reinvested . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,876 15,639 Minority interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168 432

Distribution of added value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,656 35,128

EXHIBIT 2.17

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Worldwide Accounting Diversity 53

Akzo Nobel includes a noncurrent liability on its balance sheet titled Provisions. Provisions are accrued liabilities that by their nature involve a substantial amount of estimation. In note 17 to the " nancial statements, Akzo Nobel provides consid- erable detail about the various items for which provisions have been established and the change in each of these items during the year (see Exhibit 2.18 ). This in- formation can be used to assess the quality of the estimates made by the company with respect to expected future liabilities. For example, note 17 indicates that for the year 2009, Akzo Nobel had a beginning restructuring provision of €165 mil- lion and €263 million was added to the provision throughout the year. During 2009, €198 million of the estimated liability related to restructuring was paid and another €12 million was reversed as a result of overestimating the liability in a previous year. Note 17 also discloses that only €31 million of the €318 million the company expects in environmental cleanup costs was paid in 2009.

Recognition and Measurement Perhaps the most important international differences that exist in " nancial report- ing are those related to the recognition and measurement of assets, liabilities, rev- enues, and expenses. Recognition refers to the decision of whether an item should be reported in the " nancial statements. Measurement refers to the determination of the amount to be reported. For example, national accounting standards establish whether costs associated with acquiring the use of a resource should be recognized as an asset on the balance sheet. If so, then guidance must be provided with respect to both the initial measurement of the asset and measurement at subsequent bal- ance sheet dates.

AKZO NOBEL NV Note 17, Movements in Provisions

In € millions Total

Pensions and other post-retirement

benefi ts Restructuring of

activities Environmental

costs Other

Balance at January 1, 2009 . . . . . . . . . 2,917 1,626 165 318 808 Additions made during the year . . . . . . . 648 179 263 40 166

Utilization . . . . . . . . . . . . . . . . . . . . . . . (961) (451) (198) (31) (281) Amounts reversed during the year . . . . . . . . . . . . . . . . . . . . . . . (64) — (12) (24) (28) Unwind of discount . . . . . . . . . . . . . . . . 60 — 2 32 26

Acquisitions/divestments . . . . . . . . . . . . 6 1 — — 5 Pension plans changing to net asset position . . . . . . . . . . . . . . . . 77 77 — — — Changes in exchange rates . . . . . . . . . . 33 7 6 17 3

Balance at December 31, 2009 2,716 1,439 226 352 699

Non-current portion of provisions. . . . . . 1,919 1,200 40 280 399 Current portion of provisions . . . . . . . . . 797 239 186 72 300

2,716 1,439 226 352 699

EXHIBIT 2.18

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54 Chapter Two

We close this chapter by describing the diversity that exists with respect to mea- suring property, plant, and equipment (PPE) subsequent to acquisition. Possible values at which these assets can be reported on the balance sheet include:

1. Historical cost (HC). 2. Historical cost adjusted for changes in the general purchasing power (GPP) of

the currency. 3. Fair value (FV).

In most cases, GPP and FV accounting result in PPE being written up to an amount higher than historical cost. The counterpart to the asset write-up generally is treated as an increase in stockholders’ equity, often included in a Revaluation Reserve account. The larger asset value results in a larger depreciation expense and therefore smaller net income.

U.S. GAAP requires PPE to be carried on the balance sheet at historical cost less accumulated depreciation. If an asset is impaired, that is, its carrying value exceeds the amount of cash expected to result from use of the asset, it must be writ- ten down to fair value. Upward revaluation of " xed assets is not acceptable. HC accounting also is required in Japan. Although the speci" c rules vary from those in the United States, write-down to a lower value is required if a permanent impair- ment of value has occurred.

In contrast, under IFRS, publicly traded companies in the European Union are free to choose between two different methods for valuing their assets. PPE may be carried on the balance sheet at historical cost or at revalued amounts. The basis of revaluation is the fair value of the asset at the date of revaluation, which in many cases will be determined through appraisals. If a company chooses to report assets at revalued amounts, it has an obligation to keep the valuations up to date, which might require annual adjustments.

Until 2008, in Mexico, PPE was reported initially at historical cost and then restated in terms of GPP at subsequent balance sheet dates. Similarly, until the early 1990s, publicly traded companies in Brazil were required to use GPP in pre- paring " nancial statements. In addition to PPE, inventories and investments also were adjusted upward for in! ation on each balance sheet date, and receivables were discounted to their present value. These procedures no longer are required in Brazil but still may be followed at the option of the company.

Summary 1. Considerable diversity exists across countries with respect to the form and con- tent of individual " nancial statements, the rules used to measure assets and li- abilities and recognize and measure revenues and expenses, and the magnitude and nature of the disclosures provided in a set of " nancial statements.

2. Many environmental factors are thought to contribute to the differences in " - nancial reporting that exist across countries. Some of the more commonly men- tioned factors include the legal system, the in! uence of taxation on " nancial reporting, corporate " nancing system, in! ation, political and economic ties between countries, and national culture.

3. The diversity that exists in " nancial reporting creates problems for multina- tional corporations in preparing consolidated " nancial statements on the basis of a single set of accounting rules. Accounting diversity also can result in in- creased cost for companies in tapping into foreign capital markets. The compar- ison of " nancial statements across companies located in different countries is

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Worldwide Accounting Diversity 55

hampered by accounting diversity. Low-quality " nancial reporting contributed to the " nancial crisis in East Asia in the 1990s.

4. Several authors have classi" ed countries according to similarities and differ- ences in " nancial reporting. Two dominant models of accounting used in the developed world are the Anglo-Saxon model and the Continental European model.

5. Concentrating on the Anglo-Saxon and Continental European model countries, Nobes developed a classi" cation scheme that attempts to show how the " nancial reporting systems in 14 developed countries relate to one another. Nobes breaks down the two major classes of accounting system " rst into subclasses and then into families. This classi" cation scheme shows how different families of accounting are related.

6. Culture has long been considered a determinant of accounting. Using the cul- tural dimensions identi" ed by Hofstede, Gray developed a framework for the relationship between culture and accounting systems. Cultural values affect a country’s accounting system in two ways: (1) through their in! uence on the accounting values of conservatism, secrecy, uniformity, and professionalism shared by a country’s accountants and (2) through their in! uence on institu- tional factors such as the capital market and legal system.

7. In a more recent model of the reasons for international differences in " nancial reporting, Nobes suggests that the dominant factor is the extent to which corpo- rate " nancing is obtained through the sale of equity securities to outside share- holders. For whatever reason, some cultures lead to a strong equity-outsider " nancing system and other cultures lead to a weaker equity-outsider " nanc- ing system. In countries with strong equity-outsider " nancing, measurement practices are less conservative, disclosure is extensive, and accounting practice differs from tax rules. This is consistent with what may be called Anglo-Saxon accounting. In accounting systems found in countries with weak equity– outside shareholder " nancing systems, measurement is more conservative, dis- closure is not as extensive, and accounting practice follows tax rules. This is consistent with the Continental European accounting model.

8. Differences in " nancial reporting exist with regard to the " nancial statements provided by companies; the format, level of detail, and terminology used in presenting " nancial statements; the nature and amount of disclosure provided; and the principles used to recognize and measure assets, liabilities, revenues, and expenses.

Appendix to Chapter 2

" e Case of Daimler-Benz Daimler-Benz was the " rst German company to list on the New York Stock Ex- change (NYSE), doing so in 1993. This was a major event for the NYSE and the Securities and Exchange Commission (SEC) because German companies had previously refused to make the adjustments necessary to reconcile their German law–based " nancial statements to U.S. generally accepted accounting principles (GAAP). After some compromise on the part of the SEC and because of Daimler’s

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56 Chapter Two

strong desire to enter the U.S. capital market (and be the " rst German company to do it), Daimler agreed to comply with SEC regulations.

Subsequent to its NYSE listing, Daimler-Benz " led an annual report on Form 20-F with the SEC. 1 In its 20-F " ling, Daimler prepared " nancial statements in English, in both German deutschemarks (DM) and U.S. dollars, and, until 1996, according to German accounting principles. In the notes to the 1995 " nancial state- ments, Daimler provided a “Reconciliation to U.S. GAAP” in which adjustments were made to net income and stockholders’ equity prepared in accordance with German accounting law to reconcile to U.S. GAAP. The net effect of these adjust- ments over the period 1993–1995 is shown in Exhibit A2.1 .

The fact that in 1993 Daimler-Benz reported a pro" t under German GAAP but a loss under U.S. GAAP created quite a stir in the international " nancial commu- nity. Because German companies were well known for intentionally understat- ing income through the creation of hidden reserves, one would have expected German GAAP income to be smaller than U.S. GAAP income (as was true in 1994). In 1993, however, Daimler incurred a net loss for the year (as can be seen from the negative amount of U.S. GAAP income). To avoid reporting this loss, the company “released” hidden reserves that had been created in earlier years, thus reporting a pro" t of DM 615 million under German GAAP. The difference in German GAAP and U.S. GAAP income in 1993 of some DM 2.5 billion shows just how unreliable German GAAP income can be in re! ecting the actual performance of a company. In fact, the German Financial Analysts Federation (DVFA) developed a method for adjusting German GAAP earnings to a more reliable amount (known as DVFA earnings).

In 1996, Daimler-Benz decided to abandon German GAAP and implement a U.S. GAAP accounting system worldwide. The 1996 annual report was prepared using U.S. GAAP and received a clean opinion on this basis from KPMG. The rationale for this decision was outlined in the 1996 annual report and is reproduced in Exhibit A2.2 . The company indicated that U.S. GAAP " gures not only allowed external analysts to better evaluate the company but also served as a better basis for the internal controlling of the company. This clearly points out the differences in orientation between a typical macro-uniform accounting system that is geared toward minimizing taxes and protecting creditors, and a micro-based accounting system that has the objective of providing information that is useful for making decisions, not only by external parties but by management as well.

1 U.S. companies fi le their annual reports with the SEC on Form 10-K; foreign companies fi le theirs on Form 20-F.

DAIMLER-BENZ Excerpt from Form 20-F: Reconciliation to U.S. GAAP 1995

(all amounts in DM) 1993 1994 1995

Net income as reported in the consolidated income statement under German GAAP. . . . . . . . . . . . . . . . . . . . . 615 895 (5,734) Net income in accordance with U.S. GAAP. . . . . . . . . . . . . . . (1,839) 1,052 (5,729) Stockholders’ equity as reported in the consolidated balance sheet under German GAAP . . . . . . . . . . . . . . . . . . 18,145 20,251 13,842 Stockholders’ equity in accordance with U.S. GAAP. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,281 29,435 22,860

EXHIBIT A2.1

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Worldwide Accounting Diversity 57

DAIMLER-BENZ Excerpts from Annual Report 1996

Excerpts from Value-Based Management, U.S. GAAP, and New Controlling Instruments (pages 44–45)

1996 Financial Statements Prepared Entirely in Accordance with U.S. GAAP for the First Time Since our listing on the New York Stock Exchange we have increasingly aligned our external reporting in accordance with the information requirements of the international fi nancial world. . . . With our 1996 annual report, we are the fi rst German company to present an entire year’s fi nancial statements in accordance with U.S. GAAP while at the same time complying with the German Law to Facilitate Equity Borrowing. The report thus also conforms with EU guidelines and European accounting principles.

Improved External Disclosure Instead of providing various fi gures concerning the economic performance of the Company that are derived using the HGB and U.S. GAAP but that in some instances differ signifi cantly from each other because of the distinct accounting philosophies, we supply a complete set of fi gures in conformance with U.S. GAAP for our shareholders, the fi nancial analysts, and the interested public. In so doing, we fulfi ll accounting standards of the highest reputation worldwide, and we believe our approach more clearly and accurately refl ects the economic performance, fi nancial situation, and net worth of the Company than any other accounting system available at this time. This is not least due to the fact that U.S. accounting principles focus on investor information rather than creditor protection, which is the dominant concern under German accounting principles. Discretionary valuation is greatly limited, and the allocation of income and expenses to the individual accounting period is based on strict economic considerations.

Advantages for All Shareholders Using U.S. accounting principles makes it signifi cantly easier to internationally active fi nancial analysts or experienced institutional investors to accurately assess the fi nancial situation and development of the Company. Moreover, it improves disclosure at Daimler-Benz as well as comparability on an international scale. This helps promote the worldwide acceptance of our stock.

Internal Controlling on the Basis of Balance Sheet Values in Accordance with U.S. GAAP The U.S. GAAP not only made Daimler-Benz more transparent from an external perspective. Because the earnings fi gures as derived with American accounting principles accurately refl ect the economic performance of the Company, we are now able to use fi gures from our external reporting for the internal controlling of the Company and its individual business units rather than relying on the internal operating profi t used in the past. We thus make use of the same fi gures both internally and externally to measure the economic performance of the Company and the business units.

Excerpt from Letter to the Stockholders and Friends of Our Company (page 4) 1996 marks the fi rst time we have prepared our accounts in accordance with U.S. accounting principles which gives our investors worldwide the transparency they require. This means that our success as well as our shortcomings will be reported with new clarity. The terms operating profi t, return on capital employed, and cash fl ow have become part of the language of the entire company and part of our corporate philosophy.

EXHIBIT A2.2

Questions 1. What are the two most common methods used internationally for the order in which assets are listed on the balance sheet? Which of these two methods is most common in North America? In Europe?

2. What are the two major types of legal systems used in the world? How does the type of legal system affect accounting?

3. How does the relationship between " nancial reporting and taxation affect the manner in which income is measured for " nancial reporting purposes?

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4. Who are the major providers of capital (" nancing) for business enterprises? What in! uence does the relative importance of equity " nancing in a country have on " nancial statement disclosure?

5. What are the major problems caused by worldwide accounting diversity for a multinational corporation?

6. What are the major problems caused by worldwide accounting diversity for international portfolio investment?

7. What are the hypothesized relationships between the cultural value of uncer- tainty avoidance and the accounting values of conservatism and secrecy?

8. How are the Anglo and less developed Latin cultural areas expected to differ with respect to the accounting values of conservatism and secrecy?

9. According to Nobes, what are the two most important factors in! uencing dif- ferences in accounting systems across countries?

10. What are the different ways in which " nancial statements differ across countries?

11. How are the various costs that comprise cost of goods sold re! ected in a “type of expenditure” format income statement?

12. What information is provided in a statement of added value? 13. What are the alternative methods used internationally to present " xed assets

on the balance sheet subsequent to acquisition?

1. Refer to the income statements presented in Exhibits 2.9 , 2.10 , 2.11 , 2.12 , and

2.13 for Callaway Golf Company, Südzucker AG, Cemex S.A.B. de CV, Sol Meliá SA, and Thai Airways.

Required: a. Calculate gross pro" t margin (gross pro" t/sales), operating pro" t margin

(operating pro" t/sales), and net pro" t margin (net earnings/sales) for each of these companies. If a particular ratio cannot be calculated, explain why not.

b. Is it valid to compare the pro" t margins calculated in part (a) across these companies in assessing relative pro" tability? Why or why not?

2. Access the " nancial statements from the most recent annual report of a foreign company and a domestic company with which you are familiar to complete this assignment.

Required: a. Determine the accounting principles (GAAP) the foreign and domestic com-

panies use to prepare " nancial statements. b. Determine whether the foreign and domestic companies provide a set of

" nancial statements that includes the same components (e.g., consolidated balance sheet, consolidated income statement, and consolidated cash ! ows statement).

c. List " ve format differences in the companies’ income statements. d. List " ve format differences in the companies’ balance sheets. e. Note any terminology differences that exist between the two companies’

income statements and balance sheets.

Exercises and Problems

58 Chapter Two

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f. Assess whether the scope and content of the information provided in the notes to the " nancial statements is similar between the two companies.

g. Compare the overall presentation of the " nancial statements and notes to the " nancial statements between the two companies.

3. Access the " nancial statements from the most recent annual report of two for- eign companies located in the same country to complete this assignment.

Required: a. Determine the accounting principles (GAAP) the two foreign companies use

to prepare " nancial statements. b. Determine whether the two foreign companies provide a set of " nancial state-

ments that includes the same components (e.g., consolidated balance sheet, consolidated income statement, and consolidated cash ! ows statement).

c. List any format differences in the companies’ income statements. d. List any format differences in the companies’ balance sheets. e. Note any terminology differences that exist between the two companies’

income statements and balance sheets. f. Assess whether the scope and content of the information provided in the

notes to the " nancial statements is similar between the two companies. g. Compare the overall presentation of the " nancial statements and notes to the

" nancial statements between the two companies.

4. Cultural dimension index scores developed by Hofstede for six countries are reported in the following table:

a1 = highest rank; 53 = lowest rank. b1 = highest rank; 34 = lowest rank.

Power Distance Uncertainty Avoidance Individualism Masculinity

Long-Term Orientation

Country Index Ranka Index Ranka Index Ranka Index Ranka Index Rankb

Belgium 65 20 94 5–6 75 8 54 22 38 18 Brazil 69 14 76 21–22 38 26–27 49 27 65 6 Korea (South) 60 27–28 85 16–17 18 43 39 41 75 5 Netherlands 38 40 53 35 80 4–5 14 51 44 11–12 Sweden 31 47–48 29 49–50 71 10–11 5 53 33 20 Thailand 64 21–23 64 30 20 39–41 34 44 56 8

Required: Using Gray’s hypothesis relating culture to the accounting value of secrecy, rate these six countries as relatively high or relatively low with respect to the level of disclosure you would expect to " nd in " nancial statements. Explain.

5. Refer to Nobes’s judgmental classi" cation of accounting systems in Exhibit 2.5 and consider the following countries: Austria, Brazil, Finland, Ivory Coast, Russia, and South Africa.

Required: Identify the family of accounting in which you would expect to " nd each of these countries. Explain your classi" cation of these countries.

Worldwide Accounting Diversity 59

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6. Five factors are often mentioned as affecting a country’s accounting practices: (a) legal system, (b) taxation, (c) providers of " nancing, (d) in! ation, and (e) political and economic ties.

Required: Consider your home country. Identify which of these factors has had the stron- gest in! uence on the development of accounting in your country. Provide speci" c examples to support your position.

7. As noted in the chapter, diversity in accounting practice across countries gener- ates problems for a number of different groups.

Required: Answer the following questions and provide explanations for your answers. a. Which is the greatest problem arising from worldwide accounting diversity? b. Which group is most affected by worldwide accounting diversity? c. Which group can most easily deal with the problems associated with

accounting diversity?

8. Various attempts have been made to reduce the accounting diversity that ex- ists internationally. This process is known as convergence and is discussed in more detail in Chapter 3. The ultimate form of convergence would be a world in which all countries followed a similar set of " nancial reporting rules and practices.

Required: Consider each of the following factors that contribute to existing accounting diversity as described in this chapter:

• Legal system • Taxation • Providers of " nancing • In! ation • Political and economic ties • Culture

Which factor do you believe represents the greatest impediment to the inter- national convergence of accounting? Which factor do you believe creates the smallest impediment to convergence? Explain your reasoning.

Case 2-1

The Impact of Culture on Conservatism

PART I The framework created by Professor Sidney Gray in 1988 to explain the develop- ment of a country’s accounting system is presented in the chapter in Exhibit 2.8 . Gray theorized that culture has an impact on a country’s accounting system through its in! uence on accounting values. Focusing on that part of a country’s

60 Chapter Two

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Worldwide Accounting Diversity 61

accounting system comprised of " nancial reporting rules and practices, the model can be visualized as follows:

Financial reporting rules and practices

Accounting valuesCultural dimensions

Accountant’s application of financial reporting rules

Accounting valuesCultural dimensions

In short, cultural values shared by members of a society in! uence the account- ing values shared by members of the accounting subculture. The shared values of the accounting subculture in turn affect the " nancial reporting rules and practices found within a country.

With respect to the accounting value of conservatism, Gray hypothesized that the higher a country ranks on the cultural dimensions of uncertainty avoidance and long-term orientation, and the lower it ranks in terms of individualism and masculinity, then the more likely it is to rank highly in terms of conservatism. Con- servatism is a preference for a cautious approach to measurement. Conservatism is manifested in a country’s accounting system through a tendency to defer rec- ognition of assets and items that increase net income and a tendency to accelerate the recognition of liabilities and items that decrease net income. One example of conservatism in practice would be a rule that requires an unrealized contingent li- ability to be recognized when it is probable that an out! ow of future resources will arise but does not allow the recognition of an unrealized contingent asset under any circumstances.

Required: Discuss the implications for the global convergence of " nancial reporting stan- dards raised by Gray’s model.

PART II Although Gray’s model relates cultural values to the accounting value of conser- vatism as it is embodied in a country’s " nancial reporting rules, it can be argued that the model is equally applicable to the manner in which a country’s accoun- tants apply those rules:

Required: Discuss the implications this argument has for the comparability of " nancial state- ments across countries, even in an environment of substantial international ac- counting convergence. Identify areas in which differences in cultural dimensions across countries could lead to differences in the application of " nancial reporting rules.

PART III Cancan Enterprises Inc. is a Canadian-based company with subsidiaries located in Brazil, Korea, and Sweden. (Hofstede’s cultural dimension index scores for these countries are presented in Exercise 4.) Cancan Enterprises must apply Canadian GAAP worldwide in preparing consolidated " nancial statements. Cancan has

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62 Chapter Two

developed a corporate accounting manual that prescribes the accounting policies based on Canadian GAAP that are to be applied by all the company’s operations. Each year Cancan’s internal auditors have the responsibility of ensuring that the company’s accounting policies have been applied consistently companywide.

Required: Discuss the implications that the model presented in Part II of this case has for the internal auditors of Cancan Enterprises in carrying out their responsibilities.

Case 2-2

SKD Limited SKD Limited is a biotechnology company that prepares " nancial statements using internally developed accounting rules (referred to as SKD GAAP). To be able to compare SKD’s " nancial statements with those of companies in their home coun- try, " nancial analysts in Country A and Country B prepared a reconciliation of SKD’s current year net income and stockholders’ equity. Adjustments were based on the actual accounting policies and practices followed by biotechnology compa- nies in Country A and Country B. The following table shows the adjustments to income and stockholders’ equity made by each country analyst:

Country A Country B

Income under SKD GAAP. . . . . . . . . . . . . . . . . . . 1,050 1,050 Adjustments: Goodwill amortization . . . . . . . . . . . . . . . . . . . 300 (100) Capitalized interest. . . . . . . . . . . . . . . . . . . . . . 50 50 Depreciation related to capitalized interest . . . . (20) (20) Depreciation related to revalued fi xed assets. . . — (8)

Income under local GAAP . . . . . . . . . . . . . . . . . . 1,380 972

Stockholders’ equity under SKD GAAP. . . . . . . . . 15,000 15,000 Adjustments: Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900 (300) Capitalized interest. . . . . . . . . . . . . . . . . . . . . . 30 30 Revaluation of fi xed assets . . . . . . . . . . . . . . . . — 56

Stockholders’ equity under local GAAP . . . . . . . . 15,930 14,786

Description of Accounting Differences

Goodwill. SKD capitalizes goodwill and amortizes it over a 20-year period. Goodwill is also treated as an asset in Country A and Country B. However, goodwill is not amortized in Country A, but instead is subjected to an annual impairment test. Goodwill is amortized over a 5-year period in Country B.

Interest. SKD expenses all interest immediately. In both Country A and Country B, interest related to self-constructed assets must be capitalized as a part of the cost of the asset.

Fixed assets. SKD carries assets on the balance sheet at their historical cost, less accumulated depreciation. The same treatment is required in Country A. In Country B, companies in the biotechnology industry generally carry assets on the balance sheet at revalued amounts. Depreciation is based on the revalued amount of fi xed assets.

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Worldwide Accounting Diversity 63

Required: 1. With respect to the adjustments related to goodwill, answer the following:

a. Why does the adjustment for goodwill amortization increase net income under Country A GAAP but decrease net income under Country B GAAP?

b. Why does the goodwill adjustment increase stockholders’ equity in Country A but decrease stockholders’ equity in Country B?

c. Why are the adjustments to stockholders’ equity larger than the adjustments to income?

2. With respect to the adjustments made by the analyst in Country A related to interest, answer the following: a. Why are there two separate adjustments to income related to interest? b. Why does the adjustment to income for capitalized interest increase in-

come, whereas the adjustment for depreciation related to capitalized interest decreases income?

c. Why is the positive adjustment to stockholders’ equity for capitalized interest smaller than the positive adjustment to income for capitalized interest?

3. With respect to the adjustments made by the analyst in Country B related to " xed assets, answer the following: a. Why does the adjustment for depreciation related to revalued " xed assets

decrease income, whereas the adjustment for revaluation of " xed assets in- creases stockholders’ equity?

References Afterman , Allan B. International Accounting, Financial Reporting, and Analysis. New York: Warren, Gorham & Lamont , 1995 , pp. C1–17, C1–22. Brooks , Jermyn Paul , and Dietz Mertin . Neues Deutsches Bilanzrecht. Düsseldorf:

IDW-Verlag, 1986 . Cochrane , James L. , James E. Shapiro , and Jean E. Tobin . “Foreign Equities and

U.S. Investors: Breaking Down the Barriers Separating Supply and Demand.” NYSE Working Paper, 95-04 , 1995 .

Collins , Stephen H. “The Move to Globalization.” Journal of Accountancy, March 1989 .

Doupnik , Timothy S. , and Stephen B. Salter . “An Empirical Test of a Judgemental International Classi" cation of Financial Reporting Practices.” Journal of Interna- tional Business Studies, First Quarter 1993 , pp. 41–60 .

Doupnik , Timothy S. , and George T. Tsakumis . “A Review of Empirical Tests of Gray’s Framework and Suggestions for Future Research.” Journal of Accounting Literature, 2004 , pp. 1–48 .

Gernon , H. , and Gary Meek . Accounting: An International Perspective, 5th ed. Burr Ridge, IL: Irwin/McGraw-Hill, 2001 .

Gray , S. J. “Towards a Theory of Cultural In! uence on the Development of Accounting Systems Internationally.” Abacus, March 1988 , pp. 1–15 .

Hofstede , G. Culture’s Consequences: International Differences in Work-Related Values. London: Sage, 1980 .

———. Culture’s Consequences: Comparing Values, Behaviors, Institutions, and Organi- zations across Nations, 2nd ed. Thousand Oaks, CA: Sage , 2001 .

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64 Chapter Two

Malaysian Accounting Standards Board. MASB i-1, Presentation of Financial State- ments of Islamic Financial Institutions, 2001 .

Meek , Gary K. , and Sharokh M. Saudagaran . “A Survey of Research on Financial Reporting in a Transnational Context.” Journal of Accounting Literature, 1990 , pp. 145–82 .

Nobes , Christopher W. “A Judgemental International Classi" cation of Financial Reporting Practices.” Journal of Business Finance and Accounting, Spring 1983 .

———. “Towards a General Model of the Reasons for International Differences in Financial Reporting.” Abacus , September 1998, p. 166 .

Radebaugh , Lee H. , and Sidney J. Gray . International Accounting and Multinational Enterprises, 5th ed. New York: Wiley , 2002 .

Rahman , Zubaidur M. “The Role of Accounting in the East Asian Financial Crisis: Lessons Learned?” Transnational Corporations 7, no. 3 (December 1998 ), pp. 1–52 .

U.S. Department of Commerce. “U.S. International Transactions.” Survey of Current Business, January 2005 , pp. 45–76 .

Violet , William J. “The Development of International Accounting Standards: An Anthropological Perspective.” International Journal of Accounting, 1983 , pp. 1–12 .

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65

Chapter Three

International Convergence of Financial Reporting Learning Objectives

After reading this chapter, you should be able to

• Explain the meaning of convergence. • Identify the arguments for and against international convergence of fi nancial

reporting standards. • Discuss major harmonization efforts under the IASC. • Explain the principles-based approach used by the IASB in setting accounting

standards. • Describe the proposed changes to the IASB’s Framework. • Discuss the IASB’s Standards related to the fi rst-time adoption of International

Financial Reporting Standards (IFRS) and the presentation of fi nancial statements. • Describe the support for, and the use of, IFRS across countries. • Examine the issues related to international convergence of fi nancial reporting

standards. • Describe the progress made with regard to the IASB/FASB convergence project. • Explain the meaning of “Anglo-Saxon” accounting.

INTRODUCTION

In Chapter 2, we discussed worldwide diversity in accounting practices and some of the problems caused by such diversity. Sir Bryan Carsberg, former secretary- general of the International Accounting Standards Committee (IASC), explained how accounting diversity affects international capital markets:

Imagine the case of an international business, with operations in many different countries. It is likely to be required to prepare accounts for its operations in each country, in compliance with the rules of that country. It will then have to con- vert those accounts to conform to the rules of the country in which the holding company is resident, for the preparation of group accounts. If the company has listings on stock exchanges outside its home country, these exchanges or their

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66 Chapter Three

regulators may require the accounts to be ! led under some other basis. The extra cost could be enormous. Heavy costs also fall on investors in trying to compare the results of companies based in different countries and they may just be unable to make such comparisons. . . . But the biggest cost may be in limiting the effectiveness of the international capital markets. Cross border investment is likely to be inhibited. 1

The accounting profession and standard-setters have been under pressure from multinational companies, stock exchanges, securities regulators, international lending institutions such as the World Bank, and other international bodies such as G20 to reduce diversity and harmonize accounting standards and practices internationally. This chapter focuses on the activities of the International Account- ing Standards Board (IASB), which replaced the IASC in 2001. The chapter also includes a discussion of the major harmonization efforts under the IASC. We identify the arguments for and against convergence, and discuss the adoption of International Financial Reporting Standards (IFRS), including national efforts to converge with those standards.

INTERNATIONAL ACCOUNTING STANDARD-SETTING

The evolution of the International Accounting Standards Committee and the International Accounting Standards Board shows international accounting standard-setting in the private sector with the support of the accounting bodies, standard-setters, capital market regulators, and government authorities in various countries, as well as the preparers and users of ! nancial statements around the world.

Before the formation of the IASC in 1973, even within the Anglo-American countries, there were important differences in ! nancial reporting; for example, in the United Kingdom, Australia, and New Zealand, companies could revalue their ! xed assets, whereas in the United States and Canada, this was not allowed. Even greater differences existed between the GAAP in the Anglo-American countries and those in the Continental European countries and in Japan. For example, unlike in the Anglo-American countries, in countries on the European continent and in Japan, income taxation drove accounting practice. In most developing countries, ! nancial disclosure was minimal. There was a rapid expansion of international trade, foreign direct investment, and engagement in international transactions by companies during the 1950s and 1960s. This situation fueled the clamor for harmo- nization of ! nancial reporting standards by various interested groups, the main argument being that it would assist companies to compare ! nancial statements prepared by companies in different countries for investment and other purposes.

The word harmonization appears to have had its day. It means different things to different people. Some view harmonization as the same as standardization. How- ever, whereas standardization implies the elimination of alternatives in accounting for economic transactions and other events, harmonization refers to the reduction of alternatives while retaining a high degree of " exibility in accounting practices. Harmonization allows different countries to have different standards as long as

1 Excerpt from Sir Bryan Carsberg, “Global Issues and Implementing Core International Accounting Standards: Where Lies IASC’s Final Goal?” Remarks made at the 50th Anniversary Dinner, Japanese Institute of CPAs, Tokyo, October 23, 1998.

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International Convergence of Financial Reporting 67

the standards do not con" ict. For example, prior to 2005, within the European Union harmonization program, if appropriate disclosures were made, companies were permitted to use different measurement methods: German companies could use historical cost for valuing assets, while Dutch companies could use replace- ment cost without violating the harmonization requirements.

Harmonization is a process that takes place over time. Accounting harmoni- zation can be considered in two ways, namely, harmonization of accounting regulations or standards (also known as formal or de jure harmonization), and harmonization of accounting practices (also known as material or de facto har- monization). Harmonization of accounting practices is the ultimate goal of inter- national harmonization efforts. Harmonization of standards may not necessarily lead to harmonization of accounting practices adopted by companies. For exam- ple, a study in China in 2002 found that despite the Chinese government’s efforts through legislation to ensure harmonization between Chinese GAAP and IASC GAAP, there was no evidence that such efforts eliminated or signi! cantly reduced the differences that exist between earnings calculated under Chinese and IASC GAAP. 2 Other factors such as differences in the quality of audits, enforcement mechanisms, culture, legal requirements, and socioeconomic and political systems may lead to noncomparable accounting numbers despite similar accounting stan- dards. An empirical study conducted in 1996 to assess the impact of the IASC’s harmonization efforts, focusing on the accounting practices of major companies based in France, Germany, Japan, the United Kingdom, and the United States, con- cluded that the impact had been quite modest. The study considered 26 major accounting measurement issues and found that in 14 cases harmonization had in- creased, but in 12 cases harmonization had decreased. 3

The phrase “international convergence of accounting standards” refers to both a goal and the process adopted to achieve it. The goal of “convergence” in account- ing standards can be interpreted differently. From a strict viewpoint, it refers to the enforcement of a single set of accepted standards by several regulatory bod- ies, for example, the convergence project of the IASB and the FASB. From a soft viewpoint, it refers to diminishing differences among accounting standards issued by several regulators. According to a third viewpoint, it refers to a situation where two or more jurisdictions agree on a core set of common standards, allowing vary- ing interpretations regarding non-core issues. Similarly, in implementing the in- ternational “convergence” process, three fundamental approaches can be adopted. First, the aim could be to merge all standard-setting bodies into a uni! ed “global” body. From a theoretical point of view, it is often argued that the uni! ed solution of a single international standard-setting body is optimal. Second, the aim could be to recognize each of the existing standard-setting bodies as the sole authority in its respective jurisdiction. Accordingly, it can also be argued that discretion and " ex- ibility in accounting standards through mutual recognition is theoretically more desirable than uniformity and rigidity, and when the incentive consequences and the investment effects of accounting standards are taken into consideration, then discretion can be superior to uniformity. Third, the aim could also be to recognize

2 S. Chen, Z. Sun, and Y. Wang, “Evidence from China on Whether Harmonized Accounting Standards Harmonize Accounting Practices,” Accounting Horizons 16, no. 3 (2002), pp. 183–97. 3 Emmanuel N. Emenyonu and Sidney J. Gray, “International Accounting Harmonization and the Major Developed Stock Market Countries: An Empirical Study,” International Journal of Accounting 31, no. 3 (1996), pp. 269–79.

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68 Chapter Three

that a national standard-setting body can coexist with international coordination bodies. The IASB’s main objective is to achieve international convergence with its standards. In other words, the efforts of the IASB are directed toward developing a high-quality set of standards for use internationally for ! nancial reporting pur- poses (global standard-setting). 4

HARMONIZATION EFFORTS

Several international organizations were involved in harmonization efforts either regionally (such as the Association of Southeast Asian Nations) or worldwide (such as the United Nations). The two most important players in this effort were the European Union (regionally) and the International Accounting Standards Committee (globally). The International Organization of Securities Commissions, the International Federation of Accountants, and the International Forum of Ac- countancy Development also have contributed to the harmonization efforts at the global level.

International Organization of Securities Commissions Established in 1974, the International Organization of Securities Commissions (IOSCO) was initially limited to providing a framework in which securities regula- tory agencies in the Americas could exchange information, and providing advice and assistance to those agencies supervising emerging markets. In 1986, IOSCO opened its membership to regulatory agencies in other parts of the world, thus giving it the potential to become a truly international organization. Today, IOSCO is the leading organization for securities regulators around the world, with about 177 ordinary, associate, and af! liate members (including the U.S. Securities and Exchange Commission) from about 100 countries.

IOSCO aims, among other things, to ensure a better regulation of the markets on both the domestic and international levels. It provides assistance to ensure the integrity of the markets by a rigorous application of the standards and by effective enforcement.

As one of its objectives, IOSCO works to facilitate cross-border securities offer- ings and listings by multinational issuers. It has consistently advocated the adop- tion of a set of high-quality accounting standards for cross-border listings. For example, a 1989 IOSCO report entitled “International Equity Offers” noted that cross-border offerings would be greatly facilitated by the development of interna- tionally accepted accounting standards. 5 To this end, IOSCO supported the efforts of the International Accounting Standards Committee (IASC) in developing in- ternational accounting standards that foreign issuers could use in lieu of local ac- counting standards when entering capital markets outside of their home country. As one observer notes: “This could mean, for example, that if a French company had a simultaneous stock offering in the United States, Canada, and Japan, ! nan- cial statements prepared in accordance with international standards could be used in all three nations.” 6

4 G. Whittington, “The Adoption of International Accounting Standards in the European Union,” European Accounting Review 14, no.1 (2005), pp. 127–53. 5 This report is available from IOSCO’s Web site, www.iosco.org . 6 Stephen H. Collins, “The SEC on Full and Fair Disclosure,” Journal of Accountancy, January 1989, p. 84.

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International Convergence of Financial Reporting 69

International Federation of Accountants The International Federation of Accountants (IFAC) was established in October 1977 at the 11th World Congress of Accountants in Munich, with 63 founding members representing 51 countries. It is now a global organization of 158 member bodies and associates in 123 countries, representing over 2.5 million accountants employed in public practice, industry and commerce, government, and academia. Its mission is to serve the public interest and to strengthen the worldwide accountancy profession and contribute to the development of strong international economies by establishing and promoting adherence to high-quality professional standards on auditing, ethics, education, and training.

In June 1999, IFAC launched the International Forum on Accountancy Develop- ment (IFAD) in response to a criticism from the World Bank (following the Asian ! nancial crisis) that the accounting profession was not doing enough to enhance the accounting capacity and capabilities in developing and emerging nations. IFAD’s membership includes the international ! nancial institutions (such as the World Bank, International Monetary Fund, and Asian Development Bank); other key international organizations (such as IOSCO, IASB, and SEC); and the large ac- countancy ! rms. 7 The primary aim of this forum is to promote transparent ! nan- cial reporting, duly audited to high standards by a strong accounting and auditing profession.

In May 2000, IFAC and the large international accounting ! rms established the Forum of Firms, also aimed at raising standards of ! nancial reporting and audit- ing globally in order to protect the interests of cross-border investors and promote international " ows of capital. The forum works alongside IFAD in achieving com- mon objectives.

European Union The European Union (EU) was founded in March 1957 with the signing of the Treaty of Rome by six European nations: Belgium, France, Germany, Italy, Luxembourg, and the Netherlands. 8 Between 1973 and 1995, nine other countries joined the common market (Denmark, Ireland, and the United Kingdom in 1973; Greece in 1981; Portugal and Spain in 1986; and Austria, Finland, and Sweden in January 1995), creating a 15-nation trading bloc. Another 10 new members (namely, Latvia, Estonia, Lithuania, Poland, Hungary, Czech Republic, Slovakia, Slovenia, and the Mediterranean islands of Cyprus and Malta) joined the EU in May 2004. In addition, Bulgaria and Romania joined in 2007, and Croatia in 2013, for a total of 28 countries. Until May 2004 all EU countries possessed similar traits in many re- spects. They all were wealthy industrial nations with similar political goals, com- parable standards of living, high volumes of trade within the union, and good transportation links. The 2004 additions to EU membership are likely to change the dynamics of the group, especially considering that 8 of the 10 new entrants were members of the former Soviet bloc.

The European Commission is responsible for administering the EU. From the beginning, the EU’s aim has been to create a uni! ed business environment. Ac- cordingly, the harmonization of company laws and taxation, the promotion of full freedom in the movement of goods and labor between member countries, and the

7 Details at www.ifad.org . 8 The original European Economic Community (EEC) became the European Union (EU) on January 1, 1994.

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70 Chapter Three

creation of a community capital market have been high on its agenda. In July 2002, most EU members adopted a single currency, the euro, as envisaged in the Treaty of Maastricht signed in 1991. 9

The EU attempted to harmonize ! nancial reporting practices within the com- munity by issuing directives that member nations had to incorporate into their laws. EU directives possess the force of law. 10 They were binding on EU members with respect to the results to be achieved, but the manner in which the desired results were achieved was left to the discretion of the individual countries.

Two directives aimed at harmonizing accounting: the Fourth Directive (issued in 1978) dealt with valuation rules, disclosure requirements, and the format of ! nancial statements, and the Seventh Directive (issued in 1983) dealt with consoli- dated ! nancial statements. The latter required companies to prepare consolidated ! nancial statements and outlined the procedures for their preparation. It had a signi! cant impact on European accounting, as consolidations were previously uncommon in Continental Europe.

The Fourth Directive included comprehensive accounting rules covering the content of annual ! nancial statements, their methods of presentation, and mea- surement and disclosure of information for both public and private companies. It established the “true and fair view” principle, which required ! nancial state- ments to provide a true and fair view of a company’s assets and liabilities, and of its ! nancial position and pro! t and loss for the bene! t of shareholders and third parties.

The Fourth Directive provided considerable " exibility. Dozens of provisions beginning with the expression “Member states may require or permit compa- nies to . . .” allowed countries to choose from among acceptable alternatives. For example, under Dutch and British law, companies could write assets up to higher market values, whereas in Germany this was strictly forbidden. Both approaches were acceptable under the Fourth Directive. By allowing different options for a variety of accounting issues, the EU directives opened the door for noncompa- rability in ! nancial statements. As an illustration of the effects of differing prin- ciples within the EU, the pro! ts of one case study company were measured using the accounting principles of various member states. The results, presented in the following table, reveal the lack of comparability: 11

9 Several EU members—namely, Denmark, Sweden, and the United Kingdom—have not adopted the euro as their national currency. 10 The EU has issued numerous directives covering a broad range of business issues, including directives related to accounting, auditing, taxation, e-commerce, and the prevention of money laundering. 11 Anthony Carey, “Harmonization: Europe Moves Forward,” Accountancy, March 1990.

Most Likely Profi t—Case Study Company

Country ECUs (millions)

Spain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131 Germany . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133 Belgium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135 Netherlands . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140 France . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149 Italy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174 United Kingdom . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192

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International Convergence of Financial Reporting 71

Pro! t measurement across EU countries differed in part because the directives failed to cover several important topics, including lease accounting, foreign cur- rency translation, accounting changes, contingencies, income taxes, and long-term construction contracts.

Notwithstanding the " exibility afforded by the directives, their implementa- tion into local law caused extensive change in accounting practice in several EU member countries. The following are some of the changes in German accounting practice brought about by the integration of the EU’s Fourth and Seventh Direc- tives into German law in 1985:

1. Required inclusion of notes to the ! nancial statements. 2. Preparation of consolidated ! nancial statements on a worldwide basis (i.e., for-

eign subsidiaries no longer could be excluded from consolidation). 3. Elimination of unrealized intercompany losses on consolidation. 4. Use of the equity method for investments in associated companies. 5. Disclosure of comparative ! gures in the balance sheet and income statement. 6. Disclosure of liabilities with a maturity of less than one year. 7. Accrual of deferred tax liabilities and pension obligations. 12

Most of these “innovations” had been common practice in the United States for several decades.

Although the EU directives did not lead to complete comparability across mem- ber nations, they helped reduce differences in ! nancial statements. In addition, the EU directives have served as a basic framework of accounting that has been adopted by other countries in search of an accounting model. With the economic reforms in Eastern Europe since 1989, several countries in that region found it necessary to abandon the Soviet-style accounting system previously used in favor of a Western, market-oriented system. For example, in the early 1990s, Hungary, Poland, and the Czech and Slovak Republics all passed new accounting laws pri- marily based on the EU directives in anticipation of securing EU membership. This is further evidence of the in" uence that economic ties among countries can have on accounting practice.

In 1990, the European Commission indicated that there would be no further EU directives related to accounting. Instead, the commission indicated in 1995 that it would associate the EU with efforts undertaken by the IASC toward a broader international harmonization of accounting standards. In June 2000, the European Commission issued the following communication to the European Parliament:

• Before the end of 2000, the Commission will present a formal proposal requiring all listed EU companies to prepare their consolidated accounts in accordance with one single set of accounting standards, namely International Accounting Standards (IAS).

• This requirement will go into effect, at the latest, from 2005 onwards. • Member states will be allowed to extend the application of IAS to unlisted com-

panies and to individual accounts. 13

12 Timothy S. Doupnik, “Recent Innovations in German Accounting Practice Through the Integration of EC Directives,” Advances in International Accounting 5 (1992), pp. 75–103. 13 Commission of the European Communities, “EU Financial Reporting Strategy: The Way Forward,” Communication from the Commission to the Council and the European Parliament, June 13, 2000.

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72 Chapter Three

The International Forum on Accountancy Development (IFAD) IFAD was created as a working group between the Basel Committee, the IFAC, IOSCO, the large accounting ! rms, OECD, UNCTAD, and the World Bank and regional development banks, which " owed from the East Asian crisis in the late 1990s. Its mission was to improve market security and transparency and ! nancial stability on a global basis. The objectives of IFAD were to promote understanding by national governments of the value of transparent ! nancial reporting, in accor- dance with sound corporate governance; assist in de! ning expectations as to how the accountancy profession (in both the public and private sectors) should carry out its responsibilities to support the public interest; encourage governments to focus more directly on the needs of developing countries (including economies in transition); help harness funds and expertise to build accounting and auditing capacity in developing countries; contribute to a common strategy and framework of reference for accountancy development; and promote cooperation among gov- ernments, the accountancy and other professions, the international ! nancial insti- tutions, regulators, standard-setters, capital providers, and issuers.

IFAD promoted the view that the national accounting standards of most coun- tries should be raised, with the IAS as the benchmark. IFAD completed its work with the publication of GAAP Convergence 2002.

The International Accounting Standards Committee (IASC) IASC was established in 1973 by an agreement of the leading professional ac- counting bodies in 10 countries (Australia, Canada, France, Germany, Ireland, Japan, Mexico, the Netherlands, the United Kingdom, and the United States) with the broad objective of formulating “international accounting standards.” Prior to its dissolution, the IASC consisted of 156 professional accountancy bodies in 114 countries, representing more than 2 million accountants in public practice, educa- tion, government service, industry, and commerce. The IASC was funded by con- tributions from member bodies, multinational companies, ! nancial institutions, accounting ! rms, and the sale of IASC publications.

The “Lowest-Common-Denominator” Approach The IASC’s harmonization efforts from 1973 to 2001 evolved in several different phases. In the initial phase, covering the ! rst 15 years, the IASC’s main activity was the issuance of 26 generic International Accounting Standards (IASs), many of which allowed multiple options. The IASC’s approach to standard-setting dur- ing this phase can be described as a lowest-common-denominator approach, as the standards re" ected an effort to accommodate existing accounting practices in various countries. For example, International Accounting Standard (IAS) 11, Construction Contracts, as originally written in 1979, allowed companies to choose between the percentage-of-completion method and the completed contract method in accounting for long-term construction contracts, effectively sanctioning the two major methods used internationally. A study conducted by the IASB in 1988 found that all or most of the companies listed on the stock exchanges of the countries included in Nobes’s classi! cation presented in Chapter 2 of this book (except for Germany and Italy) were in compliance with the International Accounting Stan- dards. 14 Given the lowest-common-denominator approach adopted by the IASC, it was obvious that IASC standards existing in 1988 introduced little if any compa- rability of ! nancial statements across countries.

14 International Accounting Standards Committee, Survey of the Use and Application of International Accounting Standards 1988 (London: IASC, 1988).

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International Convergence of Financial Reporting 73

The Comparability Project Two signi! cant activities took place from 1989 to 1993, which can be described as the IASC’s second phase. The ! rst was the 1989 publication of the Framework for the Prepa- ration and Presentation of Financial Statements (hereafter referred to as the Framework ), which set out the objectives of ! nancial statements, the qualitative characteristics of ! nancial information, de! nitions of the elements of ! nancial statements, and the crite- ria for recognition of ! nancial statement elements. The second activity was the Com- parability of Financial Statements Project, the purpose of which was “to eliminate most of the choices of accounting treatment currently permitted under International Accounting Standards.” 15 As a result of the Comparability Project, 10 revised Interna- tional Accounting Standards were approved in 1993 and became effective in 1995. As an example of the changes brought about by the Comparability Project, IAS 11 was revised to require the use of the percentage-of-completion method when certain cri- teria are met, thereby removing the option to avoid the use of this method altogether.

The IOSCO Agreement The ! nal phase in the work of the IASC began with the IOSCO agreement in 1993 and ended with the creation of the IASB in 2001. The main activity during this phase was the development of a core set of international standards that could be endorsed by IOSCO for cross-listing purposes. This period also was marked by the proposal to restructure the IASC and the proposal’s ! nal approval.

IOSCO became a member of the IASC’s Consultative Group in 1987 and sup- ported the IASC’s Comparability Project. In 1993, IOSCO and the IASC agreed on a list of 30 core standards that the IASC needed to develop that could be used by companies involved in cross-border security offerings and listings. In 1995, the IASC and IOSCO agreed on a work program for the IASC to develop the set of core international standards, and IOSCO agreed to evaluate the standards for possible endorsement for cross-border purposes upon their completion.

With the publication of IAS 39, Financial Instruments: Recognition and Measure- ment, in December 1998, the IASC completed its work program to develop the set of 30 core standards. In May 2000, IOSCO’s Technical Committee recommended that securities regulators permit foreign issuers to use the core IASC standards to gain access to a country’s capital market as an alternative to using local stan- dards. The Technical Committee consisted of securities regulators representing the 14 largest and most developed capital markets, including Australia, France, Germany, Japan, the United Kingdom, and the United States. IOSCO’s endorse- ment of IASC standards was an important step in the harmonization process. 16

U.S. Reaction to International Accounting Standards Of the 14 countries represented on IOSCO’s Technical Committee, only Canada and the United States did not allow foreign companies to use International Ac- counting Standards (IASs) without reconciliation to local GAAP for listing pur- poses. 17 In 1996, the U.S. Securities and Exchange Commission (SEC) announced

15 International Accounting Standards Committee, International Accounting Standards 1990 (London: IASC, 1990), p. 13. 16 IOSCO, Final Communique of the XXIXth Annual Conference of the International Organization of Securities Commissions, Amman, May 17–20, 2004. 17 The SEC allows foreign companies listed on U.S. stock exchanges to fi le annual reports based on IAS, but only if a reconciliation from IAS to U.S. GAAP for income and stockholders’ equity is included in the notes to the fi nancial statements. Many foreign companies fi nd this reconciliation to be very costly and view this requirement as a signifi cant barrier to entering the U.S. capital market.

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74 Chapter Three

three criteria IASs would have to meet to be acceptable for cross-listing purposes. Namely, IASs would have to:

• Constitute a comprehensive, generally accepted basis of accounting. • Be of high quality, resulting in comparability and transparency, and providing

for full disclosure. • Be rigorously interpreted and applied.

Partly in response to the third criterion, the IASC created a Standing Interpreta- tions Committee (SIC) to provide guidance on accounting issues where there is likely to be divergent or unacceptable treatment in the absence of speci! c guid- ance in an International Accounting Standard.

The SEC began its assessment of the IASC’s core set of standards in 1999 and issued a concept release in 2000 soliciting comments on whether it should modify its requirement that all ! nancial statements be reconciled to U.S. GAAP.

The FASB conducted a comparison of IASC standards and U.S. GAAP in 1996, identifying 218 items covered by both sets of standards. 18 The following table lists the degree of similarity across these items:

18 Financial Accounting Standards Board, The IASC-U.S. Comparison Project: A Report on the Similarities and Differences between IASC Standards and U.S. GAAP , ed. Carrie Bloomer (Norwalk, CT: FASB, 1996). 19 See, for example, Donna L. Street, Sidney J. Gray, and Stephanie M. Bryant, “Acceptance and Obser- vance of International Accounting Standards: An Empirical Study of Companies Claiming to Comply with IASs,” The International Journal of Accounting 34, no. 1 (1999), pp. 11–48; and David Cairns, Financial Times International Accounting Standards Survey (London: FT Finance, 1999). 20 Apparently concerned with the lack of full compliance with IFRS, one of the SEC’s major requirements to allow foreign registrants to use IFRS without reconciliation to U.S. GAAP is the existence of “an infra- structure that ensures that the standards are rigorously interpreted and applied,” SEC Concept Release: International Accounting Standards (2000). 21 David Cairns, “IAS Lite Is Alive and Well,” Accountancy, May 2001. Cairns identifi es three types of IAS lite: (1) disclosed IAS lite, where companies disclose exceptions from full IAS compliance; (2) implied IAS lite, where companies refer to the use of rather than compliance with IAS; and (3) undisclosed IAS lite, where companies claim to comply with IAS but fail to comply fully with it.

Although it was widely assumed that U.S. GAAP and IASs were generally consis- tent, the FASB’s comparison showed that differences existed for 74 percent of the accounting items covered by both sets of standards.

Compliance with International Accounting Standards Several studies investigated the extent of compliance by those ! rms that claimed to follow International Accounting Standards. 19 These studies found various lev- els of noncompliance with IAS. 20 Former IASC Secretary-General David Cairns referred to the use of IAS with exceptions as “IAS-lite.” 21 In response to the use of “IAS-lite,” IAS 1 was revised in 1997 to preclude a ! rm from claiming to be in com- pliance with IAS unless it complies with all requirements (including disclosure

Number Percent

Similar approach and guidance . . . . . . . . . . . . . . . 56 26% Similar approach but different guidance  . . . . . . . . 79 36 Different approach  . . . . . . . . . . . . . . . . . . . . . . . . 56 26 Alternative approaches permitted . . . . . . . . . . . . . 27 12

218 100%

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International Convergence of Financial Reporting 75

requirements) of each standard and each applicable Interpretation. A number of ! rms that previously disclosed in the annual report their use of IAS “with excep- tions” discontinued this disclosure subsequent to this revision to IAS 1.

In its accounting policies note to its 1998 ! nancial statements, the French ! rm Thomson-CSF stated:

In a February 1998 recommendation, the C.O.B. (the French Securities Regulator) observed that for operating periods starting as from July 1, 1998, a company could no longer state that it complied with the International Accounting Standards Com- mittee (I.A.S.C.) reference system, if it did not apply all I.A.S.C. standards currently in force. Consequently, as from the 1998 operating period, the consolidated ! nancial statements of Thomson-CSF, prepared in accordance with accounting principles applicable in France, as also the provisions of the 7th European Directive, no longer refer to the I.A.S.C. standards. (p. 82)

Prior to 1998, Thomson-CSF claimed to follow IAS when it apparently did not. From the excerpt above, it appears that Thomson-CSF elected not to fully comply with IAS and in 1998 no longer claimed to do so as required by the French Securi- ties Regulator. Because the IASC itself did not have the power to enforce it, IAS 1 had to be enforced by national securities regulators and auditors.

Challenges to the IASC • During the 1970s and 1980s, the UN and the OECD were concerned that the

IASC lacked legitimacy because it was created by the accounting profession (private sector), with its self-interests.

• The IASC also faced problems of legitimacy with regard to constituent support, independence, and technical expertise. For example, some interested parties perceived the fact that IASC board members worked at international standard- setting only part-time and were not necessarily selected because of their techni- cal expertise as an indication of a lack of commitment on the part of the IASC to develop i the highest-quality standards possible.

• The IFAC, arguing on the issue of who should control the international standard- setting, tried unsuccessfully on two occasions during the 1980s to bring the IASC under its control.

• In 1993–94, standard setters from the United Kingdom, the United States, Canada, and Australia began meeting quarterly to discuss issues related to international standard-setting. The group came to be known as the G4+1, the 1 being a represen- tative, usually the secretary-general of the IASC, who attended as an observer.

CREATION OF THE IASB

Responding to these challenges, the IASC appointed a Strategy Working Party in 1996, which issued a discussion document in December 1998 entitled “Shaping IASC for the Future.” This document proposed a vastly different structure and process for the development of international accounting standards.

The ! nal recommendations of the IASC Strategy Working Party were approved at its Venice meeting in November 1999. These recommendations, designed to deal with the issue of legitimacy, attempted to balance calls for a structure based on geographic representativeness and those based on technical competence and inde- pendence. Accordingly, it was decided that representativeness would be provided by the geographic distribution of the trustees, who would be essential to ensuring

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76 Chapter Three

the effectiveness and independence of the board, but that board members would be selected based on their expertise.

On April 1, 2001, the newly created International Accounting Standards Board (IASB) took over from the IASC as the creator of international accounting stan- dards, which were to be called International Financial Reporting Standards (IFRS). The process of restructuring the IASC into the IASB took over ! ve years and is summarized in Exhibit 3.1 . The formation of the IASB in 2001, with a change in focus from harmonization to convergence or global standard-setting, marked the beginning of a new era in international ! nancial reporting.

EXHIBIT 3.1 The Process of Restructuring the IASC into the IASB

Date Activity

September 1996 IASC board approves formation of a Strategy Working Party (SWP) to consider what IASC’s strategy and structure should be when it completes the Core Standards work program.

December 1998 SWP publishes a discussion paper, “Shaping IASC for the Future,” and invites comments.

April to October 1999 SWP holds various meetings to discuss the comments on their initial proposal and to develop fi nal recommendations.

December 1999 SWP issues fi nal report, Recommendations on Shaping IASC for the Future. IASC board passes a resolution supporting the report and appoints a nominating committee for the initial trustees.

January 2000 Nominating committee elects SEC chairman Arthur Levitt as its chair and invites nominations from public.

March 2000 IASC board approves a new constitution refl ecting the SWP proposals.

May 2000 Nominating committee announces initial trustees.

May 2000 IASC member bodies approve the restructuring and the new IASC constitution.

June 2000 Trustees appoint Sir David Tweedie as the fi rst chairman of new IASC board.

July 1, 2000 New IASC constitution takes effect.

Starting in July 2000 Trustees invite nominations for membership on the new IASC board, narrow the list to approximately 45 fi nalists, and conduct interviews in London, New York, and Tokyo.

January 2001 Trustees invite nominations for membership on the new advisory council.

January 2001 Members of the IASB announced.

March 2001 IASC trustees activate Part B of IASC’s constitution and establish a nonprofi t Delaware corporation, named the International Accounting Standards Committee Foundation, to oversee the International Accounting Standards Board.

April 2001 On April 1, 2001, the new IASB takes over from the IASC the responsibility for setting International Accounting Standards.

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International Convergence of Financial Reporting 77

The Structure of the IASB The IASB is organized under an independent foundation called the IFRS Founda- tion. Components of the structure are as follows ( Exhibit 3.2 ) (the titles of some of the components are as changed on March 31, 2010):

1. International Accounting Standards Board (IASB). 2. IFRS Foundation (IFRSF). 3. Monitoring Board. 4. IFRS Interpretations Committee (IFRSIC). 5. IFRS Advisory Council (IFRSAC). 6. Working Groups (expert task forces for individual agenda projects).

Monitoring Board The IASC Foundation Constitution was amended in February 2009 to create a Monitoring Board of public authorities. The Monitoring Board comprises the rele- vant leaders of the European Commission, the Japanese Financial Services Agency, the U.S. Securities and Exchange Commission, the Emerging Markets Commit- tee of IOSCO, and the Technical Committee of IOSCO. The chairman of the Basel Committee on Banking Supervision is a nonvoting observer. The Monitoring Board oversees the IFRS Foundation Trustees, participates in the Trustee nomina- tion process, and approves appointments to the Trustees. The speci! c functions of the Monitoring Board include the following:

• To enhance public accountability of the IASC Foundation. • To participates in the Trustee nomination process and approval of appointments

to the Trustees. • To carry out oversight responsibilities in relation to the Trustees and their over-

sight of the IASB’s activities, in particular the agenda-setting process and the IASB’s efforts to improve the accuracy and effectiveness of ! nancial reporting and to protect investors.

Monitoring Board Approve and oversee trustees

IFRS Foundation 22 trustees appoint, oversee, raise funds

IFRS interpretations committee

14 members

Key

Appoints Reports to Advises

IFRS advisory council

approx. 40 members

Working groups for major agenda projects

Board 16 (maximum 3 part-time) Set technical agenda. Approve standards,

exposure drafts, and interpretations.

EXHIBIT 3.2 The Structure of the IASB

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78 Chapter Three

Trustees of the IFRS Foundation The IFRS Foundation consists of 22 Trustees (the number of trustees was increased from 19 to 22 as a result of revisions to the IFRS Foundation in June 2005). These 22 Trustees represent different geographical areas (six from North America; six from Europe; six from the Asia/Oceania region; four from any area, subject to establishing overall geographical balance). With regard to the composition of the Trustees, the constitution requires an appropriate balance of professional back- grounds, including auditors, preparers, users, academics, and other of! cials serv- ing the public interest. Two Trustees will normally be senior partners of prominent international accounting ! rms. The Trustees of the IFRS Foundation have the responsibility, among other things, to:

• Appoint the members of the IASB and establish their contracts of service and performance criteria.

• Appoint the members of the International Financial Reporting Interpretations Committee and the IFRS Advisory Council.

• Review annually the strategy of the IASC Foundation and the IASB and its effectiveness, including consideration, but not determination, of the IASB’s agenda.

• Approve annually the budget of the IFRS Foundation and determine the basis for funding.

• Review broad strategic issues affecting accounting standards, promote the IASC Foundation and its work, and promote the objective of rigorous applica- tion of International Accounting Standards and International Financial Report- ing Standards—provided that the Trustees shall be excluded from involvement in technical matters relating to accounting standards.

• Establish and amend operating procedures, consultative arrangements, and due process for the IASB, the International Financial Reporting Interpretations Committee, and the Standards Advisory Council.

• Review compliance with the operating procedures, consultative arrangements, and due process procedures.

• Approve amendments to the constitution after following a due process, includ- ing consultation with the IFRS Advisory Council and publication of an Expo- sure Draft for public comment and subject to the voting requirements.

• Exercise all powers of the IFRS Foundation, except for those expressly reserved to the IASB, the IFRS Interpretations Committee, and the IFRS Advisory Council.

• Foster and review the development of educational program and materials that are consistent with the IFRS Foundation’s objectives.

International Accounting Standards Board The IASB has sole responsibility for establishing International Financial Reporting Standards (IFRS).

The principal responsibilities of the IASB are to:

• Develop and issue International Financial Reporting Standards and Exposure Drafts.

• Approve Interpretations developed by the International Financial Reporting Interpretations Committee (IFRIC).

The Board consists of 16 members (effective February 1, 2009), of whom at least 13 serve full-time and not more than 3 part-time.

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International Convergence of Financial Reporting 79

The Board members are selected on the basis of professional competence and prac- tical experience. They are expected to represent a geographical mix, and to ensure a broad international diversity. Since July 2012, the composition of the board has been:

• Four members from the Asia/Oceania region. • Four members from Europe. • Four members from North America. • One member from Africa. • One member from South America. • Two members appointed from any area, subject to maintaining overall geo-

graphical balance.

Due process procedures followed by the IASB include the following (the steps that are required by the IASC Foundation constitution are indicated by an asterisk*):

1. Ask the staff to identify and review the issues associated with the topic and to consider the application of the Framework to the issues.

2. Study national accounting requirements and practice and exchange views about the issues with national standard-setters.

3. Consult the Standards Advisory Council about the advisability of adding the topic to the IASB’s agenda.*

4. Form an advisory group (generally called a “working group”) to advise the IASB and its staff on the project.

5. Publish for public comment a discussion document. 6. Publish for public comment an Exposure Draft approved by the vote of at least

nine IASB members, including any dissenting opinions held by IASB members (in Exposure Drafts, dissenting opinions are referred to as “alternative views”).*

7. Publish within an Exposure Draft a basis for conclusions. 8. Consider all comments received within the comment period on discussion

documents and Exposure Drafts.* 9. Consider the desirability of holding a public hearing and the desirability of

conducting ! eld tests and, if considered desirable, holding such hearings and conducting such tests.

10. Approve a standard by the votes of at least nine IASB members and include in the published standard any dissenting opinions.*

11. Publish within a standard a basis for conclusions, explaining, among other things, the steps in the IASB’s due process and how the IASB dealt with public comments on the Exposure Draft.

In March 2006, the Trustees of the IFRS Foundation published a new Due Process Handbook for the IASB. The Handbook describes the IASB’s consultative procedures.

IFRS Advisory Council The IFRS Advisory Council provides a forum for participation by organizations and individuals with an interest in international ! nancial reporting, having diverse geographical and functional backgrounds, with the objective of:

• Advising the IASB on agenda decisions and priorities in the IASB’s work. • Informing the IASB of the views of the organizations and individuals on the

Council on major standard-setting projects. • Giving other advice to the IASB or the Trustees.

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80 Chapter Three

The Advisory Council currently has about 40 members. The requirement is to have at least 30 members. Members are appointed by the Trustees for a renewable term of three years. They have diverse geographic and functional backgrounds.

IFRS Interpretations Committee The IFRS Interpretations Committee (initially this committee was known as the Standing Interpretations Committee, and later changed to the International Financial Reporting Interpretations Committee) has 14 members appointed by the Trustees for terms of three years (in November 2007, the membership was increased from 12 to 14).

The Committee’s responsibilities include the following:

• To interpret the application of International Financial Reporting Standards (IFRS) and provide timely guidance on ! nancial reporting issues not speci! - cally addressed in IFRS or IASs, in the context of the IASB’s framework, and undertake other tasks at the request of the Board.

• To publish Draft Interpretations for public comment and consider comments made within a reasonable period before ! nalizing an Interpretation.

• To report to the Board and obtain Board approval for ! nal Interpretations.

IFRS Foundation Constitution In January 2009, the Trustees voted to revise the constitution for changes resulting from the ! rst phase of the review, including formation of the Monitoring Board. In January 2010, the Trustees again voted to revise the constitution for changes resulting from the second phase of the review, including name changes from IASC Foundation to IFRS Foundation, from International Financial Reporting Interpre- tations Committee to IFRS Interpretations Committee, and from Standards Advi- sory Council to IFRS Advisory Council.

Review of the IASC Foundation’s Constitution The IASC Foundation’s constitution states that the Trustees should undertake:

[A] review of the entire structure of the IASC Foundation and its effectiveness, such review to include consideration of changing the geographical distribution of Trustees in response to changing global economic conditions, and publishing the proposals of that review for public comment, the review commencing three years after the coming into force of this Constitution, with the objective of implement- ing any agreed changes ! ve years after the coming into force of this Constitution (6 February 2006, ! ve years after the date of the incorporation of the IASC Foundation [Section 18 (b)]).

Consistent with Section 18 of the constitution, the IASC Foundation’s Constitu- tion Committee initiated in May 2004 a broad review of the constitution and iden- ti! ed 10 issues for consideration. These issues are based on the concerns expressed by important constituencies through various processes of consultation. They are as follows:

1. Whether the objectives of the IASC Foundation should expressly refer to the challenges facing small and medium-sized entities (SMEs). ( Concern: The

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International Convergence of Financial Reporting 81

language of the constitution does not adequately address the position of SMEs and emerging economies.)

2. Number of Trustees and their geographical and professional distribution. ( Concern: Certain regions are overrepresented, while the Asia-Oceania region as well as emerging economies are underrepresented.)

3. The oversight role of the Trustees. ( Concern: Trustees should demonstrate more clearly how they are ful! lling the oversight function.)

4. Funding of the IASC Foundation. ( Concern: The funding structure of the IASC Foundation needs to be examined.)

5. The composition of the IASB. ( Concern: The geographic backgrounds of the IASB members need to be examined.)

6. The appropriateness of the IASB’s existing formal liaison relationships. ( Con- cern: More guidance is needed in the constitution regarding the role that liai- son relationships play.)

7. Consultation arrangements of the IASB. ( Concern: Consultative arrangements need to be improved.)

8. Voting procedures of the IASB. ( Concern: For approval of a standard, the cur- rent “simple majority” approach should be replaced with a “super majority” approach.)

9. Resources and effectiveness of the International Financial Reporting Interpre- tations Committee (IFRIC). ( Concern: Given the likely increase in demand for IFRIC interpretations, the current arrangements are inadequate.)

10. The composition, role, and effectiveness of the SAC. ( Concern: Steps should be taken to make better use of the SAC.)

A proposal published by the Trustees of the IFRS Foundation builds on gov- ernance enhancements implemented as a result of the ! rst Constitution Review, completed in 2005 (these reviews will take place every ! ve years). For example, in 2005, the IASC Foundation’s Trustees changed the most important criterion for IASB membership from “technical expertise” to “professional competence and practical experience.” Indeed, Hans Hoogervorst, who succeeded David Tweedie as IASB chairman in July 2011, was the immediate past chairman of the Dutch securities regulator, and he did not have an accounting background. The Trustees published a report on the changes to the Foundation’s constitution made as a re- sult of the second part of their 2008–2010 constitution review. They have launched a program to enhance investors’ participation in the development of IFRS. In early 2009, the Trustees revised the constitution to increase the number of Board members from 14 to 16 and speci! ed geographical quotas for membership: four from North America, four from Europe, four from Asia/Oceania, one from South America, one from Africa, and two to achieve geographical balance. Further, as many as three of the 16 members may be part-timers. Further, in response to the criticism that the IASB is a private-sector standard-setter and is not likely to act in the public interest, the Trustees created a Monitoring Board, which consisted of leading ! gures from regulators in the world (namely, representatives of the SEC, Japan’s Financial Services Agency, the European Commission, and the Emerg- ing Markets and Technical Committees of IOSCO) with the functions of oversee- ing the standard-setting activities of the IASB and approving the appointment of Trustees. One of the proposals could see the IASB become the IFRS Board (or IFRSB) in the future.

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82 Chapter Three

ARGUMENTS FOR AND AGAINST INTERNATIONAL CONVERGENCE OF FINANCIAL REPORTING STANDARDS

Arguments for Convergence Proponents of accounting convergence put forward several arguments. First, they argue that comparability of ! nancial statements worldwide is necessary for the globalization of capital markets. Financial statement comparability would make it easier for investors to evaluate potential investments in foreign securities and thereby take advantage of the risk reduction possible through international diver- si! cation. Second, it would simplify the evaluation by multinational companies of possible foreign takeover targets. Third, convergence would reduce ! nancial reporting costs for companies that seek to list their shares on foreign stock ex- changes. Cross-listing of securities would allow companies to gain access to less expensive capital in other countries and would make it easier for foreign investors to acquire the company’s stock. Fourth, national differences in corporate report- ing cause loss of investor con! dence, which affects the availability and cost of capital. Investors often build in a premium to the required return on their invest- ment if there is any uncertainty or lack of comparability about the ! gures—such premiums can be as large as 40 percent. 22 Fifth, one set of universally accepted accounting standards would reduce the cost of preparing worldwide consolidated ! nancial statements, and the auditing of these statements also would be simpli- ! ed. Sixth, multinational companies would ! nd it easier to transfer accounting staff to other countries. This would be true for the international auditing ! rms as well. Finally, convergence would help raise the quality level of accounting prac- tices internationally, thereby increasing the credibility of ! nancial information. In relation to this argument, some point out that as a result of convergence, develop- ing countries would be able to adopt a ready-made set of high-quality standards with minimum cost and effort.

Arguments against Convergence The greatest obstacle to convergence is the magnitude of the differences that exist between countries and the fact that the political cost of eliminating those differ- ences would be enormous. One of the main obstacles is nationalism. Whether out of deep-seated tradition, indifference born of economic power, or resistance to in- trusion of foreign in" uence, some say that national entities will not bow to any international body. Arriving at principles that satisfy all of the parties involved throughout the world seems an almost impossible task. Not only is convergence dif! cult to achieve, but the need for such standards is not universally accepted. A well-developed global capital market exists already. It has evolved without uni- form accounting standards. Opponents of convergence argue that it is unneces- sary to force all companies worldwide to follow a common set of rules. They also point out that this would lead to a situation of “standards overload” as a result of requiring some enterprises to comply with a set of standards not relevant to them. The international capital market will force those companies that can bene! t from accessing the market to provide the required accounting information without con- vergence. Yet another argument against convergence is that because of different

22 David Illigworth, President of the Institute of Chartered Accountants in England and Wales, in a speech at the China Economic Summit 2004 of the 7th China Beijing International High-Tech Expo, May 21, 2004.

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International Convergence of Financial Reporting 83

environmental in" uences, differences in accounting across countries might be ap- propriate and necessary. For example, countries that are at different stages of eco- nomic development or that rely on different sources of ! nancing perhaps should have differently oriented accounting systems. Professor Frederick Choi refers to this as the dilemma of global harmonization: “The thesis of environmentally stim- ulated and justi! ed differences in accounting runs directly counter to efforts at the worldwide harmonization of accounting. Hence, the dilemma.” This applies equally to the idea of convergence.

A PRINCIPLES-BASED APPROACH TO INTERNATIONAL FINANCIAL REPORTING STANDARDS

The IASB uses a principles-based approach in developing accounting standards, rather than a rules-based approach. Principles-based standards focus on establishing general principles derived from the IASB Framework , providing recognition, measure- ment, and reporting requirements for the transactions covered by the standard. By fol- lowing this approach, IFRS tend to limit guidance for applying the general principles to typical transactions and encourage professional judgment in applying the general principles to transactions speci! c to an entity or industry. Sir David Tweedie, IASB chairman, explained the principles-based approach taken by the IASB as follows:

The IASB concluded that a body of detailed guidance (sometimes referred to as brightlines ) encourages a rule-based mentality of “where does it say I can’t do this?” We take the view that this is counter-productive and helps those who are intent on ! nding ways around standards more than it helps those seeking to apply standards in a way that gives useful information. Put simply, adding the detailed guidance may obscure, rather than highlight, the underlying principles. The emphasis tends to be on compliance with the letter of the rule rather than on the spirit of the ac- counting standard. We prefer an approach that requires the company and its audi- tors to take a step back and consider with the underlying principles. This is not a soft option. Our approach requires both companies and their auditors to exercise professional judgement in the public interest. Our approach requires a strong commitment from preparers to ! nancial statements that provide a faithful repre- sentation of all transactions and strong commitment from auditors to resist client pressures. It will not work without those commitments. There will be more indi- vidual transactions and situations that are not explicitly addressed. We hope that a clear statement of the underlying principles will allow companies and auditors to deal with those situations without resorting to detailed rules. 23

A report published by the Institute of Chartered Accountants in Scotland in early 2006 stated that rules-based accounting adds unnecessary complexity, encour- ages ! nancial engineering, and does not necessarily lead to a true and fair view or a fair presentation . Further, it pointed out that the volume of rules would hin- der the translation into different languages and cultures. The Global Accounting Alliance (GAA- This was formed in November 2005 and is an alliance of 11 lead- ing professional accounting bodies in U.S., U.K., Canada, Hong Kong, Australia, Germany, Japan, New Zealand and South Africa. Its objective is to promote quality services, share information and collaborate on important international iussues.) supports a single set of globally accepted and principles-based account- ing standards that focus on transparency and capital market needs and would be

23 Excerpt from a speech delivered before the Committee on Banking, Housing and Urban Affairs of the United States Senate, Washington, DC, February 14, 2002.

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84 Chapter Three

ideal for all stakeholders. In February 2010, the IOSCO, in a report entitled “Prin- ciples for Periodic Disclosure by Listed Entities,” provided securities regulators with a framework for establishing or reviewing their periodic disclosure regimes. According to the report, its principles-based format allows for a wide range of application and adaptation by securities regulators.

THE IASB FRAMEWORK

The Need for a Framework With no conceptual framework, accounting standards would be developed unsys- tematically. As a result, accounting standards may be inconsistent and, according to Gresham’s law, 24 bad accounting practices will triumph over good practices. In this situation, a principle or practice would be declared to be “right” because it was generally accepted, but it would not be generally accepted because it was “right.” Further, it is unwise to develop standards unless there is agreement on the scope and objective of ! nancial reporting, the type of entities that should produce ! nan- cial reports, recognition and measurement rules, and qualitative characteristics of ! nancial information. Furthermore, by adding rigor and discipline, a conceptual framework enhances public con! dence in ! nancial reports, and preparers and auditors can use the conceptual framework as a point of reference to resolve an accounting issue in the absence of a standard that speci! cally deals with that issue.

The Framework for the Preparation and Presentation of Financial Statements was ! rst approved by the IASC board in 1989 and was reaf! rmed by the newly formed IASB in 2001. The objective of the Framework is to establish the concepts underlying the prepa- ration and presentation of IFRS-based ! nancial statements. It deals with the following:

1. Objective of ! nancial statements and underlying assumptions. 2. Qualitative characteristics that affect the usefulness of ! nancial statements. 3. De! nition, recognition, and measurement of the ! nancial statements elements. 4. Concepts of capital and capital maintenance.

Among other things, the purpose of the Framework is to assist the IASB in devel- oping future standards and revising existing standards. It also is intended to assist preparers of ! nancial statements in applying IFRS and in dealing with topics that have not yet been addressed in IFRS. The Framework identi! es investors, creditors, employees, suppliers, customers, government agencies, and the general public as potential users of ! nancial statements but concludes that ! nancial statements that are designed to meet the needs of investors will also meet most of the information needs of other users. This is an important conclusion because it sets the tone for the nature of individual IFRS, that is, that their application will result in a set of ! nancial statements that is useful for making investment decisions.

Objective of Financial Statements and Underlying Assumptions The Framework establishes that the primary objective of IFRS-based ! nancial state- ments is to provide information useful for decision making. Financial statements also show the results of management’s stewardship of enterprise resources, but that is not their primary objective. To meet the objective of decision usefulness, ! nancial state- ments must be prepared on an accrual basis. The other underlying assumption is that the enterprise for which ! nancial statements are being prepared is a going concern.

24 Gresham’s law is named after Sir Thomas Gresham (1519–1579), an English fi nancier in Tudor times. It means, briefl y, “Bad money drives out good.”

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International Convergence of Financial Reporting 85

Qualitative Characteristics of Financial Statements The four characteristics that make ! nancial statement information useful are understandability, relevance, reliability, and comparability. Information is relevant if it can be used to make predictions of the future or if it can be used to con! rm expectations from the past. The Framework indicates that the relevance of informa- tion is affected by its nature and its materiality. An item of information is material if its misstatement or omission could in" uence the decision of a user of ! nancial statements.

Information is reliable when it is neutral (i.e., free of bias) and represents faith- fully what it purports to. The Framework speci! cally states that re" ecting items in the ! nancial statements based on their economic substance rather than their legal form is necessary for faithful representation. The Framework also states that while the exercise of prudence (conservatism) in measuring accounting elements is nec- essary, it does not allow the creation of hidden reserves or excessive provisions to deliberately understate income, as this would be biased and therefore would not have the quality of reliability.

Elements of Financial Statements: Defi nition, Recognition, and Measurement Assets are de! ned as resources controlled by the enterprise from which future eco- nomic bene! ts are expected to " ow to the enterprise. Note that a resource need not be owned to be an asset of an enterprise. This allows, for example, for leased resources to be treated as assets. An asset should be recognized only when it is prob- able that future economic bene! ts will " ow to the enterprise and the asset has a cost or value that can be measured reliably. The Framework acknowledges that several differ- ent measurement bases may be used to measure assets, including historical cost, current cost, realizable value, and present value.

Liabilities are present obligations arising from past events that are expected to be settled through an out" ow of resources. Obligations need not be contractual to be treated as a liability. Similar to assets, liabilities should be recognized when it is probable that an out" ow of resources will be required to settle them and the amount can be measured reliably. Also as with assets, several different bases exist for measuring li- abilities, including the amount of proceeds received in exchange for the obligation, the amount that would be required to settle the obligation currently, undiscounted settlement value in the normal course of business, and the present value of future cash out" ows expected to settle the liabilities.

The Framework identi! es income and expenses as the two elements that con- stitute pro! t. Income, which encompasses both revenues and gains, is de! ned as increases in equity other than from transactions with owners. Expenses, including losses, are decreases in equity other than through distributions to owners. Equity is de! ned as assets minus liabilities. Income should be recognized when the in- crease in an asset or decrease in a liability can be measured reliably. The Framework does not provide more speci! c guidance with respect to income recognition. (This topic is covered in IAS 18, Revenue. ) Expenses are recognized when the related decrease in assets or increase in liabilities can be measured reliably. The Framework acknowledges the use of the matching principle in recognizing liabilities but spe- ci! cally precludes use of the matching principle to recognize expenses and a re- lated liability when it does not meet the de! nition of a liability. For example, it is inappropriate to recognize an expense if a present obligation arising from a past event does not exist.

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86 Chapter Three

Concepts of Capital Maintenance The Framework describes different concepts of capital maintenance (! nancial capi- tal maintenance versus physical capital maintenance) and acknowledges that each leads to a different basis for measuring assets (historical cost versus current cost). The Framework does not prescribe one measurement basis (and related model of accounting) over another, but indicates that it (the Framework ) is applicable to a range of accounting models.

The IASB Framework is similar in content and direction to the FASB’s Conceptual Framework embodied in Statements of Financial Accounting Concepts 1, 2, 5, and 6. However, the IASB Framework is considerably less detailed.

INTERNATIONAL FINANCIAL REPORTING STANDARDS

As of July 2013, 41 International Accounting Standards (IAS) and 13 International Financial Reporting Standards (IFRS) had been issued (see Exhibit 3.3 ). Several IASs have been revised one or more times since original issuance. For example, IAS 21, The Effects of Changes in Foreign Exchange Rates, was originally issued in 1983 and then revised as part of the comparability project in 1993. This standard was again updated in 2003 as part of the improvements project undertaken by the IASB that resulted in revisions to 13 IASs. A minor amendment to the standard was issued in 2005, and it was amended again in 2007 as a result of the revision to IAS 1 that resulted in amendments to 23 IASs. Other IASs have been withdrawn or replaced by later standards. Of 41 IASs issued by the IASC, only 30 were still in force as of July 2013. The ! rst IFRS was issued by the IASB in 2003, providing guidance on the important question of how a company goes about restating its ! nancial statements when it adopts IFRS for the ! rst time.

As Exhibit 3.3 shows, IFRS constitutes a comprehensive system of ! nancial reporting, addressing accounting concerns ranging from accounting for income taxes, to the recognition and measurement of ! nancial instruments, to the prepa- ration of consolidated ! nancial statements. Because the IASB is a private body, it does not have the ability to enforce its standards. Instead, the IASB develops IFRS for the public good, making them available to any country or company that might choose to adopt them.

PRESENTATION OF FINANCIAL STATEMENTS (IAS 1)

IAS 1, Presentation of Financial Statements, is a single standard providing guidelines for the preparation and presentation of ! nancial statements. In September 2007, the IASB published a revised IAS 1, effective for annual periods beginning on or after January 1, 2009. It provides guidance in the following areas:

• Purpose of ! nancial statements. To provide information for decision making. • Components of ! nancial statements. A set of ! nancial statements must include a

balance sheet, income statement, statement of cash " ows, statement of changes in equity, and notes, comprising a summary of signi! cant accounting policies and other explanatory notes.

• Overriding principle of fair presentation. IAS 1 states that ! nancial statements “shall present fairly the ! nancial position, ! nancial performance and cash " ows of an entity. Fair presentation requires the faithful representation of the effects

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87

EXHIBIT 3.3 International Financial Reporting Standards (IFRS) as of May 2011

Title Issued (Revised) Effective Date

Framework for the Preparation and Presentation of Financial Statementsa 1989

IAS 1 Presentation of Financial Statementsa 1975 (1997, 2003, 2007) Jan. 1, 2009

IAS 2 Inventoriesb 1975 (1993, 2003) Jan. 1, 2005

IAS 7 Cash Flow Statementsb 1977 (1992, 2007) Jan. 1, 2009

IAS 8 Accounting Policies, Changes in Accounting Estimates and Errorsb 1978 (1993, 2003, 2007) Jan. 1, 2009

IAS 10 Events After the Balance Sheet Dateb 1978 (1999, 2003, 2007) Jan. 1, 2009

IAS 11 Construction Contracts 1979 (1993, 2007) Jan. 1, 2009

IAS 12 Accounting for Taxes on Incomeb 1979 (1997, 2000, 2007) Jan. 1, 2009

IAS 16 Property, Plant and Equipmentb 1982 (1993, 1998, 2003, 2007) Jan. 1, 2009

IAS 17 Leasesb 1982 (1997, 2003) Jan. 1, 2005

IAS 18 Revenueb 1982 (1993) Jan. 1, 1995

IAS 19 Employee Benefi tsb 1983 (1997, 2000, 2007) Jan. 1, 2009

IAS 20 Accounting for Government Grants and Disclosure of Government Assistance 1983 (2007) Jan. 1, 2009

IAS 21 The Effects of Changes in Foreign Exchange Ratesc 1983 (1993, 2003, 2007) Jan. 1, 2009

IAS 23 Borrowing Costsb 1984 (1993) Jan. 1, 1995

IAS 24 Related Party Disclosuresb 1984 (2003, 2007) Jan. 1, 2009

IAS 26 Accounting and Reporting by Retirement Benefi t Plans 1987 Jan. 1, 1988

IAS 27 Consolidated Financial Statements and Accounting for Investments in Subsidiariesd 1989 (2003, 2007) Jan. 1, 2009

IAS 28 Accounting for Investments in Associatesd 1989 (1998, 2003, 2007) Jan. 1, 2009

IAS 29 Financial Reporting in Hyperinfl ationary Economiesd 1989 (2007) Jan. 1, 2009

IAS 31 Financial Reporting of Interests in Joint Venturesd 1990 (1998, 2003) Jan. 1, 2005

IAS 32 Financial Instruments: Disclosure and Presentationb 1995 (2003, 2007) Jan. 1, 2009

IAS 33 Earnings per Shareb 1997 (2003, 2007) Jan. 1, 2009

IAS 34 Interim Financial Reportingb 1998 (2007) Jan. 1, 2009

IAS 38 Intangible Assetsb 1998 (2004, 2007) April 1, 2009

(continued)

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88

EXHIBIT 3.3 (continued)

Title Issued (Revised) Effective Date

IAS 39 Financial Instruments: Recognition and Measurementb 1998 (2000, 2003, 2004, 2007) Jan. 1, 2009

IAS 40 Investment Property b 2000 (2003, 2004, 2007) Jan. 1, 2009

IAS 41 Agriculture 2001 (2007) Jan. 1, 2009

IFRS 1 First-time Adoption of International Financial Reporting Standardsa 2003 (2007) Jan. 1, 2009

IFRS 2 Share-based Paymentb 2004 Jan. 1, 2005

IFRS 3 Business Combinationsd 2004 March 31, 2004

IFRS 4 Insurance Contracts 2004 (2007) Jan. 1, 2009

IFRS 5 Non-current Assets Held for Sale and Discontinued Operationsb 2004 (2007) Jan. 1, 2009

IFRS 6 Exploration for and Evaluation of Mineral Resources 2004 Jan. 1, 2006

IFRS 7 Financial Instruments: Disclosures 2005 Jan. 1, 2007

IFRS 8 Operating Segmentsd 2006 Jan. 1, 2009

IFRS 9 Financial Instruments 2010 Jan. 1, 2013

IFRS 10 Consolidated Financial Statements May 2011 Jan. 1, 2013

IFRS 11 Joint Arrangements May 2011 Jan. 1, 2013

IFRS 12 Disclosure of Interests in Other Entities May 2011 Jan. 1, 2013

IFRS 13 Fair Value Measurement May 2011 Jan. 1, 2013

Standards covered in this book:  a Denotes standards covered in Chapter 3.  b Denotes standards covered in Chapter 4.  c Denotes standards covered in Chapters 7 and 8.  d Denotes standards covered in Chapter 9.

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International Convergence of Financial Reporting 89

of transactions, other events and conditions in accordance with the de! nitions and recognition criteria for assets, liabilities, income and expenses set out in the Framework. ” 25 Compliance with IFRS generally ensures fair presentation. In the extremely rare circumstance when management concludes that compliance with the requirement of a standard or interpretation would be so misleading that it would con" ict with the objective of ! nancial statements set out in the Frame- work, IAS 1 requires departing from that requirement, with extensive disclosures made in the notes. If the local regulatory framework will not allow departing from a requirement, disclosures must be made to reduce the misleading aspects of compliance with that requirement.

• Accounting policies. Management should select and apply accounting policies to be in compliance with all IASB standards and all applicable interpretations. If guidance is lacking on a speci! c issue, management should refer to (a) the requirements and guidance in other IASB standards dealing with similar issues; (b) the de! nitions, recognition, and measurement criteria for assets, liabilities, income, and expenses set out in the IASB Framework; and (c) pronouncements of other standard-setting bodies and accepted industry practices to the extent, but only to the extent, that these are consistent with (a) and (b). IAS 1 does not indicate that this is a hierarchy. It is important to note that individual country GAAP may be used to ! ll in the blanks, but only if consistent with other IASB standards and the IASB Framework.

• Basic principles and assumptions. IAS 1 reiterates the accrual basis and going-concern assumptions and the consistency and comparative information principles found in the Framework. IAS 1 adds to the guidance provided in the Framework by indi- cating that immaterial items should be aggregated. It also stipulates that assets and liabilities, and income and expenses should not be offset and reported at a net amount unless speci! cally permitted by a standard or interpretation.

• Structure and content of ! nancial statements. IAS 1 also provides guidance with respect to: (a) current/noncurrent distinction, (b) items to be presented on the face of ! nancial statements, and (c) items to be disclosed in the notes.

IAS 1 requires companies to classify assets and liabilities as current and non- current on the balance sheet, except when a presentation based on liquidity pro- vides information that is reliable and more relevant. IAS 1 also provides guidance with respect to the items, at a minimum, that should be reported on the face of the income statement or balance sheet. Exhibit 3.4 presents an illustrative income statement, and Exhibit 3.5 presents an illustrative statement of ! nancial position demonstrating minimum compliance with IAS 1. The line items comprising pro! t before tax must be re" ected using either a nature of expense format (common in Continental Europe) or a function of expense format (commonly found in Anglo countries). Both formats are presented in Exhibit 3.4 . IAS 1 speci! cally precludes designating items as extraordinary on the income statement or in the notes.

In Exhibit 3.5 , assets are presented on one side of the balance sheet, and liabilities and equity are presented on the other side. Other formats are equally acceptable so long as the current/noncurrent distinction is clear. For example, British balance sheets commonly present noncurrent assets, net current assets (working capital), and noncurrent liabilities on one side of the balance sheet and equity on the other side. In addition, assets and liabilities may be presented in order of liquidity, as is common in North America.

25 IAS 1, paragraph 13.

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90 Chapter Three

FIRST-TIME ADOPTION OF INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRS 1)

IFRS 1, First-time Adoption of International Financial Reporting Standards, issued in June 2003, was the ! rst IFRS developed by the IASB. IFRS 1 sets out the require- ments for adopting IFRS and preparing a set of IFRS ! nancial statements for the ! rst time. As companies make the transition from their previous GAAP to IFRS, guidance on this issue is very important.

In general, IFRS 1 requires an entity adopting IFRS to comply with each IFRS ef- fective at the reporting date of its ! rst IFRS ! nancial statements. For example, if an entity is preparing IFRS ! nancial statements for the year ended December 31, 2013, it must comply with all IFRS in force at that date. Moreover, if the entity provides comparative ! nancial statements for the year 2012 in its 2013 IFRS ! nancial state- ments, the comparative statements also must be prepared in accordance with IFRS in force at December 31, 2013. According to IFRS 1, if the entity’s date of transition

EXHIBIT 3.4 Illustrative IFRS Income Statement

MODEL COMPANY Income Statement

For the year ended 31 December 20XX

( in thousands of currency units)

Nature of Expenses Format Function of Expenses Format

Revenue Revenue

Changes in inventories of fi nished goods and work in progress

Cost of sales

Gross profi t

Work performed by the entity and capitalized Other income

Raw materials and consumables used Distribution costs

Employee benefi ts expense Administrative expenses

Depreciation and amortization expense Other expenses

Impairment of property, plant, and equipment Finance costs

Other expenses Share of profi t of associates

Finance costs Profi t before tax

Share of profi t of associates Income tax expense

Profi t before tax Income tax expense

Profi t for the period from continuing operations

Profi t for the period from continuing operations

Gain (loss) from discontinued operations

Profi t for the period

Gain (loss) from discontinued operations Attributable to:

Profi t for the period Equity holders of the parent

Attributable to: Minority interest

Equity holders of the parent

Minority interest

Note: IAS 33, Earnings per Share, requires that basic and diluted earnings per share also be reported on the face of the income statement. Additional required disclosures must be made either on the face of the income statement or in the notes.

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International Convergence of Financial Reporting 91

to IFRS is January 1, 2012, the entity should prepare an “opening IFRS balance sheet” as of that date, which becomes the starting point for accounting under IFRS.

In preparing its opening IFRS balance sheet, IFRS 1 requires an entity to do the following:

1. Recognize all assets and liabilities whose recognition is required by IFRS. 2. Derecognize items previously recognized as assets or liabilities if IFRS do not

permit such recognition. 3. Reclassify items that it recognized under previous GAAP as one type of asset,

liability, or component of equity, but are a different type of asset, liability, or component of equity under IFRS.

4. Apply IFRS in measuring all recognized assets and liabilities.

EXHIBIT 3.5 Illustrative IFRS Statement of Financial Position

MODEL COMPANY Consolidated Statement of Financial Position

As at 31 December, Year 1

(in thousands of currency units)

Assets Equity and Liabilities

Noncurrent assets Equity attributable to owners of the parent

Property, plant, and equipment Share capital

Goodwill Other reserves

Other intangible assets Retained earnings

Investments in associates

Available-for-sale fi nancial assets Minority interest

Total equity

Current assets

Inventories Noncurrent liabilities

Trade receivables Long-term borrowings

Other current assets Deferred tax

Cash and cash equivalents Long-term provisions

Total noncurrent liabilities

Total assets

Current liabilities

Trade and other payables

Short-term borrowings

Current portion of long-term borrowings

Current tax payable

Short-term provisions

Total current liabilities

Total liabilities

Total equity and liabilities

Note: Additional required disclosures must be made on the face of the balance sheet or in the notes.

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92 Chapter Three

To understand the signi! cance of these requirements, consider their imple- mentation with respect to intangible assets. In preparing its opening IFRS balance sheet, an entity would need to (1) exclude previously recognized intangible assets that do not meet the recognition criteria in IAS 38, Intangible Assets, at the date of transition to IFRS, and (2) include intangible assets that do meet the recognition criteria in IAS 38 at that date, even if they previously had been accounted for as an expense. For example, an entity adopting IFRS must determine whether pre- viously expensed development costs would have quali! ed for recognition as an intangible asset under IAS 38 at the date of transition to IFRS. If so, then an asset should be recognized in the opening IFRS balance sheet, even if the related costs had been expensed previously. Furthermore, if amortization methods and useful lives for intangible assets recognized under previous GAAP differ from those that would be acceptable under IFRS, then the accumulated amortization in the open- ing IFRS balance sheet must be adjusted retrospectively to comply with IFRS.

In speci! c areas where the cost of complying with an IFRS would likely ex- ceed the bene! ts to users, IFRS 1 provides exemptions from complying with IFRS. Exemptions are allowed with respect to speci! c aspects of accounting in the fol- lowing areas: business combinations, asset revaluations, employee bene! ts, cumu- lative translation differences, and ! nancial instruments. Recently, IFRS 1 has been further amended to assist ! rst-time adopters.

INTERNATIONAL CONVERGENCE TOWARD IFRS

The IASB has earned a great deal of goodwill from many interested parties. Its new approach clearly re" ects a change of role from a harmonizer to a global standard- setter. According to its chairman, the IASB’s strategy is to identify the best in stan- dards around the world and build a body of accounting standards that constitute the “highest common denominator” of ! nancial reporting. The IASB has adopted a principles-based approach to standard-setting and has obtained the support of U.S. regulators (even though U.S. standard-setters historically have taken a rules- based approach). On the other hand, the IASB’s structure is similar to that of the U.S. standard-setter, recognizing that the FASB has the best institutional structure for developing accounting standards.

In 2002, the six largest public accounting ! rms worldwide conducted a survey of national efforts in 54 countries to promote and achieve convergence with IFRS. 26 Almost all the countries surveyed intend to converge with IFRS, indicating that the IASB is the appropriate body to develop a global accounting language. Coun- tries indicating a plan to achieve convergence included members of the European Union, the six countries of the Western Hemisphere with the largest economies (Argentina, Brazil, Canada, Chile, Mexico, and the United States), and China, India, Malaysia, New Zealand, South Korea, and Thailand. The survey identi! ed three different convergence strategies:

1. Replacing national GAAP with IFRS (supplemented for issues not addressed by IFRS).

2. Adopting IFRS as national GAAP on a standard-by-standard basis. 3. Eliminating differences between national GAAP and IFRS when possible and

practicable.

26 BDO, Deloitte Touche Tohmatsu, Ernst & Young, Grant Thornton, KPMG, and PricewaterhouseCoopers, GAAP Convergence 2002: A Survey of National Efforts to Promote and Achieve Convergence with Inter- national Financial Reporting Standards. Available at www.ifad.net.

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International Convergence of Financial Reporting 93

The major concerns in achieving IFRS convergence as expressed by respondents to the 2002 survey included:

• The complicated nature of particular standards, especially those related to ! nancial instruments and fair value accounting (51 percent of countries).

• The tax-driven nature of the national accounting regime; using IFRS as the basis for taxation is seen as a problem (47 percent of countries).

• Disagreement with certain signi! cant IFRS, especially those related to ! nancial statements and fair value accounting (39 percent of countries).

• Insuf! cient guidance on ! rst-time application of IFRS (35 percent of countries). • Limited capital markets, and therefore little bene! t to be derived from using

IFRS (30 percent of countries). • Investor/user satisfaction with national accounting standards (21 percent of

countries). • IFRS language translation dif! culties (18 percent of countries).

The IASB has taken initiatives to facilitate and enhance its role as a global standard-setter. The issuance of IFRS 1 is one such initiative. IFRS 1 was issued in response to the concern about a lack of guidance on ! rst-time application of IFRS. The of! cial language of the IASB is English, and IFRS are written in this language. The IASB has attempted to address the translation issue by permitting national accountancy bodies to translate IFRS into more than 30 languages, includ- ing Chinese, French, German, Japanese, Portuguese, and Spanish. In addition to the problem that IFRS have not yet been translated into very many languages, research has shown that translation can be problematic, as some terms in English have no direct equivalent in other languages. 27

With the increasing trend in many countries, including Australia and the EU member nations, to adopt IFRS, a large number of companies (over 7,000 listed companies in Europe alone) now use IFRS in preparing their ! nancial statements. The IASB’s decision to hold a series of public roundtable forums to provide opportunities for those who have commented on an exposure draft to discuss their views on the proposals with members of the IASB is another important initiative.

A signi! cant number of board members have direct liaison responsibility with national standard-setters. 28 As a result, unlike its predecessor, the IASB now is for- mally linked to national standard-setters in at least some countries, and the liaison board members are able to coordinate agendas and ensure that the IASB and those national bodies are working toward convergence.

IFAC supports the IASB’s objective of convergence. For example, at its July 2003 meeting, held in Quebec, Canada, IFAC approved a Compliance Program designed to provide clear benchmarks to current and potential member organi- zations in ensuring high-quality performance by accountants worldwide. This program requires member bodies to implement, with appropriate investigation and disciplinary regulations, both IFAC standards and IFRS. IFAC’s Auditing

27 T. S. Doupnik and M. Richter, “Interpretation of Uncertainty Expressions: A Cross-National Study,” Accounting, Organizations and Society 28, no. 1 (2003), pp. 15–35. These researchers fi nd, for example, that German speakers do not view the English word “remote” (used in the context of the probability that a loss will occur) and its German translation “Wahrscheinlichkeit äußerst gering” as being equivalent. 28 The IASB initially had offi cial liaison with national standard-setters from Australia, Canada, France, Germany, Japan, New Zealand, the United Kingdom, and the United States.

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94 Chapter Three

and Assurance Standards Board (IAASB) also has issued new guidance clarify- ing when ! nancial statements are in full compliance with IFRS. In its 2007 annual report, the IFAC highlights, among other things, the progress in achieving interna- tional convergence through IFRS.

As stated earlier in this chapter, the main objective of the IASB is to achieve in- ternational convergence with IFRS. However, Zeff 29 points out that some obstacles to comparability are likely to arise in areas of the business and ! nancial culture, the accounting culture, the auditing culture, and the regulatory culture. He also warns that, in addition to the obstacles to convergence due to the problems of interpre- tation, language, and terminology, the impact of politics can create a “catch-22” situation. He states:

The more rigorous the enforcement mechanism—that is, the more authority and the larger budget a country gives to its securities market regulator to fortify the effort to secure compliance with IFRS—the more lobbying pressure that will be brought on the IASB, because companies in such countries will know that they have no “escape valve,” no way of side-stepping the adverse consequences, as they see them, of a pro- posed IASB standard or interpretation. If the auditor is strict and the regulator is strict, political lobbying of the standard setter, IASB, may become more intense. If a powerful company or group of companies do not like a draft standard, they will have an incen- tive to engage in politicking of the standard-setting body. Hence it becomes a Catch-22.

Regardless of the arguments against harmonization, substantial efforts to re- duce differences in accounting practice have been ongoing for several decades. The question is no longer whether harmonization should be strived for, but going a step further, it is to ask how to achieve convergence.

THE ADOPTION OF INTERNATIONAL FINANCIAL REPORTING STANDARDS

There are a number of different ways in which a country might adopt IFRS, includ- ing requiring (or permitting) IFRS to be used by the following:

1. All companies; in effect, IFRS replace national GAAP. 2. Parent companies in preparing consolidated ! nancial statements; national GAAP

is used in parent company-only ! nancial statements. 3. Stock exchange listed companies in preparing consolidated ! nancial statements.

Nonlisted companies use national GAAP. 4. Foreign companies listing on domestic stock exchanges. Domestic companies

use national GAAP. 5. Domestic companies that list on foreign stock exchanges. Other domestic com-

panies use national GAAP.

The endorsement of IFRS for cross-listing purposes by IOSCO and the EU’s de- cision to require domestic listed companies to use IFRS for consolidated accounts beginning in 2005 have provided a major boost to the efforts of the IASB. Exhibit 3.6 shows the use of IFRS around the world as of June 2012.

IFAC supports IASB in its efforts at global standard-setting. The IFAC 2008 annual report highlights initiatives during the credit crisis and the need for convergence to global standards.

29 S. Zeff, “Political Lobbying on Proposed Standards: A Challenge to the IASB,” Accounting Horizons 16, no. 1 (2002), pp. 43–54.

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International Convergence of Financial Reporting 95

EXHIBIT 3.6 Use of IFRS in Preparing Consolidated Financial Statements as of June 2012

IFRS Required for All Domestic Listed Companies Abu Dhabi (UAE) Ecuador Kenya Norway Anguilla Egypt Korea (South) Oman Antigua and Barbuda Estonia Kuwait Panama Argentina Fiji Kyrgyzstan Papua New Guinea Armenia Finland Latvia Peru Australia France Lebanon Poland Austria Georgia Libya Portugal Bahamas Germany Liechtenstein Qatar Bahrain Ghana Lithuania Romania Barbados Greece Luxembourg Serbia Belgium Grenada Macedonia Sierra Leone Bosnia & Herzegovina Guatemala Malawi Slovak Republic Botswana Guyana Malta Slovenia Bulgaria Honduras Mauritius South Africa Canada Hong Kong Mexico Spain Chile Hungary Mongolia St. Kitts & Nevis Costa Rica Iceland Montenegro Sweden Croatia Iraq Namibia Tajikistan Cyprus Ireland Nepal Tanzania Czech Republic Italy Netherlands Trinidad & Tobago Denmark Jamaica New Zealand United Kingdom Dominican Republic Jordan Nicaragua West Bank/Gaza Dubai (UAE) Kazakhstan Nigeria Zambia

IFRS Required for Some Domestic Listed Companies

Azerbaijan Israel Saudi Arabia China Morocco

IFRS Permitted for Domestic Listed Companies

Aruba Gibraltar Mozambique Switzerland Bermuda Haiti Myanmar Turkey Bolivia India Netherlands Antilles Uganda Cayman Islands Japan Paraguay Virgin Is. (British) Dominican Republic Laos Sri Lanka Zimbabwe Ecuador Lesotho Suriname El Salvador Maldives Swaziland

IFRS Not Permitted for Domestic Listed Companies

Bangladesh Iran Singapore United States Benin Malaysia Syria Uruguay Bhutan Mali Taiwan Uzbekistan Burkina Faso Moldova Thailand Venezuela Colombia Niger Togo Vietnam Cote d’Ivoire Pakistan Tunisia Cuba Philippines Turkmenistan Indonesia Russia Ukraine

IFRSs in Your Pocket 2012, www.iasplus.com (accessed on May 22, 2012)

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96 Chapter Three

The IFAC G20 accountancy summit in July 2009 issued a renewed mandate for adoption of global standards in which they recommended that governments and regulators should step up initiatives to promote convergence to global accoun- tancy and auditing standards. The latest IFAC Global Leadership Survey, which polled its membership of 157 accountancy organizations in 123 countries, empha- sizes that investors and all consumers of ! nancial information deserve simpler and more useful information, and that the adoption, implementation, and enforce- ment of international ! nancial standards are crucial in this regard.

Recently, China, Japan, and Korea formed the Asian-Oceanian Standard Set- ters Group (AOSSG) as a forum for the countries in the region to exchange their ideas but also to have a joint voice in matters relating to IFRS and to bring together Asian-Oceanian standard-setters. The IASB has responded to concerns expressed by various parties. For example, it has issued amendments to IFRS 1, First-time Adoption of IFRS, that address the retrospective application of IFRS to particu- lar situations and are aimed at ensuring that entities applying IFRS will not face undue cost or effort in the transition process. The IASB has also issued a revised version of IAS 24, Related Party Disclosures, that simpli! es the disclosure require- ments for government-related entities and clari! es the de! nition of a related party.

Many developing countries have adopted IFRS with little or no amendment as their national standards. For some of them, it may have been a less expensive option than developing their own standards. The need to attract foreign invest- ment also may have been an in" uencing factor. Countries changing from centrally planned to market-based economies also have found IFRS attractive, as they offer a ready-made set of standards to facilitate the development of a market system.

Although many countries do not allow domestic listed companies to use IASB standards, some of these countries nevertheless allow foreign companies listed on domestic stock exchanges to use IFRS in accordance with IOSCO’s recommen- dation. Japan, for example, allows foreign companies listing on the Tokyo stock exchange to ! le ! nancial statements prepared in accordance with IFRS without any reconciliation to Japanese GAAP. (The same is now true in the United States.)

A global leadership survey conducted by the IFAC in late 2007 revealed that a large majority (89 percent) indicated that convergence to IFRS was “very impor- tant” or “important” for economic growth in their countries. The survey included 143 business leaders from 91 countries. 30 A majority of recent Deloitte IFRS survey respondents preferred a set date for global accounting standards. Currently, ap- proximately 120 countries and reporting jurisdictions permit or require IFRS for domestic listed companies. However, approximately 90 countries have fully con- formed with IFRS as promulgated by the IASB and include a statement in audit report to that effect.

IFRS IN THE EUROPEAN UNION

In July 2002, the European Union issued a directive (Regulation 1606/2002) re- quiring all listed companies of member states to prepare consolidated ! nancial statements based on IFRS beginning January 1, 2005. The aim was to improve the quality of corporate ! nancial reporting by increasing their comparability and transparency, and to promote the development of a single capital market in Europe.

The European Union has adopted the strategy of replacing national GAAP (supplemented for issues not addressed by IFRS) with respect to the preparation

30 http://accountingeducation.com/index.cfm?page=newsdetails&id=145923.

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International Convergence of Financial Reporting 97

of consolidated ! nancial statements by listed companies. Nonlisted companies continue to apply national GAAP. However, several EU countries (Denmark and Estonia) also have adopted a convergence strategy with respect to nonlisted com- panies, by adopting a plan to converge national GAAP with IFRS. This strategy could eventually result in no substantive differences between IFRS and a country’s national GAAP. In January 2003, the European Parliament approved amendments to the EU Fourth and Seventh Directives removing all inconsistencies between the directives and IFRS.

The switch to IFRS involved signi! cant changes to the accounting policies of listed companies. With this in mind, the U.K. Institute of Chartered Accountants in England and Wales urged British companies to provide investors and analysts with clear explanations of their preparations for adopting IFRS and changes to ac- counting policies ahead of publication of their 2005 accounts, as this was seen as being important in securing investor con! dence.

The EU decided to adopt a version of IAS 39, Financial Instruments: Recogni- tion and Measurement, with two “carve outs.” The EU-approved version of IAS 39 removes speci! c provisions related to the use of a fair value option and of hedge accounting. This was not well received internationally, including in the United Kingdom. The concerns included that this could have adverse consequences for the cost of capital of European companies if the adopted standard prevents European companies from complying with the complete standard as issued by the IASB, as it will damage the credibility of European ! nancial reporting. Further, it was pointed out that the adopted standard includes seriously weakened hedge ac- counting requirements and may give rise to arti! cial volatility in reported pro! ts and dif! culties in application as a result of limiting the fair value option.

Some European companies are careful to disclose the fact that they are using “IFRS as adopted by the EU,” meaning that IAS 39 is not applied in its entirety. The following disclosure made by the Swedish ! rm AB Electrolux in Note 1, Account- ing and Valuation Principles of the 2006 Annual Report is an example:

The consolidated ! nancial statements are prepared in accordance with International Financial Reporting Standards (IFRS) as adopted by the European Union. Electrolux’s auditor, PricewaterhouseCoopers, uses similar language in its audit opinion.

So far, no research has been conducted to examine the full effect of adopting an amended version of IAS 39 in Europe. In the area of enforcement of accounting stan- dards, there are considerable challenges in Europe. The Committee of European Securities Regulators (CESR) issued Standard No. 1, Financial Information: Enforce- ment of Standards on Financial Information in Europe, in 2003 to provide principles that could underpin the development and implementation of a common approach to the enforcement of IFRS. However, application of the standard is not mandatory, and CESR will rely on the cooperation of member states in adopting the stated principles.

There is a wide variety of accounting enforcement systems used in Europe. Some countries, such as Germany, Finland, and the Netherlands, have no institu- tional oversight of ! nancial reporting. Further, the enterprises that are expected to apply IFRS in Europe are heterogeneous in terms of jurisdiction, size, capi- tal structure, ownership structure, and degree of accounting sophistication. 31 In pre-2005 Europe, there was a variety of national standards of varying degrees of

31 K. Schipper, “The Introduction of International Accounting Standards in Europe: Implications for Inter- national Convergence,” European Accounting Review 14, no.1 (2005), pp. 101–26.

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98 Chapter Three

completeness, sophistication, and authority, re" ecting different national traditions and institutional arrangements. 32 Starting in 2005, although the European Union will have a single ! nancial reporting standard-setter, securities regulation is sub- ject to considerable cross-jurisdictional variation due to existing legal and cultural differences among EU jurisdictions. As a result, EU countries decided to evaluate existing enforcement strategies and introduce enforcement bodies. 33

Recent IFRS (especially IAS 39) have increasingly required fair value mea- surements, with the intent of enhancing the relevance of reported numbers. A key issue for convergence is whether fair value measurements can be accepted as having suf! cient reliability. One dif! culty in developing fair value measures particularly in Europe is a lack of organized and liquid markets for many assets and obligations.

In September 2009, the EU published Commission Regulation (EC) No. 839/2009 (Adoption of Eligible Hedged Items—Amendments to IAS 39 Financial Instru- ments: Recognition and Measurement), amending Regulation (EC) No. 1226/2008, adopting certain international accounting standards in accordance with Regula- tion (EC) No. 1606/2002. EFRAG commented on the IASB’s Exposure Draft on Fair Value Measurement, supporting most aspects of the IASB proposal to de! ne fair value, but recommending that the proposal should apply to ! nancial assets and ! nancial liabilities only after there has been a public consultation and debate on its use for non! nancial assets and liabilities. The UK FRC also supports the view that an EU focus on principles and values in corporate reporting should be adopted and suggests that “comply or explain” should remain a fundamental cornerstone of the EU framework. In February 2013, the IFRS Foundation had a Memorandum of Understanding with the International Integrated Reporting Council (IIRC) in the UK.

IFRS IN THE UNITED STATES

Support for a Principles-Based Approach It is interesting that support for a principles-based approach has come from many quarters, including current and former U.S. regulators. It has been pointed out that as part of the commitment to convergence, the FASB and SEC should change their behavior and become more like the rest of the world. For example, a former SEC chairman, expressing preference for the IASB’s principles-based standards, referred to the IASB’s approach as a “Ten Commandments” approach in contrast to the FASB’s “cookbook” approach. 34 The SEC chairman, in a speech made in Puerto Rico in February 2002, also expressed preference for a principles-based set of accounting standards. 35 In addition, in an editorial in the June 27, 2002, edition of Financial Times , titled “The World after WorldCom,” the U.S. regulators were

32 G. Whittington, “The Adoption of International Accounting Standards in the European Union,” European Accounting Review 14, no.1 (2005), pp. 127–53. 33 Committee of European Securities Regulators, CESR’s First Initiative towards More Robust Enforcement of Financial Information in Europe, press release CESR/03-081b, 2 April, (2003). Available at www .europefesco.org/v2/default.asp . 34 http://banking.senate.gov/02_02hrg/021202/index.htm . 35 www.sec.gov/news/speech/spch539.htm .

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International Convergence of Financial Reporting 99

urged to move to principles-based standards. The following is an extract from this editorial:

It is time for US accounting standards to move away from prescriptive rulemaking towards the alternative used in many other countries, which focuses on “substance over form.” US regulators have been suspicious of principles-based standards drafted by the International Accounting Standards Board, arguing that the US approach is superior. As the list of US accounting scandals mounts, it is hard to maintain such a position.

The 2008 ! nancial crisis led to much soul-searching among global standard- setters and regulators for its underlying root causes, as many commentators pointed to inaccurate accounting standards and the need for improvement. Fur- ther, the standard-setters such as the IASB and FASB came under intense political pressure to accommodate the interests of the banking regulators, who required ! nancial stability and accounting standards that would not result in “credit crunches” by depressing bank capital at a time of falling securities prices. In the United States, these efforts were driven by the SEC, FASB, and AICPA. 36 In recent years, the standard-setting activities at the international level were characterized by the efforts at converging U.S. GAAP and IFRS.

The SEC and IFRS Convergence In November 2007, the SEC decided to remove the requirement that foreign pri- vate issuers using IFRS reconcile their ! nancial statements to U.S. GAAP. This re- " ects the recognition that IFRS is a high-quality set of accounting standards which is capable of ensuring adequate disclosure for the protection of investors and the promotion of fair, orderly, and ef! cient markets. This decision was supported by the experience in the European markets, where there has been no market disrup- tion or loss of investor con! dence as a result of the introduction of IFRS in 2005. Substantial amounts of capital have been invested by U.S. investors in European companies which report under IFRS, thus suggesting that many U.S. investors al- ready have concluded that IFRS is a ! t-for-purpose ! nancial reporting framework. Of the 1,100 foreign companies that ! le ! nancial statements with the SEC, 180 use IFRS. Beginning in 2007, the Form 20-F ! led by these companies with the SEC no longer includes a reconciliation to U.S. GAAP.

Elimination of the reconciliation requirement for foreign ! lers who prepare their ! nancial reports in accordance with IFRS creates an asymmetric situation, as domestic ! lers do not have the option of preparing their ! nancial reports in accordance with IFRS. In July 2007, the SEC issued a concept release soliciting public comment on the idea of allowing U.S. companies to choose between the use of IFRS and U.S. GAAP. In October 2007, the AICPA recommended that the SEC should allow American public companies to report ! nancial results using in- ternational accounting standards. Preliminary results of a survey conducted by Deloitte & Touche LLP in November 2007 show that approximately 205 CEOs and senior ! nance professionals (representing approximately 300 U.S. companies) would consider adopting IFRS, if given a choice by the SEC. Even the chairmen of the FASB and Financial Accounting Foundation, which oversees the FASB, have

36 Full text of the testimony is available at www.iasplus.com/index.htm.

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100 Chapter Three

expressed approval for a move toward the use of IFRS in the United States. They concluded that:

Investors would be better served if all U.S. public companies used accounting stan- dards promulgated by a single global standard setter as the basis for preparing their ! nancial reports. This would be best accomplished by moving U.S. public compa- nies to an improved version of International Financial Reporting Standards (IFRS). 37

In November 2008, the SEC issued a rule called “Roadmap for the Potential Use of Financial Statements Prepared in Accordance with International Financial Reporting Standards (IFRS) by U.S. Issuers.” Since 2009, the SEC has been suggest- ing that gradual convergence toward IFRS be engineered by the FASB, stating that a single set of high-quality, globally accepted accounting standards would bene! t U.S. investors. In February 2010, the SEC issued a statement supporting global accounting standards and convergence with IFRS. That statement was based on the responses to its November 2008 proposed rule. However, the move to IFRS in the United States will be a complex, multiyear process that will involve making signi! cant changes to the U.S. ! nancial reporting system, including changes in auditing standards, licensing requirements, and how accountants are educated.

Further, for companies and ! nancial professionals that have been using detailed rules associated with U.S. GAAP, the prospect of IFRS presents both opportunities and challenges.

There is widespread support for the SEC’s “Roadmap for the Potential Use of Financial Statements Prepared in Accordance with International Financial Report- ing Standards by U.S. Issuers”; for example, the UK FRC, the UK’s independent regulator responsible for promoting con! dence in corporate reporting and gover- nance, emphasized that permitting U.S. domestic issuers to use IFRS will be sig- ni! cant to the future development and credibility of IFRS. U.S. executives want an option for early IFRS adoption, according to a KPMG IFRS institute survey, which found that nearly half of those polled say they would like the option for “early adoption” once the SEC decides to require or permit U.S. companies to use IFRS. However, the National Association of State Boards of Accountancy, support- ing the joint effort by the IASB and the FASB to converge standards by 2011, has recommended that moving to convergence with, rather than adoption of, IFRS is the right path for the SEC to be following and that the SEC should withdraw its idea of a “road map” for adoption of IFRS. U.S. President Obama’s administration has supported global standards in its ! nancial reform proposal, which has been applauded by IFAC.

Challenges to International Convergence • In different countries there are different views on what is or should be the pri-

mary purpose of ! nancial statements. In the United States, the investors or their decisions are considered to be the most important; in Germany, creditors’ infor- mation needs are considered the top priority; in France, the information needs of the government play a major role. This diversity has led to the use of a variety of de! nitions of the elements of ! nancial statements.

• Some politicians in the United States and the United Kingdom blame IFRS, par- ticularly fair value accounting, for the recent ! nancial crisis.

37 Letter to Ms. Nancy M. Morris, Securities and Exchange Commission, signed by Robert E. Denham, Chairman, Financial Accounting Foundation, and Robert H. Herz, Chairman, Financial Accounting Standards Board, dated November 7, 2007 ( www.fasb.org/FASB_FAF_Response_SEC_Release_msw.pdf ).

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International Convergence of Financial Reporting 101

• Now the IASB must consider the consequences of an IFRS world without the United States, where the SEC is the world’s most respected securities market regulator.

• The IASB will need to manage and balance the diverse feedback from the regional standard-setter groups. Such feedback from different parts of the world has become better organized and more persistent.

• There is a great deal of variability in the effectiveness of enforcement of IFRS in different countries, for example, within the EU and developing countries.

• In countries where IFRS are adopted as the governing set of standards for listed companies, the af! rmation of compliance with IFRS by the company or the auditor, or both, may refer to the ! nancial reporting framework in a way that makes it unclear to readers whether, and to what degree, it corresponds with IFRS as issued by the IASB.

• Taking proper cognizance of the fundamentally different ways in which busi- ness is done in different countries is necessary when developing standards. For example, in developing a standard on consolidated ! nancial statements: in Japan, keiretsu are networks of af! liated companies that may not have a parent company; in China, most business is done by government-owned entities, not by private-sector enterprise.

• Impossibility of determining a clear winner between two approaches to accounting education. Some accounting educators follow a “rules-based” ap- proach to accounting education; for example, many accounting educators in the United States seem to take this approach. Accordingly, accounting exercises have “right” and “wrong” solutions, and there exists a “correct” way to account for a certain transaction. A much lesser importance is placed on the theoretical aspects of accounting problems. An alternative approach can be described as “concept- based.” The IASB has taken this approach. Accordingly, theoretical aspects of an accounting problem are ! rst considered, and then possible alternative solutions are chosen, and ! nally, the solutions which are consistent with the current regula- tory guidance are determined.

• Use of IFRS could be expected to have visible repercussions for the ! nancial statements of listed ! rms in different countries. For example, France, which is a code law country, is presumed to have an outlook that contrasts with the dominant view in the IASB conceptual framework, which has been extensively inspired by its founding members (including Australia, Canada, the United Kingdom, and the United States).

The differences between the French GAAP (Continental European model) and IFRS (“Anglo-American” model) can be explained by distinct features at the origin of divergent development of national accounting systems: the in" u- ence of the legal system (common law or code law), the tax system (whose de- gree of independence from accounting varies), the primary source of ! nancing for businesses (stock markets or banks), and accounting rules that re" ect both cultural and institutional differences.

• Overall, standardization cannot be expected to resolve dilemmas in accounting education. As noted by Baxter 38 some thirty years ago:

Standards are a godsend to the feebler type of writer and teacher who ! nds it eas- ier to recite a creed than to analyze facts and to engage in argument. If an of! cial

38 W. T. Baxter, “Accounting Standards: Boon or Curse?” The Saxe Lectures in Accounting (1979). Avail- able at http://newman.baruch.cuny.edu/DIGITAL/saxe/saxe_1978/baxter_79.htm.

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102 Chapter Three

answer is available to a problem, why should a teacher confuse examination candidates with rival views? Thus, learning by rote replaces reason; the good student of today is he who can parrot most rules. On this spare diet, accounting students are not likely to develop the habits of reasoning and skepticism that education should instill.

• There is an ongoing debate concerning the ef! cacy of mandating high-quality accounting standards in unsuitable contexts with inadequate institutional in- frastructures. Greece provides an example of an unfavorable jurisdiction for enforcement of IFRS, due to its code law tradition, bank orientation, concen- trated corporate ownership, poor shareholders’ protection, and low regulatory quality. 39

New Direction for the IASB Recently, IASB Chairman Hans Hoogervoorst, suggesting that the IASB would no longer seek to converge with U.S. GAAP, waved goodbye to a quick conver- gence of IFRS and U.S. GAAP. This means that U.S. GAAP and IFRS convergence is likely to remain an elusive dream.

The IASB no longer takes the view that a failure to converge with U.S. GAAP will be fatal for the IFRS project. According to Hoogervoorst, ! ve years ago a standstill in the United States would have had very serious consequences for the IASB, because the risk was that without the United States on board, Europe would go its own way and Asia would develop its own regional standards; but today, such risk has disappeared. However, given the importance of the United States, this is probably a setback to the IASB. On the other hand, the international weight of IFRS has grown so much that it has long since reached critical mass.

Indeed, worldwide IFRS adoption has picked up dramatically over the past few years; for example, over 100 countries now use the standards, including three- quarters of the G20, according to the IASB.

It is quite inconceivable that the formal end to convergence with U.S. GAAP will cause any IFRS adopters to reverse their decision once the cost of the transi- tion to IFRS is behind them, and it is unlikely that they would undo this work and revert to national or regional standards.

Nonetheless, the decision to give up the objective of convergence with U.S. GAAP would not have been possible without the change at the helm of the IASB after 20 years, from Sir David Tweedie, who was a strong proponent of conver- gence, to Hoogervoorst, who is critical of the concept of prudence, believing that companies could be smoothing their ! gures under its guise, and who has pointed out that conservative accounting comes at the cost of transparency and trust in ! nancial ! gures. Given the growing internationality of IFRS, the IASB must sat- isfy a growing constituency. It has become increasingly imperative for the IASB to listen to the voices of that constituency. Pursuing convergence with U.S. GAAP at the cost of ignoring concerns raised by the swelling constituency was becoming an increasingly costly exercise.

However, the formal end to convergence with U.S. GAAP does not mean the project is completely dead. It has merely been relegated to a lower priority level. Regular consultations between the FASB and IASB will also continue. The recent appointment of former senior SEC member Mary Tokar to the IASB board also suggests that not all hope has been discarded by the IASB.

39 The wide variance between Greek accounting standards and IFRS has frequently been reported in the international accounting literature.

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International Convergence of Financial Reporting 103

Both the previous EU experience and the current state of the IASB/FASB con- vergence process suggest that two or more sets of slightly different standards are likely to coexist in future.

The FASB and IFRS Convergence The FASB’s mission is to improve U.S. ! nancial accounting standards for the ben- e! t of present and potential investors, lenders, donors, and other creditors. Its ulti- mate goal of convergence is a single set of high-quality, international accounting standards that companies worldwide would use for both domestic and cross- border ! nancial reporting. The FASB was of the view that these groups should bene! t from the increased comparability that would result from internationally converged accounting standards, and that working cooperatively with the IASB to develop common stan- dards would improve ! nancial reporting in the United States and internationally, and that would foster global comparability and ful! ll FASB’s mission.

The Norwalk Agreement In September 2002, at a meeting in Norwalk, Connecticut, the FASB and IASB pledged to use their best efforts (1) to make their existing ! nancial reporting standards fully compatible as soon as is practicable, and (2) to coordinate their work program to ensure that once achieved, compatibility is maintained. This has become known as the “Norwalk Agreement.” Note that this agreement does not mean that the FASB will always try to move in the direction of IASB standards to remove existing differences, but that the opposite also will occur. Signi! cantly, the two standard-setters have agreed to work together on future issues to try to develop common solutions. In March 2003, the IASB decided to use identical style and wording in the standards issued by the FASB and IASB on joint projects.

The following are key FASB initiatives to further convergence between IFRS and U.S. GAAP:

1. Joint projects. Joint projects involve sharing staff resources and working on a similar time schedule. Revenue recognition, business combinations, and review of the conceptual framework are three major topics covered by joint projects.

2. Short-term convergence project. The two Boards agreed to undertake a short- term project to remove a variety of differences that exist between IFRS and U.S. GAAP. The scope of the short-term convergence project is limited to those dif- ferences between the two sets of standards in which convergence is likely to be achieved in the short term. Convergence is expected to occur by selecting either existing U.S. GAAP or IFRS requirements as the high-quality solution.

3. Liaison IASB member. A full-time IASB member is in residence at the FASB of! ces. This facilitates information exchange and cooperation between the FASB and the IASB.

4. Monitoring of IASB projects. The FASB monitors IASB projects according to the FASB’s level of interest in the topic being addressed.

5. The convergence research project. The FASB staff embarked on a project to identify all the substantive differences between U.S. GAAP and IFRS and catalog differ- ences according to the FASB’s strategy for resolving them.

6. Consideration of convergence potential in board agenda decisions. All topics consid- ered for addition to the FASB’s agenda are assessed for the potential coopera- tion with the IASB.

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104 Chapter Three

The expectation was that through these initiatives, signi! cant progress could be made toward convergence with IFRS in the short to medium term. Toward the end of 2004, the FASB issued three standards resulting from the short-term convergence project designed to eliminate some differences between the U.S. and IASB standards: SFAS 123 (revised 2004), Share-based Payments, issued in Decem- ber 2004; SFAS 151, Inventory Costs (an amendment of ARB 43, Chapter 4), issued in November 2004; and SFAS 153, Exchange of Non-monetary Assets (an amendment of APB Opinion 29), issued in December 2004. SFAS 123 requires that compensa- tion cost relating to share-based payments transactions be recognized in ! nancial statements. The cost is to be measured on the basis of the fair value of the equity or liability instrument issued. This standard eliminates the use of the intrinsic value method, which was allowed under Opinion 25, and it is expected to result in con- vergence with IFRS 2. ARB 43 states that under some circumstances, items such as idle facility expenses, excessive spoilage, double freight, and rehandling costs may be so abnormal as to require treatment as current period charges. SFAS 151 eliminates the term abnormal. The term was not de! ned in ARB 43. The language used in SFAS 151 is similar to that in IAS 2. SFAS 153 eliminates certain narrow differences between Opinion 29 and IAS 2. Opinion 29 provided an exception to the basic measurement principle (fair value) for exchanges of similar productive assets (commercially substantive assets). SFAS 153 eliminates that exception and brings the U.S. standard closer to IAS 16.

At a conference held in New York in April 2007, the chairmen of the IASB and FASB stressed that principles-based accounting standards would best serve users of ! nancial statements and the public interest. More recently, the joint project on business combinations resulted in the FASB issuing a new standard on this topic in December 2007. SFAS 141 (revised), Business Combinations, adopts the acquisi- tion method of accounting for business combinations that was ! rst introduced by the IASB in IFRS 3, Business Combinations, in 2004. The FASB and IASB worked together to agree on solutions to a number of issues related to the application of the acquisition method. The IASB issued a revised IFRS 3 adopting these solutions in January 2008. In introducing SFAS 141 (revised 2007), the FASB states:

This Statement, together with the IASB’s IFRS 3, Business Combinations (as revised in 2007), completes a joint effort by the FASB and the IASB to improve ! nancial report- ing about business combinations and to promote the international convergence of accounting standards. 40

Following the global ! nancial crisis, the Financial Crisis Advisory Group (FCAG), a high-level group of recognized leaders with broad experience in in- ternational ! nancial markets, was formed at the request of the IASB and FASB to consider ! nancial reporting issues arising from the crisis. The FCAG published in July 2009 a wide-ranging review of standard-setting activities following the global ! nancial crisis. The report articulates four main principles and contains a series of recommendations to improve the functioning and effectiveness of global stan- dard-setting. The main areas addressed in the report are:

• Effective ! nancial reporting. • Limitations of ! nancial reporting. • Convergence of accounting standards. • Standard-setting independence and accountability.

40 FASB Statement of Financial Accounting Standards No. 141 (revised 2007), Business Combinations, p. vi.

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International Convergence of Financial Reporting 105

As the co-chairmen of the FCAG stated, accounting was not a root cause of the ! nancial crisis, but it has an important role to play in its resolution. Improved ! nancial reporting will help restore the con! dence of ! nancial market participants and serve as a catalyst for increased ! nancial stability and sound economic growth. The independence and integrity of the standard-setting process, including wide consultation, is critical to developing high-quality, broadly accepted accounting standards responsive to the issues highlighted by the crisis.

In September 2008, at the peak of the ! nancial crisis, the IASB and the FASB described their plans to achieve convergence, in addition to the Norwalk Agreement issued in 2002, and the Memorandum of Understanding (MoU), origi- nally issued in 2006. They reaf! rmed the list of 11 fundamental topics that would lead to accounting convergence (namely, business combinations, consolidation, fair value measurement guidance, liabilities and equities distinction, performance reporting, postretirement bene! ts, derecognition, ! nancial instruments, revenue recognition, intangible assets, and leases) and stated 2011 as the deadline.

In November 2009, the IASB and FASB issued a joint statement detailing the status of the convergence process and identi! ed two particularly controversial topics: (1) accounting for ! nancial instruments, and (2) de recognition of assets and liabilities. With respect to accounting for ! nancial instruments, the IASB is- sued a new standard in November 2009 (IFRS 9). This new standard modi! ed extant rules on accounting for ! nancial instruments as assets, whereas it leaves ! nancial instruments as liabilities under the scope of the old IAS 39. Indications were that the FASB had also reached an agreement about many speci! cs of a new standard on ! nancial instruments.

In 2011, the FASB and IASB completed the Fair Value Measurement project and is- sued SFAS 257 and IFRS 13, respectively. However, the FASB’s activities during the aftermath of the global ! nancial crisis were described as “riding two horses.” On the one hand, it had to respond to the ! nancial reporting crisis, and on the other hand, it needed to take timely actions to improve U.S. GAAP while also working with the IASB.

AICPA and IFRS Convergence The AICPA announced in May 2008 that private companies were allowed to adopt IFRS ahead of publicly traded companies. This gave AICPA members the option to conduct audits in line with IFRS as an alternative to U.S. GAAP. As a result, U.S.- based private companies that were subsidiaries of foreign parent companies using IFRS were allowed to adopt IFRS in their audited ! nancial statements.

The attempts at convergence between IFRS and U.S. GAAP have brought about an actual narrowing of differences. As a result, U.S. accounting professionals have found it much easier to work in Europe. Further, international companies no longer have to reconcile from IFRS to U.S. GAAP to be registered in the United States. In 2009, a survey conducted by KPMG and the AAA, collecting about 500 responses from U.S. accounting academics, showed 75 percent of the respondents indicating that IFRS should immediately be introduced into the accounting curriculum.

However, the 2008 ! nancial crisis had an impact on the convergence process. In particular, it prompted debates on such fundamental issues as (1) how to re- port information about ! nancial instruments, (2) the appropriateness of fair val- ues, and (3) the perimeter of consolidation in cases of “special purpose” business combinations. These three items were already on the list of the fundamental top- ics considered in the MoU of 2006, and the Boards were under pressure to issue accounting standards on these controversial issues.

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106 Chapter Three

Revision of the Conceptual Framework The IASB and FASB have agreed to work together to produce a conceptual frame- work that will be built upon the IASB’s and FASB’s existing frameworks and will provide a basis for developing future accounting standards by the boards. The boards have agreed to the following phases of this project:

A. Objectives and qualitative characteristics B. Elements and recognition C. Measurement D. Reporting entity E. Presentation and disclosure F. Purpose and status G. Application to not-for-pro! t entities H. Finalization

The two boards jointly published a discussion paper, Preliminary Views on an Improved Conceptual Framework for Financial Reporting: The Objective of Finan- cial Reporting and Qualitative Characteristics of Decision-useful Financial Reporting Information. 41 As part of this project, the IASB has consulted views from interested parties with the aim of converging international and U.S. accounting standards. In response, the Institute of Chartered Accountants in Scotland pointed out that the term “fair value” is used in different ways in the two sets of standards, and sug- gested that the IASB develop its own higher-level guidance that could be relevant to the U.S. context. They state, “The problem is that U.S. GAAP requires fair val- ues in much more limited circumstances than IFRS, especially for ! nancial instru- ments, for some of which there are ef! cient markets. For other types of assets and liabilities, such as stock or a straightforward loan, applying this guidance would result in numbers that bear little resemblance to economic reality.”

The preceding discussion paper sets out a draft of the ! rst chapter of their pro- posed improved “conceptual framework,” and includes several changes. First, it proposes a decision-useful objective and argues that information relevant to assessing stewardship will be encompassed in that objective. However, it is im- portant to note that stewardship and decision usefulness are parallel objectives with different emphases. It can be argued that they should be de! ned as separate objectives. For example, there is strong support in Europe for stewardship as a core objective of ! nancial reporting. The European Financial Reporting Advisory Group (EFRAG), the Accounting Standards Board (ASB), and a number of other European accounting standard-setters have published a brief paper discussing the rationale for including stewardship or directors’ accountability to shareholders as a separate objective of ! nancial reporting.

Second, taking a stakeholder approach, the users of ! nancial reports, other than capital providers, would be explicitly acknowledged in the proposed objective of ! nancial reporting. This re" ects an amendment to the current U.S. “conceptual framework,” which takes a shareholder approach. Third, the IASB and the FASB have tentatively decided that an asset of an entity would be “a present economic resource to which, through an enforceable right or other means, the entity has access or can limit the access of others .” Fourth, emphasis would be placed on

41 This “preliminary views” document deals only with fi nancial reporting by business entities in the private sector. It does not consider issues that arise in connection with not-for-profi t entities (such as charities) or entities in the public sector.

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International Convergence of Financial Reporting 107

developing principles and measurement guidance for fair value measurements in IFRS. In particular, the IASB plans to assess whether an “exit price” was the mea- surement basis intended by each standard, and when an exit price was not the measurement basis intended, whether additional guidance should be developed.

The question of whether ! nancial reporting should be based on “decision use- fulness” or should also recognize stewardship as a separate objective is not new, but it has come to the fore again as a result of the publication of this discussion paper by the IASB and the FASB.

In regard to the use of “fair values” in ! nancial statements, in November 2006, the IASB published for public comment a discussion paper on fair value mea- surement in ! nancial reports. In February 2007, the FASB issued a standard, SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, which provides companies with an option to report selected ! nancial assets and liabili- ties at fair value. SFAS 159 establishes a single de! nition of fair value together with a framework for measuring fair value for ! nancial reports in accordance with U.S. GAAP. The standard requires companies to provide additional information that will help investors and other users of ! nancial statements to more easily under- stand the effect of the company’s choice to use fair value on its earnings. It also requires entities to display the fair value of those assets and liabilities for which the company has chosen to use fair value on the face of the balance sheet. 42

IFRS require some assets, liabilities, and equity instruments to be measured at fair value. However, the current guidance on fair value measurement is inconsis- tent, incomplete, and scattered. The IASB has published its proposed changes to the accounting for ! nancial liabilities. These proposed changes follow work com- pleted on the classi! cation and measurement of ! nancial assets (IFRS 9, Financial Instruments ). They involve limited changes to the accounting for liabilities, with changes to the fair value option. The proposals respond to the view that volatility in pro! t or loss resulting from changes in the credit risk of liabilities that an entity chooses to measure at fair value is counter intuitive and does not provide useful information to investors.

It is clear that the revised conceptual framework will include elements of both the IASB and FASB frameworks. For example, the IASB/FASB joint project on rev- enue recognition has as its objective the development of a single comprehensive set of principles for revenue recognition that is based on assets and liabilities. Under the asset and liability approach, revenue would be recognized based on changes in contract assets and liabilities, as opposed to the performance of obligations.

In a joint statement issued by the FASB and IASB in November 2009, the two boards af! rmed June 2011 as the target date for completing the major projects in the 2006 Memorandum of Understanding (MoU), as updated in May 2008 through a Discussion Paper, “Preliminary Views on an Improved Conceptual Framework for Financial Reporting: The Reporting Entity.” Accordingly, the two boards is- sued an Exposure Draft in March 2010, “Conceptual Framework for Financial Reporting—The Reporting Entity” (Exposure Draft ED/2010/2), with a view to bringing about signi! cant improvement and convergence between IFRS and U.S. GAAP. Many aspects of IASB’s and FASB’s conceptual frameworks are consistent with each other. For example, neither the IASB’s Framework for the Preparation and Presentation of Financial Statements nor FASB Concepts Statements override author- itative standards, even though some may be inconsistent with them.

42 This statement is effective as of the beginning of an entity’s fi rst fi scal year beginning after November 15, 2007.

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108 Chapter Three

The boards focused mainly on the improvement and convergence of their ex- isting frameworks, and they initially considered concepts applicable to business entities in the private sector. In this phase of the conceptual framework project, the boards are considering conceptual matters relating to the reporting entity. The conceptual matters considered by other phases include the objective of ! nancial reporting and the qualitative characteristics of ! nancial reporting information, the elements of ! nancial statements, and measurement. Matters of presentation and disclosure, and the applicability of the concepts in earlier phases to other types of entities, are expected to be considered in later phases.

The IASB’s Framework de! nes the reporting entity as “an entity for which there are users who rely on the ! nancial statements as their major source of ! nancial in- formation about the entity.” The FASB’s Statement of Financial Accounting Concepts does not contain a de! nition of a reporting entity or a discussion of how to identify one. The Exposure Draft jointly issued by the IASB and FASB de! nes a reporting entity as “a circumscribed area of economic activities whose ! nancial information has the potential to be useful to existing and potential equity investors, lenders, and other creditors who cannot directly obtain the information they need in mak- ing decisions about providing resources to the entity and in assessing whether the management and the governing board of that entity have made ef! cient and effec- tive use of the resources provided.”

This concept of reporting entity is intended to further the objective of ! nancial reporting, which is to provide ! nancial information about the reporting entity that is useful in making decisions about providing resources to the entity and in assess- ing whether the management and the governing board of that entity have made ef! cient and effective use of the resources provided. However, during late 2010, the IASB deferred further work on the joint project with the FASB on the concep- tual framework until after other more urgent convergent projects were ! nalized. In September 2012, the IASB reactivated the conceptual framework project as an IASB-only comprehensive project.

SOME CONCLUDING REMARKS

In the quest to achieve convergence with national accounting standards, the IASB must remain alert to the potential for it to be unduly in" uenced by interested par- ties. Commenting on the IASB’s strategy to engineer convergence through a pro- cess of formal liaison with leading national standard-setters, Professor Steven Zeff warns about the political pressures that may be triggered by any board initiative to prescribe speci! c accounting treatments, eliminate alternative treatments, impose additional disclosure requirements, or tighten interpretations. 43 Most accounting issues are politically sensitive, because the need for standards often arises where there is controversy, and accounting can have economic consequences that affect the wealth of different groups. As a result, different groups interested in a particu- lar accounting issue can be expected to lobby for the standard most bene! cial to them, or to prevent the establishment of a proposed standard which they believe would be less favorable than the status quo.

The issue of accounting standards convergence versus ! nancial statement comparability also should not be overlooked. Convergence of standards does not necessarily produce comparable ! nancial statements. Cultural and other factors

43 S. Zeff, “Political Lobbying on Proposed Standards: A Challenge to the IASB,” Accounting Horizons 16, no. 1 (2002), pp. 43–54.

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International Convergence of Financial Reporting 109

could lead to different interpretations of standards and different levels of compli- ance across countries, leading to the production of ! nancial statements that might not be entirely comparable.

Summary 1. Harmonization and convergence are processes of reducing differences in ! - nancial reporting practices across countries.

2. Unlike harmonization, convergence implies the adoption of one set of stan- dards internationally. The major goal of both harmonization and convergence is comparability of ! nancial statements.

3. Harmonization or convergence of accounting standards might not necessar- ily result in comparable ! nancial statements internationally due to nation- speci! c factors such as culture.

4. Proponents of international accounting harmonization/convergence argue that cross-country comparability of ! nancial statements is required for the globalization of capital markets. Opponents argue that globalization is occur- ring without harmonization/convergence and that it might be appropriate for countries with different environments to have different standards.

5. Several organizations were involved in the harmonization efforts at global and regional levels, including IOSCO, IFAC, and the EU.

6. To achieve a common capital market, the European Union (EU) attempted to harmonize accounting through the issuance of the Fourth and the Seventh Directives. Although the EU directives reduced differences in accounting in Europe, complete comparability was not achieved. Rather than developing additional directives, the European Commission decided to require the use of IFRS beginning in 2005.

7. The International Accounting Standards Committee (IASC) was formed in 1973 to develop international accounting standards universally acceptable in all countries. In 2001, the IASC was replaced by the International Accounting Standards Board (IASB).

8. The IASB has 16 members (13 full-time and 3 part-time). The IASB adheres to an open process in developing standards, which are principles-based (rather than rules-based). With the establishment of the IASB, there has been a shift in emphasis from harmonization to global standard-setting or convergence.

9. The IASB’s main item is to develop a set of high-quality ! nancial reporting standards for global use.

10. As of August 2010, International Financial Reporting Standards (IFRS) consisted of 30 IASs, 9 IFRS, and a number of interpretations. As a private organization, the IASB does not have the ability to require the use of its standards.

11. The International Organization of Securities Commissions (IOSCO) rec- ommends that securities regulators permit foreign issuers to use IFRS for cross-listing. Most major stock exchanges are in compliance with this rec- ommendation. In addition, a large and growing number of countries either require or allow domestic listed companies to use IFRS in preparing consoli- dated ! nancial statements. The EU’s adoption of IFRS in 2005 was a major boost to the IASB’s legitimacy as a global accounting standard-setter.

12. The IASB’s Framework for the Preparation and Presentation of Financial Statements establishes usefulness for decision making as the primary objective of ! nancial

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110 Chapter Three

statements prepared under IFRS. Understandability, relevance, reliability, and comparability are the primary qualitative characteristics that make ! nancial statements useful. The Framework also provides workable de! nitions of the accounting elements.

13. IAS 1 is a single standard providing guidelines for the presentation of ! nancial statements. The standard stipulates that a set of IFRS-based ! nancial state- ments must include a balance sheet, an income statement, a statement of cash " ows, a statement of changes in equity, and accounting polices and explana- tory notes. IAS 1 establishes the overriding principle of fair presentation and permits an override of a requirement of an IASB standard in the extremely rare situation where management concludes that compliance with a requirement of a standard would be misleading.

14. IFRS 1 provides guidance to companies that are adopting IFRS for the ! rst time. IFRS 1 requires an entity to comply with each IFRS effective at the re- porting date of its ! rst IFRS ! nancial statements. However, IFRS 1 provides exemptions to this rule where the cost of complying with this requirement would likely exceed the bene! t to users.

15. In 2002, the FASB and IASB signed the Norwalk Agreement, in which they agreed to work toward convergence of their two sets of ! nancial reporting standards.

16. In February 2007, the FASB issued SFAS 159, The Fair Value Opinion for Finan- cial Assets and Financial Liabilities, which provides companies with an option to report selected ! nancial assets and liabilities at fair values, bringing U.S. GAAP and IFRS closer together.

17. In November 2007, the SEC removed the requirement that foreign private is- suers using IFRS must reconcile their ! nancial statements to U.S. GAAP.

18. Although the two boards had previously agreed to revise their respective con- ceptual frameworks as a joint project, recently the IASB has decided to launch an IASB-only project to develop a conceptual framework.

Appendix to Chapter 3

What Is ! is ! ing Called Anglo-Saxon Accounting? The term Anglo-Saxon or Anglo-American is used for a group of countries that includes the United States, the United Kingdom, Canada, Australia, and New Zealand. This group often ! gures in international accounting textbooks and ar- ticles, particularly with regard to international classi! cation of accounting sys- tems and international harmonization of accounting standards. The efforts of the IASB (and its predecessor, the IASC) are usually associated with Anglo-Saxon accounting. Some even criticize the IASB for attempting to promote Anglo-Saxon accounting throughout the world. However, many non-Anglo countries are al- ready using IFRS. Given this, it is important to examine some of the important features of Anglo-Saxon accounting, which is the basis for IFRS.

In a broad sense, the term Anglo-Saxon accounting refers to the accounting sys- tems prevalent in the English-speaking countries mentioned in the preceding

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International Convergence of Financial Reporting 111

paragraph. Although the accounting systems in these countries are not identical, they share some fundamental features that distinguish them from other systems of accounting:

• A focus on how businesses operate at the ! rm level (micro orientation), with an emphasis on the importance of professional judgment (recognition of profes- sional rules and professional self-regulation).

• An investor orientation, with the provision of information for ef! cient opera- tion of the capital market as the primary aim (recognition of the importance of being transparent).

• Less emphasis on prudence and measurement of taxable income or distribut- able income, and willingness to go beyond super! cial legal form (substance over form). 1

There are other recognizable commonalities that are related to the above features. For example, because of the investor orientation and emphasis on trans- parency in accounting reports, the principle of true and fair view or fair presenta- tion is predominant in Anglo-Saxon ! nancial reporting. Auditors are required to report on whether, in their opinion, the ! nancial statements have been prepared in such a way that they adhere to this principle. In the United Kingdom, the con- cept of true and fair view has not been clearly de! ned in legislation. The courts have placed considerable reliance on expert witnesses in developing a meaning for this concept. The UK government’s view has been that this is a highly techni- cal matter and therefore should be dealt with by the profession. This leaves open the possibility for different interpretations. There is no single true and fair view. There are also some differences in how the concept of true and fair view is ap- plied. For example, in the United Kingdom, it is an overriding requirement. In other words, complying with the legal requirements does not necessarily lead to a true and fair view, in which case additional information should be provided. However, in Canada and Australia, a true-and-fair-view override does not apply. Further, the U.S. equivalent to true and fair view, present fairly, is de! ned in terms of conformity with U.S. GAAP. In other words, if the ! nancial statements have been prepared in accordance with U.S. GAAP, then it is assumed that the infor- mation is presented fairly. In general, it is recognized that the application of the qualitative characteristics and appropriate accounting standards would normally result in ! nancial statements that convey a true and fair view of such information, or that present it fairly. 2

The use of a conceptual framework to provide guidance for developing account- ing standards is another common feature among these countries. The qualitative characteristics such as understandability, relevance, reliability, and objectivity or representational faithfulness are found in the conceptual frameworks developed by all Anglo-Saxon countries and by the IASB. The IASB’s conceptual framework is largely based on that of the U.S. FASB. This has been one of the reasons for the view that the IASB has been heavily in" uenced by Anglo-Saxon accounting. An- other recognizable common feature among Anglo-Saxon countries is that they all have common law traditions rather than code law traditions. This means they all use common law legal systems, which tend to be " exible in terms of legislation

1 Christopher W. Nobes, “On the Myth of ‘Anglo-Saxon’ Financial Accounting: A Comment,” International Journal of Accounting 38 (2003), pp. 95–104. 2 IASC, Framework for the Preparation and Presentation of Financial Statements (London: IASC, 1989).

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112 Chapter Three

Questions 1. How does harmonization differ from convergence? 2. What are the potential bene! ts that a multinational corporation could derive

from the international convergence of accounting standards? 3. Were the EU directives effective in generating comparability of ! nancial state-

ments across companies located in member nations? Why or why not? 4. What were the three phases in the life of the IASC? 5. Why was IOSCO’s endorsement of IASs so important to the IASC’s efforts? 6. How does the structure of the IASB help to establish its legitimacy as a global

standard-setter? 7. What is the IASB’s principles-based approach to accounting standard-setting? 8. Are there any major accounting issues that have not yet been covered by IFRS? 9. Do you see a major change of emphasis in the harmonization process since the

establishment of the IASB? Explain. 10. What are the different ways in which IFRS might be used within a country? 11. Would the worldwide adoption of IFRS result in worldwide comparability of

! nancial statements? Why or why not? 12. In what way is the IASB’s Framework intended to assist ! rms in preparing

IFRS-based ! nancial statements? 13. As expressed in IAS 1, what is the overriding principle that should be fol-

lowed in preparing IFRS-based ! nancial statements?

and rely heavily on private-sector and market mechanisms for regulation. Related to this, all these countries have private-sector standard-setting bodies recognizing the profession’s capacity to self-regulate. 3

Some differences can be observed among Anglo-Saxon countries with regard to the recognizable common features described in the preceding paragraph. For example, the conceptual frameworks are not always used as the basis for de- veloping accounting standards. As a case in point, SFAS 87, Employers’ Account- ing for Pensions, in the United States speci! cally states that it does not follow the FASB’s conceptual framework. Further, a common law legal system does not necessarily lead to " exible standards. U.S. accounting standards are increas- ingly becoming more detailed and rigidly prescriptive as compared to account- ing standards developed in the United Kingdom. With regard to private-sector standard-setting, traditionally the U.S. standard-setting system is signi! cantly more public-sector-oriented than the UK system, because the U.S. Securities and Exchange Commission (SEC) has the ultimate responsibility for authorizing ac- counting standards. On the basis of these differences, some commentators have argued that Anglo-Saxon accounting is a myth. 4 However, such differences do not necessarily indicate that these countries cannot usefully be seen as members of the same group. 5

3 Nobes (2003), op cit. 4 David Alexander and Simon Archer, “On the Myth of ‘Anglo-Saxon’ Accounting,” International Journal of Accounting 35, no. 4 (2000), pp. 539–57. 5 Nobes (2003), op cit.

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14. Under what conditions should a ! rm claim to prepare ! nancial statements in accordance with IFRS?

15. To what extent have IFRS been adopted by countries around the world? 16. How has the U.S. SEC policy toward IFRS changed?

International Convergence of Financial Reporting 113

Exercises and Problems

1. “The IASB has been repeatedly accused of devising accounting standards that pay insuf! cient attention to the concerns and practices of companies. . . . Some European banks and insurers complain about poor due process by the IASB, and Frits Bolkestein, European commissioner responsible for accounting mat- ters, endorsed their concerns earlier this month.” ( Financial Times, March 24, 2004, p. 20)

Required: Elaborate on the concerns raised in the preceding quote, and discuss the mea- sures that have been taken by the IASB to alleviate those concerns.

2. Since 2005, publicly traded companies in the European Union have been required to use IFRS in preparing their consolidated ! nancial statements.

Required: a. Explain the EU’s objective in requiring the use of IFRS. b. Identify and describe two issues that might hamper the EU from achieving

the objective underlying the use of IFRS.

3. Assume that you have been invited to advise the newly established accounting oversight body in one of the former Eastern European countries that became a member of the EU in May 2004. The accounting oversight body is charged with the task of identifying the main issues to be addressed in implementing the use of IFRS.

Required: Prepare a report outlining the key points you would include in your advice to this accounting oversight body.

4. Refer to Exhibit 3.6 in this chapter and note the countries that do not permit domestic listed companies to use IFRS.

Required: Identify three countries from this group that are likely to have different rea- sons for not permitting the use of IFRS by domestic listed companies. Describe those reasons.

5. On May 19, 2004, the IASB published a single volume of its of! cial pronounce- ments that will be applicable from January 1, 2005.

Required: Access the IASB Web site ( www.iasb.org ), search for these pronouncements, and prepare a list of them.

6. The professional accounting bodies in many countries have taken, or are tak- ing, steps to adopt IFRS.

Required: Go to the Web site of a professional accounting body of your choice and out- line the steps it has taken so far to facilitate adoption of IFRS.

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7. The appendix to this chapter describes what is commonly referred to as Anglo-Saxon accounting.

Required: Explain why Anglo-Saxon accounting might be of interest to Chinese account- ing regulators.

8. In its 2003 annual report, Honda Motor Company Ltd. states:

Honda’s manufacturing operations are principally conducted in 25 separate factories, 5 of which are located in Japan. Principal overseas manufacturing factories are located in the United States of America, Canada, the United Kingdom, France, Italy, Spain, India, Pakistan, the Philippines, Thailand, Vietnam, Brazil, and Mexico. . . . The company and its domestic subsidiar- ies maintain their books of account in conformity with ! nancial account- ing standards of Japan, and its foreign subsidiaries generally maintain their books of account in conformity with those of the countries of their domicile. The consolidated ! nancial statements presented herein have been prepared in a manner and re" ect the adjustments which are necessary to conform them with accounting principles generally accepted in the United States of America. (p. 59)

Required: Discuss the possible reasons for Honda to prepare its consolidated ! nancial statements in conformity with U.S. GAAP.

9. A list of foreign companies with shares traded on the New York Stock Exchange (NYSE) can be found on the NYSE’s Web site ( www.nyse.com ).

Required: a. Refer to Exhibit 3.6 . Identify a developing country in Asia, Africa, and Latin

America listed in Exhibit 3.6 , and determine how many companies from each of these countries are listed on the NYSE. If the country you select ! rst from a region does not have any NYSE-listed companies, identify another country included in Exhibit 3.6 from that region that does.

b. Describe the manner in which IFRS are used in each of the countries you have selected.

10. The Financial Times, on Tuesday, April 13, 2004, made the following comment in its editorial “Parmalat: Perennial Lessons of European Scandal: Urgent need for better enforcement and investor scepticism”:

After the accounting scandals in the US, there was an unseemly amount of crowing in Europe. As it happens, Parmalat is a much older scandal than Enron or WorldCom. It just took longer to come out at the Italian dairy company. . . . Convergence of standards—in accounting, for instance—will help spread best practice. . . . But we are nowhere near having a world super-regulator. . . . In Italy regulation has been weak because of fragmen- tation and lack of clout and resources. Attempts to tackle this and to ensure regulators’ independence from political interference should be urgently pursued. (p. 12)

Required: Discuss the lessons referred to above concerning the objectives of the current efforts at setting global standards for accounting and ! nancial reporting.

114 Chapter Three

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11. The chapter describes different phases in the harmonization efforts of the IASC.

Required: Identify one such phase and prepare a brief report describing its importance in the overall scheme of international harmonization of accounting standards. You should consult relevant literature in preparing this report.

12. The IASB’s main objective is to develop a set of high-quality standards for ! nancial reporting by companies at the international level.

Required: Critically examine the possibility of achieving this objective.

13. Geneva Technology Company (GTC), a Swiss-based company founded in 1999, is considering the use of IFRS in preparing its annual report for the year ended December 31, 2013. You are the manager of GTC’s ! xed assets account- ing department.

Required: Identify the steps that you will need to take in your department to comply with the requirements of IFRS 1.

14. Recently the IASB revised IFRS 1.

Required: What is the main reason for this revision?

15. The SEC lifted the requirement for foreign companies that have used IFRS as the basis for preparing their ! nancial statements: that to be eligible to list their shares in U.S. stock exchanges, they should reconcile their ! nancial statements using U.S. GAAP.

Required: Discuss the possible reasons for this relaxation of rules.

16. The objective of convergence between IFRS and U.S. GAAP is no longer a priority for the IASB.

Required: Discuss the possible reasons for, and the consequences of, the IASB’s above decision.

Case 3-1

Jardine Matheson Group (Part 1) With its broad portfolio of market-leading businesses, the Jardine Matheson Group is an Asian-based conglomerate with extensive experience in the region. Its business interests include Jardine Paci! c, Jardine Motors Group, Hongkong Land, Dairy Farm, Mandarin Oriental, Cycle & Carriage, and Jardine Lloyd Thompson. These companies are leaders in the ! elds of engineering and construction, transport services, motor trading, property, retailing, restaurants, hotels, and insurance broking.

International Convergence of Financial Reporting 115

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116 Chapter Three

References Alexander , David , and Simon Archer . “On the Myth of ‘Anglo-Saxon’ Accounting.” International Journal of Accounting 35, no. 4 (2000), pp. 539–57 . BDO, Deloitte Touche Tohmatsu , Ernst & Young, Grant Thornton , KPMG, Price-

waterhouseCoopers. GAAP Convergence 2002: A Survey of National Efforts to Promote and Achieve Convergence with International Financial Reporting Standards. Available at www.ifad.net.

Beresford , Dennis R. “Accounting for International Operations.” CPA Journal, October 1988 , pp. 79–80 .

Cairns , David . “Compliance Must Be Enforced.” Accountancy International, September 1998 , pp. 64–65 .

———. Financial Times International Accounting Standards Survey. London: FT Finance , 1999 .

Carey , Anthony . “Harmonization: Europe Moves Forward.” Accountancy, March 1990 .

Carsberg , Sir Bryan . “Global Issues and Implementing Core International Accounting Standards: Where Lies IASC’s Final Goal?” Remarks made at the 50th Anniversary Dinner, Japanese Institute of CPAs, Tokyo, October 23, 1998 .

Chen , S. , Z. Sun , and Y. Wang . “Evidence from China on Whether Harmonized Accounting Standards Harmonize Accounting Practices.” Accounting Horizons 16, no. 3 ( 2002 ), pp. 183–97 .

Choi , F. D. S. “A Cluster Approach to Harmonization.” Management Accounting, August 1981 , pp. 27–31 .

Collins , Stephen H. “The SEC on Full and Fair Disclosure.” Journal of Accountancy, January 1989 , p. 84 .

The Group’s strategy is to build its operations into market leaders across Asia Paci! c, each with the support of Jardine Matheson’s extensive knowledge of the region and its long-standing relationships. Through a balance of cash-producing activities and investment in new businesses, the Group aims to produce sustained growth in shareholder value.

Incorporated in Bermuda, Jardine Matheson has its primary share listing in London, with secondary listings in Singapore and Bermuda. Jardine Matheson Limited operates from Hong Kong and provides management services to Group companies, making available senior management and providing ! nancial, legal, human resources, and treasury support services throughout the Group. 1

Jardine Matheson uses International Financial Reporting Standards in preparing its ! nancial statements and has done so for a number of years.

Required Access Jardine Matheson’s most recent annual report on the company’s Web site ( www.jardine-matheson.com ). Review the company’s consolidated ! nancial state- ments to evaluate whether the ! nancial statements presented comply with the presentation requirements in IAS 1, Presentation of Financial Statements. Document your evaluation.

1 www.jardine-matheson.com/profi le/intro.html .

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Commission of the European Communities. “EU Financial Reporting Strategy: The Way Forward.” Communication from the Commission to the Council and the European Parliament, June 13, 2000.

Doupnik , Timothy S. “Recent Innovations in German Accounting Practice Through the Integration of EC Directives.” Advances in International Accounting 5 ( 1992 ), pp. 75–103 .

———, and M. Richter . “Interpretation of Uncertainty Expressions: A Cross- national Study.” Accounting, Organizations and Society 28, no. 1 ( 2003 ), pp. 15–35 .

Emenyonu , Emmanuel N. , and Sidney J. Gray . “International Accounting Har- monization and the Major Developed Stock Market Countries: An Empirical Study.” International Journal of Accounting 31, no. 3 ( 1996 ), pp. 269–79 .

Ernst & Young . “Mind the GAAP: The Rise and Fall of IAS Lite.” Eye on IAS News- letter, June 2002 , pp. 2–8 .

Financial Accounting Standards Board. The IASC-U.S. Comparison Project: A Re- port on the Similarities and Differences between IASC Standards and U.S. GAAP, ed. Carrie Bloomer. Norwalk, CT: FASB, 1996 .

Financial Accounting Standards Board. The IASC-U.S. Comparison Project, 2nd ed. Norwalk, CT: FASB, 1999 .

Goeltz , Richard Karl . “International Accounting Harmonization: The Impossible (and Unnecessary?) Dream.” Accounting Horizons, March 1991 , pp. 85–86 .

International Accounting Standards Committee. Survey of the Use and Application of International Accounting Standards 1988. London: IASC , 1988 .

IOSCO. Final Communique of the XXIXth Annual Conference of the International Organization of Securities Commissions. Amman, May 17–20, 2004 .

Nobes , Christopher W. “On the Myth of ‘Anglo-Saxon’ Financial Accounting: A Comment.” International Journal of Accounting 38 ( 2003 ), pp. 95–104 .

Street , Donna L. , Sidney J. Gray , and Stephanie M. Bryant . “Acceptance and Observance of International Accounting Standards: An Empirical Study of Companies Claiming to Comply with IASs.” International Journal of Accounting 34, no. 1 ( 1999 ), pp. 11–48 .

”The World After WorldCom.” Financial Times, June 27, 2002 . Zeff , S. “Political Lobbying on Proposed Standards: A Challenge to the IASB.”

Accounting Horizons 16, no. 1 ( 2002 ), pp. 43–54 .

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118

Chapter Four

International Financial Reporting Standards: Part I Learning Objectives

After reading this chapter, you should be able to

• Discuss the types of differences that exist between International Financial Report- ing Standards (IFRS) and U.S. generally accepted accounting principles (GAAP).

• Describe IFRS requirements related to the recognition and measurement of assets, specifi cally inventories; property, plant, and equipment; intangibles; and leased assets.

• Explain major differences between IFRS and U.S. GAAP on the recognition and measurement of assets.

• Describe the requirements of IFRS in a variety of disclosure and presentation standards.

• Explain major differences between IFRS and U.S. GAAP on certain disclosure and presentation issues.

• Analyze the impact that differences between IFRS and U.S. GAAP can have on the fi nancial statements.

INTRODUCTION

As noted in Chapter 3, International Financial Reporting Standards (IFRS) have been adopted as generally accepted accounting principles (GAAP) for listed com- panies in many countries around the world and are accepted for cross-listing purposes by most major stock exchanges, including those in the United States. 1 Increasingly, accountants are being called on to prepare and audit, and users are ! nding it necessary to read and analyze, IFRS-based ! nancial statements. With the U.S. Securities and Exchange Commission reaf! rming its support for a global set of accounting standards, it is likely that IFRS will be integrated into

1 The term International Financial Reporting Standards (IFRS) describes the body of authoritative pro- nouncements issued or adopted by the IASB. IFRS consist of International Accounting Standards issued by the IASC (and adopted by the IASB), International Financial Reporting Standards issued by the IASB, and interpretations developed by IFRIC or the former SIC.

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the U.S. ! nancial reporting system in the near future. 2 This chapter describes and demonstrates the requirements of selected IASB standards, particularly those re- lating to the recognition and measurement of assets, through numerical examples. IFRS that deal exclusively with disclosure and presentation issues also are brie# y summarized.

The International Accounting Standards Committee (IASC) issued a total of 41 International Accounting Standards (IASs) during the period 1973–2001. Thirteen of these standards have been superseded or withdrawn. Most of the 28 remaining standards have been revised one or more times. Since 2001, the IASB has issued 13 International Financial Reporting Standards (IFRS). Exhibit 3.3 in Chapter 3 provides a list of IAS and IFRS issued by the IASB as of September 2013. In addi- tion, more than 20 interpretations issued by the Standing Interpretations Commit- tee (SIC) or International Financial Reporting Interpretations Committee (IFRIC) complement the standards to comprise the complete set of IFRS.

In this chapter, in addition to describing the guidance provided by IFRS, we make comparisons with U.S. GAAP to indicate the differences and similarities between the two sets of standards. 3 In this way, we can begin to appreciate the impact a choice between the two sets of standards has on ! nancial statements.

TYPES OF DIFFERENCES BETWEEN IFRS AND U.S. GAAP

Numerous differences exist between IFRS and U.S. GAAP. The types of differ- ences that exist can be classi! ed as follows:

• De! nition differences. Differences in de! nitions exist even though concepts are similar. De! nition differences can lead to recognition or measurement differences.

• Recognition differences. Differences in recognition criteria and/or guidance are related to (1) whether an item is recognized or not, (2) how it is recognized (e.g., as a liability or as equity), and/or (3) when it is recognized (timing difference).

• Measurement differences. Differences in the amount recognized resulting from ei- ther (1) a difference in the method required or (2) a difference in the detailed guidance for applying a similar method.

• Alternatives. One set of standards allows a choice between two or more alterna- tive methods; the other set of standards requires one speci! c method to be used.

• Lack of requirements or guidance. IFRS may not cover an issue addressed by U.S. GAAP, and vice versa.

• Presentation differences. Differences exist in the presentation of items in the ! nan- cial statements.

• Disclosure differences. Differences in information presented in the notes to ! nan- cial statements are related to (1) whether a disclosure is required and (2) the manner in which disclosures are required to be made.

In many cases, IFRS are more # exible than U.S. GAAP. For example, several IASB standards allow ! rms to choose between two alternative treatments in ac- counting for a particular item. Also, IFRS generally have less bright-line guidance

2 Securities and Exchange Commission, Release Nos. 33-9109; 34-61578, Commission Statement in Support of Convergence and Global Accounting Standards, February 2010. 3 It is important to remember that both IFRS and U.S. GAAP are moving targets, constantly changing. This chapter describes IFRS and makes comparisons with U.S. GAAP as of September 2013.

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120 Chapter Four

than U.S. GAAP; therefore, more judgment is required in applying IFRS. IFRS are said to constitute a principles-based accounting system (broad principles with limited detailed rules), whereas U.S. GAAP is a rules-based system. 4 However, for some accounting issues, IFRS are more detailed than U.S. GAAP.

Ernst & Young conducted a survey of 130 companies that provided reconcilia- tion from IFRS to U.S. GAAP in their 2005 Form 20-F ! led with the U.S. Securities and Exchange Commission. 5 Companies included in the survey were primarily located in the European Union, but it also included several companies in Switzer- land, South Africa, and China. The 130 companies in the survey reported a total of 1,900 reconciling items, and 200 unique differences between IFRS and U.S. GAAP were identi! ed. Many of the adjustments related to ! rst-time application of IFRS. Pensions and business combinations were the two accounting issues that required adjustments by the greatest number of companies (122 companies and 100 compa- nies, respectively). Other issues requiring adjustment by a large number of com- panies included provisions (74 companies), impairment of assets (62 companies), leases (49 companies), and intangibles (36 companies).

INVENTORIES

IAS 2, Inventories, is an example of an International Accounting Standard that pro- vides more extensive guidance than U.S. GAAP, especially with regard to inven- tories of service providers and disclosures related to inventories. IAS 2 provides guidance on determining the initial cost of inventories, the cost formulas to be used in allocating the cost of inventories to expense, and the subsequent measure- ment of inventories on the balance sheet.

The cost of inventories includes costs of purchase, costs of conversion, and other costs:

• Costs of purchase include purchase price; import duties and other taxes; and transportation, handling, and other costs directly attributable to acquiring ma- terials, services, and ! nished products.

• Costs of conversion include direct labor and a systematic allocation of variable and ! xed production overhead. Fixed overhead should be applied based on a normal level of production.

• Other costs are included in the cost of inventories to the extent they are incurred to bring the inventories to their present location and condition. This can include the cost of designing products for speci! c customers. Under certain conditions, interest costs are allowed to be included in the cost of inventories for those items that require a substantial period of time to bring them to a salable condition.

Costs that are expressly excluded from the costs of inventories are:

• Abnormal amounts of wasted materials, labor, or other production costs. • Storage costs, unless they are necessary in the production process before a fur-

ther stage of production.

4 In response to several accounting scandals, including those at Enron and WorldCom, the Sarbanes- Oxley Act passed by the U.S. Congress in 2002 required the FASB to investigate the desirability of U.S. GAAP shifting to a principles-based approach. 5 Ernst & Young, Towards Convergence—A Survey of IFRS/US GAAP Differences (EYGM Limited, 2007). The publication is available at www.ey.com .

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International Financial Reporting Standards: Part I 121

• Administrative overhead that does not contribute to bringing inventories to their present location and condition.

• Selling costs.

IAS 2 does not allow as much choice with regard to cost formulas as does U.S. GAAP. First-in, ! rst-out (FIFO) and weighted-average cost are acceptable treat- ments, but last-in, ! rst-out (LIFO) is not. The standard cost method and retail method also are acceptable provided that they approximate cost as de! ned in IAS 2. The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for speci! c projects must be ac- counted for using the speci! c identi! cation method. An entity must use the same cost formula for all inventories having a similar nature and use to the entity, even if they are located in different geographical locations. For inventories with a dif- ferent nature or use, different cost formulas may be justi! ed. U.S. GAAP does not require use of a uniform inventory valuation method for inventories having a similar nature. It is common for U.S. companies to use different methods in dif- ferent jurisdictions for tax reasons—for example, LIFO in the United States and FIFO or average cost elsewhere.

Lower of Cost or Net Realizable Value IAS 2 requires inventory to be reported on the balance sheet at the lower of cost or net realizable value. Net realizable value is de! ned as estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. This rule typically is applied on an item-by-item basis. However, the standard indicates that it may be appropriate to group similar items of inventory relating to the same product line. Write- downs to net realizable value must be reversed when the selling price increases.

U.S. GAAP requires inventory to be reported at the lower of cost or market, where market is de! ned as replacement cost with a ceiling (net realizable value) and a # oor (net realizable value less normal pro! t margin). The two sets of stan- dards will provide similar results only when replacement cost is greater than net realizable value. Application of this valuation rule may be done either item by item, by groups of inventory, or on a total inventory basis. Under U.S. GAAP, write-downs to market may not be reversed if replacement costs should subse- quently increase.

Example: Application of Lower of Cost or Net Realizable Value Rule Assume that Distributor Company Inc. has the following inventory item on hand at December 31, Year 1:

Historical cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000.00

Replacement cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800.00

Estimated selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 880.00

Estimated costs to complete and sell . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50.00

Net realizable value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 830.00

Normal profi t margin—15% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124.50

Net realizable value less normal profi t margin . . . . . . . . . . . . . . . . . . . . . $ 705.50

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122 Chapter Four

Net realizable value is $830, which is lower than historical cost. In accordance with IFRS, inventory must be written down by $170 ($1,000  −  $830). The journal entry at December 31, Year 1, is:

Inventory Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $170 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $170 To record the write-down on inventory due to decline in net realizable value.

Under U.S. GAAP, market is replacement cost of $800 (falls between $705.50 and $830), which is lower than historical cost. Inventory must be written down by $200 ($1,000  −  $800).

Assume that at the end of the ! rst quarter in Year 2, replacement cost has in- creased to $900, the estimated selling price has increased to $980, and the esti- mated cost to complete and sell remains at $50. The item now has a net realizable value of $930. This is $100 greater than carrying amount (and $70 less than his- torical cost). Under IFRS, $100 of the write-down that was made at December 31, Year 1, is reversed through the following journal entry:

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100 Recovery of Inventory Loss (increase in income). . . . . . . . . . . . . . . . . . . . . . . . . . . . $100 To record a recovery of inventory loss taken in the previous period.

Under U.S. GAAP, the new carrying amount for the item is $800, which is less than the current replacement cost of $900. However, no adjustment is made.

In effect, under IFRS, the historical cost of $1,000 is used in applying the lower of cost or net realizable value rule over the entire period the inventory is held. In con- trast, under U.S. GAAP, the inventory write-down at the end of Year 1 establishes a new cost used in subsequent periods in applying the lower of cost or market rule.

Over the period of time that inventory is held by a ! rm, the two sets of standards result in the same amount of expenses (cost of goods sold plus any net inventory loss). However, the amount of expense recognized in any given accounting period can differ between the two rules, as can the amount at which inventory is mea- sured on the balance sheet.

PROPERTY, PLANT, AND EQUIPMENT

IAS 16, Property, Plant, and Equipment, provides guidance for the following aspects of accounting for ! xed assets:

1. Recognition of initial costs of property, plant, and equipment. 2. Recognition of subsequent costs. 3. Measurement at initial recognition. 4. Measurement after initial recognition. 5. Depreciation. 6. Derecognition (retirements and disposals).

Impairment of assets, including property, plant, and equipment, is covered by IAS 36, Impairment of Assets. Accounting for impairments is discussed later in this chapter.

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International Financial Reporting Standards: Part I 123

Recognition of Initial and Subsequent Costs Relying on the de! nition of an asset provided in the IASB’s Framework for the Preparation and Presentation of Financial Standards, both initial costs and subsequent costs related to property, plant, and equipment should be recognized as an asset when (1) it is probable that future economic bene! ts will # ow to the enterprise and (2) the cost can be measured reliably. Replacement of part of an asset should be capitalized if (1) and (2) are met, and the carrying amount of the replaced part should be derecognized (removed from the accounts).

Example: Replacement of Part of an Asset Road Warriors Inc. acquired a truck with a useful life of 20 years at a cost of $150,000. At the end of the sixth year, the power train requires replacement. The remainder of the truck is perfectly roadworthy and is expected to last another 14 years. The cost of the new power train is $35,000.

The new power train will provide economic bene! t to Road Warriors (it will allow the company to continue to use the truck), and the cost is measurable. The $35,000 cost of the new power train meets the asset recognition criteria and should be added to the cost of the truck. The original cost of the truck of $150,000 was not broken down by component, so the cost attributable to the original power train must be estimated. Assuming annual price increases for power trains of 5 percent, Road Warriors estimates that the cost of the original power train was $26,117 ($35,000/1.05 6 ). The appropriate journal entries to account for the replace- ment would be:

Truck . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $35,000 Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $35,000 Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $26,117 Truck . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $26,117

Measurement at Initial Recognition Property, plant, and equipment should be initially measured at cost, which in- cludes (1) purchase price, including import duties and taxes; (2) all costs directly attributable to bringing the asset to the location and condition necessary for it to perform as intended; and (3) an estimate of the costs of dismantling and removing the asset and restoring the site on which it is located.

An item of property, plant, and equipment acquired in exchange for a non- monetary asset or combination of monetary and nonmonetary assets should be initially measured at fair value unless the exchange transaction lacks commercial substance. Fair value is de! ned as the “amount for which an asset could be ex- changed between knowledgeable, willing parties in an arm’s length transaction.” 6 If the transaction lacks commercial substance or the fair value of the asset ac- quired and given up cannot be determined, then the cost of the asset acquired is measured as the carrying value of the asset given up. As a result, no gain or loss is recognized.

6 IAS 16, paragraph 6.

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124 Chapter Four

Example: Dismantling and Removal Costs Caylor Corporation constructed a powder coating facility at a cost of $3,000,000: $1,000,000 for the building and $2,000,000 for machinery and equipment. Local law requires the company to dismantle and remove the plant assets at the end of their useful life. Caylor estimates that the net cost, after deducting salvage value, for removal of the equipment is $100,000, and the net cost for dismantling and removing the building will be $400,000. The useful life of the facility is 20 years, and the company uses a discount rate of 10 percent in determining present values.

The initial cost of the machinery and equipment and the building must in- clude the estimated dismantling and removal costs discounted to present value. The present value factor for a discount rate of 10 percent for 20 periods is 0.14864 (1/1.10 20 ). The calculations are as follows:

Building

Construction cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000 Present value of dismantling and removal costs ($400,000 × 0.14864) . . . . . . 59,457 Total cost of the building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,059,457

Machinery and equipment

Construction cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000,000 Present value of dismantling and removal costs ($100,000 × 0.14864) . . . . . . 14,864 Total cost of the machinery and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . $2,014,864

The journal entry to record the initial cost of the assets would be:

Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,059,457 Machinery and Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,014,864 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000,000 Provision for dismantling and removal (long-term liability) . . . . 74,321

Measurement Subsequent to Initial Recognition A substantive area of difference between IFRS and U.S. GAAP relates to the mea- surement of property, plant, and equipment subsequent to initial recognition. IAS 16 allows two treatments for reporting ! xed assets on balance sheets subsequent to their acquisition: the cost model and the revaluation model.

Under the cost model, an item of property, plant, and equipment is carried on the balance sheet at cost less accumulated depreciation and any accumulated im- pairment losses. This is consistent with U.S. GAAP.

Under the revaluation model, an item of property, plant, and equipment is carried at a revalued amount, measured as fair value at the date of revaluation, less any subsequent accumulated depreciation and any accumulated impairment losses. If an enterprise chooses to follow this measurement model, revaluations must be made often enough that the carrying amount of assets does not differ materially from the assets’ fair value. When revaluations are made, an entire class of property, plant, and equipment must be revalued. Revaluation increases are credited directly to the other comprehensive income component of equity as a revaluation surplus. Revaluation decreases are ! rst recognized as a reduction in any related revaluation surplus, and, once the surplus is exhausted, additional revaluation decreases are recognized as an expense. The revaluation surplus may

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International Financial Reporting Standards: Part I 125

be transferred to retained earnings on disposal of the asset. Revalued assets may be presented either (1) at a gross amount less a separately reported accumulated depreciation (both revalued) or (2) at a net amount. Allowing ! rms the option to revalue ! xed assets is one of the most substantial differences between IFRS and U.S. GAAP. Guidelines for applying this option are presented in more detail in the following paragraphs.

Determination of Fair Value The basis of revaluation is the fair value of the asset at the date of revaluation. The de! nition in IAS 16 indicates that fair value is the amount at which an asset could be exchanged between knowledgeable, willing parties in an arm’s-length transaction. The fair value of land and buildings is usually determined through appraisals conducted by professionally quali! ed valuers. The fair value of plant and equipment is also usually determined through appraisal. In the case of a spe- cialized asset that is not normally sold, fair value may need to be estimated using, for example, a depreciated replacement cost approach. In 2009, the IASB issued an exposure draft, Fair Value Measurement, that is intended to provide considerably more guidance with respect to measuring the fair value of assets, including prop- erty, plant, and equipment, and liabilities. If approved as a ! nal standard, this exposure draft also will substantially converge IFRS with U.S. GAAP with respect to how fair value is measured.

Frequency of Revaluation IAS 16 requires that revalued amounts should not differ materially from fair val- ues at the balance sheet date. The effect of this rule is that once an enterprise has opted for the revaluation model, it has an obligation to keep the valuations up to date. Although the IASB avoids mandating annual revaluations, these will be necessary in some circumstances in order to comply with the standard. In other cases, annual changes in fair value will be insigni! cant and revaluation may be necessary only every several years.

Selection of Assets to Be Revalued IAS 16 requires that all assets of the same class be revalued at the same time. Se- lectivity within a class is not permitted, but selection of a class is. Different classes of assets described in the standard are as follows: land; land and buildings; machin- ery; of! ce equipment; furniture and ! xtures; motor vehicles; ships; and aircraft.

Detailed disclosures are required for each class of property, plant, and equip- ment (whether revalued or not). Thus, if a company divides its assets into many classes to minimize the effect of the rule about revaluing a whole class of assets, it will incur the burden of being required to make additional disclosures for each of those classes.

Accumulated Depreciation Two alternative treatments are described in IAS 16 for the treatment of accumu- lated depreciation when a class of property, plant, and equipment is revalued:

1. Restate the accumulated depreciation proportionately with the change in the gross carrying amount of the asset so that the carrying amount of the asset after revaluation equals its revalued amount. The standard comments that this method is often used where an asset is revalued by means of an index and is the appropriate method for those companies using current cost accounting.

2. Eliminate the accumulated depreciation against the gross carrying amount of the asset, and restate the net amount to the revalued amount of the asset.

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126 Chapter Four

Example: Treatment of Accumulated Depreciation upon Revaluation Assume that Kiely Company Inc. has buildings that cost $1,000,000, with accumu- lated depreciation of $600,000 and a carrying amount of $400,000 on December 31, Year 1. On that date, Kiely Company determines that the market value for these buildings is $750,000. Kiely Company wishes to carry buildings on the Decem- ber 31, Year 1, balance sheet at a revalued amount. Under treatment 1, Kiely Com- pany would restate both the buildings account and accumulated depreciation on buildings such that the ratio of net carrying amount to gross carrying amount is 40 percent ($400,000/$1,000,000) and the net carrying amount is $750,000. To ac- complish this, the following journal entry would be made at December 31, Year 1:

Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $875,000 Accumulated Depreciation—Buildings . . . . . . . . . . . . . . . . . . . . . . . . $525,000 Revaluation Surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350,000 To revalue buildings and related accumulated depreciation.

Under treatment 2, accumulated depreciation of $600,000 is ! rst eliminated against the buildings account, and then the buildings account is increased by $350,000 to result in a net carrying amount of $750,000. The necessary journal entries are as follows:

Accumulated Depreciation—Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600,000 Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600,000 To eliminate accumulated depreciation on buildings to be revalued. Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $350,000 Revaluation Surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $350,000 To revalue buildings.

As a result of making these two entries, the buildings account has a net carrying amount of $750,000 ($1,000,000  −  600,000  +  350,000). Under both treatments, both assets and equity are increased by a net amount of $350,000.

Treatment of Revaluation Surpluses and De! cits On the ! rst revaluation after initial recording, the treatment of increases and de- creases in carrying amount as a result of revaluation is very straightforward:

• Increases are credited directly to a revaluation surplus in the other comprehen- sive income component of equity.

• Decreases are charged to the income statement as an expense.

At subsequent revaluations, the following rules apply:

• To the extent that there is a previous revaluation surplus with respect to an asset, a decrease ! rst should be charged against it and any excess of de! cit over that previous surplus should be expensed.

Original Cost Revaluation Total %

Gross carrying amount $1,000,000 + $875,000 = $1,875,000 100% Accumulated depreciation 600,000 + 525,000 = 1,125,000 60 Net carrying amount $ 400,000 + $350,000 = $ 750,000 40%

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• To the extent that a previous revaluation resulted in a charge to expense, a sub- sequent upward revaluation ! rst should be recognized as income to the extent of the previous expense and any excess should be credited to other comprehen- sive income in equity.

Example: Treatment of Revaluation Surplus Assume that Kiely Company Inc. has elected to measure property, plant, and equipment at revalued amounts. Costs and fair values for Kiely Company’s three classes of property, plant, and equipment at December 31, Year 1 and Year 2, are as follows:

The following journal entries are made at December 31, Year 1, to adjust the car- rying amount of the three classes of property, plant, and equipment to fair value:

Land Buildings Machinery

Cost. . . . . . . . . . . . . . . . . . . . . . . . $100,000 $500,000 $200,000

Fair value at 12/31/Y1 . . . . . . . . . . 120,000 450,000 210,000

Fair value at 12/31/Y2 . . . . . . . . . . 150,000 460,000 185,000

At December 31, Year 2, the following journal entries are made:

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000 Revaluation Surplus—Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000

Loss on Revaluation—Buildings (expense). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50,000 Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50,000

Machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000 Revaluation Surplus—Machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000

IAS 16 indicates that the revaluation surplus in equity may be transferred to retained earnings when the surplus is realized. The surplus may be considered to be realized either through use of the asset or upon its sale or disposal. Accord- ingly, the revaluation surplus in equity may be transferred in one of two ways to retained earnings:

• A lump sum may be transferred at the time the asset is sold or scrapped. • Within each period, an amount equal to the difference between depreciation on

the revalued amount and depreciation on the historical cost of the asset may be transferred to retained earnings.

A third possibility apparently allowed by IAS 16 would be to do nothing with the revaluation surplus. However, this would result in a revaluation surplus being reported in equity related to assets no longer owned by the ! rm.

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $30,000 Revaluation Surplus—Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $30,000

Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000 Recovery of Loss on Revaluation—Buildings (income) . . . . . . . . . . . . . . . $10,000

Revaluation Surplus—Machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000 Loss on Revaluation—Machinery (expense) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

Machinery. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $25,000

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Insight into the effect the revaluation model has on ! nancial statements can be gained by examining the U.S. GAAP reconciliations that were required of foreign companies with shares publicly traded in the United States. With shares traded on the New York Stock Exchange, until 2007 China Eastern Airlines Corporation (CEA) was required to reconcile IFRS-based income and shareholders’ equity to a U.S. GAAP basis. Exhibit  4.1 presents CEA’s reconciliation to U.S. GAAP, along with the note describing signi! cant differences between IFRS and U.S. GAAP with respect to revaluation of property, plant, and equipment. In recon- ciling “consolidated pro! t/(loss) attributable to the Company’s equity holders,” CEA makes an adjustment for the “reversal of net revaluation surplus, net of de- preciation charges.” This adjustment re# ects the amount of additional deprecia- tion expense recognized under IFRS on higher revalued amounts that would not be taken under U.S. GAAP. In 2006, pro! t/(loss) under IFRS was increased by 53.7 million renminbi (RMB) to adjust to a U.S. GAAP basis. CEA also makes a positive adjustment in reconciling to U.S. GAAP income for the “pro! t/(loss) on disposals of aircraft and related assets.” Revalued assets have a higher book value than assets carried at cost. As a result, when revalued assets are sold, the gain on sale is smaller than it otherwise would be. In 2006, CEA increased U.S. GAAP income by RMB 156.5 million to include the larger gain that would have been rec- ognized if assets had been carried at cost (under U.S. GAAP) rather than revalued amounts (under IFRS).

EXHIBIT 4.1

CHINA EASTERN AIRLINES CORPORATION LIMITED Form 20-F

2006 Revaluation of Property, Plant, and Equipment

Notes to the Consolidated Financial Statements

Excerpt from Note 40, Signifi cant Differences between IFRS and U.S. GAAP

Differences between IFRS and U.S. GAAP which have signifi cant effects on the consolidated profi t/(loss) attributable to equity holders and consolidated net assets of the Group are summarized as follows:

2004 2005 2006

Note RMB’000 RMB’000 RMB’000

Consolidated profi t/(loss) attributable to the Company’s equity holders As stated under IFRS 456,371 (438,728) (3,452,765) Less: Minority interests (h) (135,680) (28,579) 139,340

320,691 (467,307) (3,313,425) U.S. GAAP adjustments: Net (loss)/income after tax effect attributable to CEA Northwest and CEA Yunnan (a) 24,424 (575,326) — Reversal of net revaluation surplus, net of depreciation charges (b) 57,568 73,803 53,772 Profi t/(loss) on disposals of aircraft and related assets (b) 7,099 861 156,589 Rescission of related party lease arrangements (c) (133,029) — — Reversal of the impact of the new overhaul accounting policy adopted in 2005 (d) 227,510 (471,756) — Recognition of additional write-down in relation to assets held for sale (e) — — (434,561) Reversal of gain on sale and leaseback of aircraft recognized under IFRS (f) — — (126,470)

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Others (i) (1,518) (3,720) 26,997 Deferred tax effect on the U.S. GAAP adjustments (j) (43,598) 60,122 (23,872) As stated under U.S. GAAP 459,147 (1,383,323) (3,660,970) Basic and fully diluted earning/(loss) per share under U.S. GAAP RMB 0.094 (RMB 0.284) (RMB 0.741) Basic and fully diluted earning/(loss) per American Depository Share (“ADS”) under U.S. GAAP RMB 9.43 (RMB 28.42) (RMB 74.12) Consolidated net assets As stated under IFRS 7,302,086 6,918,542 3,476,643 Less: Minority interests (h) (820,835) (822,477) (661,746)

6,481,251 6,096,065 2,814,897 U.S. GAAP adjustments: Impact on equity before tax effect attributable to CEA Northwest and CEA Yunnan (a) (1,426,741) 413,841 413,841 Reversal of net revaluation surplus net of depreciation charges and profi t/(loss) on disposals of aircraft and related assets (b) (480,010) (405,346) (194,985) Reversal of impact of the new overhaul accounting policy adopted in 2005 (d) 471,756 — — Recognition of additional write-down in relation to assets held for sale (e) — — (434,561) Reversal of gain on sale-and-leaseback of aircraft recognized under IFRS (f) — — (126,470) Recognition of the funded status of postretirement benefi ts obligations under U.S. GAAP (g) — — (548,428) Others (i) 34,453 (12,140) (12,365) Deferred tax effect on the U.S. GAAP adjustments (j) (52,993) 7,129 (16,232) As stated under U.S. GAAP 5,027,716 6,099,549 1,895,697

(b) Revaluation of property, plant, and equipment

Under IFRS, the Group’s property, plant, and equipment are initially recorded at cost and are subsequently restated at revalued amounts less accumulated depreciation. The excess depreciation charge arising from the revaluation surplus was approximately RMB57,568,000, RMB73,803,000, and RMB53,772,000 for the years ended December 31, 2004, 2005, and 2006, respectively. The additional gains arising from the revaluation surplus on disposals of revalued property, plant, and equipment were approximately gains of RMB7,099,000, RMB861,000, and RMB156,589,000 for the years ended December 31, 2004, 2005, and 2006, respectively.

Under U.S. GAAP, property, plant, and equipment are stated at cost less accumulated depreciation and impairment charges, if any. Accordingly, the revaluation surplus, the related differences in depreciation charges and gains or losses on disposals on aircraft and the related assets are reversed.

In reconciling “consolidated net assets” (stockholders’ equity) from IFRS to U.S. GAAP, CEA includes an adjustment for the “reversal of net revaluation surplus net of depreciation charges and pro! t/(loss) on disposals of aircraft and related assets.” This one-line item actually combines three different adjustments:

1. The original revaluation surplus (less accumulated depreciation) included in other comprehensive income (stockholders’ equity) under IFRS is reversed. This results in a smaller amount of other comprehensive income under U.S. GAAP.

2. The difference in depreciation expense under IFRS and U.S. GAAP results in an adjustment to retained earnings; U.S. GAAP retained earnings is larger.

3. The additional amount of gain on disposal of assets that would have been recognized under U.S. GAAP also results in a larger amount of U.S. GAAP retained earnings.

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130 Chapter Four

The ! rst adjustment is larger in amount than the latter two. In 2006, the sum of these three adjustments caused net assets on a U.S. GAAP basis to be RMB194 million smaller than under IFRS. This amount represents 6.9 percent of IFRS net assets.

Depreciation Depreciation is based on estimated useful lives, taking residual value into account. The depreciation method should re# ect the pattern in which the asset’s future economic bene! ts are expected to be consumed; straight-line depreciation will not always be appropriate. IAS 16 requires estimates of useful life, residual value, and the method of depreciation to be reviewed on an annual basis. Changes in depre- ciation method, residual value, and useful life are treated prospectively as changes in estimates.

When an item of property, plant, and equipment is comprised of signi! cant parts for which different depreciation methods or useful lives are appropriate, each part must be depreciated separately. This is commonly referred to as com- ponent depreciation. Components can be physical, such as an aircraft engine, or nonphysical, such as a major inspection. Component depreciation is not com- monly used under U.S. GAAP.

Example: Component Depreciation On January 1, Year 1, an entity acquires a new piece of machinery with an esti- mated useful life of 10 years for $120,000. The machine has an electrical motor that must be replaced every ! ve years and is estimated to cost $10,000 to replace. In ad- dition, by law the machine must be inspected every two years; the inspection cost is $2,000. The company has determined that the straight-line method of deprecia- tion best re# ects the pattern in which the asset’s future bene! ts will be consumed. Assuming no residual value, depreciation of $13,800 on this machinery in Year 1 is determined in the following manner:

Derecognition Derecognition refers to the removal of an asset or liability from the balance sheet and the accounts. The carrying amount of an item of property, plant, and equip- ment is derecognized (1) upon disposal, or (2) when no future economic bene! ts are expected from its use or disposal. The gain or loss arising from the derecogni- tion of an item of property, plant, and equipment is included in net income.

Note that an item of property, plant, and equipment should be reclassi! ed as “noncurrent assets held for sale” when the asset’s carrying amount is to be recov- ered by selling the asset rather than by using the asset. IFRS 5, Noncurrent Assets Held for Sale and Discontinued Operations, provides guidance with respect to the accounting treatment for noncurrent assets, including property, plant, and equip- ment, that are held for sale, as well as guidance with respect to the accounting for discontinued operations.

Component Cost Useful Life Depreciation

Motor $ 10,000 5 years $ 2,000

Inspection 2,000 2 years 1,000

Machine 108,000 10 years 10,800

Total $120,000 $13,800

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INVESTMENT PROPERTY

IAS 40, Investment Property, prescribes the accounting treatment for investment property, which is de! ned as land and/or buildings held to earn rentals, capital appreciation, or both. The principles related to accounting for property, plant, and equipment generally apply to investment property, including the option to use either a cost model or a fair value model in measuring investment property sub- sequent to acquisition. The fair value model for investment property differs from the revaluation method for property, plant, and equipment in that changes in fair value are recognized as gains or losses in current income and not as a revaluation surplus. Even if an entity chooses the cost model, it is required to disclose the fair value of investment property in the notes to ! nancial statements. In contrast to IFRS, U.S. GAAP generally requires use of the cost model for investment property.

IMPAIRMENT OF ASSETS

IAS 36, Impairment of Assets, requires impairment testing and recognition of im- pairment losses for property, plant, and equipment; intangible assets; goodwill; and investments in subsidiaries, associates, and joint ventures. It does not apply to inventory, construction in progress, deferred tax assets, employee bene! t as- sets, or ! nancial assets such as accounts and notes receivable. U.S. GAAP also re- quires impairment testing of assets. However, several important differences exist between the two sets of standards.

Under IAS 36, an entity must assess annually whether there are any indicators that an asset is impaired. Events that might indicate an asset is impaired are:

• External events, such as a decline in market value, increase in market interest rate, or economic, legal, or technological changes that adversely affect the value of an asset.

• Internal events, such as physical damage, obsolescence, idleness of an asset, the restructuring of part of an asset, or the worse-than-expected economic perfor- mance of the asset.

If indicators of impairment are present, an entity must estimate the recoverable amount of the asset and compare that amount with the asset’s carrying amount (book value).

Defi nition of Impairment Under IAS 36, an asset is impaired when its carrying amount exceeds its recover- able amount.

• Recoverable amount is the greater of net selling price and value in use. • Net selling price is the price of an asset in an active market less disposal costs. • Value in use is determined as the present value of future net cash # ows expected

to arise from continued use of the asset over its remaining useful life and upon disposal. In calculating value in use, projections of future cash # ows should be based on approved budgets and should cover a maximum of ! ve years (unless a longer period can be justi! ed). The discount rate used to determine present value should re# ect current market assessments of the time value of money and the risks speci! c to the asset under review.

Under U.S. GAAP, impairment exists when an asset’s carrying amount exceeds the future cash # ows (undiscounted) expected to arise from its continued use and

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132 Chapter Four

disposal. Net selling price is not involved in the test, and future cash # ows are not discounted to their present value. When value in use is the recoverable amount under IAS 36, an impairment is more likely to arise under IFRS (discounted cash # ows) than under U.S. GAAP (undiscounted cash # ows).

Measurement of Impairment Loss The measurement of impairment loss under IAS 36 is straightforward. It is the amount by which carrying value exceeds recoverable amount, and it is recognized in income. In the case of property, plant, and equipment carried at a revalued amount, the impairment loss is ! rst taken against revaluation surplus and then to income.

The comparison of carrying value and undiscounted future cash # ows under U.S. GAAP is done to determine whether an asset is impaired. The impairment loss is then measured as the amount by which carrying value exceeds fair value. Fair value may be determined by reference to quoted market prices in active markets, estimates based on the values of similar assets, or estimates based on the results of valuation techniques. It is unlikely that fair value (U.S. GAAP) and recoverable amount (IFRS) for an asset will be the same, resulting in differences in the amount of impairment loss recognized between the two sets of standards.

Example: Determination and Measurement of Impairment Loss At December 31, Year 1, Toca Company has specialized equipment with the fol- lowing characteristics:

In applying IAS 36, the asset’s recoverable amount would be determined as follows:

Carrying amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50,000

Selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000

Costs of disposal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Expected future cash fl ows . . . . . . . . . . . . . . . . . . . . . 55,000

Present value of expected future cash fl ows . . . . . . . . . 46,000

The determination and measurement of impairment loss would be:

Net selling price . . . . . . . . . . . . . . . . . . . . . . . . . $40,000 − 1,000 = $39,000 Value in use . . . . . . . . . . . . . . . . . . . . . . . . . . . . $46,000 Recoverable amount (greater of the two) $46,000

The following journal entry would be made to re# ect the impairment of this asset:

Carrying amount . . . . . . . . . . . . . . . . . . . . $50,000

Recoverable amount . . . . . . . . . . . . . . . . . 46,000

Impairment loss . . . . . . . . . . . . . . . . . . . . . $ 4,000

Impairment Loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,000 Equipment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,000 To recognize an impairment loss on equipment.

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Under U.S. GAAP, an impairment test would be carried out as follows:

Because expected future cash # ows exceed the asset’s carrying value, no impair- ment is deemed to exist. The asset would be reported on the December 31, Year 1, balance sheet at $50,000.

Reversal of Impairment Losses At each balance sheet date, a review should be undertaken to determine if im- pairment losses have reversed. (Indicators of impairment reversal are provided in IAS  36.) If, subsequent to recognizing an impairment loss, the recoverable amount of an asset is determined to exceed its new carrying amount, the im- pairment loss should be reversed. However, the loss should be reversed only if there are changes in the estimates used to determine the original impairment loss or there is a change in the basis for determining the recoverable amount (from value in use to net selling price or vice versa). The carrying value of the asset is increased, but not to exceed what it would have been if no impairment loss had been recognized. The reversal of an impairment loss should be recognized in income immediately. U.S. GAAP does not allow the reversal of a previously recognized impairment loss.

Example: Reversal of Impairment Loss Spring Valley Water Company purchased new water ! ltration equipment at the beginning of Year 1 for $1,000,000. The equipment is expected to have a useful life of 40 years with no residual value. Therefore, annual depreciation is $25,000. By the end of Year 3, Spring Valley concluded that the ! ltration system was not performing up to expectations. The company determined that the system had a recoverable amount based on net selling price of $740,000. The carrying amount of the asset at the end of Year 3 was $925,000 [$1,000,000  −  ($25,000  ×  3 years)], so the company recognized an impairment loss of $185,000 in Year 3. Annual depreciation of $20,000 [$740,000/37 years] subsequently was recognized in Years 4 and 5. The carrying amount of the equipment at the end of Year 5 was $700,000 [$740,000  −  ($20,000  ×  2)]. The summary journal entries to account for this asset in Years 1 through 5 are shown here:

Carrying value . . . . . . . . . . . . . . . . . . . . . . . . . . . $50,000 Expected future cash fl ows (undiscounted). . . . . . 55,000

January 1, Year 1 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000 December 31, Year 1, Year 2, Year 3 Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $25,000

Accumulated Depreciation—Equipment . . . . . . . . . . . . . . . . . $25,000 December 31, Year 3 Impairment Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $185,000

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $185,000 December 31, Year 4, Year 5 Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000

Accumulated Depreciation—Equipment . . . . . . . . . . . . . . . . . $20,000

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134 Chapter Four

In January, Year 6, a technician discovered that the ! ltration equipment had not been properly set up at the time of initial installation. Adjustments to the installation resulted in a signi! cant boost in performance, which led the com- pany to reevaluate whether the equipment was still impaired. New estimates of future cash # ows to be generated through continued operation of the equip- ment resulted in a recoverable amount based on value in use of $900,000, and the company determined that it was appropriate to reverse the impairment loss recognized in Year 3. To determine the amount of impairment loss to reverse, the company calculates what the carrying amount of the equipment would have been if the impairment had never been recognized. Annual depreciation of $25,000 would have been taken for ! ve years, resulting in a carrying amount of $875,000 [$1,000,000  −  ($25,000  ×  5 years)], which is less than the new recoverable amount of $900,000. With impairment, the carrying amount of the equipment at the end of Year 5 is $700,000. Therefore, early in Year 6, Spring Valley increased the carrying amount of the equipment by $175,000 to write it up to $875,000 and recorded a reversal of impairment loss of the same amount. The reversal of impairment loss results in an increase in income:

January, Year 6 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $175,000

Reversal of Impairment Loss (increase in income) . . . . . . . . . . . . . . $175,000

The shares of Lihir Gold Limited, a mining company based in Papua New Guinea, are traded on the NASDAQ market in the United States. Lihir Gold uses IFRS in preparing its ! nancial statements. The reconciliation of net income to U.S. GAAP and the procedures followed by Lihir Gold in complying with IAS 36’s impairment rules are summarized in Exhibit 4.2 . The company explains that impairment losses on mine properties were recorded in 1999 and 2000 under IAS 36 and that these losses were partially reversed in 2004 in the amount of $205.7 million. This reversal of a previously recognized impairment loss (which increases income) is not acceptable under U.S. accounting rules, so IFRS income was reduced by $205.7 million in 2004 to reconcile to U.S. GAAP. IFRS stockhold- ers’ equity (retained earnings) was reduced by the same amount to reconcile to U.S. GAAP.

INTANGIBLE ASSETS

IAS 38, Intangible Assets, provides accounting rules for purchased intangible as- sets, intangible assets acquired in a business combination, and internally gener- ated intangible assets. Goodwill is covered by IFRS 3, Business Combinations.

IAS 38 de! nes an intangible asset as an identi! able, nonmonetary asset with- out physical substance held for use in the production of goods or services, for rental to others, or for administrative purposes. As an asset, it is a resource controlled by the enterprise as a result of past events from which future economic bene! ts are expected to arise. If a potential intangible asset does not meet this de! - nition (i.e., it is not identi! able, not controlled, or future bene! ts are not prob- able) or cannot be measured reliably, it should be expensed immediately, unless it is obtained in a business combination, in which case it should be included in goodwill.

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International Financial Reporting Standards: Part I 135

Purchased Intangibles Purchased intangibles are initially measured at cost, and their useful life is as- sessed as ! nite or inde! nite. The cost of intangible assets with a ! nite useful life is amortized on a systematic basis over the useful life. The residual value is assumed to be zero unless (1) a third party has agreed to purchase the asset at the end of its useful life or (2) there is an active market for the asset from which a residual value can be estimated.

An intangible asset is deemed to have an inde! nite life when there is no fore- seeable limit to the period over which it is expected to generate cash # ows for the entity. If the useful life of an intangible asset is inde! nite, no amortization should be taken until the life is determined to be de! nite. The distinction made in IAS 38

EXHIBIT 4.2

LIHIR GOLD LIMITED Form 20-F

2006 Impairment of Assets

Notes to the Financial Statements

Excerpt from Note 34. Reconciliation to U.S. GAAP

The basis of preparation of these fi nancial statements is set out in Note 1. These accounting policies vary in certain important respects from the accounting principles generally accepted in the United States (U.S. GAAP). The material differences affecting the fi nancial statement line items between generally accepted accounting principles followed by the Company and those generally accepted in the United States are summarized below.

2006 2005 2004 Reference US $’000 US $’000 US $’000

Net income under IFRS 53,837 9,788 329,221 Mine properties—capitalized interest b 559 3,661 — Depreciation of mine properties c 9,226 9,205 2,974 Mine properties—impairment reversal d — — (205,723) EGS—impairment reversal e — — (90,200) Deferred mining costs j — — (3,123) Adjustment of deferred charges to inventory f 25,839 — — Recognition of deferred waste as a charge f (56,349) — — Deferred tax benefi t adjustment for U.S. GAAP i 3,167 (808) 108,465

Net income under U.S. GAAP 36,279 21,845 141,614

d. Impairment: Mine properties

Under IAS 36, the impairment test for determining the recoverable amount of a noncurrent asset is the higher of net selling price and its value in use. Value in use is the net present value of cash fl ows expected to be realized from the asset, assessed based on the current condition of the asset. Under IFRS, impairment losses may be reversed in subsequent periods.

Under SFAS 144, an impairment loss is recognized if the carrying amount of a long-lived asset (asset group) exceeds the sum of the undiscounted cash fl ows expected to result from the use and eventual disposition of the asset (asset group). An impairment loss is measured as the excess of the carrying amount of the long-lived asset (asset group) over its fair value. Fair value has been estimated using present value techniques. Under U.S. GAAP, impairment reversals are not permitted.

No impairments or impairment reversals occurred in 2006 or 2005. In 2004, as a result of signifi cant changes in the critical assumptions used to determine the value in use, including increases in the life of mine and reserves and increases in the estimated long-term gold price, the directors resolved to partially reverse impairments recognized in 2000 and 1999 to the value of $205.7 million. In determining the value in use, the Company used the long-term gold price assumptions of $380 for the year ended 2004 and a pretax real discount rate of 7 percent. As a result of the reversal in 2004, all the impairments recognized in 2000 and 1999, excluding the amount that would have been depreciated of $82.7 million, have been reversed for IFRS as the impairment write-back is limited to the amount that would have been the written-down value of the assets had there been no impairment.

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136 Chapter Four

between intangibles with a ! nite life and those with an inde! nite life and corre- sponding accounting treatment is consistent with U.S. GAAP.

Intangibles Acquired in a Business Combination Under both IAS 38 and U.S. GAAP, intangibles such as patents, trademarks, and customer lists acquired in a business combination should be recognized as assets apart from goodwill at their fair value. The acquiring company should recognize these intangibles as assets even if they were not recognized as assets by the acquiree, so long as their fair value can be measured reliably. If fair value cannot be measured reliably, the intangible is not recognized as a separate asset but is included in good- will. Similar to purchased intangibles, intangibles acquired in a business combina- tion must be classi! ed as having a ! nite or an inde! nite useful life.

A special situation arises with respect to development costs that have been incurred by the acquiree prior to the business combination, often called in-process research and development. In accordance with IAS 38, in-process development costs that meet certain criteria (described in more detail in the fol- lowing subsections) must be capitalized as an intangible asset unless their fair value cannot be measured reliably, in which case they are included in good- will. In either case, the development costs are capitalized under IFRS. Recent changes in U.S. GAAP converged the treatment of in-process research and de- velopment with IFRS.

Internally Generated Intangibles A major difference between IFRS and U.S. GAAP lies in the treatment of internally generated intangibles. To determine whether an internally generated intangible should be recognized as an asset, IAS 38 requires the expenditures giving rise to the potential intangible to be classi! ed as either research or development expendi- tures. If the two cannot be distinguished, all expenditures should be classi! ed as research expenditures. Research expenditures must be expensed as incurred. De- velopment expenditures, in contrast, are recognized as an intangible asset when an enterprise can demonstrate all of the following:

1. The technical feasibility of completing the intangible asset so that it will be available for use or sale.

2. Its intention to complete the intangible asset and use or sell it. 3. Its ability to use or sell the intangible asset. 4. How the intangible asset will generate probable future economic bene! ts.

Among other things, the enterprise should demonstrate the existence of a mar- ket for the output of the intangible asset or the existence of the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset.

5. The availability of adequate technical, ! nancial, and other resources to com- plete the development and to use or sell the intangible asset.

6. Its ability to reliably measure the expenditure attributable to the intangible asset during its development.

Considerable management judgment is required in determining whether devel- opment costs should be capitalized as an internally generated intangible. Manag- ers must determine the point at which research ends and development begins. IAS 38 provides the following examples of activities generally included in research:

• Activities aimed at obtaining new knowledge. • The search for application of research ! ndings or other knowledge.

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International Financial Reporting Standards: Part I 137

• The search for alternatives for materials, devices, products, processes, systems, or services.

• The formulation, design, evaluation, and selection of possible alternatives for new or improved materials, devices, products, processes, systems, or services.

Development activities typically include the following:

• The design, construction, and testing of preproduction prototypes and models. • The design of tools, jigs, molds, and dies involving new technology.

• The design, construction, and operation of a pilot plant that is not of a scale economically feasible for commercial production.

• The design, construction, and testing of a chosen alternative for new or im- proved materials, devices, products, processes, systems, or services.

IAS 38 also provides a list of activities that are neither research nor develop- ment, including the following:

• Engineering follow-through in an early phase of commercial production. • Quality control during commercial production, including routine testing of

products. • Troubleshooting in connection with breakdowns during commercial production. • Routine efforts to re! ne, enrich, or otherwise improve upon the qualities of an

existing product. • Adaptation of an existing capability to a particular requirement or customer’s

need as part of a continuing commercial activity. • Seasonal or other periodic design changes to existing products. • Routine design of tools, jigs, molds, and dies. • Activities, including design and construction engineering, related to the con-

struction, relocation, rearrangement, or start-up of facilities or equipment other than facilities or equipment used solely for a particular research and develop- ment project.

Once the research and development phases of a project have been determined, management must assess whether all six criteria (listed earlier) for development cost capitalization have been met. Judgments of future circumstances often will be necessary and may be highly subjective. The ultimate decision can depend on the degree of optimism or pessimism of the persons making the judgment.

Development costs consist of (1) all costs directly attributable to development activities and (2) those costs that can be reasonably allocated to such activities, including:

• Personnel costs. • Materials and services costs. • Depreciation of property, plant, and equipment. • Amortization of patents and licenses. • Overhead costs, other than general administrative costs.

In other words, development costs are similar to costs incurred in producing inventory. Because the costs of some, but not all, development projects will be deferred as assets, it is necessary to accumulate costs for each development project as if it were a separate work in progress.

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138 Chapter Four

In accordance with IAS 23, Borrowing Costs, borrowing costs should be included as part of the cost of development activities to the extent that the costs of those activities constitute a “qualifying asset.” IAS 23 is discussed in more detail later in this chapter.

Development costs capitalized as an internally generated intangible can only be treated as having a ! nite useful life. They must be amortized over their useful life using a method that best re# ects the pattern in which the asset’s economic bene! ts are consumed. Declining-balance, units-of-production, and straight-line methods are among the acceptable methods. Amortization begins when the intangible asset is available for sale or use.

Example: Deferred Development Costs Szabo Company Inc. incurred costs to develop a speci! c product for a customer in Year 1, amounting to $300,000. Of that amount, $250,000 was incurred up to the point at which the technical feasibility of the product could be demonstrated, and other recognition criteria were met. In Year 2, Szabo Company incurred an additional $300,000 in costs in the development of the product. The product was available for sale on January 2, Year 3, with the ! rst shipment to the customer oc- curring in mid-February, Year 3. Sales of the product are expected to continue for four years, at which time it is expected that a replacement product will need to be developed. The total number of units expected to be produced over the product’s four-year economic life is 2,000,000. The number of units produced in Year 3 is 800,000. Residual value is zero.

In Year 1, $250,000 of development costs is expensed and $50,000 is recognized as an asset. The journal entry is as follows:

In Year 2, $300,000 of development costs is recognized as an asset:

Development Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $250,000 Deferred Development Costs (intangible asset). . . . . . . . . . . . . . . . . . . . . . . . 50,000 Cash, payables, etc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300,000 To record development expense and deferred development costs.

Amortization of deferred development costs begins on January 2, Year 3, when the product becomes available for sale. Szabo Company determines that the units-of- production method best re# ects the pattern in which the asset’s economic bene! ts are consumed. Amortization expense for Year 3 is calculated as follows:

Deferred Development Costs (asset). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300,000 Cash, payables, etc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300,000 To record deferred development costs.

Carrying amount of deferred development cost . . . . . . . . . . . . . . . . . . . . . . $350,000 Units produced in Year 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000 Total number of units to be produced over economic life. . . . . . . . . . 2,000,000 % of total units produced in Year 3 . . . . . . . . . . . . . . . . . . . . . . . . 40% Amortization expense in Year 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $140,000

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International Financial Reporting Standards: Part I 139

The journal entry to record amortization of deferred development costs at De- cember 31, Year 3, is as follows:

If Szabo Company were unable to estimate with reasonable certainty the number of units to be produced, it would be appropriate to amortize the deferred develop- ment costs on a straight-line basis over the four-year expected life. In that case, the journal entry to record amortization in Year 3 is as follows:

Amortization Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $140,000 Deferred Development Costs (asset) . . . . . . . . . . . . . . . . . . . . . . . . . . $140,000 To record annual amortization expense.

Examples of Internally Generated Intangible Assets Items that might qualify for capitalization as internally generated intangible assets under IAS 38 include:

• Computer software costs • Patents, copyrights • Motion picture ! lms • Mortgage servicing rights • Fishing licenses • Franchises • Customer or supplier relationships • Customer loyalty • Market share • Marketing rights • Import quotas

IAS 38 speci! cally excludes the following from being recognized as internally generated intangible assets:

• Brands • Mastheads • Publishing titles • Customer lists • Advertising costs • Training costs • Business relocation costs

Internally generated goodwill may not be recognized as an asset. Finnish cellular telephone manufacturer Nokia Corporation is a European mul-

tinational that has used IFRS for many years. Exhibit 4.3 presents the reconcilia- tion of net income from IFRS to U.S. GAAP provided by Nokia in its 2006 Form 20-F ! led with the U.S. Securities and Exchange Commission (SEC), and the note describing the U.S. GAAP adjustment related to development costs. Adjusting for

Amortization Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $87,500 Deferred Development Costs (asset). . . . . . . . . . . . . . . . . . . . . . . . . . . $87,500 To record annual amortization expense.

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140 Chapter Four

the capitalization of development costs under IFRS that would not be allowed under U.S. GAAP resulted in U.S. GAAP net income being €55 million less than IFRS net income in 2006. However, in 2004 and 2005, U.S. GAAP net income was €42 million and €10 million greater than IFRS income, respectively. The larger in- come under U.S. GAAP in these years most likely is attributable to the amount of amortization expense related to deferred development costs under IFRS exceeding the development costs expensed immediately under U.S. GAAP. Related adjust- ments also are made each year to reconcile stockholders’ equity (retained earn- ings) from IFRS to U.S. GAAP. The amount of the adjustment is equal to the book

NOKIA Form 20-F

2006 Development Costs

EXHIBIT 4.3

Notes to the Consolidated Financial Statements

Excerpt from Note 38. Differences between International Financial Reporting Standards and U.S. Generally Accepted Accounting Principles

The Group’s consolidated fi nancial statements are prepared in accordance with International Financial Reporting Standards, which differ in certain respects from accounting principles generally accepted in the United States of America (US GAAP). The principal differences between IFRS and US GAAP are presented below together with explanations of certain adjustments that affect consolidated net income and total shareholders’ equity under US GAAP as of and for the years ended December 31:

Development costs

Development costs are capitalized under IFRS after the product involved has reached a certain degree of technical feasibility. Capitalization ceases and depreciation begins when the product becomes available to customers. The depreciation period of these capitalized assets is between two and fi ve years.

Under U.S. GAAP, software development costs are similarly capitalized after the product has reached a certain degree of technological feasibility. However, certain non-software-related development costs capitalized under IFRS are not capitalizable under U.S. GAAP and therefore are expensed as incurred.

The U.S. GAAP development cost adjustment refl ects the reversal of capitalized non-software-related development costs under U.S. GAAP net of the reversal of associated amortization expense and impairments under IFRS. The adjustment also refl ects differences in impairment methodologies under IFRS and U.S. GAAP for the determination of the recoverable amount and net realizable value of software-related development costs.

2006 2005 2004 EURm EURm EURm

Reconciliation of profi t attributable to equity holders of the parent under IFRS to net income under US GAAP:

Profi t attributable to equity holders of the parent reported under IFRS 4,306 3,616 3,192 U.S. GAAP adjustments: Pensions (1) (3) — Development costs (55) 10 42 Share-based compensation expense (8) (39) 39 Cash fl ow hedges — (12) 31 Amortization of identifi able intangible assets acquired — — (11) Impairment of identifi able intangible assets acquired — — (47) Amortization of goodwill — — 106 Other differences 22 (1) (6) Deferred tax effect of U.S. GAAP adjustments 11 11 (3) Net income under U.S. GAAP 4,275 3,582 3,343

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value of the deferred development costs reported as an asset under IFRS; equity is smaller under U.S. GAAP.

Revaluation Model IAS 38, Intangible Assets, allows the use of the revaluation model for intangible assets with ! nite lives, but only if the intangible has a price that is available on an active market, a condition rarely met in practice. Examples of intangible assets that may be priced on an active market include taxi licenses, ! shing licenses, and production quotas. If the company chooses the revaluation method, the asset’s fair value should be assessed regularly, typically annually. An increase in fair value of the asset is credited to “revaluation surplus” in equity, except to the extent it re- verses a previously recorded decrease reported directly in net income. U.S. GAAP does not provide for the revaluation of intangible assets.

Impairment of Intangible Assets Even though they are subject to amortization, ! nite-lived intangible assets also must be tested for impairment whenever changes in events or circumstances indicate an asset’s carrying amount may not be recoverable. Goodwill and intangible assets with inde! nite lives must be reviewed at least annually for impairment, regardless of the existence of impairment indicators. IAS 36, Impair- ment of Assets, allows reversals of impairment losses on intangible assets under special circumstances. However, reversal of impairment losses on goodwill is prohibited.

GOODWILL

IFRS 3, Business Combinations, contains the international rules related to the initial measurement of goodwill. Goodwill is recognized only in a business combination and is measured as the difference between (a) and (b):

(a) The consideration transferred by the acquiring ! rm plus any amount recog- nized as noncontrolling interest.

(b) The fair value of net assets acquired (identi! able assets acquired less liabilities assumed).

When (a) exceeds (b), goodwill is recognized as an asset. When (a) is less than (b), a “bargain purchase” is said to have taken place and the difference between (a) and (b) (sometimes called “negative goodwill”) is recognized as a gain in net income by the acquiring ! rm.

The amount recognized as goodwill depends on the option selected to measure any noncontrolling interest in the acquired company that might exist. Under IFRS 3, noncontrolling interest may be measured at either (1) a proportionate share of the fair value of the acquired ! rm’s net assets excluding goodwill or (2) fair value, which includes the noncontrolling interest’s share of goodwill.

Example: Initial Measurement of Goodwill George Company acquired 90 percent of the outstanding shares of Chris Com- pany by paying $360,000 in cash. The fair value of Chris’s identi! able assets is $320,000, and the liabilities assumed by George in this business combination are $40,000. George can choose between two alternatives to determine the amount to recognize as goodwill in this business combination.

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142 Chapter Four

Alternative 1 Noncontrolling Interest Measured at Proportionate Share of Acquired Firm’s Net Assets

In Alternative 2, goodwill of $120,000 is comprised of $108,000 purchased by George plus $12,000  [$40,000  −   $28,000] attributed to the noncontrolling interest.

Example: Gain on Bargain Purchase Assume the same facts as in the previous example, except George acquires 90 per- cent of Chris for $240,000. Also, assume that noncontrolling interest is measured at the proportionate share of net assets (Alternative 1).

Alternative 2 Noncontrolling Interest Measured at Fair Value

Fair value of Chris’s identifi able net assets ($320,000 − $40,000) $280,000 Noncontrolling interest percentage . . . . . . . . . . . . . . . . . . . . 10% Noncontrolling interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 28,000 Consideration transferred . . . . . . . . . . . . . . . . . . . . . . . . . . . $360,000 Plus: Noncontrolling interest . . . . . . . . . . . . . . . . . . . . . . . . . 28,000

Subtotal. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $388,000 Less: Fair value of Chris’s identifi able net assets . . . . . . . . . . . 280,000

Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $108,000

Implied fair value of 100% of Chris Company ($360,000/90%) $400,000 Noncontrolling interest percentage . . . . . . . . . . . . . . . . . . . . 10% Noncontrolling interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 40,000 Consideration transferred . . . . . . . . . . . . . . . . . . . . . . . . . . . $360,000 Plus: Noncontrolling interest . . . . . . . . . . . . . . . . . . . . . . . . . 40,000

Subtotal. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $400,000 Less: Fair value of Chris’s identifi able net assets . . . . . . . . . . . 280,000

Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,000

Consideration transferred . . . . . . . . . . . . . . . . . . . . . $240,000 Plus: Noncontrolling interest . . . . . . . . . . . . . . . . . . . 28,000

Subtotal. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $268,000 Less: Fair value of Chris’s identifi able net assets . . . . . 280,000

Gain on bargain purchase . . . . . . . . . . . . . . . . . . . . . $ (12,000)

In this case, George would recognize a gain from a bargain purchase in net in- come in the year in which the acquisition takes place.

Impairment of Goodwill As an inde! nite-lived intangible asset, goodwill is not amortized. Instead, good- will must be tested at least annually for impairment. IAS 36, Impairment of Assets, provides speci! c rules with respect to the impairment of goodwill.

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International Financial Reporting Standards: Part I 143

Impairment testing of goodwill is performed at the level of the cash-generating unit (CGU). The CGU is the “smallest identi! able group of assets that generates cash in# ows that are largely independent of the cash in# ows from other assets or groups of assets.” The impairment test is conducted by comparing the carrying value of the entire CGU, including goodwill attributable to that CGU, with its recoverable amount. The recoverable amount is the higher of the CGU’s (1) value in use and (2) fair value less costs to sell. Under U.S. GAAP, impairment of good- will is tested at the level of the “reporting unit,” which can be different (typically larger) than a cash-generating unit.

If noncontrolling interest was originally measured at the proportionate share of net assets (Alternative 1), then the carrying value of the entire CGU must be increased by the amount of goodwill attributable to the noncontrolling interest (as if Alterna- tive 2 had been applied). The impairment loss on the CGU is the amount by which the CGU’s carrying amount, including goodwill, exceeds its recoverable amount. An impairment loss identi! ed at the CGU level is ! rst applied against goodwill. Once goodwill has been eliminated, any remaining impairment is allocated to the other assets of the CGU on a prorated basis based on their relative carrying amounts.

Example: Impairment of Goodwill Continuing with the initial measurement of goodwill example presented earlier, at least annually, George Company must conduct an impairment test of the goodwill related to the acquisition of Chris Company. The assets of Chris Company are the smallest group of assets that generate cash in# ows that are largely independent of the cash in# ows from other assets or groups of assets. Therefore, Chris Company is a separate CGU. The goodwill related to the acquisition of Chris Company will be tested by comparing Chris Company’s carrying amount with its recoverable amount. At the end of the year, George Company develops the following esti- mates for Chris Company:

Alternative 1 Assuming that George Company adopted the proportionate share of acquired ! rm’s net assets approach to measure noncontrolling interest, the im- pairment loss is determined as follows:

Fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $280,000 Costs to sell . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000 Present value of future cash fl ows . . . . . . . . . . . . . . $270,000

Chris Co. Net Assets

Chris Co. Goodwill Total

Carrying amount . . . . . . . . . . . . . . . . . . . . . . . . . . . $280,000 $108,000 $388,000 Unrecognized noncontrolling interest in goodwill. . . 12,000 12,000 Adjusted carrying amount . . . . . . . . . . . . . . . . . . . . $280,000 $120,000 $400,000 Determination of recoverable amount: Fair value less costs to sell (1) . . . . . . . . . . . . . . . . . . $250,000 Present value of future cash fl ows (2). . . . . . . . . . . . 270,000 Recoverable amount [higher of (1) and (2)] . . . . . . . $270,000 Impairment loss (adjusted carrying amount less recoverable amount) . . . . . . . . . . . . . $130,000

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144 Chapter Four

In terms of allocation of impairment loss, $120,000 of the impairment loss is al- located to goodwill. The goodwill impairment is shared between the controlling and noncontrolling interest. Thus, $108,000 (90 percent) is allocated to the parent’s investment in Chris Company; the remaining $12,000 (10 percent) is attributable to the noncontrolling interest (but is not recognized because the noncontrolling in- terest’s goodwill is not recognized under this alternative). The remaining $10,000 ($130,000  −  $120,000) of impairment loss is allocated to Chris Company’s identi! - able assets on a pro rata basis.

Alternative 2 Now assume that George Company had adopted the fair value method to measure noncontrolling interest. The impairment loss is determined in the following manner:

Allocation of impairment loss:

Chris Co. Chris Co. Net Assets Goodwill Total

Carrying amount . . . . . . . . . . . . . . . . . . . . . . . . $280,000 $108,000 $388,000 Impairment loss . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 108,000 118,000

Carrying amount after impairment loss . . . . . . . $270,000 $ 0 $270,000

Chris Co. Chris Co. Net Assets Goodwill Total

Carrying amount . . . . . . . . . . . . . . . . . . . . . . . . $280,000 $120,000 $400,000 Determination of recoverable amount: Fair value less costs to sell (1) . . . . . . . . . . . . . . . $250,000

Present value of future cash fl ows (2). . . . . . . . . 270,000

Recoverable amount [higher of (1) and (2)] . . . . $270,000

Impairment loss (carrying amount less recoverable amount) . . . . . . . . . . . . . . . . . . . $130,000

Chris Co. Chris Co. Net Assets Goodwill Total

Carrying amount $280,000 $120,000 $400,000 Impairment loss 10,000 120,000 130,000

Carrying amount after impairment loss $270,000 $ 0 $270,000

Goodwill Not Allocable to Cash-Generating Unit under Review In testing goodwill for impairment, the recoverable amount is determined for the CGU to which the goodwill belongs by ! rst applying a so-called bottom-up test. In this test, goodwill is allocated to the individual CGU under review, if possible, and impairment of that CGU is then determined by comparing (1) the carrying amount

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plus allocated goodwill and (2) the recoverable amount. The example presented previously demonstrated application of the bottom-up test.

If goodwill cannot be allocated on a reasonable and consistent basis to the CGU under review, then both a bottom-up test and a top-down test should be applied. Under the top-down test, goodwill is allocated to the smallest group of CGUs to which it can be allocated on a reasonable and consistent basis, and impairment of the group of CGUs is then determined by comparing (1) the carrying amount of the group plus allocated goodwill and (2) the recoverable amount. U.S. GAAP requires only a bottom-up test and only for that goodwill associated with those assets that are being reviewed for impairment.

Example: Application of the Bottom-Up and Top-Down Tests for Goodwill In Year 1, La Brea Company acquired another company that operates a chain of three restaurants, paying $300,000 for goodwill. By the end of Year 4, it is clear that the restaurant located in Anaheim is not generating the pro! t and cash # ows expected at the date of purchase. Therefore, La Brea Company is required to test for impairment.

Each restaurant is a cash-generating unit, but La Brea cannot allocate the good- will on a reasonable and consistent basis to individual restaurants. Both a bottom- up test and a top-down test must be applied.

Bottom-Up Test A bottom-up test is applied to each restaurant by estimating the recoverable amount of the assets of each restaurant and comparing with the carry- ing amount of those assets excluding goodwill. An impairment loss is recognized for the amount by which a restaurant’s carrying amount exceeds its recoverable amount. The loss is allocated to the impaired restaurant’s assets on a pro rata basis according to the relative carrying amount of the assets. The bottom-up test checks for impairment of the assets of the individual restaurants but provides no informa- tion about the impairment of the goodwill that was purchased in the acquisition of the chain of restaurants. Assume the following carrying values and recoverable amounts for the three restaurants acquired:

Cash-Generating Unit (restaurant location)

Carrying Amount

Recoverable Amount

Impairment Loss

Anaheim . . . . . . . . . . . . . . . . . . . . $1,000,000 $ 970,000 $30,000 Buena Park . . . . . . . . . . . . . . . . . . 1,000,000 1,050,000 0 Cerritos . . . . . . . . . . . . . . . . . . . . . 1,000,000 1,020,000 0

An impairment loss of $30,000 is recognized, and the assets of the Anaheim res- taurant are written down by that amount. The carrying amount of Anaheim’s net assets is now $970,000. Top-Down Test La Brea determines that the smallest cash-generating unit to which goodwill can be allocated is the entire chain of restaurants. Therefore, La Brea estimates the recoverable amount of the chain of restaurants and compares this with the carrying amount (after any impairment has been recognized) of the assets of all the restaurants plus goodwill. Goodwill is considered to be impaired to the extent that the carrying amount of the assets plus goodwill exceeds the res- taurant chain’s recoverable amount.

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146 Chapter Four

La Brea estimates the recoverable amount of the chain of restaurants to be $3,000,000. La Brea compares this amount with the total carrying amount of $3,270,000 to determine that goodwill is impaired. A loss on the impairment of goodwill of $270,000 must be recognized.

BORROWING COSTS

Prior to its revision in 2007, IAS 23, Borrowing Costs, provided two methods of ac- counting for borrowing costs:

1. Benchmark treatment: Expense all borrowing costs in the period incurred. 2. Allowed alternative treatment: Capitalize borrowing costs to the extent they are

attributable to the acquisition, construction, or production of a qualifying asset; other borrowing costs are expensed in the period incurred.

Adoption of the benchmark treatment would not have been acceptable under U.S. GAAP. As part of the FASB-IASB convergence project, IAS 23 was revised in 2007. The benchmark treatment was eliminated, and the allowed alternative treatment has become the only acceptable treatment. Borrowing costs directly at- tributable to the acquisition, construction, or production of a qualifying asset must be capitalized as part of the cost of that asset; all other borrowing costs must be expensed immediately.

IAS 23 (as revised in 2007) is similar to U.S. GAAP, but some de! nitional and implementation differences exist. IAS 23 de! nes borrowing costs as interest and other costs incurred by an enterprise in connection with the borrowing of funds. This de! nition is broader in scope than the de! nition of interest cost under U.S. GAAP. Borrowing costs in accordance with IAS 23 speci! cally include foreign ex- change gains and losses on foreign currency borrowings to the extent they are regarded as an adjustment to interest costs. An asset that quali! es for borrowing cost capitalization is one that necessarily takes a substantial period to get ready for its intended use or sale. Both IAS 23 and U.S. GAAP exclude inventories that are routinely manufactured or produced in large quantities on a repetitive basis over a short period. However, IAS 23 speci! cally includes inventories that require a substantial period to bring them to a marketable condition.

The amount to be capitalized is the amount of interest cost that could have been avoided if the expenditure on the qualifying asset had not been made. This is determined by multiplying the weighted-average accumulated expenditures by an appropriate interest rate. The appropriate interest rate is determined simi- larly under both IAS 23 and U.S. GAAP, being a weighted-average interest rate on borrowings outstanding. If a speci! c new borrowing can be associated with a

Cash-Generating Unit (restaurant location)

Carrying Amount

Anaheim . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 970,000 Buena Park . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000

Cerritos . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000 Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,970,000 Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,270,000

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qualifying asset, the actual interest rate is used to the extent the weighted-average accumulated expenditures are less than the amount of the speci! c borrowing. In- terest income earned on the temporary investment of a speci! c new borrowing is offset against the interest cost to determine the net amount of interest to be capitalized. Netting interest income against interest cost is not acceptable under U.S. GAAP. The capitalization of borrowing costs begins when expenditures for the asset are incurred and ceases when substantially all the activities necessary to prepare the asset for sale or use are completed.

Example: Capitalization of Borrowing Costs On January 1, Year 1, Pinquill Company borrows 30,000,000 euros (€) at an annual interest rate of 8 percent to ! nance the construction of a new facility in Spain. The facility is expected to cost €30,000,000 and take two years to build. Pinquill tempo- rarily invests the euros borrowed until cash is needed to pay costs. During Year 1, expenditures of €20,000,000 are incurred; the weighted-average expenditures are €12,000,000. Pinquill makes annual interest payments on the loan and will repay the loan in full on December 31, Year 2, by converting U.S. dollars into euros, The U.S. dollar/euro exchange rate was $1.42 on January 1, Year 1, and $1.40 on December 31, Year 1. The change in exchange rate is the result of the difference in interest rates on U.S. dollar and euro borrowings. The following information relates to Year 1:

Capitalizable interest cost (€12,000,000 × 8% = €960,000 × $1.40 exchange rate on 12/31/Y1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,344,000 Income earned on temporary investment of borrowing (€225,000 × $1.40) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315,000 Exchange rate gain [€12,000,000 × ($1.42 − $1.40)] . . . . . . . . . . . . . . . . . . 240,000

The net interest cost is $1,029,000 ($1,344,000 − $315,000). After deducting the exchange rate gain, the total amount of borrowing cost to be capitalized as part of the cost of the facility is $789,000. Under U.S. GAAP, the amount of interest cost to be capitalized would be $1,344,000.

LEASES

The discussion in this section on leases is based upon guidance in effect at the time this book went to press in late 2013. As noted at the end of this section, the accounting for leases under both IFRS and U.S. GAAP is likely to be changed and substantially converged.

IAS 17, Leases, distinguishes between ! nance (capitalized) leases and operating leases. IAS 17 provides guidance for classifying leases as ! nance or operating, and then describes the accounting procedures that should be used by lessees and lessors in accounting for each type of lease. IAS 17 also provides rules for sale– leaseback transactions. IAS 17 and U.S. GAAP are conceptually similar, but IAS 17 provides less speci! c guidance than U.S. GAAP.

Lease Classifi cation As a case in point, IAS 17 indicates that a lease should be classi! ed and accounted for as a ! nance lease when it transfers substantially all the risks and rewards in- cidental to ownership to the lessee. The standard then provides examples of ! ve

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148 Chapter Four

situations that individually or in combination normally would lead to a lease being classi! ed as a ! nance lease:

1. The lease transfers ownership of the asset to the lessee by the end of the lease term.

2. The lessee has the option to purchase the asset at a price less than fair market value.

3. The lease term is for the major part of the leased asset’s economic life. 4. The present value of minimum lease payments at the inception of the lease is

equal to substantially all the fair value of the leased asset. 5. The leased asset is of a specialized nature such that only the lessee can use it

without major modi! cations.

IAS 17 provides three additional indicators of situations that individually or in combination could lead to a lease being classi! ed as a ! nance lease:

6. The lessee bears the lessor’s losses if the lessee cancels the lease. 7. The lessee absorbs the gains or losses from # uctuations in the fair value of the

residual value of the asset. 8. The lessee may extend the lease for a secondary period at a rent substantially

below the market rent.

In contrast, U.S. GAAP stipulates that if any one of four very speci! c criteria is met, a lease must be capitalized. These criteria are similar to 1 through 4 just listed; in fact, the ! rst two are exactly the same. In the U.S. GAAP version of criterion 3, major part is speci! cally de! ned as 75 percent, and in criterion 4, substantially all is de! ned as 90 percent. Depending on the manner by which a ! nancial statement preparer de! nes the terms major part and substantially all, application of IAS 17 and U.S. GAAP might or might not lead to similar classi! cation of leases. In addition, there is nothing similar to criteria 5 through 8 in U.S. GAAP.

In assessing criterion 4, minimum lease payments include (1) periodic lease payments; (2) any amounts guaranteed by the lessee, such as a guaranteed re- sidual value; and (3) the exercise price in a bargain renewal option. The discount rate to be used in determining the present value of minimum lease payments is the implicit interest rate earned by the lessor in the lease, if this is practicable to determine. If not, the lessee’s incremental borrowing rate should be used. In con- trast, U.S. GAAP requires the lessee’s incremental borrowing rate to be used as the discount rate, unless the lessor’s implicit interest rate can be determined and is less than the lessee’s incremental borrowing rate.

Example: Classi! cation of Leases On January 1, Year 1, Creative Transportation Company (CTC) entered into a lease with Arnold Aircraft Inc. for a pre-owned airplane with the following terms:

• Lease term is seven years. • Annual lease payments are $3,000, due on December 31. • Fair value of the airplane at the inception of the lease is $20,000. • The airplane has a 10-year remaining economic life. • Estimated residual value (unguaranteed) is $5,124. CTC does not absorb any

gains or losses in the # uctuations of the fair value of the residual value. • CTC has the option to purchase the airplane at the end of the lease term for

$8,000.

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• Implicit annual interest rate is 5 percent (disclosed to CTC by Arnold). • CTC’s incremental annual borrowing rate is 4 percent. • Ownership is not transferred at the end of the lease term. • The lease may not be extended.

To determine the present value (PV) of minimum lease payments (MLP) the lessor’s implicit interest rate of 5 percent is used because it is known, regardless of the lessee’s incremental borrowing rate. The PV factor for an ordinary annuity of 7 payments at a 5 percent discount rate is 5.786373. The PV of MLP is calculated as $3,000  ×  5.786373  =  $17,359. The residual value is not included in the MLP be- cause it is not guaranteed, and there is no renewal option to consider.

Based on the analysis presented in the following table, CTC most likely would not classify the lease as a ! nance lease under IFRS. However, this decision is not clear-cut. The company could decide that the lease term of seven years is the major part of the remaining economic life of the airplane and, as a result, treat this as a ! nance lease. Under U.S. GAAP, CTC de! nitely would not capitalize the lease because none of the four criteria are met.

Finance Lease Indicator Indicator Present?

Ownership is transferred to the lessee by the end of the lease term.

No. Ownership is not transferred at the end of the lease term.

The lease contains a bargain purchase option.

No. The purchase option price of $8,000 is greater than the estimated residual value of $5,124.

The lease term is a major part of the esti- mated economic life of the leased property.

Maybe. The lease term is for 70% of the estimated economic life of the airplane, which might (or might not) be considered “a major part” by CTC.

The PV of MLP is substantially all of the fair value of the leased property.

Probably not. The PV of MLP is 87% of the fair value of the leased property ($17,359/$20,000). This does not appear to meet the threshold of “substantially all.”

The leased assets are of a specialized nature such that only the lessee can use them with- out major modifi cations being made.

No. There is no indication that this is the case.

The lessee bears the lessor’s losses if the les- see cancels the lease.

No. There is no indication that this is the case.

The lessee absorbs the gains or losses from fl uctuations in the fair value of the residual value of the asset.

No. CTC does not guarantee the residual value.

The lessee may extend the lease for a sec- ondary period at a rent substantially below the market rent.

No. The lease may not be extended.

Finance Leases IAS 17 requires leases classi! ed as ! nance leases to be recognized by the lessee as assets and liabilities at an amount equal to the fair value of the leased property or, if lower, at the present value of the future minimum lease payments. Initial direct

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150 Chapter Four

costs incurred by the lessee in connection with negotiating the lease are capital- ized as part of the cost of the asset under IAS 17. U.S. GAAP is silent with respect to this issue, but common practice is to defer and amortize the costs over the lease term.

Lease payments are apportioned between interest expense and a reduction in the lease obligation using an effective interest method to amortize the lease obli- gation. The leased asset is depreciated in a manner consistent with assets owned by the lessee. Normally, depreciable ! nance lease assets are depreciated over the shorter of useful life and lease term. If it is reasonably certain that the lessee will obtain ownership of the asset at the end of its lease term, the asset is depreciated over its expected useful life. IAS 36, Impairment of Assets, applies to ! nance lease assets the same as it does to assets owned by the entity.

A lease classi! ed as a ! nance lease by the lessee should also be classi! ed as a ! nance lease by the lessor. The leased asset is replaced by the “net investment” in the lease, which is equal to the present value of future minimum lease payments (including any unguaranteed residual value). Any pro! t on the “sale” is recog- nized at the inception of the lease, and interest is recognized over the life of the lease using an effective interest method. Under U.S. GAAP, the net investment in the lease is determined simply as the lessor’s cost or carrying amount for the leased asset. Under U.S. GAAP, a lessor classi! es a capital lease as either a sales- type lease (which includes the recognition of pro! t) or a direct-! nance lease (no pro! t; fair value and carrying value of the leased asset are equal). IFRS does not make this distinction.

Operating Leases Any lease not classi! ed as a ! nance lease is an operating lease. With an operating lease, lease payments are recognized by the lessee as an expense and by the lessor as income. The asset remains on the books of the lessor and is accounted for in a similar fashion to any other asset owned by the lessor.

Lease payments under an operating lease are recognized as an expense on a straight-line basis over the lease term, unless another systematic basis is more representative of the time pattern of the user’s bene! t, in which case, that basis is used. SIC-15, Operating Leases-Incentives, provides guidance for situations where the lessee receives an incentive, such as a rent-free period, from the lessor to enter into the lease. In those situations, the total amount of rent to be paid over the life of the lease is allocated on a straight-line basis to the periods covered by the lease term.

Example: Operating Lease Budget Company enters into a two-year lease for a computer with lease payments of $200 per month in the ! rst year, and $250 per month in the second year. The total amount of lease payments will be $5,400  [($200  ×  12)  +   ($250  ×  12)]. The straight-line method accurately re# ects the time pattern of the user’s bene! t from using the computer. On a straight-line basis, an expense in the amount of $225 ($5,400/24 months) should be recognized each month.

Sale–Leaseback Transaction A sale–leaseback transaction involves the sale of an asset by the initial owner of the asset and the leasing of the same asset back to the initial owner. If the lease is classi! ed as a ! nance lease, IAS 17 requires the initial owner to defer any gain on the sale and amortize it to income over the lease term. U.S. GAAP rules are

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generally similar. If the fair value of property at the time of the sale–leaseback is less than its carrying amount, IAS 17 allows recognition of a loss only if the loss is due to an impairment in the value of the asset sold. U.S. GAAP requires immedi- ate recognition of the loss regardless of its source.

If the lease in a sale–leaseback transaction is classi! ed as an operating lease, IAS 17 requires the difference between the fair value of the asset and its carry- ing amount to be recognized immediately in income. Any difference between the fair value of the asset and its selling price is amortized ratably over the lease term. In contrast, U.S. GAAP requires the seller to amortize any gain over the lease term.

Example: Gain on Sale and Leaseback Berlin Corporation sells a building to Essen Finance Company for $2,200,000. Essen Finance then leases the building back to Berlin under a 10-year agreement, which Berlin classi! es as an operating lease. On the date of sale, the carrying amount of the building on Berlin’s books is $1,800,000, and the building had an appraised fair value of $2,100,000.

Under IFRS, Berlin recognizes a gain on sale and leaseback of $300,000 ($2,100,000  −   $1,800,000) at the date of sale for the difference between the fair value and the carrying amount of the building. The company has a deferred gain of $100,000 ($2,200,000  −  $2,100,000) for the difference between the fair value and the selling price; this will be amortized to income at the rate of $10,000 per year over the 10-year life of the lease. Under U.S. GAAP, the entire gain of $400,000 is deferred and amortized at the rate of $40,000 per year over the lease term.

The difference in accounting treatment for gains on sale–leaseback transactions between IAS 17 and U.S. GAAP is described by Swisscom AG in Exhibit 4.4 . In its 2006 reconciliation to U.S. GAAP, Swisscom made an adjustment for this account- ing difference that resulted in an increase in income, as stated under U.S. GAAP, of 17 million Swiss francs. This re# ects the amount of original gain on sale and leaseback that was realized in 2001 that is amortized to income in 2006 under U.S. GAAP. The gain was recognized in full in 2001 under IFRS. An adjustment also is made to stockholders’ equity to reverse the difference between the full amount of gain recognized under IFRS (included in IFRS retained earnings) and the portion of the gain that has been recognized through amortization under U.S. GAAP. This adjustment reduced IFRS equity by 280 million Swiss francs in 2006 to reconcile to a U.S. GAAP basis.

Disclosure Lessees must disclose the amount of future minimum lease payments related to operating leases and related to ! nance leases, separately, for each of the following periods:

1. Amount to be paid within one year (Year 1). 2. Amount to be paid after one year and not later than ! ve years (Years 2–5) as a

single amount. 3. Amount to be paid later than ! ve years (Year 6 and beyond) as a single amount.

Also, the present value of the future minimum lease payments under ! nance leases must be disclosed. Entities provide more detailed information under U.S. GAAP, which requires disclosure of the amount to be paid in each of the next ! ve years (Years 1–5) by year, as well as the amount to be paid later than ! ve years (Year 6 and beyond) as a single amount.

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152 Chapter Four

m) Sale and leaseback transaction

In March 2001 Swisscom entered into two master agreements for the sale of real estate. At the same time, Swisscom entered into agreements to lease back part of the sold property space. The gain on the sale of the properties after transaction costs of CHF 105 million and including the reversal of environmental provisions, was CHF 807 million under IFRS.

A number of the leaseback agreements are accounted for as fi nance leases under IFRS and the gain on the sale of these properties of CHF 129 million is deferred and released to income over the individual lease terms. The remaining gain of CHF 678 million represents the gain on the sale of buildings which were sold outright and the gain on the sale of land and buildings which qualify as operating leases under IFRS. Under IFRS, the gain on a leaseback accounted for as an operating lease is recognized immediately. Under U.S. GAAP, in general the gain is deferred and amortized over the lease term. If the leaseback was minor, the gain was immediately recognized. In addition, certain of the agreements did not qualify as sale-and- leaseback accounting under U.S. GAAP because of continuing involvement in the form of purchase options. These transactions are accounted for under the fi nance method and the sales proceeds are reported as a fi nancing obligation and the properties remain on the balance sheet and continue to be depreciated as in the past. The lease payments are split between interest and amortization of the obligation.

Excerpt from Note 43. Differences between International Financial Reporting Standards and U.S. Generally Accepted Accounting Principles The consolidated fi nancial statements of Swisscom have been prepared in accordance with International Financial Reporting Standards (IFRS), which differ in certain signifi cant respects from generally accepted accounting principles in the United States (U.S. GAAP). Application of U.S. GAAP would have affected the shareholders’ equity as of December 31, 2006, 2005, and 2004, and net income for each of the years in the three-year period ended December 31, 2006, to the extent described below. A description of the signifi cant differences between IFRS and U.S. GAAP as they relate to Swisscom are discussed in further detail below.

Reconciliation of net income from IFRS to U.S. GAAP The following schedule illustrates the signifi cant adjustments to reconcile net income in accordance with IFRS to the amounts determined in accordance with U.S. GAAP for each of the three years ended December 31.

SWISSCOM AG Form 20-F

2006 Sale and Leaseback Transactions

EXHIBIT 4.4

CHF in millions 2006 2005 2004

Net income according to IFRS attributable to equity holders of Swisscom AG 1,599 2,022 1,596 U.S. GAAP adjustments: a) Capitalization of interest cost 20 14 (4) b) Retirement benefi ts (16) (27) (21) c) Termination benefi ts — (31) (10) d) Impairment of investments — 9 — e) Cross-border tax leases 15 (20) 49 f) Debitel purchase accounting — — (23) g) Sale of debitel — 254 342 h) Deferred interest — 21 (21) i) Revenue recognition 18 35 56 j) Outsourcing contracts (40) 16 — k) Site restoration (2) 3 15 l) Goodwill and other intangible assets — — 106 m) Sale and leaseback transaction 17 29 24 n) Onerous contracts (5) 6 10 o) Share buyback (17) — — p) Income taxes — (2) (6)

Net income according to U.S. GAAP 1,589 2,329 2,113

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Exhibit 4.5 shows the disclosures made by British retailer Marks and Spencer Group plc related to operating leases. Note that Marks and Spencer has elected to disaggregate the period beyond ! ve years into ! ve-year increments up to 25 years, even though IAS 17 does not require the company to do so.

IASB/FASB Convergence Project In 2010, the IASB and FASB jointly issued an exposure draft for a proposed new standard on the accounting for leases. The Boards issued a revised exposure draft on leases in 2013, but provided no information about a possible effective date for a new standard. If approved, the exposure draft will result in signi! cant changes to the accounting requirements for both lessees and lessors, and the accounting for leases under both IASB and FASB standards will be substantially converged. Under the proposal, lessees would recognize a “right-of-use” asset and a liabil- ity to make lease payments for all leases. Leases would no longer be classi! ed as ! nance or operating; in essence, all leases with a maximum possible term of more than 12 months would be treated as ! nance leases. Lease assets and liabili- ties would be measured based on the longest possible lease term that is more likely than not to occur, and an expected outcome approach would be used to re# ect lease payments. Lessors would recognize an asset representing the right to receive lease payments and would either derecognize the leased asset or recognize a li- ability, depending on exposure to the risks and rewards associated with the leased asset. On sale–leasebacks, the seller would recognize the transaction either as a sale or as a borrowing, depending on whether the transaction meets conditions for recognition as a sale as stipulated in the exposure draft.

Other Recognition and Measurement Standards The next chapter covers IASB standards pertaining to the recognition and measure- ment of current liabilities, provisions, employee bene! ts, share-based payment,

EXHIBIT 4.5

MARKS AND SPENCER GROUP PLC 2012

Annual Report

Excerpt from Note 25. Contingencies and Commitments

C. Commitments under operating leases

The Group leases various stores, offi ce, warehouses, and equipment under non-cancelable operating lease agreements. The leases have varying terms, escalation clauses, and renewal rights.

2012 2011 £m £m

Total future minimum rentals payable under non-cancelable operating leases are as follows: Within one year ..................................................................................................................................... 257.8 242.6 Later than one year and not later than fi ve years .................................................................................... 997.4 923.0 Later than fi ve years and not later than ten years ................................................................................... 1,029.5 990.8

Later than ten years and not later than 15 years ..................................................................................... 772.7 767.4 Later than 15 years and not later than 20 years ...................................................................................... 385.1 402.9 Later than 20 years and not later than 25 years ...................................................................................... 259.3 243.1 Later than 25 years ................................................................................................................................ 1,210.1 1,210.3 Total ...................................................................................................................................................... 4,911.9 4,780.1

The total future sublease payments to be received are £63.3m (last year £65.8m).

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154 Chapter Four

income taxes, revenue, and ! nancial instruments. IAS 21, Foreign Currency Trans- lation, which provides guidance for dealing with foreign currency transactions and the translation of foreign currency ! nancial statements, is covered in detail in Chapters 7 and 8. Standards related to ! nancial reporting in hyperin# ation- ary economies (IAS 29), business combinations (IFRS 3), consolidated ! nancial statements (IAS 27), investments in associates (IAS 28), and investments in joint ventures (IAS 31) are covered in Chapter 9, Additional Financial Reporting Issues.

DISCLOSURE AND PRESENTATION STANDARDS

Several IFRS deal primarily with disclosure and presentation issues. This section summarizes some of those standards. While brie# y introduced here, IFRS 8, Oper- ating Segments, is discussed in greater detail in Chapter 9.

Statement of Cash Flows IAS 7, Statement of Cash Flows, reiterates the requirement in IAS 1 that a company must present a statement of cash # ows as an integral part of its ! nancial state- ments. IAS 7 contains the following requirements:

• Cash # ows must be classi! ed as being related to operating, investing, or ! nanc- ing activities.

• Cash # ow from operations may be presented using the direct method or the indi- rect method. When using the indirect method, IAS 7 does not specify that the rec- onciliation from income to cash # ows must begin with any particular line item, e.g., net income. Thus, an entity could begin the reconciliation with operating income or some other measure of income. When using the direct method, there is no requirement to also present a reconciliation of income to cash from operations.

• Cash # ows related to interest, dividends, and income taxes must be reported separately.

• Interest and dividends paid may be classi! ed as operating or ! nancing. • Interest and dividends received may be classi! ed as operating or investing. • Income taxes are classi! ed as operating unless they are speci! cally identi! ed

with investing or ! nancing activities. • Noncash investing and ! nancing transactions are excluded from the statement

of cash # ows but must be disclosed elsewhere within the ! nancial statements. • Components of cash and cash equivalents must be disclosed and reconciled

with amounts reported on the statement of ! nancial position (balance sheet). However, the total for cash and cash equivalents in the statement of cash # ows need not agree with a single line item in the balance sheet.

• IAS 7 makes an explicit distinction between bank borrowings and bank over- drafts. Overdrafts may be classi! ed as a component (i.e., reduction) of cash and cash equivalents, if considered to be an integral part of an enterprise’s cash management. Otherwise, bank overdrafts are classi! ed as a ! nancing activity.

Several differences exist between IFRS and U.S. GAAP in the presentation of a statement of cash # ows. Under U.S. GAAP:

• Interest paid, interest received, and dividends received are all classi! ed as op- erating cash # ows. Dividends paid are classi! ed as ! nancing cash # ows.

• When using the indirect method of presenting operating cash # ows, the recon- ciliation from income to cash # ows must begin with net income.

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• When using the direct method of presenting operating cash # ows, a reconcilia- tion from net income to operating cash # ows also must be presented.

• The cash and cash equivalents line item in the statement of cash # ows must recon- cile with the cash and cash equivalents line in the statement of ! nancial position.

Example: Classi! cation of Interest and Dividends in the Statement of Cash Flows Star Kissed Corporation (SKC) currently reports under U.S. GAAP but is investi- gating the effect that the adoption of IFRS might have on its statement of cash # ows. For the current year, SKC has interest received of $500, interest paid of $1,250, divi- dends received of $200, and dividends paid of $2,700. Under U.S. GAAP, the com- pany classi! es interest paid, interest received, and dividends received as operating activities, and dividends paid are classi! ed as a ! nancing activity. These items are presented in the company’s U.S. GAAP statement of cash # ows as follows:

This classi! cation would be acceptable under IFRS. However, the following presentation, among others, also would be acceptable under IAS 7:

Operating activities:

Interest paid. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(1,250) Interest received. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 Dividends received . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 Cash fl ow from operating activities . . . . . . . . . . . . . . . . . . . . . $ (550) Investing activities: Nothing reported. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0 Financing activities: Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,700)

Cash fl ow from fi nancing activities. . . . . . . . . . . . . . . . . . . . . . $(2,700)

Net change in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(3,250)

Operating activities: Nothing reported $ 0 Investing activities: Interest received $ 500 Dividends received 200 Cash fl ow from investing activities $ 700 Financing activities: Interest paid $(1,250) Dividends paid (2,700) Cash fl ow from fi nancing activities $(3,950) Net change in cash $(3,250)

Events after the Reporting Period IAS 10, Events after the Reporting Period, prescribes when an entity should adjust its ! nancial statements for events occurring after the balance sheet date (referred to in the United States as “subsequent events”) and the disclosures to be made related to those events. Events after the reporting period are those events, favorable and unfavorable, that occur between the balance sheet date and the date that the ! nan- cial statements are authorized for issuance. Under U.S. GAAP, the subsequent event

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period runs through the date that the ! nancial statements are issued (or are avail- able to be issued), which is later than the date they are authorized for issuance.

There are two types of after-the-reporting-period events that are treated differently:

1. Adjusting events after the reporting period. 2. Nonadjusting events after the reporting period.

Adjusting Events Those events that provide evidence of conditions that existed at the end of the reporting period are adjusting events. These events must be recognized through adjustment of the ! nancial statements. For example, assume a company has re- corded an estimated liability related to litigation on its December 31, Year 1, bal- ance sheet of $2 million. On January 20, Year 2, before the board of directors has approved the ! nancial statements for issuance, the judge orders the company to pay $3 million. The liability on the December 31, Year 1, balance sheet should be adjusted upward to $3 million. The judge’s decision clari! es the value of the liabil- ity that existed at the balance sheet date.

Nonadjusting Events Events that are indicative of conditions that arise after the balance sheet date but before the date the ! nancial statements are authorized for issue are nonadjust- ing events. No adjustments are made to the ! nancial statements related to these events. However, disclosures are required of:

1. The nature of the event. 2. An estimate of the ! nancial effect, or a statement that an estimate cannot be made.

For example, assume inventory carried on the December 31, Year 1, balance sheet at $3 million decreases in net realizable value to $1 million due to a change in the law on February 15, Year 2. The ! nancial statements are approved for issuance on February 20, Year 2. The decline in market value does not relate to the condi- tion of the inventory at the balance sheet date, so no adjustment should be made. If material, the decrease in value should be disclosed in the notes to the ! nancial statements.

IAS 10 speci! cally states that ! nancial statements should not be adjusted for cash dividends declared after the balance sheet date. The same is true for stock dividends and stock splits.

Accounting Policies, Changes in Accounting Estimates, and Errors IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors, provides guidance with respect to (1) the selection of accounting policies, (2) accounting for changes in accounting policies, (3) dealing with changes in accounting estimates, and (4) correction of errors.

Selection of Accounting Policies IAS 8 establishes the following hierarchy of authoritative pronouncements to be followed in selecting accounting policies to apply to a speci! c transaction or event:

1. IASB Standard or Interpretation that speci! cally applies to the transaction or event.

2. IASB Standard or Interpretation that deals with similar and related issues.

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3. De! nitions, recognition criteria, and measurement concepts in the IASB Framework.

4. Most recent pronouncements of other standard-setting bodies that use a similar conceptual framework to develop accounting standards.

Changes in Accounting Policy To ensure comparability of ! nancial statements over time, an entity is required to apply its accounting policies consistently. A change in accounting policy is al- lowed only if the change:

1. Is required by an IFRS. 2. Results in the ! nancial statements providing more relevant and reliable

information.

If practical, the change in accounting policy should be applied retrospectively. The cumulative effect of adopting the new accounting policy is treated as an adjustment to the carrying amounts of the assets and liabilities affected and as an adjustment to the beginning balance in retained earnings. The cumulative effect is not included in net income.

Changes in Estimates A change in estimate due to new developments or new information should be accounted for in the period of the change or in future periods, depending on the periods affected by the change. In other words, the change in estimate should be handled prospectively.

Correction of Errors Material, prior-period errors should be corrected retrospectively by restating all prior reported accounts (assets, liabilities, equity) affected by the error and by recording a prior-period adjustment to the beginning balance in retained earn- ings. When it is impractical to determine the period-speci! c effects of an error on comparative information for one or more prior periods, the entity restates the opening balances in assets, liabilities, and equity for the earliest period for which retrospective restatement is practicable. This might be the current period. Whereas IFRS provides an exception if it is impractical to restate ! nancial state- ments for a correction of an error, U.S. GAAP does not provide such an excep- tion but instead requires all material errors to be corrected through restatement.

Related Party Disclosures Transactions between related parties must be disclosed in the notes to ! nancial statements. Parties are related if one party has the ability to control or exert signi! - cant in# uence over the other party. Related parties can include parent companies, subsidiaries, equity method associates, individual owners, and key management personnel. Similar rules exist in U.S. GAAP.

Earnings per Share Basic and diluted earnings per share must be reported on the face of the income statement. IAS 33, Earnings per Share, provides guidance for calculating earnings per share. U.S. GAAP provides more detailed guidance with respect to the calcula- tion of diluted earnings per share. Application of this guidance would appear to be consistent with IAS 33.

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Interim Financial Reporting IAS 34, Interim Financial Reporting, does not mandate which companies should pre- pare interim statements, how frequently, or how soon after the end of an interim period. The standard de! nes the minimum content to be included in interim state- ments by those entities required by their national jurisdiction to present them and identi! es the accounting principles that should be applied. With certain excep- tions, IAS 34 requires interim periods to be treated as discrete reporting periods. This differs from the position in U.S. GAAP, which treats interim periods as an in- tegral part of the full year. As an example, IAS 34 would require annual bonuses to be recognized as expense in the interim period in which bonuses are paid. Under U.S. GAAP, on the other hand, one-fourth of the expected annual bonus is accrued each quarter.

Noncurrent Assets Held for Sale and Discontinued Operations Noncurrent assets held for sale must be reported separately on the balance sheet at the lower of (1) carrying value or (2) fair value less costs to sell. Assets held for sale are not depreciated. Similar rules exist in U.S. GAAP.

A discontinued operation is a component of an entity that represents a major line of business or geographical area of operations that either has been disposed of or has been classi! ed as held for sale. The after-tax pro! t or loss and after-tax gain or loss on disposal must be reported as a single amount on the face of the income statement. Detail of the revenues, expenses, gain or loss on disposal, and income taxes comprising this single amount must be disclosed in the notes or on the face of the income statement. If presented on the face of the income statement, it must be presented in a section identi! ed as discontinued operations. The de! nition of the type of operation that can be classi! ed as discontinued is somewhat narrower than under U.S. GAAP. In addition, U.S. GAAP requires both pre-tax and after-tax pro! t or loss to be reported on the income statement. Otherwise, the two sets of standards are substantially similar.

Operating Segments As part of the short-term convergence project with the FASB, the IASB issued IFRS 8, Operating Segments, in 2006 to replace IAS 14, Segment Reporting. IFRS 8 adopted the FASB’s so-called management approach. Extensive disclosures are required for each separately reportable operating segment. Operating segments are compo- nents of a business (1) that generate revenues and expenses, (2) whose operating results are regularly reviewed by the chief operating of! cer, and (3) for which separate ! nancial information is available. IFRS 8 provides the following guide- lines with regard to segment reporting:

• An operating segment is separately reportable if it meets any of three quantita- tive tests (revenue test, pro! t or loss test, asset test). Operating segments can be de! ned in terms of products and services or on the basis of geography.

• Disclosures required for each operating segment include assets, capital expen- ditures, liabilities, pro! t or loss, and the following components of pro! t or loss: external revenues, intercompany revenues, interest income and expense, de- preciation and amortization, equity method income, income tax expense, and noncash expenses. Similar disclosures are required by U.S. GAAP except that liabilities by operating segment need not be reported.

• If the revenue reported by operating segments is less than 75 percent of total revenues, additional operating segments must be reported separately—even if

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they do not meet any of the three quantitative tests—until at least 75 percent of total revenue is included in reportable segments.

• In addition to disclosures by operating segment, entitywide disclosures related to products and services, geographic areas, and major customers are required.

• If operating segments are not de! ned on the basis of products and services, revenue derived from each major product and service must be disclosed, even if the company has only one operating segment.

• Revenues and noncurrent assets must be disclosed for the domestic country and all foreign countries combined. These two items also must be disclosed for each foreign country in which a material amount of revenues or noncurrent as- sets is located. Materiality is not de! ned.

• The existence and amount of revenue derived from major customers must be disclosed, along with the identity of the segment generating the revenue. A major customer is de! ned as one from which 10 percent or more of total rev- enues are generated.

Summary 1. Many countries currently use IFRS, and it is likely that IFRS will be integrated into the U.S. ! nancial reporting system in the near future. An understanding of IFRS is important for accountants who prepare or audit ! nancial statements.

2. Differences exist between IFRS and U.S. GAAP with respect to recognition, measurement, presentation, disclosure, and choice among alternatives. In some cases, IFRS are more # exible than U.S. GAAP. Several IFRS allow ! rms to choose between alternative treatments in accounting for a particular item. Also, IFRS generally have less bright-line guidance than U.S. GAAP; there- fore, more judgment is required in applying individual IFRS. However, in some cases, IFRS are more detailed than U.S. GAAP.

3. Some of the more important asset recognition and measurement differences between IFRS and U.S. GAAP relate to the following issues: inventory valua- tion; revaluation of property, plant, and equipment; component depreciation; capitalization of development costs; measurement of impairment losses; and classi! cation of leases.

4. IAS 2 requires inventory to be reported on the balance sheet at the lower of cost and net realizable value. Write-downs to net realizable value must be reversed when the selling price increases. Under U.S. GAAP, inventory is carried at the lower of cost or replacement cost (with a ceiling and # oor), and the reversal of write-downs is not permitted. Unlike U.S. GAAP, IAS 2 does not allow the use of last-in, ! rst-out (LIFO) in determining the cost of inventory.

5. IAS 16 allows property, plant, and equipment to be carried at cost less ac- cumulated depreciation and impairment losses or at a revalued amount less any subsequent accumulated depreciation and impairment losses. Speci! c guidance is provided for those ! rms that choose the revaluation option. U.S. GAAP does not permit use of the revaluation model.

6. IAS 16 requires an item of property, plant, and equipment comprised of signif- icant parts for which different useful lives or depreciation methods are appro- priate to be split into components for purposes of depreciation. Component depreciation is uncommon in U.S. GAAP.

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160 Chapter Four

7. IAS 36 requires impairment testing of property, plant, and equipment; intan- gibles, including goodwill; and long-term investments. An asset is impaired when its carrying value exceeds its recoverable amount, which is the greater of net selling price and value in use. An impairment loss is the amount by which carrying value exceeds the recoverable amount. If, subsequent to rec- ognizing an impairment loss, the recoverable amount of an asset exceeds its new carrying amount, the impairment loss is reversed and the asset is written back up to the carrying amount that would have existed if the impairment had never been recognized. U.S. GAAP employs a different impairment test, and impairment losses may not be reversed.

8. IAS 38 requires development costs to be capitalized as an intangible asset when six speci! c criteria are met. Development costs can include personnel costs; materials and services; depreciation of property, plant, and equipment; amortization of patents and licenses; and overhead costs, other than general ad- ministrative costs. Development costs generally are not capitalized under U.S. GAAP. Intangible assets (including deferred development costs) are classi! ed as having a ! nite or inde! nite useful life. Finite-lived intangibles are amortized over their useful lives using a straight-line method; inde! nite-lived intangibles are reviewed each year to determine if the useful life still is inde! nite. If not, the intangible is reclassi! ed as having a ! nite life and amortization begins.

9. Goodwill is measured as the excess of the consideration transferred in a busi- ness acquisition by the acquiring ! rm, plus any noncontrolling interest, over the fair value of net assets acquired. IFRS 3 allows two options in measuring noncontrolling interest, which results in two possible measures of goodwill. U.S. GAAP only allows one method for measuring noncontrolling interest.

10. Inde! nite-lived intangibles and goodwill must be reviewed for impairment at least once per year. Finite-lived intangibles are tested for impairment when- ever changes in circumstances indicate an asset’s carrying amount may not be recoverable. IAS 36 allows the reversal of impairment losses on intangibles when certain conditions are met; however, the reversal of goodwill impair- ment is not allowed.

11. IAS 23 requires borrowing costs to be capitalized to the extent they are attrib- utable to the acquisition of a qualifying asset; other borrowing costs are ex- pensed immediately. Borrowing costs include interest and other costs, such as foreign exchange gains and losses on foreign currency borrowings, incurred in connection with a borrowing. The amount of borrowing cost to be capital- ized is reduced by any interest income earned from the temporary investment of the amount borrowed. U.S. GAAP has a narrower de! nition of capitalizable interest costs and does not allow the netting of interest income.

12. At the time this book went to press, leases were required to be classi! ed as ! nance leases or operating leases under both IFRS and U.S. GAAP. How- ever, the classi! cation guidelines differ between the two sets of standards. While there are more ! nance lease indicators provided in IAS 17 than in U.S. GAAP, the guidelines in IAS 17 tend to be less prescriptive and avoid the use of bright-line thresholds.

13. A sale-and-leaseback transaction generally results in a gain or loss on the sale for the seller-lessee. IFRS and U.S. GAAP differ with regard to the timing of when the gain or loss on the sale–leaseback can be recognized.

14. In addition to IAS 1, which was described in the previous chapter, several other IASB standards primarily provide guidance with respect to disclosure and presentation of information in the ! nancial statements.

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15. IAS 7 contains requirements for the presentation of the statement of cash # ows. Several differences exist from U.S. GAAP, including the option to present interest and dividends paid as either operating or ! nancing activities and interest and dividends received as either operating or investing activities.

16. IAS 10 prescribes when ! nancial statements should be adjusted for events occurring after the end of the reporting period. The cutoff date for adjusting events is the date ! nancial statements are authorized for issuance. Under U.S. GAAP, the cutoff date is the date ! nancial statements are issued or are available to be issued, which is later than the date the statements are approved.

17. IAS 8 establishes a hierarchy of authoritative pronouncements to be consid- ered in selecting accounting policies. The lowest level in the hierarchy is guid- ance issued by other standard-setting bodies that use a conceptual framework similar to the IASB’s. This includes standards set by the FASB.

18. Once selected, an entity must use its accounting policies consistently over time. A change in accounting policy is allowed only if the change results in the ! nancial statements providing more relevant and reliable information or the change is required by an IASB pronouncement.

19. Other disclosure and presentation standards provide guidance with respect to related party disclosures, earnings per share, noncurrent assets held for sale and discontinued operations, interim reporting, and segment reporting.

Questions Unless otherwise indicated, questions should be answered based on IFRS. 1. What are the types of differences that exist between IFRS and U.S. GAAP? 2. How does application of the lower of cost or market rule for inventories differ

between IFRS and U.S. GAAP? 3. How are the estimated costs of removing and dismantling an asset handled

upon initial recognition of the asset? 4. What are the two models allowed for measuring property, plant, and equip-

ment at dates subsequent to original acquisition? 5. Which items of property, plant, and equipment may be accounted for under

the revaluation model, and how frequently must revaluation occur? 6. How is the revaluation surplus handled under the revaluation model? 7. How is depreciation determined for an item of property, plant, and equip-

ment that is comprised of signi! cant parts, such as an airplane? 8. In what way does the fair value model for investment property differ from the

revaluation model for property, plant, and equipment? 9. How is an impairment loss on property, plant, and equipment determined

and measured under IFRS? How does this differ from U.S. GAAP? 10. When a previously recognized impairment loss is subsequently reversed,

what is the maximum amount at which the affected asset may be carried on the balance sheet?

11. What are the three major types of intangible asset, and how does the account- ing for them differ?

12. How are internally generated intangibles handled under IFRS? How does this differ from U.S. GAAP?

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162 Chapter Four

13. Which intangible assets are subject to annual impairment testing? 14. How is goodwill measured in a business combination with a noncontrolling

interest? 15. What is a gain on bargain purchase? 16. What is the process for determining whether goodwill allocated to a speci! c

cash-generating unit is impaired? 17. What is the current treatment with respect to borrowing costs? 18. What are the differences in the amount of borrowing costs that can be capital-

ized under IFRS and U.S. GAAP? 19. How do the criteria for determining whether a lease quali! es as a ! nance (cap-

italized) lease differ between IFRS and U.S. GAAP? 20. What is the difference between IFRS and U.S. GAAP with regard to the recog-

nition of gains and losses on sale–leaseback transactions? 21. How does the classi! cation of interest and dividends in the statement of cash

# ows differ between IFRS and U.S. GAAP? 22. What is the cutoff date for the occurrence of events after the reporting period

requiring adjustment to the ! nancial statements? 23. What are the guidelines on selecting and changing accounting policies?

Unless otherwise indicated, exercises and problems should be solved based on IFRS.

1. A company incurred the following costs related to the production of inventory in the current year:

Exercises and Problems

Cost of materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000 Cost of direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 Allocation of variable overhead costs . . . . . . . . . . . . . . . . . . . . . . 30,000 Allocation of fi xed overhead costs (based on normal production levels) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000 Storage costs (after production, prior to sale) . . . . . . . . . . . . . . . . 2,000 Selling costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000

The cost of materials included abnormal waste of $10,000. What is the cost of inventory in the current year?

a. $190,000. b. $205,000. c. $215,000. d. $217,000.

2. A company determined the following values for its inventory as of the end of its ! scal year:

Historical cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50,000 Current replacement cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000 Net realizable value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000 Net realizable value less a normal profi t margin . . . . . . . . . . . . . . 40,000 Fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48,000

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What amount should the company report for inventory on its balance sheet?

a. $35,000. b. $40,000. c. $45,000. d. $48,000.

3. When an entity chooses the revaluation model as its accounting policy for measuring property, plant, and equipment, which of the following statements is correct?

a. When an asset is revalued, the entire class of property, plant, and equip- ment to which that asset belongs must be revalued.

b. When an asset is revalued, individual assets within a class of property, plant, and equipment to which that asset belongs may be selectively revalued.

c. Revaluations of property, plant, and equipment must be made at least every three years.

d. Increases in an asset’s carrying value as a result of the ! rst revaluation must be recognized in net income.

4. On January 1, Year 1, an entity acquires a new machine with an estimated use- ful life of 20 years for $100,000. The machine has an electrical motor that must be replaced every ! ve years at an estimated cost of $20,000. Continued opera- tion of the machine requires an inspection every four years after purchase; the inspection cost is $10,000. The company uses the straight-line method of depreciation. What is the depreciation expense for Year 1?

a. $5,000. b. $5,500. c. $8,000. d. $10,000.

5. An asset is considered to be impaired when its carrying amount is greater than its

a. Net selling price. b. Value in use. c. Undiscounted future cash # ows. d. Recoverable amount.

6. Under IFRS, an entity that acquires an intangible asset may use the revalua- tion model for subsequent measurement only if

a. The useful life of the intangible asset can be reliably determined. b. An active market exists for the intangible asset. c. The cost of the intangible asset can be measured reliably. d. The intangible asset has a ! nite life.

7. Which of the following is a criterion that must be met in order for an item to be recognized as an intangible asset?

a. The item’s fair value can be measured reliably. b. The item is part of the entity’s activities aimed at gaining new scienti! c or

technical knowledge.

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164 Chapter Four

c. The item is expected to be used in the production or supply of goods or services.

d. The item is identi! able and lacks physical substance.

8. An entity incurs the following costs in connection with the purchase of a trademark:

Purchase price of the trademark. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $80,000 Nonrefundable value added tax paid on the purchase of the trademark . . . . . . . . 4,000 Training sales department staff on the use of the trademark . . . . . . . . . . . . . . . . 2,000 Research expenditures incurred prior to the purchase of the trademark . . . . . . . . 15,000 Legal fees to register the trademark . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 Salaries of personnel who negotiated the purchase of the trademark during the period of negotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Assuming that the trademark meets the criteria for recognition as an intan- gible asset, at what amount should the trademark be initially measured?

a. $84,000. b. $92,000. c. $104,000. d. $119,000.

9. Which of the following best describes the accounting for goodwill subsequent to initial recognition?

a. Goodwill is amortized over its expected useful life, not to exceed 20 years. b. Goodwill is tested for impairment whenever impairment indicators are

present. c. Goodwill is tested for impairment on an annual basis. d. Goodwill is revalued using a revaluation model.

10. An entity must adjust its ! nancial statements for an event that occurs after the end of the reporting period if

a. The event occurs before the ! nancial statements have been approved for issuance and it provides evidence of conditions that existed at the end of the reporting period.

b. The event occurs before the ! nancial statements have been issued and it changes the value of an asset that existed at the end of the reporting period.

c. The event occurs before the ! nancial statements have been audited and it changes the value of a liability that existed at the end of the reporting period.

d. The event occurs within 15 days of the end of the reporting period and it changes the level of ownership in another entity from a noncontrolling to a controlling interest.

11. In selecting an accounting policy for a transaction, which of the following is the ! rst level within the hierarchy of guidance that should be considered?

a. The most recent pronouncements of other standard-setting bodies to the extent they do not con# ict with IFRS or the IASB Framework.

b. An IASB Standard or Interpretation that speci! cally relates to the transaction.

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c. The de! nitions, recognition criteria, and measurement concepts in the IASB Framework.

d. An IASB Standard or Interpretation that deals with similar and related issues.

12. An entity can justify a change in accounting policy if

a. The change will result in a reliable and more relevant presentation of the ! nancial statements.

b. The entity encounters new transactions that are substantively different from existing or previous transactions.

c. The entity previously accounted for similar, though immaterial, transac- tions under an unacceptable accounting method.

d. An alternative accounting policy gives rise to a material change in current year net income.

13. As a result of a downturn in the economy, Optiplex Corporation has excess productive capacity. On January 1, Year 3, Optiplex signed a special order con- tract to manufacture custom-design generators for a new customer. The cus- tomer requests that the generators be ready for pickup by June 15, Year 3, and guarantees it will take possession of the generators by July 15, Year 3. Optiplex incurred the following direct costs related to the custom-design generators:

Cost to complete the design of the generators. . . . . . . . . . . . . . . . . . . . $ 3,000 Purchase price for materials and parts . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 Transportation cost to get materials and parts to manufacturing facility. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 Direct labor (10,000 labor hours at $12 per hour) . . . . . . . . . . . . . . . . . 120,000 Cost to store fi nished product (from June 15 to June 30) . . . . . . . . . . . . 2,000

Because of the company’s inexperience in manufacturing generators of this design, the cost of materials and parts included an abnormal amount of waste totaling $5,000. In addition to direct costs, Optiplex applies variable and ! xed overhead to inventory using predetermined rates. The variable overhead rate is $2 per direct labor hour. The ! xed overhead rate based on a normal level of production is $6 per direct labor hour. Given the decreased level of production expected in Year 3, Optiplex estimates a ! xed overhead application rate of $9 per direct labor hour in Year 3.

Required: Determine the amount at which the inventory of custom-design generators should be reported on Optiplex Corporation’s June 30, Year 3, balance sheet.

14. To determine the amount at which inventory should be reported on the De- cember 31, Year 1, balance sheet, Monroe Company compiles the following information for its inventory of Product Z on hand at that date:

• Historical cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000 • Replacement cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000 • Estimated selling price. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,000 • Estimated costs to complete and sell . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 • Normal profi t margin as a percentage of selling price . . . . . . . . . . . . . . . 20%

International Financial Reporting Standards: Part I 165

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166 Chapter Four

The entire inventory of Product Z that was on hand at December 31, Year 1, was completed in Year 2 at a cost of $1,800 and sold at a price of $17,150.

Required: a. Determine the impact that Product Z has on income in Year 1 and Year 2

under (1) IFRS and (2) U.S. GAAP. b. Summarize the difference in income, total assets, and total stockholders’

equity using the two different sets of accounting rules over the two-year period.

15. Beech Corporation has three ! nished products (related to three different prod- uct lines) in its ending inventory at December 31, Year 1. The following table provides additional information about each product:

Product Cost Replacement

Cost Selling Price Normal Profi t

Margin

101 $130 $140 $160 20% 202 $160 $135 $140 20% 303 $100 $ 80 $100 15%

Beech Corporation expects to incur selling costs equal to 5 percent of the sell- ing price on each of the products.

Required: Determine the amount at which Beech should report its inventory on the De- cember 31, Year 1, balance sheet under (1) IFRS and (2) U.S. GAAP.

16. This is a continuation of problem 15. At December 31, Year 2, Beech Corpora- tion still had the same three different products in its inventory. The following table provides updated information for the company’s products:

Beech Corporation still expects to incur selling costs equal to 5 percent of the selling price.

Required: Determine the amount at which Beech should report its inventory on the De- cember 31, Year 2, balance sheet under (1) IFRS and (2) U.S. GAAP.

17. Steffen-Zweig Company exchanges two used printing presses with a total net book value of $24,000 ($40,000 cost less accumulated depreciation of $16,000) for a new printing press with a fair value of $24,000 and $3,000 in cash. The fair value of the two used printing presses is $27,000. The transaction is deemed to lack commercial substance.

Product Cost Replacement

Cost Selling Price Normal Profi t

Margin

101 $130 $180 $190 20% 202 $160 $150 $160 20% 303 $100 $100 $130 15%

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International Financial Reporting Standards: Part I 167

Required: Determine the amount of gain or loss that would be recognized from this ex- change of assets.

18. Stevenson Corporation acquires a one-year-old building at a cost of $500,000 at the beginning of Year 2. The building has an estimated useful life of 50 years. However, based on reliable historical data, the company believes the carpet- ing will need to be replaced in 5 years, the roof will need to be replaced in 15 years, and the HVAC system will need to be replaced in 10 years. On the date of acquisition, the cost to replace these items would have been carpeting, $10,000; roof, $15,000; HVAC system, $30,000. Assume no residual value.

Required: Determine the amount to be recognized as depreciation expense in Year 2 re- lated to this building.

19. Quick Company acquired a piece of equipment in Year 1 at a cost of $100,000. The equipment has a 10-year estimated life, zero salvage value, and is depre- ciated on a straight-line basis. Technological innovations take place in the in- dustry in which the company operates in Year 4. Quick gathers the following information for this piece of equipment at the end of Year 4:

Expected future undiscounted cash fl ows from continued use . . . . . . . . . . . $59,000 Present value of expected future cash fl ows from continued use . . . . . . . . . 51,000 Net selling price in the used equipment market . . . . . . . . . . . . . . . . . . . . . . 50,000

At the end of Year 6, it is discovered that the technological innovations re- lated to this equipment are not as effective as ! rst expected. Quick estimates the following for this piece of equipment at the end of Year 6:

Expected future undiscounted cash fl ows from continued use . . . . . . . . . . . $50,000 Present value of expected future cash fl ows from continued use . . . . . . . . . 44,000 Net selling price in the used equipment market . . . . . . . . . . . . . . . . . . . . . . 42,000

Required: a. Discuss whether Quick Company must conduct an impairment test on this

piece of equipment at December 31, Year 4. b. Determine the amount at which Quick Company should carry this piece

of equipment on its balance sheet at December 31, Year 4; December 31, Year 5; and December 31, Year 6. Prepare any related journal entries.

20. Godfrey Company constructed a new, highly automated chemical plant in Year 1, which began production on January 1, Year 2. The cost to construct the plant was $5,000,000: $1,500,000 for the building and $3,500,000 for machin- ery and equipment. The useful life of the plant (both building and machinery) is estimated to be 20 years. Local environmental laws require the machinery and equipment to be inspected by engineers after every ! ve years of opera- tion. The inspectors could require Godfrey to overhaul equipment at that time to be able to continue to operate the plant. Godfrey estimates that the costs of the inspection and any required overhaul to take place in ! ve years to be

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168 Chapter Four

$200,000. Environmental laws also require Godfrey to dismantle and remove the plant assets at the end of their useful life. The company estimates that the net cost, after deducting any salvage value, for removal of the equipment will be $100,000, and the net cost for dismantling and removal of the building, after deducting any salvage value, will be $1,500,000. Godfrey has determined that the straight-line method of depreciation will best re# ect the pattern in which the plant’s future economic bene! ts will be received by the company. The company uses the cost model to account for its property, plant, and equip- ment. The company uses a discount rate of 10 percent in determining present values.

Required: Determine the cost of the plant assets at January 1, Year 2. Determine the amount of depreciation expense that should be recognized related to the plant assets in Year 2.

21. Jefferson Company acquired equipment on January 2, Year 1, at a cost of $10 million. The equipment has a ! ve-year life, no residual value, and is de- preciated on a straight-line basis. On January 2, Year 3, Jefferson Company determines the fair value of the asset (net of any accumulated depreciation) to be $12 million.

Required: a. Determine the impact the equipment has on Jefferson Company’s income

in Years 1–5 using (1) IFRS, assuming that the revaluation model is used for measurement subsequent to initial recognition, and (2) U.S. GAAP.

b. Summarize the difference in income, total assets, and total stockholders’ equity using the two different sets of accounting rules over the period of Years 1–5.

22. Madison Company acquired a depreciable asset at the beginning of Year 1 at a cost of $12 million. At December 31, Year 1, Madison gathered the following information related to this asset:

Carrying amount (net of accumulated depreciation). . . . . . . . . . . . . . . $10 million Fair value of the asset (net selling price) . . . . . . . . . . . . . . . . . . . . . . . . $7.5 million Sum of future cash fl ows from use of the asset . . . . . . . . . . . . . . . . . . $10 million Present value of future cash fl ows from use of the asset . . . . . . . . . . . $8 million Remaining useful life of the asset. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 years

Required: a. Determine the impact on Year 2 and Year 3 income from the depreciation

and possible impairment of this equipment under (1) IFRS and (2) U.S. GAAP.

b. Determine the difference in income, total assets, and total stockholders’ eq- uity for the period of Years 1–6 under the two different sets of accounting rules.

Note: If the asset is determined to be impaired, there would be no adjustment to Year 1 depreciation expense of $2 million.

23. Iptat International Ltd. provided the following reconciliation from IFRS to U.S. GAAP in its most recent annual report (amounts in thousands of CHF):

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International Financial Reporting Standards: Part I 169

Required: a. Explain why U.S. GAAP adjustment (a) results in an addition to net income.

Explain why U.S. GAAP adjustment (a) results in an addition to sharehold- ers’ equity that is greater than the addition to net income. What is the share- holders’ equity account affected by adjustment (a)?

b. Explain why U.S. GAAP adjustment (b) results in a subtraction from share- holders’ equity but does not affect net income. What is the shareholders’ equity account affected by adjustment (b)?

24. In Year 1, in a project to develop Product X, Lincoln Company incurred re- search and development costs totaling $10 million. Lincoln is able to clearly distinguish the research phase from the development phase of the proj- ect. Research-phase costs are $6 million, and development-phase costs are $4 million. All of the IAS 38 criteria have been met for recognition of the de- velopment costs as an asset. Product X was brought to market in Year 2 and is expected to be marketable for ! ve years. Total sales of Product X are estimated at more than $100 million.

Required: a. Determine the impact research and development costs have on Lincoln

Company’s Year 1 and Year 2 income under (1) IFRS and (2) U.S. GAAP. b. Summarize the difference in income, total assets, and total stockholders’

equity related to Product X over its ! ve-year life under the two different sets of accounting rules.

25. Xanxi Petrochemical Company provided the following reconciliation from IFRS to U.S. GAAP in its most recent annual report (amounts in thousands of RMB):

Net Income Shareholders’

Equity

As stated under IFRS . . . . . . . . . . . . . . . . . . . . . . . . . . 541,713 7,638,794 U.S. GAAP adjustments (a) Reversal of additional depreciation charges

arising from revaluation of fi xed assets . . . . . . . . . . 85,720 643,099 (b) Reversal of revaluation surplus of fi xed

assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — (977,240)

As stated under U.S. GAAP . . . . . . . . . . . . . . . . . . . . . 627,433 7,305,653

Net Income Shareholders’

Equity

As stated under IFRS . . . . . . . . . . . . . . . . . . . . . . . . . . 938,655 4,057,772 U.S. GAAP adjustments (a) Reversal of amortization charge on

deferred development costs . . . . . . . . . . . . . . . . . . 5,655 16,965 (b) Gain on sale and leaseback of building . . . . . . . . . . (40,733) (66,967)

As stated under U.S. GAAP . . . . . . . . . . . . . . . . . . . . . 903,577 4,007,770

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170 Chapter Four

Required: a. Explain why U.S. GAAP adjustment (a) results in an addition to net income.

Explain why U.S. GAAP adjustment (a) results in an addition to sharehold- ers’ equity that is greater than the addition to net income. What is the share- holders’ equity account affected by adjustment (a)?

b. Explain why U.S. GAAP adjustment (b) reduces net income. Explain why U.S. GAAP adjustment (b) reduces shareholders’ equity by a larger amount than it reduces net income. What is the shareholders’ equity account af- fected by adjustment (b)?

26. Buch Corporation purchased Machine Z at the beginning of Year 1 at a cost of $100,000. The machine is used in the production of Product X. The machine is expected to have a useful life of 10 years and no residual value. The straight- line method of depreciation is used. Adverse economic conditions develop in Year 3 that result in a signi! cant decline in demand for Product X. At De- cember 31, Year 3, the company develops the following estimates related to Machine Z:

Expected future cash fl ows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $75,000 Present value of expected future cash fl ows . . . . . . . . . . . . . . . . . . . . . . . . . 55,000 Selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000 Costs of disposal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

At the end of Year 5, Buch’s management determines that there has been a substantial improvement in economic conditions, resulting in a strengthening of demand for Product Z. The following estimates related to Machine Z are developed at December 31, Year 5:

Expected future cash fl ows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $70,000 Present value of expected future cash fl ows . . . . . . . . . . . . . . . . . . . . . . . . . 53,000 Selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 Costs of disposal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Required: Determine the carrying amounts for Machine Z to be reported on the balance sheet at the end of Years 1–5, and the amounts to be reported in the income statement related to Machine Z for Years 1–5.

27. On January 1, Year 1, Holzer Company hired a general contractor to begin construction of a new office building. Holzer negotiated a $900,000, five-year, 10 percent loan on January 1, Year 1, to finance construction. Payments made to the general contractor for the building during Year 1 amount to $1,000,000. Payments were made evenly throughout the year. Construction is completed at the end of Year 1, and Holzer moves in and begins using the building on January 1, Year 2. The building is estimated to have a 40-year life and no residual value. On December 31, Year 3, Holzer Company determines that the market value for the building is $970,000.

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International Financial Reporting Standards: Part I 171

On December 31, Year 5, the company estimates the market value for the building to be $950,000.

Required: Use the two alternative methods allowed by IAS 16 with respect to the mea- surement of property, plant, and equipment subsequent to initial recognition to determine:

a. The carrying amount of the building that would be reported on the balance sheet at the end of Years 1–5.

b. The amounts to be reported in net income related to this building for Years 1–5.

In each case, assume that the building’s value in use exceeds its carrying value at the end of each year and therefore impairment is not an issue.

28. Quantacc Company began operations on January 1, Year 1, and uses IFRS to prepare its ! nancial statements. Quantacc reported net income of $100,000 in Year 5 and had stockholders’ equity of $500,000 at December 31, Year 5. The company wishes to determine what its Year 5 income and December 31, Year 5, stockholders’ equity would be if it had used U.S. GAAP. Relevant in- formation follows:

• Quantacc carries ! xed assets at revalued amounts. Fixed assets were last revalued upward by $35,000 on January 1, Year 3. At that time, ! xed assets had a remaining useful life of 10 years.

• Quantacc capitalized development costs related to a new product in Year 4 in the amount of $80,000. Quantacc began selling the new product in January, Year 5, and expects the product to be marketable for a total of ! ve years.

• Early in January, Year 5, Quantacc realized a gain on the sale-and-leaseback of an of! ce building in the amount of $150,000. The lease is accounted for as an operating lease, and the term of the lease is 20 years.

Required: Calculate the following for Quantacc Company using U.S. GAAP (ignore in- come taxes):

a. Net income for Year 5. b. Stockholders’ equity at December 31, Year 5.

29. Stratosphere Company acquires its only building on January 1, Year 1, at a cost of $4,000,000. The building has a 20-year life, zero residual value, and is depreciated on a straight-line basis. The company adopts the revaluation model in accounting for buildings. On December 31, Year 2, the fair value of the building is $3,780,000. The company eliminates accumulated deprecia- tion against the building account at the time of revaluation. The company’s accounting policy is to reverse a portion of the revaluation surplus account related to increased depreciation expense. On January 2, Year 4, the company sells the building for $3,500,000.

Required: Determine the amounts to be re# ected in the balance sheet related to this building for Years 1–4 in the following table. (Use parentheses to indicate credit amounts.)

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172 Chapter Four

30. During Year 1, Reforce Company conducted research and development on a new product. By March 31, Year 2, the company had determined the new product was technologically feasible, and the company obtained a patent for the product in April, Year 2. The company developed an initial prototype by June 30, Year 2. Also, by June 30, Year 2, the company had developed a busi- ness plan including identi! cation of a ready market for the product, and a commitment of resources to ready the product for market. After completion of the second prototype at the end of September, Year 2, the product was ready for commercial production and marketing. The company has tracked costs as- sociated with the new product as follows:

Date Cost Accumulated Depreciation

Carrying Amount

Revaluation Surplus Income

Retained Earnings

January 1, Year 1 $4,000,000 $4,000,000 December 31, Year 1 Balance December 31, Year 2 Balance December 31, Year 3 Balance January 2, Year 4 Balance

Market research costs, Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 25,000 Research costs, Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 Research costs, 1st quarter, Year 2. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000 Legal fees to register patent, April, Year 2 . . . . . . . . . . . . . . . . . . . . . . . . . 25,000 Development costs for initial prototype, 2nd quarter, Year 2 . . . . . . . . . . . 500,000 Testing of initial prototype, June, Year 2 . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 Management time to develop business plan, 2nd quarter, Year 2 . . . . . . . 15,000 Cost of revisions and second prototype, 3rd quarter, Year 2 . . . . . . . . . . . 175,000 Legal fees to defend patent, October, Year 2 . . . . . . . . . . . . . . . . . . . . . . . 50,000 Commercial production costs, 4th quarter, Year 2 . . . . . . . . . . . . . . . . . . . 400,000 Marketing campaign, 4th quarter, Year 2 . . . . . . . . . . . . . . . . . . . . . . . . . 80,000

Required: Determine the amount related to this new product that will be reported as intangible assets on the company’s December 31, Year 2, balance sheet.

31. Philosopher Stone Inc. incurred costs of $20,000 to develop an intranet Web site for internal use. The intranet will be used to store information related to company policies, customers, and products. Access to the intranet is password-protected and is restricted to company personnel. As the company’s

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International Financial Reporting Standards: Part I 173

auditor, you have been asked to determine whether Philosopher Stone can capitalize the Web site development costs as an intangible asset or whether the company must expense the costs in the period in which they were incurred. Your research ! nds that SIC 32 , Intangible Assets–Web Site Costs, indicates that a Web site developed for internal or external use is an internally generated intangible asset that is subject to the requirements of IAS 38. Speci! cally, SIC 32 indicates that the recognition criteria in IAS 38 related to development costs must be satis! ed. The criterion most in question is whether the company can demonstrate the usefulness of the intranet and how it will generate probable future economic bene! ts.

Required: Develop a justi! cation for why Philosopher Stone should, or should not, be allowed to account for the intranet development costs as an intangible asset.

32. Bartholomew Corporation acquired 80 percent of the outstanding shares of Samson Company in Year 1 by paying $5,500,000 in cash. The fair value of Samson’s identi! able net assets is $5,000,000. Bartholomew uses the propor- tionate share of the acquired ! rm’s net assets approach to measure noncontrol- ling interest. Samson is a separate cash-generating unit. At the end of Year 1, Bartholomew compiles the following information for Samson:

Amount at which the shares of Samson could be sold . . . . . . . . . . . . . . . $5,000,000 Costs that would be incurred to sell the shares of Samson . . . . . . . . . . . . $ 200,000 Present value of future cash fl ows from continuing to control Samson . . . $4,750,000

Required: At what amount should Samson’s identi! able net assets and goodwill from the acquisition of Samson be reported on Bartholomew’s consolidated balance sheet at the end of Year 1?

33. This exercise consists of two parts.

Part A. The following table summarizes the assets of the Rocker Division (a separate cash-generating unit) at December 31, Year 5, prior to testing good- will for impairment. Property, Plant, and Equipment and Other Intangibles are amortized on a straight-line basis over an average useful life of 12 years and 5 years, respectively. Management has estimated the present value of fu- ture cash # ows from operating the Rocker Division to be $1,560. No fair mar- ket value is available.

Required: Complete the following table to determine the carrying amounts at 12/31/Y5 for the assets of the Rocker Division.

Goodwill Property, Plant, and Equipment

Other Intangibles Total

Carrying amount, 12/31/Y4 . . . . . $1,000 $1,500 $500 $3,000 Amortization expense, Year 5 . . . 0 (125) (100) (225) Subtotal. . . . . . . . . . . . . . . . . . . . $1,000 $1,375 $400 $2,775 Impairment loss . . . . . . . . . . . . . . Carrying amount, 12/31/Y5 . . . . .

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174 Chapter Four

Part B. Due to favorable changes in export laws, management revises its es- timate of the value in use for the Rocker Division at 12/31/Y6 to be $1,930.

Required: Complete the following table to determine the carrying amounts at 12/31/Y6 for the assets of the Rocker Division.

Goodwill Property, Plant, and Equipment

Other Intangibles Total

Carrying amount, 12/31/Y5 . . . . . Amortization expense, Year 6 . . . Subtotal. . . . . . . . . . . . . . . . . . . . Impairment loss/recovery . . . . . . . Carrying amount, 12/31/Y6 . . . . .

34. This exercise consists of three parts.

Part A. On January 1, Year 1, Complete Company acquired 60 percent of the outstanding shares of Partial Company by paying $1,200,000 in cash. The fair value of Partial’s identi! able assets and liabilities is $2,000,000 and $500,000, respectively.

Required: Determine the possible amounts at which Complete Company should recog- nize goodwill from this business combination.

Part B. Assume the same facts as in part A, except Complete Company ac- quires 80 percent of Partial Company for $1,100,000.

Required: Determine the possible amounts at which Complete Company should recog- nize goodwill from this business combination.

Part C. Assume the same facts as in part A and that Complete Company measured noncontrolling interest at the date of acquisition at the proportion- ate share of fair value of Partial Company’s net assets. Complete Company determines that Partial Company is a separate cash-generating unit. At the end of Year 1, Complete Company develops the following estimates for Partial Company:

Fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,900,000 Costs to sell . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000 Present value of future cash fl ows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,860,000

Required: Determine the amount of impairment loss, if any, to be recognized in the Year 2 consolidated income statement, and the amount at which Partial Com- pany’s net assets, goodwill, and noncontrolling interest would be carried on the consolidated balance sheet at the end of Year 2.

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International Financial Reporting Standards: Part I 175

35. Thurstone Company, a U.S.-based company, borrows 1,500,000 British pounds (£) on January 1, Year 1, at an interest rate of 4 percent to ! nance the construction of a new of! ce building for its employees in England. Construction is expected to take six months and cost £1,500,000. Thurstone temporarily invests the British pounds borrowed until cash is needed to pay costs. Interest earned in the ! rst quarter of Year 1 is £5,000. During the ! rst quarter of Year 1, expenditures of £500,000 are incurred; the weighted-average expenditures are £300,000. Thur- stone will repay the borrowing plus interest on June 30, Year 1, by converting U.S. dollars into British pounds. The U.S. dollar/British pound exchange rate was $2.00 on January 1, Year 1, and $2.10 on March 31, Year 1. The change in exchange rate is the result of the difference in interest rates in the United States and Great Britain.

Required: Determine the amount of borrowing costs (in U.S. dollars) that Thurstone should include in the cost of the new of! ce building at March 31, Year 1.

36. Atlanta Tours Company entered into a ! ve-year lease on January 1, Year 1, with Duck Boats Inc. for a customized duck boat. Duck Boats Inc. will provide a vehicle to Atlanta Tours Company with the words “Gone with the Wind” carved into the sides. Following are the terms of the lease arrangement:

• Fair value of the wagon at the inception of the lease is $10,000. • There is an eight-year estimated economic life. • Estimated (unguaranteed) residual value is $3,500. Atlanta Tours Company

does not absorb any gains or losses in the # uctuations of the fair value of the residual value.

• Annual lease payments of $2,000 are due on January 1 of each year. The implicit interest rate in the lease is 6 percent.

• There is an option to purchase at end of lease term for $4,000. • The lease is noncancelable and may not be extended.

Required: Discuss whether Atlanta Tours Company should classify this lease as an oper- ating lease or as a ! nance lease under (a) IFRS and (b) U.S. GAAP.

37. This problem is comprised of three parts.

Part A. Fields Company sells a building to Victory Finance Company. The selling price of the building is $500,000, which approximates its fair value, and the carrying amount is $400,000. Fields then leases the building back from Vic- tory under an operating lease for a period of three years.

Required: Determine how Fields should account for the gain or loss on sale-and-leaseback.

Part B. Fields Company sells a building to Victory Finance Company. The selling price of the building is $500,000, which exceeds its fair value of $470,000. The carrying amount is $400,000. Fields then leases the building back from Victory under an operating lease for a period of three years.

Required: Determine how Fields should account for the gain or loss on sale-and- leaseback.

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176 Chapter Four

Part C. Fields Company sells a building to Victory Finance Company. The selling price of the building is $500,000, which is equal to its fair value. The carrying amount of the building is $400,000. Fields then leases the building back from Victory under a ! nance lease for a period of 20 years.

Required: Determine how Fields should account for the gain or loss on sale-and-leaseback.

38. Bridget’s Bakery Inc. enters into a new operating lease for a 10-year term at a monthly rental of $2,500. To induce Bridget’s Bakery into the lease, the lessor agreed to a free-rent period for the ! rst three months.

Required: Determine the amount of lease expense, if any, that Bridget’s Bakery would recognize in the ! rst month of the lease.

39. Indicate whether each of the following describes an accounting treatment that is acceptable under IFRS, U.S. GAAP, both, or neither, by checking the appro- priate box.

Acceptable Under

IFRS U.S. GAAP Both Neither

• A company takes out a loan to fi nance the construction of a building that will be used by the company. The interest on the loan is capitalized as part of the cost of the building.

• Inventory is reported on the balance sheet using the last-in, fi rst-out (LIFO) cost fl ow assumption.

• The gain on a sale–leaseback transaction classifi ed as an operating lease is deferred and amortized over the lease term.

• A company writes a fi xed asset down to its recoverable amount and recognizes an impairment loss in Year 1. In a subsequent year, the recoverable amount is determined to exceed the asset’s carrying value, and the previously recognized impairment loss is reversed.

• A company pays less than the fair value of net assets acquired in the acquisition of another company. The acquirer recognizes the difference as a gain on purchase of another company.

• A company enters into an eight-year lease on equipment that is expected to have a useful life of 10 years. The lease is accounted for as an operating lease.

• An intangible asset with an active market that was purchased two years ago is carried on the balance sheet at fair value.

• In preparing interim fi nancial statements, interim periods are treated as discrete reporting periods rather than as an integral part of the full year.

• Development costs are capitalized when certain criteria are met.

• Interest paid on borrowings is classifi ed as an operating activity in the statement of cash fl ows.

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International Financial Reporting Standards: Part I 177

Case 4-1

Bessrawl Corporation Bessrawl Corporation is a U.S.-based company that prepares its consolidated ! - nancial statements in accordance with U.S. GAAP. The company reported income in 2014 of $1,000,000 and stockholders’ equity at December 31, 2014, of $8,000,000.

The CFO of Bessrawl has learned that the U.S. Securities and Exchange Com- mission is considering requiring U.S. companies to use IFRS in preparing con- solidated ! nancial statements. The company wishes to determine the impact that a switch to IFRS would have on its ! nancial statements and has engaged you to prepare a reconciliation of income and stockholders’ equity from U.S. GAAP to IFRS. You have identi! ed the following ! ve areas in which Bessrawl’s accounting principles based on U.S. GAAP differ from IFRS.

1. Inventory 2. Property, plant, and equipment 3. Intangible assets 4. Research and development costs 5. Sale-and-leaseback transaction

Bessrawl provides the following information with respect to each of these ac- counting differences.

Inventory At year-end 2014, inventory had a historical cost of $250,000, a replacement cost of $180,000, a net realizable value of $190,000, and a normal pro! t margin of 20 percent.

Property, Plant, and Equipment The company acquired a building at the beginning of 2013 at a cost of $2,750,000. The building has an estimated useful life of 25 years, an estimated residual value of $250,000, and is being depreciated on a straight-line basis. At the beginning of 2014, the building was appraised and determined to have a fair value of $3,250,000. There is no change in estimated useful life or residual value. In a switch to IFRS, the company would use the revaluation model in IAS 16 to determine the carrying value of property, plant, and equipment subsequent to acquisition.

Intangible Assets As part of a business combination in 2011, the company acquired a brand with a fair value of $40,000. The brand is classi! ed as an intangible asset with an in- de! nite life. At year-end 2014, the brand is determined to have a selling price of $35,000 with zero cost to sell. Expected future cash # ows from continued use of the brand are $42,000, and the present value of the expected future cash # ows is $34,000.

Research and Development Costs The company incurred research and development costs of $200,000 in 2014. Of this amount, 40 percent related to development activities subsequent to the point

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178 Chapter Four

at which criteria had been met indicating that an intangible asset existed. As of the end of the 2014, development of the new product had not been completed.

Sale-and-Leaseback In January 2012, the company realized a gain on the sale-and-leaseback of an of- ! ce building in the amount of $150,000. The lease is accounted for as an operating lease, and the term of the lease is ! ve years.

Required Prepare a reconciliation schedule to convert 2014 income and December 31, 2014, stockholders’ equity from a U.S. GAAP basis to IFRS. Ignore income taxes. Prepare a note to explain each adjustment made in the reconciliation schedule.

Ernst & Young. “The Evolution of IAS 39 in Europe.” Eye on IFRS Newsletter, November 2004, pp. 1–4.

Financial Accounting Standards Board. The IASC-U.S. Comparison Project, 2nd ed. Norwalk, CT: FASB, 1999.

Reimers, J. L. “Additional Evidence on the Need for Disclosure Reform.” Account- ing Horizons, March 1992, pp. 36–41.

U.S. Securities and Exchange Commission. Release Nos. 33-9109; 34-61578, Commission Statement in Support of Convergence and Global Accounting Standards, February 2010.

References

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179

Chapter Five

International Financial Reporting Standards: Part II Learning Objectives

After reading this chapter, you should be able to

• Describe and apply the requirements of International Financial Reporting Standards (IFRS) related to the fi nancial reporting of current liabilities, provisions, employee benefi ts, share-based payment, income taxes, revenue, and fi nancial instruments.

• Explain and analyze the effect of major differences between IFRS and U.S. GAAP related to the fi nancial reporting of current liabilities, provisions, employee benefi ts, share-based payment, income taxes, revenue, and fi nancial instruments.

INTRODUCTION

International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB) comprise a comprehensive set of standards providing guidance for the preparation and presentation of ! nancial state- ments. Chapter 4 described and demonstrated the requirements of selected IASB standards, particularly those relating to the recognition and measurement of assets. This chapter continues the study of IFRS by focusing on the recognition and measurement of current liabilities, provisions, employee bene! ts, share-based payment, income taxes, revenue, and ! nancial instruments.

CURRENT LIABILITIES

IAS 1, Presentation of Financial Statements, requires liabilities to be classi! ed as cur- rent or noncurrent. Current liabilities are those liabilities that a company:

1. Expects to settle in its normal operating cycle. 2. Holds primarily for the purpose of trading. 3. Expects to settle within 12 months of the balance sheet date. 4. Does not have the right to defer until 12 months after the balance sheet date.

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180 Chapter Five

The classi! cation and accounting for current liabilities under IFRS is very simi- lar to U.S. GAAP. Differences relate to the following:

• Re! nanced short-term debt: May be reclassi! ed as long-term debt only if re! nanc- ing is completed prior to the balance sheet date. Under U.S. GAAP, a re! nanc- ing agreement must be reached, but the re! nancing need not be completed by the balance sheet date.

• Amounts payable on demand due to violation of debt covenants: Must be classi! ed as current unless a waiver of at least 12 months is obtained from the lender by the balance sheet date. The waiver must be obtained by the annual report issuance date under U.S. GAAP.

• Bank overdrafts: Are netted against cash if the overdrafts form an integral part of the entity’s cash management; otherwise bank overdrafts are classi! ed as cur- rent liabilities. Bank overdrafts are always classi! ed as current liabilities under U.S. GAAP.

Example: Violation of Debt Covenant On June 30, Year 1, Sprockets Inc. obtains a $100,000 loan from a bank for a manufac- turing facility. The loan is due in 24 months and is subject to a number of debt cov- enants. In December, Year 1, Sprockets distributes too much of its cash on employee bonuses and incurs a debt covenant violation as of December 31, Year 1. As a result of the violation, the loan becomes due within 30 days. Sprockets’ CFO asks the bank to waive the violation. On January 5, Year 2, the bank agrees to waive the violation, stipulating that it must be recti! ed within 90 days. Sprockets issues its ! nancial statements on January 30, Year 2. In this situation, Sprockets would be required to classify the bank loan as a current liability on its December 31, Year 1, balance sheet because it did not obtain a waiver from the bank by the balance sheet date.

Now assume that Sprockets’ CFO obtained a waiver from the bank on Decem- ber 30, Year 1, stipulating that the debt covenant violation must be recti! ed within 90 days. In this case, although the waiver was obtained before the balance sheet date, Sprockets still would be required to classify the bank loan as a current liabil- ity, because the waiver is not for at least 12 months, but is for only 90 days.

PROVISIONS, CONTINGENT LIABILITIES, AND CONTINGENT ASSETS

IAS 37, Provisions, Contingent Liabilities and Contingent Assets, provides guidance for reporting liabilities (and assets) of uncertain timing, amount, or existence. It contains speci! c rules related to onerous contracts and restructuring costs. By way of examples in IAS 37, Part B, guidance also is provided with regard to issues such as environmental costs and nuclear decommissioning costs.

Contingent Liabilities and Provisions IAS 37 distinguishes between a contingent liability, which is not recognized on the balance sheet, and a provision, which is. A provision is de! ned as a “liability of uncertain timing or amount.” A provision should be recognized when

1. The entity has a present obligation (legal or constructive) as a result of a past event.

2. It is probable (more likely than not) that an out" ow of resources embodying eco- nomic events will be required to settle the obligation.

3. A reliable estimate of the obligation can be made.

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International Financial Reporting Standards: Part II 181

A constructive obligation exists when a company through past actions or current statements indicates that it will accept certain responsibilities and, as a result, has created a valid expectation on the part of other parties that it will discharge those responsibilities. For example, an entity has a constructive obligation to restructure when it communicates the details of the restructuring plan to those employees who will be affected by it. Another example of a constructive obligation is where a manufacturer (e.g., Sony) announces that it will honor rebates offered by a retailer that goes out of business (e.g., Circuit City) on the manufacturer’s products, even though the manufacturer has no contractual obligation to do so. A constructive obligation is recognized as a provision when it meets the remaining criteria (2 and 3) just listed. U.S. GAAP does not have the concept of a constructive obligation. Thus, only legal obligations might be accrued when criteria are met.

Contingent liabilities are de! ned in IAS 37 as one of the following:

• Possible obligations that arise from past events and whose existence will be con- ! rmed by the occurrence or nonoccurrence of a future event.

• A present obligation that is not recognized because (1) it is not probable that an out" ow of resources will be required to settle the obligation or (2) the amount of the obligation cannot be measured with suf! cient reliability.

Contingent liabilities are disclosed unless the possibility of an out" ow of resources embodying the economic future bene! ts is remote.

The rules for recognition of a provision and disclosure of a contingent liability are generally similar to the U.S. GAAP rules related to contingent liabilities. Under U.S. GAAP, a contingent liability is neither recognized nor disclosed if the likeli- hood of an out" ow of resources is remote; it is disclosed if such an out" ow is pos- sible but not probable; and it is recognized on the balance sheet when an out" ow of resources is probable. The main difference is that U.S. GAAP requires accrual when it is probable that a loss has occurred, with no guidance as to how the word probable should be interpreted. Research suggests that U.S. accountants require the likelihood of occurrence to be in the range of 70 to 90 percent before recogniz- ing a contingent liability. 1 In de! ning a provision, IAS 37 speci! cally de! nes prob- able as “more likely than not,” which implies a threshold of just over 50 percent. Thus, in practice, the threshold for recognition of a “liability of uncertain timing or amount” is considerably lower under IFRS than under U.S. GAAP.

IAS 37 establishes guidance for measuring a provision as the best estimate of the expenditure required to settle the present obligation at the balance sheet date. The best estimate is the probability-weighted expected value when a range of estimates exists or the midpoint within a range if all estimates are equally likely. Provisions must be discounted to present value. Provisions also must be reviewed at the end of each accounting period and adjusted to re" ect the current best esti- mate. Under U.S. GAAP, contingent liabilities should be recognized at the low end of the range of possible amounts when a range of estimates exists. U.S. GAAP only allows discounting of a recognized contingent liability when the amount of the liability and the timing of payments are ! xed or reliably determinable.

Subsequent reduction of a provision can be made only for the expenditures for which the provision was established. For example, if a provision is created for warranties, the provision can only be reduced as warranty costs are incurred. A

1 Financial Accounting Standards Board, The IASC-US Comparison Project: A Report on the Similarities and Differences between IASC Standards and US GAAP: 2nd ed., Norwalk, CT: FASB, 1999.

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182 Chapter Five

provision is reversed when it is no longer probable that an out" ow of resources will occur.

With respect to disclosure of contingent liabilities, IAS 37 allows an enterprise “in extremely rare cases” to omit disclosures that “can be expected to prejudice seriously the position of the enterprise in a dispute with other parties.” No such exemption exists under U.S. GAAP.

Example: Provision for Litigation Loss Former employees of Dreams Unlimited Inc. ! led a lawsuit against the company in Year 1 for alleged age discrimination. At December 31, Year 1, external legal counsel provided an opinion that it was 60 percent probable that the company would be found liable, which would result in a total payment to the former em- ployees between $1,000,000 and $1,500,000, with all amounts in that range being equally likely.

Because it is “more likely than not” that an out" ow of resources (cash) will be required as a result of the lawsuit and an amount can be reasonably estimated, Dreams Unlimited should recognize a provision. Because all amounts in the esti- mated range of loss are equally likely, the amount recognized would be the mid- point of the range, $1,250,000 [($1,000,000 1 $1,500,000)/2]. Therefore, Dreams Unlimited would prepare the following journal entry at December 31, Year 1 to recognize a provision:

Litigation Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,250,000           Provision for Litigation Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,250,000

Note that under U.S. GAAP, a provision probably would not be recognized because the likelihood of incurring a loss is only 60 percent. If a provision were recognized under U.S. GAAP, it would be for $1,000,000, the low end of the range.

In Year 2, Dreams Unlimited settled with the former employees, making a total pay- ment of $1,100,000. As a result, the company would prepare the following journal entry:

Provision for Litigation Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,250,000         Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,100,000         Reversal of Litigation Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000

The reversal of litigation loss would result in an increase in income in Year 2.

Onerous Contract IAS 37 requires the recognition of a provision for the present obligation related to an “onerous contract,” that is, a contract in which the unavoidable costs of meet- ing the obligation of the contract exceed the economic bene! ts expected to be received from it. However, recognition of a provision for expected future operat- ing losses is not allowed. When an onerous contract exists, a provision should be recognized for the unavoidable costs of the contract, which is the lower of the cost of ful! llment and the penalty that would result from non ful! llment under the contract. When a contract becomes onerous as a result of an entity’s own action, the resulting provision should not be recognized until that action has actually occurred.

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International Financial Reporting Standards: Part II 183

Example: Onerous Contract Delicious Chocolate Company produces chocolate candies. It has a noncancelable lease on a building in Ridgeway, South Carolina, that it uses for production. The lease expires on December 31, Year 2, and is classi! ed as an operating lease for accounting purposes. The annual lease payment is $120,000. In October, Year 1, the company closed its South Carolina facility and moved production to Mexico. The company does not believe it will be possible to sublease the building located in South Carolina.

Because there is no future economic bene! t expected from the lease, it is an onerous contract. The unavoidable cost of ful! lling the lease contract for Year 2 of $120,000 should be expensed and recorded as a provision on December 31, Year 1. The journal entry would be:

Noncancelable Lease Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,000       Provision for Future Lease Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,000

Restructuring A restructuring is a program that is planned and controlled by management and that materially changes either

1. The scope of a business undertaken by an entity. 2. The manner in which that business is conducted.

Examples of restructurings include:

• Sale or termination of a line of business. • Closure of business locations in a country or region. • Change in management structure. • Fundamental reorganization that has a material effect on the nature and focus

of the entity’s operations.

A difference exists between IAS 37 and U.S. GAAP with respect to when a pro- vision should be recognized related to a restructuring plan. According to IAS 37, a restructuring provision should be recognized when an entity has a detailed formal plan for the restructuring and it has raised a valid expectation in those affected by the plan that it will carry out the restructuring, either by announcing the main features of the plan to those affected by it or by beginning to implement the plan. Also, the cost of the restructuring must be reasonably estimable and the plan must be carried out within a reasonable period of time.

U.S. GAAP does not allow recognition of a restructuring provision until a liability has been incurred. The existence of a restructuring plan and its announce- ment do not necessarily create a liability. Thus, the recognition of a restructuring provision and related loss may occur at a later date under U.S. GAAP than under IFRS.

Contingent Assets A contingent asset is a probable asset that arises from past events and whose exis- tence will be con! rmed only by the occurrence or nonoccurrence of a future event. Contingent assets should not be recognized, but should be disclosed when the in- " ow of economic bene! ts is probable. If the realization of income from a contingency

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184 Chapter Five

is determined to be virtually certain, then the related bene! t is considered to meet the de! nition of an asset and recognition is appropriate. IAS 37 allows earlier rec- ognition of a contingent asset (and related gain) than does U.S. GAAP, which gen- erally requires the asset to be realized before it can be recognized.

Exhibit 5.1 provides a summary of the recognition and disclosure guidelines in IAS 37.

EXHIBIT 5.1 IAS 37 Recognition and Disclosure Guidelines

Contingent Element Likelihood of Realization Accounting Treatment

Uncertain liability Probable (more likely than not)

—Reliably measurable Recognize provision

—Not reliably measurable Disclosure

Not probable Disclosure

Remote No disclosure

Uncertain asset Virtually certain Recognize asset

Probable Disclosure

Not probable No disclosure

Additional Guidance The IASB document published to accompany IAS 37 (IAS 37, Part B) provides a number of examples to demonstrate the application of the standard’s recognition principles. Example 2B, for example, describes a situation involving contaminated land, which gives rise to a constructive obligation.

Example: Contaminated Land Constructive Obligation Petrocan Company operates in the oil industry and contaminates land at a location in a foreign country. The foreign country does not have environmental legislation that will require the company to clean up the contamination. However, Petrocan has a widely published environmental policy to clean up all contamination that it causes, and the company has a record of honoring this policy.

The company applies the criteria of IAS 37 to determine whether recognition of a provision is appropriate:

1. Present obligation as a result of a past obligating event: The past obligating event is the contamination of the land. A present constructive obligation exists because the past conduct of the company creates a valid expectation on the part of those affected by it that the entity will clean up the contamination.

2. An out" ow of resources embodying economic bene! ts in settlement is probable: Because the contamination has occurred, and the company has a policy of cleaning up all contamination, an out" ow of resources to settle the constructive obligation is “more likely than not.”

3. A reliable estimate of the obligation can be made: The company must determine whether this criterion is met. If so, a provision would be recognized for the best estimate of the costs of clean up. If not, then disclosures would be made because there is a greater than remote likelihood of an out" ow of resources to settle the obligation.

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International Financial Reporting Standards: Part II 185

EMPLOYEE BENEFITS

IAS 19, Employee Bene! ts, is a single standard that covers all forms of employee compensation and bene! ts other than share-based compensation (e.g., stock op- tions), which is covered in IFRS 2. IAS 19 provides guidance with respect to four types of employee bene! ts:

1. Short-term employee bene! ts (such as compensated absences and bonuses). 2. Post-employment bene! ts (pensions, medical bene! ts, and other post-

employment bene! ts). 3. Other long-term employee bene! ts (such as deferred compensation and dis-

ability bene! ts). 4. Termination bene! ts (such as severance pay and early retirement bene! ts).

Short-Term Benefi ts An employer recognizes an expense and a liability at the time that the employee provides services. The amount recognized is undiscounted.

Compensated Absences For short-term compensated absences (such as sick pay or vacation pay), an amount is accrued when services are provided only if the compensated absences accumulate over time and can be carried forward to future periods. In the case of nonaccumulating compensated absences, an expense and liability are recognized only when the absence occurs.

Pro! t-Sharing and Bonus Plans An expense and a liability are accrued for pro! t-sharing or bonus plans only if:

• The company has a present legal or constructive obligation to make such pay- ments as a result of past events.

• The amount can be reliably estimated.

Even if a company has no legal obligation to pay a bonus, it can have a construc- tive obligation to do so if it has no realistic alternative but to pay the bonus.

Post-employment Benefi ts IAS 19 was revised in 2011 and made signi! cant changes in the treatment of post- employment bene! ts. Revised IAS 19 became effective in 2013.

IAS 19 distinguishes between de! ned contribution plans and de! ned bene! t plans. The accounting for a de! ned contribution plan is simple and straightfor- ward. An employer:

1. Accrues an expense and a liability at the time the employee renders service for the amount the employer is obligated to contribute to the plan.

2. Reduces the liability when contributions are made.

The accounting for a de! ned post-employment bene! t plan is considerably more complicated.

De! ned Post-employment Bene! t Plans Under IFRS, the accounting for both de! ned bene! t pension plans and other de- ! ned post-employment bene! t plans (such as medical and life insurance bene! ts)

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186 Chapter Five

is basically the same and is generally similar to the accounting under U.S. GAAP, but with some differences. The following discussion relates speci! cally to pen- sions, but it also is applicable to other post-employment bene! ts.

The two major issues in accounting for de! ned bene! t pension plans are (1) calculation of the net de! ned bene! t liability (or asset) to be reported on the bal- ance sheet and (2) calculation of the de! ned bene! t cost to be recognized in income (either net income or other comprehensive income).

Net De! ned Bene! t Liability (Asset) The amount recognized on the employer’s balance sheet as a net de! ned bene! t liability (or asset) is calculated as:

1 Present value of the de! ned bene! t obligation (PVDBO) − Fair value of plan assets (FVPA)

The PVDBO is based on assumptions related to variables such as employee turnover, life expectancy, and future salary levels. The discount rate used in deter- mining the PVDBO is determined by reference to the yield at the end of the period on high-quality corporate bonds.

When the PVDBO is greater than the FVPA, a de! cit exists, and the employer reports this amount as a net de! ned bene! t liability on the balance sheet. When the FVPA is greater than the PVDBO, a surplus arises, but the amount of the net de! ned bene! t asset recognized is limited to the larger of:

a. the surplus, and b. the asset ceiling, which is the present value of any economic bene! ts available

in the form of refunds from the plan or reductions in future contributions to the plan.

Under U.S. GAAP, the amount recognized on the balance sheet also is equal to the difference between the PVDBO and the FVPA; this is known as the funded status. However, there is no asset ceiling under U.S. GAAP.

Example: Limitation on the Recognition of the Net De! ned Bene! t Asset The de! ned bene! t pension plan of Fortsen Company Inc. has the following char- acteristics at December 31, Year 9:

Present value of defi ned benefi t obligation (PVDBO) . . . . . . . . . . . . . . . . . . . . . . $ 10,000

Fair value of plan assets (FVPA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (10,800)

Surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (800)

Asset ceiling (present value of reductions in future contributions) . . . . . . . . . . . . . $ 525

Fortsen recognizes a net de! ned bene! t asset of $525 on its December 31, Year 9, balance sheet and discloses the fact that the asset ceiling reduces the carrying amount of the asset by $275 ($800 − $525). The asset limitation of $275 also is in- cluded in the remeasurements of the net de! ned bene! t liability (asset), described below. Under U.S. GAAP, Fortsen would report a net de! ned bene! t asset of $800, equal to the difference between the PVDBO and FVPA.

De! ned Bene! t Cost The de! ned bene! t cost reported in income is comprised of four components. Three of these components are included in the computation of net income, and

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one is included in other comprehensive income. The components of de! ned ben- e! t cost included in net income are:

• Current service cost • Past service cost and gains and losses on settlements • Net interest on the net de! ned bene! t liability (asset)

Net interest on the net de! ned bene! t liability (asset) (NIDBA) is determined by multiplying the net de! ned bene! t liability (asset) by the same discount rate used to measure PVDBO. As a result, NIDBA is the difference between interest expense (PVDBO 3 discount rate) and interest income (FVPA 3 discount rate).

Past service cost arises when an employer improves the bene! ts to be paid to em- ployees in a de! ned bene! t plan. IAS 19 requires all past service costs to be recog- nized in net income in the period in which the bene! t plan is changed, regardless of the status of the employees bene! ting from the change.

In comparison, U.S. GAAP requires that the past service cost (referred to as prior service cost) be recognized in other comprehensive income (OCI) and then amortized to net income over time. The past service cost related to retirees is am- ortized to net income over their remaining expected life, and the past service cost related to active employees is amortized to net income over their expected remain- ing service period.

Example: Recognition of Past Service Cost On January 1, Year 7, Eagle Company amends its de! ned bene! t pension plan to increase the amount of bene! ts to be paid. The bene! ts vest after ! ve years of service. Eagle has no retirees. At the date of the plan amendment, the increase in the present value of the de! ned bene! t obligation (PVDBO) attributable to active employees is $18,000. The active employees have an average remaining service life of 12 years.

Under IFRS, Eagle Company recognizes the entire past service cost of $18,000 as an expense to net income in Year 7. Under U.S. GAAP, because all of the employ- ees affected by the plan amendment are active employees, the past service cost of $18,000 would be amortized to net income over the remaining service life of those employees at the rate of $1,500 per year ($18,000/12 years).

Gains and losses on settlements arise when an employer settles a de! ned bene! t plan by making a lump-sum cash payment to employees in exchange for their rights to receive de! ned future bene! ts. A pension plan curtailment arises when there is a material reduction in the number of employees covered by a plan (such as when a plant is closed as part of a restructuring) or when the future service by current employees will no longer qualify for pension bene! ts or will qualify only for reduced bene! ts. Gains and losses usually arise in conjunction with both plan settlements and curtailments.

IAS 19 treats gains and losses on settlements and curtailments similarly; both are recognized in net income in the period in which the settlement or curtailment takes place or when the related restructuring costs are recognized, if earlier. U.S. GAAP treats gains and losses on plan curtailments and settlements differently, with losses generally being recognized earlier than gains. Under U.S. GAAP, a curtailment gain cannot be recognized until the related employees terminate or the plan has been adopted.

Remeasurements of the net de! ned bene! t liability (asset) are the fourth component of the net de! ned bene! t liability (asset). Remeasurements are recognized in other

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comprehensive income (OCI) and are never recycled to net income. Remeasure- ments consist of:

1. Actuarial gains and losses. 2. The difference between the actual return on plan assets in the current period

and the interest income component of NIDBA (FVPA 3 discount rate). 3. Any change in the effect of the asset ceiling during the period.

Actuarial gains and losses arise when an employer changes the actuarial assump- tions used in determining the future bene! t obligation or makes adjustments based on differences between past assumptions and past experience. In contrast to IAS 19, which requires actuarial gains and losses to be recognized immediately through OCI with no recycling to net income, U.S. GAAP allows a choice between immediate recognition in OCI or in net income. Actuarial gains and losses recog- nized in OCI are recycled to net income by adopting either a so-called corridor approach or a systematic method that results in faster recycling.

Other Post-employment Bene! ts IAS 19 does not provide separate guidance for other post-employment bene! ts. The procedures described earlier for pension plans are equally applicable for other forms of post-employment bene! ts provided to employees, such as medical ben- e! ts and life insurance. In calculating the PVDBO for post-employment medical bene! t plans, assumptions also must be made regarding expected changes in the cost of medical services.

U.S. GAAP provides considerably more guidance than IAS 19 with regard to the assumptions to be used and the measurement of the employer’s obligation for post-employment medical bene! ts. As allowed by the IASB’s Framework, compa- nies using IFRS could refer to the guidance provided in U.S. GAAP to identify an appropriate method for determining the amount of expense to recognize related to post-employment bene! ts other than pensions.

Other Long-Term Employee Benefi ts Other long-term employee bene! ts include, for example, long-term compensated absences (e.g., sabbatical leaves), long-term disability bene! ts, bonuses payable 12 months or more after the end of the period, and deferred compensation paid 12 months or more after the end of the period. A liability should be recognized for other long-term employee bene! ts equal to the difference between:

1. The present value of the de! ned bene! t obligation. 2. The fair value of plan assets (if any).

SHARE-BASED PAYMENT

The IASB and the FASB worked closely in developing new standards related to ac- counting for share-based payments. Concurrent with the IASB’s issuance of IFRS 2, the FASB published an exposure draft in March 2004 and subsequently issued a ! nal standard on this topic in December 2004. Although a number of minor dif- ferences exist between the two standards, IFRS 2 and U.S. GAAP are substantially similar.

IFRS 2, Share-based Payment, sets out measurement principles and speci! c requirements for three types of share-based payment transactions:

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International Financial Reporting Standards: Part II 189

1. Equity-settled share-based payment transactions, in which the entity receives goods or services as consideration for equity instruments of the entity (including stock options granted to employees).

2. Cash-settled share-based payment transactions, in which the entity acquires goods or services by incurring liabilities to the supplier of those goods or services for amounts that are based on the price (or value) of the entity’s shares or other equity instruments of the entity (e.g., share appreciation rights).

3. Choice-of-settlement share-based payment transactions, in which the terms of the arrangement provide either the entity or the supplier of goods or services with a choice of whether the entity settles the transaction in cash or by issuing equity instruments.

IFRS 2 applies to share-based transactions with both employees and nonemploy- ees and requires an entity to recognize all share-based payment transactions in its ! nancial statements; there are no exceptions.

The standard applies a fair value approach in accounting for share-based pay- ment transactions. In some situations, these transactions are recognized at the fair value of the goods or services obtained; in other cases, at the fair value of the equity instrument awarded. Fair value of shares and stock options is based on market prices, if available; otherwise a generally accepted valuation model should be used. IFRS 2, Part B, contains extensive application guidance with respect to estimating the “fair value of equity instruments granted.”

Equity-Settled Share-Based Payment Transactions Share-based payment transactions entered into by an entity that will be settled by the entity issuing equity shares are accounted for as equity transactions. Typically, a debit is made to either an asset (goods acquired) or an expense (service received), and a credit is made to paid-in capital.

Share-Based Payments to Nonemployees Entities sometimes will acquire goods or services from external suppliers using shares of the entity’s stock as payment. Share-based payments to nonemployees are measured at the fair value of the goods or services received. If the fair value of the goods or services received cannot be reliably determined, then the fair value of the equity instruments is used. If the fair value of the equity instruments is used, the measurement date is the date the entity obtains the goods or services. If the goods or services are received on a number of dates over a period, the fair value at each date should be used.

Under U.S. GAAP, when the transaction is accounted for using the fair value of the equity instruments, the earlier of either the date at which a commitment for performance is reached or when the performance is completed is used as the mea- surement date for determining the fair value of the equity instruments.

Share-Based Payments to Employees For share-based payments to employees (including stock options), the transaction should be measured at the fair value of the equity instruments granted because the fair value of the service provided by the employees generally is not reliably mea- surable. The fair value of stock options must be determined at the date the options are granted (grant date).

Stock option plans typically contain vesting conditions that must be met in order for the options to become exercisable. The entity issuing stock options must

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estimate the number of options that are expected to vest. The product of the num- ber of options expected to vest multiplied by the fair value of those options is the total compensation cost that will be recognized as compensation expense over the vesting period. The estimate of options expected to vest should be revised throughout the vesting period, with corresponding adjustments to compensation expense. As compensation expense is recognized, it is offset by an increase in ad- ditional paid-in capital.

Compensation expense associated with stock options that vest on a single date (cliff vesting) is recognized on a straight-line basis over the service period. When stock options vest in installments (graded vesting), the compensation expense asso- ciated with each installment (or tranche) must be amortized over that installment’s vesting period. U.S. GAAP allows a choice in recognizing compensation cost related to graded-vesting stock options. Entities may choose to amortize compensation cost on an accelerated basis by tranche (similar to IFRS); alternatively, compensa- tion cost may be amortized on a straight-line basis over the vesting period.

Example: Graded-Vesting Stock Options Glackin Corporation grants stock options with a fair value of $100,000 to select employees at the beginning of Year 1; 50 percent vest at the end of Year 1 and 50 percent vest at the end of Year 2. Under IFRS, compensation cost associated with the ! rst tranche is fully allocated to expense in Year 1, and compensation cost as- sociated with the second tranche is amortized to expense 50 percent in Year 1 and 50 percent in Year 2. As a result, the amount of compensation expense recognized in Year 1 is $75,000 [$50,000 1 (50% 3 $50,000)], and the amount of compensa- tion expense recognized in Year 2 is $25,000 [50% 3 $50,000]. The same pattern of compensation expense recognition would be acceptable under U.S. GAAP. Alter- natively, U.S. GAAP allows the company to simply amortize the $100,000 compen- sation cost on a straight-line basis over the two-year vesting period, recognizing compensation expense of $50,000 in each of Year 1 and Year 2.

Modi! cation of Stock Option Plans Entities that grant stock options sometimes make modi! cations to the terms and conditions under which equity instruments were granted. For example, an entity might change the length of the vesting period or change the exercise price, which could change the fair value of the stock options. If an entity modi! es the terms and conditions of a stock option, IFRS 2 requires the entity to recognize, at a minimum, the original amount of compensation cost as measured at the grant date. If the fair value of the options is reduced as a result of the modi! cation, then there is no change in the total compensation cost to be recognized. If the modi! cation results in an increase in the fair value of the options, then total compensation cost must be increased by the increase in fair value (the difference between the fair value at the original grant date and the fair value at the modi! cation date). Under U.S. GAAP, when modi! cations are made to stock options, the fair value of the options at the date of modi! cation determines the total amount of compensation expense to be recognized. There is no minimum amount of compensation cost to recognize as there is under IFRS.

Cash-Settled Share-Based Payment Transactions An entity might provide employees with stock appreciation rights in which they are entitled to receive a cash payment when the entity’s stock price increases above a predetermined level. Stock appreciation rights are an example of a cash-settled

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share-based payment transaction. This type of transaction results in the recognition of a liability (because there will be a future out" ow of cash) and an expense. The liability (and expense) is measured at the fair value of the share appreciation rights using an option-pricing model. Until the liability is settled, it must be remeasured at each balance sheet date, with the change in fair value re" ected in net income. Under U.S. GAAP, certain cash-settled share-based payment transactions are clas- si! ed as equity; these transactions would be classi! ed as a liability under IFRS.

Choice-of-Settlement Share-Based Payment Transactions When the terms of a share-based payment transaction allow the entity to choose between equity settlement and cash settlement, the entity must treat the trans- action as a cash-settled share-based payment transaction only if it has a present obligation to settle in cash; otherwise the entity treats the transaction as an equity- settled share-based payment transaction.

When the terms of a share-based payment transaction allow the supplier of goods and services to choose between equity settlement and cash settlement, the entity has issued a compound ! nancial instrument the fair value of which must be split into separate debt and equity components. The debt component must be remeasured at fair value at each balance sheet date, with the change in fair value re" ected in net income. If the supplier of goods and services chooses to receive settlement in cash, the cash payment is applied only against the debt component (reduces the liability). The equity component remains in equity. If the supplier chooses to receive settlement in equity, the debt component (liability) is trans- ferred to equity.

Example: Choice-of-Settlement Share-Based Payment Transaction (Supplier Has Choice) On January 1, Year 1, Leiyu Company issued 100 stock options with an exercise price of $18 each to ! ve employees (500 options in total). The employees can choose to settle the options either (1) in shares of stock ($1 par value) or (2) in cash equal to the intrinsic value of the options on the vesting date. The options vest on December 31, Year 2, after the employees have completed two years of service. Leiyu Company expects that only four of the employees will remain with the com- pany for the next two years and vest in the options. One employee resigns in Year 1, and the company continues to assume an overall forfeiture rate of 20 percent at December 31, Year 1. As expected, four employees vest on December 31, Year 2, and exercise their stock options. Share prices and fair values of the two settlement alternatives over the vesting period are:

Date Share Price

Fair Value of Cash-Settlement

Alternative

Fair Value of Share-Settlement

Alternative

January 1, Year 1 $20 $10.00 $10.00 December 31, Year 1 $26 $11.00 $11.00 December 31, Year 2 $30 $12.00 $12.00

Because Leiyu has granted employees stock options that can be settled either

in cash or in shares of stock, this is a compound ! nancial instrument. Because this is a transaction with employees, Leiyu must determine the fair value of the compound ! nancial instrument at the measurement date, taking into account

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the terms and conditions on which the rights to cash or equity instruments are granted. To determine the fair value of a compound ! nancial instrument, the com- pany ! rst measures the fair value of the debt component (i.e., the cash-settlement alternative) and then measures the fair value of the equity component (i.e., the equity-settlement alternative), taking into account that the employee must for- feit the right to receive cash in order to receive the shares of stock. The fair value of the compound ! nancial instrument is the sum of the fair values of the two components.

The stand-alone fair value of the cash-settlement alternative at the grant date (January 1, Year 1) is $5,000 (500 options 3 $10 per option). The stand-alone fair value of the equity-settlement alternative at the grant date also is $5,000 (500 options 3 $10 per option). IFRS 2 indicates that this type of share-based payment often is structured such that the fair value of the debt component and the fair value of the equity component are the same. In such cases, the fair value of the equity component is zero. Thus, the fair value of the compound ! nancial instrument is $5,000 ($5,000 1 $0).

For equity-settled share-based payment transactions, the services received and equity recognized is measured at the fair value of the equity instrument at grant date. Because the fair value of the equity component in this case is zero, there is no compensation expense recognized related to the equity component. For cash- settled share-based payment transactions, the services received and the liability incurred are initially measured at the fair value of the liability at grant date. The fair value of the liability, adjusted to re" ect the number of options expected to vest, is recognized as expense over the period that the services are rendered. At each reporting date, and ultimately at settlement date, the fair value of the liability is remeasured, with the change in fair value affecting the amount recognized as compensation expense. As a result, the total amount of expense recognized will be the amount paid to settle the liability.

Compensation expense for Year 1 is calculated as follows:

Fair value per option at December 31, Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . $11.00 Number of options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,500 Percentage of options expected to vest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80% Total compensation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,400 Vesting period (number of years) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Compensation expense, Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,200

The journal entry on December 31, Year 1, to recognize Year 1 compensation expense is:

Compensation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,200          Share-based Payment Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,200

At December 31, Year 2, the fair value of each option is equal to its intrinsic value of $12.00 ($30 share price − $18 exercise price). The fair value of the liability is $6,000 ($12.00 3 500 options). The total compensation expense is $4,800 ($6,000 3 80%).

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The amount to be recognized as compensation expense in Year 2 is $2,600 ($4,800 − 2,200). The journal entry on December 31, Year 2, is:

Compensation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,600       Share-based Payment Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,600

Accounting for the exercise of the stock options:

• Cash-Settlement Alternative: If the four employees choose the cash-settlement alternative upon exercise of their stock options, they will receive a total of $4,800, the intrinsic value of the 400 options that they exercise. The journal entry on December 31, Year 2, would be:

Share-based Payment Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,800         Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,800

• Share-Settlement Alternative: If the four employees choose the share-settlement

alternative upon exercise of their stock options, they will receive a total of 400 shares of stock with a fair value of $12,000 in exchange for $7,200 (400 shares 3 Exercise price of $18.00 per share). The journal entry on December 31, Year 2, would be:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,200 Share-based Payment Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,800         Common Stock ($1 par 3 400) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$  400         Additional Paid-in Capital ($29 3 400) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,600

INCOME TAXES

IAS 12, Income Taxes, and U.S. GAAP take a similar approach to accounting for in- come taxes. Both standards adopt an asset-and-liability approach that recognizes deferred tax assets and liabilities for temporary differences and for operating loss and tax credit carry forwards. However, differences do exist. The accounting for income taxes is a very complex topic, and only some of the major issues are dis- cussed here.

Tax Laws and Rates IAS 12 requires that current and deferred taxes be measured on the basis of tax laws and rates that have been enacted or substantively enacted by the balance sheet date. The interpretation of substantively enacted will vary from country to coun- try. To help make this assessment, the IASB has published guidelines that address the point in time when a tax law change is substantively enacted in many of the ju- risdictions that apply IFRS. The IASB’s exposure draft (ED) on income taxes would clarify that “substantively enacted” occurs when any future steps in the enactment

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process cannot change the outcome. The ED notes, for example, that the point of substantive enactment in the United States is when a tax law is passed. U.S. GAAP requires measurement of income taxes using actually enacted tax laws and rates.

To minimize the double taxation of corporate dividends (tax paid by both the company and its shareholders), some countries apply a lower tax rate to pro! ts that are distributed to shareholders than to pro! ts that are retained by the com- pany. Therefore, companies doing business in these countries need to know which tax rate (distributed pro! ts versus undistributed pro! ts) should be applied when measuring the amount of current and deferred taxes. Examples provided in IAS 12 indicate that the tax rate that applies to undistributed pro! ts should be used to measure tax expense.

Example: Undistributed Pro! ts Multinational Corporation owns a subsidiary in a foreign jurisdiction where in- come taxes are payable at a higher rate on undistributed pro! ts than on distrib- uted pro! ts. For the year ending December 31, Year 1, the foreign subsidiary’s taxable income is $150,000. The foreign subsidiary also has net taxable temporary differences amounting to $50,000 for the year, thus creating the need for a de- ferred tax liability. The tax rate paid in the foreign country on distributed pro! ts is 40 percent, and the rate on undistributed pro! ts is 50 percent. A tax credit arises when undistributed pro! ts are later distributed. As of the balance sheet date, no distributions of dividends have been proposed or declared. On March 15, Year 2, Multinational’s foreign subsidiary distributes dividends of $75,000 from the pro! t earned in Year 1.

The tax rate on undistributed pro! ts (50 percent) is used to recognize the current and deferred tax liabilities related to earnings of the foreign subsidiary in Year 1:

Current Tax Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $75,000         Taxes Payable ($150,000 3 50%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $75,000 Deferred Tax Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $25,000         Deferred Tax Liability ($50,000 3 50%) . . . . . . . . . . . . . . . . . . . . . . . . . . . $25,000

On March 15, Year 2, when the foreign subsidiary distributes a dividend of $75,000, a tax credit receivable from the government of $7,500 [$75,000 3 (50% − 40%)] is recognized, with an offsetting reduction in the current tax expense:

Tax Credit Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,500         Current Tax Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,500

Recognition of Deferred Tax Asset IAS 12 requires recognition of a deferred tax asset if future realization of a tax ben- e! t is probable, where probable is unde! ned. Under U.S. GAAP, a deferred tax asset must be recognized if its realization is more likely than not. If the word probable is interpreted as a probability of occurrence that is greater than the phrase more likely than not, then IAS 12 provides a more stringent threshold for the recognition of a deferred tax asset.

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Example: Deferred Tax Asset During the ! scal year ended December 31, Year 1, Janeiro Corporation had a net operating loss of $450,000. Because the company has experienced losses in the last several years, it cannot utilize a net operating loss carry back. However, Janeiro has negotiated several new contracts, and management expects that it is slightly more than 50 percent likely that it will be able to utilize one-third of the net operat- ing loss in future years. The company’s effective tax rate is 40 percent.

Depending on the degree of likelihood the company assigns to the word prob- able, either it would not recognize a tax asset, or it would recognize an asset related to the amount of the net operating loss that it expects to be able to use. In the latter case, the deferred tax asset and income tax bene! t would be $60,000 [$450,000 3 1y3 3 40%].

Deferred Tax Asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60,000         Income Tax Benefi t . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60,000

Disclosures IAS 12 requires extensive disclosures to be made with regard to income taxes, in- cluding disclosure of the current and deferred components of tax expense. The standard also requires an explanation of the relationship between hypothetical tax expense based on statutory tax rates and reported tax expense based on the effective tax rate using one of two approaches: (1) a numerical reconciliation be- tween tax expense based on the statutory tax rate in the home country and tax expense based on the effective tax rate or (2) a numerical reconciliation between tax expense based on the weighted-average statutory tax rate across jurisdictions in which the company pays taxes and tax expense based on the effective tax rate.

Exhibit 5.2 demonstrates these two approaches. Tesco plc uses approach 1, showing that accounting pro! t multiplied by the UK statutory income tax rate of 28.2 percent would have resulted in tax expense of £833 in 2009. However, the actual tax expense was only £788, resulting in an effective tax rate of 26.7 percent. One of the reasons that the effective tax rate is different from the UK statutory tax rate is the fact that pro! ts earned in foreign countries are taxed at different rates (differences in overseas taxation rates).

Nestlé SA uses approach 2 in reconciling its total tax expense. The reconciliation begins with the amount that would be recognized as tax expense after multiplying the pro! t earned in each country in which the company operates by the statutory tax rate in that country and then summing across all countries. Nestlé’s effective tax rate can be measured by dividing the amount reported as taxes on continuing operations by pre-tax pro! t on continuing operations (not shown in Exhibit 5.2 ).

The expected tax expense at the weighted-average applicable tax rate results from applying the domestic statutory tax rates to pro! ts before taxes of each entity in the country it operates. For the Nestlé, the weighted-average applicable tax rate varies from one year to another, depending on the relative weight of the pro! t of each individual entity in the Nestlé Group, pro! t as well as the changes in the statutory tax rates.

IFRS versus U.S. GAAP Application of IFRS can create temporary differences unknown under U.S. GAAP. For example, the revaluation of property, plant, and equipment for ! nancial state- ment purposes (in accordance with IAS 16’s revaluation model) with no equivalent

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adjustment for tax purposes will result in a temporary difference that cannot exist under U.S. GAAP. Other differences between IFRS and U.S. GAAP can create dif- ferent amounts of temporary differences. For example, because of different de! - nitions of impairment, differences in the amount of an impairment loss can exist under the two sets of standards. With no equivalent tax adjustment, the amount of temporary difference related to the impairment loss will be different in a set of IFRS-based ! nancial statements from the amount recognized under U.S. GAAP.

Financial Statement Presentation Under U.S. GAAP, deferred tax assets and liabilities generally are classi! ed as cur- rent or noncurrent based on the classi! cation of the related asset or liability, or for tax losses and credit carry-forwards, based on the expected timing of realization.

EXHIBIT 5.2

RECONCILIATION OF ACCOUNTING PROFIT TO EFFECTIVE TAX RATE Tesco plc

2009 Annual Report

Note 6. Taxation

Reconciliation of effective tax charge 2009 £m

2008 £m

Profi t before tax  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,954 2,803

Effective tax charge at 28.2% (2008 at 30.0%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (833) (841) Effect of: Non-deductible expenses  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (189) (180) Differences in overseas taxation rates  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111 41 Adjustments in respect of prior years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67 215 Share of results of joint ventures and associates  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 123 Change in tax rate  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 69 Total income tax charge for the year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (788) (673)

Effective tax rate  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26.7% 24.0%

NESTLÉ 2009

Annual Report

Note 7. Taxes Reconciliation of taxes In millions of CHF 2009 2008

Expected tax expense at weighted average applicable tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,789 3,142 Tax effect of non-deductible or non-taxable items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (168) (105) Prior years’ taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (17) 68 Transfers to unrecognized deferred tax assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 61 Transfers from unrecognized deferred tax assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (44) (14) Changes in tax rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1) (2) Withholding taxes levied on transfers of income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340 347 Other, including taxes on capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130 190 Taxes on continuing operations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,087 3,687

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International Financial Reporting Standards: Part II 197

The net deferred tax amount arising from current assets and liabilities is classi! ed as a current asset or liability; the net deferred tax amount arising from noncurrent assets and liabilities is reported as a noncurrent asset or liability. IAS 1, Presenta- tion of Financial Statements, stipulates that deferred taxes may not be classi! ed as a current asset or current liability, but only as noncurrent.

REVENUE RECOGNITION

IAS 18, Revenue, is a single standard that covers most revenues, in particular rev- enues from the sale of goods; the rendering of services; and interest, royalties, and dividends. There is no equivalent single standard in U.S. GAAP. U.S. rules related to revenue recognition are found in more than 200 different authoritative pronouncements, making a direct comparison between IAS 18 and U.S. GAAP dif! cult.

General Measurement Principle IAS 18 requires revenue to be measured at the fair value of the consideration re- ceived or receivable.

Identifi cation of the Transaction Generating Revenue Revenue recognition criteria normally are applied to each transaction generating revenue. However, if a transaction consists of multiple elements, it may be appro- priate to split the transaction into separate units of account and recognize revenue from each element separately. For example, if a sale of computer software is ac- companied by an agreement to provide maintenance (post-contract support) for a period of time, it might be appropriate to allocate the proceeds from the sale into an amount applicable to the sale of software (revenue recognized at the time of sale) and an amount applicable to the post-contract support (revenue recognized over the period of support). Conversely, there may be situations where it is nec- essary to treat two or more separate transactions as one economic transaction to properly re" ect their true economic substance.

Sale of Goods Five conditions must be met in order for revenue from the sale of goods to be recognized:

1. The signi! cant risks and rewards of ownership of the goods have been trans- ferred to the buyer.

2. Neither continuing managerial involvement normally associated with owner- ship nor effective control of the goods sold is retained.

3. The amount of revenue can be measured reliably. 4. It is probable that the economic bene! ts associated with the sale will " ow to the

seller. 5. The costs incurred or to be incurred with respect to the sale of goods can be

measured reliably.

Evaluating whether signi! cant risks and rewards of ownership have been trans- ferred to the buyer can sometimes be dif! cult and require the exercise of judgment.

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198 Chapter Five

IAS 18 provides a list of examples in which signi! cant risks and rewards might be retained by the seller. These include the following:

• The seller assumes an obligation for unsatisfactory performance not covered by normal warranty provisions.

• Receipt of revenue by the seller is contingent on the buyer generating revenue through its sale of the goods.

• Goods sold are subject to installation, installation is a signi! cant part of the contract, and installation has not yet been completed.

• The sales contract gives the buyer the right to rescind the purchase, and the probability of return is uncertain.

Similarly, in determining whether the seller has relinquished managerial involve- ment or control over the goods sold, a careful evaluation is required for some types of sales.

Example: Sale of Goods with Right of Return Qwilleran Products Inc. is a manufacturer of lighting ! xtures. Qwilleran enters into an agreement with a company in Mexico which will import and distribute Qwilleran’s products locally. In December, Year 1, the ! rst month of the agree- ment, Qwilleran ships $2,000,000 of lighting ! xtures to the Mexican distributor to cover anticipated demand in Mexico. The distributor has the right to return products to Qwilleran if they cannot be sold in Mexico. Qwilleran has extensive experience selling its products in the United States but no experience in Mexico or other foreign countries.

Qwilleran must determine whether it is appropriate to recognize revenue in December, Year 1, when products are shipped to the Mexican distributor. The most important question is whether the signi! cant risks and rewards of ownership of the goods have been transferred to the buyer. IAS 18 indicates that this might not be the case when the buyer has the right to return the purchase, and the probabil- ity of return is uncertain. Because Qwilleran has no experience selling products in Mexico, it has no basis for estimating whether the Mexican distributor will make returns. Thus, Qwilleran should conclude that it has not transferred all the signi! - cant risks of ownership to the Mexican distributor, and it should defer revenue recognition until this criterion has been met.

Example: Sale of Goods with Contingent Payment Victoria Enterprises sells small motors to Gamma Company. Gamma mounts these motors in its water pumps and sells the completed pumps to plumbing supply distributors. When Gamma receives payment from its customers, it pays Victoria for the motors. Gamma has the right to return any unused motors at the end of the year. Historically, these returns have averaged 2 percent of sales. In the month of September, Year 1, Victoria Enterprises made sales of $500,000 to Gamma Company.

IAS 18 indicates that ! ve conditions must be met to recognize revenue from the sale of goods. In this case, it appears that conditions 2, 3, and 5 are met. It is unclear, however, whether conditions 1 and 4 are met. Because payment for the motors is only made if Gamma is able to sell its water pumps, it appears that a signi! cant risk of ownership might have been retained by Victoria, and therefore condition 1 might not be met. This is reinforced by paragraph 16 of IAS 18, which indicates that an entity may retain signi! cant risks and rewards of ownership “when the

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International Financial Reporting Standards: Part II 199

receipt of the revenue from a particular sale is contingent on the derivation of rev- enue by the buyer from its sale of the goods.”

With respect to condition 4, from past experience, it is probable that almost all (98 percent) of “the economic bene! ts associated with the transaction will " ow to the entity.” This suggests that condition 4 is met. IAS 18, paragraph 17, indicates that when the seller retains only an insigni! cant risk of ownership, the transac- tion is a sale and revenue is recognized. The last sentence of IAS 18, paragraph 17 states: “Revenue in such cases is recognized at the time of sale provided the seller can reliably estimate future returns and recognizes a liability for returns based on previous experience and other relevant factors.” As a result, it appears Victoria En- terprises would be justi! ed in recognizing revenue for 98 percent of the sales price and would prepare the following journal entry in September, Year 1 to account for its sales to Gamma Company:

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $500,000         Sales Revenue [$500,000 3 98%] . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $490,000         Deferred Revenue (liability) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Rendering of Services When (1) the outcome of a service transaction can be estimated reliably and (2) it is probable that economic bene! ts of the transaction will " ow to the enterprise, rev- enue should be recognized in proportion to some measure of the extent of services rendered (i.e., on a stage-of-completion basis). The outcome of a transaction can be estimated reliably when (1) the amount of revenue, (2) the costs incurred and the costs to be incurred, and (3) the stage of completion can all be measured reliably. The stage of completion can be estimated in a number of ways, including on the basis of the percentage of total services to be performed, percentage of total costs to be incurred, and surveys of work performed. Guidelines provided in IAS 11, Construction Contracts, related to the application of the percentage-of-completion method on construction projects are generally applicable to the recognition of rev- enue for service transactions. U.S. GAAP does not allow the percentage-of-com- pletion method to be used with service contracts.

When the outcome of a service transaction cannot be estimated reliably, rev- enue should be recognized only to the extent that expenses incurred are probable of recovery. If such underlying expenses are not probable of recovery, the expense should be recognized, but not the revenue.

Example: Recognition of Service Revenue Seese & Associates, an information technology (IT) consulting ! rm, contracted with Drexel Manufacturing Company on January 1, Year 1, to provide services over a period of 18 months for a ! xed fee of $180,000. Seese is unable to specify up- front the type and number of services that it will provide. However, based on past experience, Seese can reliably estimate the cost it will incur to ful! ll its contractual obligation as $150,000. Seese incurred actual costs of $90,000 in Year 1 and received monthly payments of $10,000 from Drexel Manufacturing.

The criteria for recognizing revenue on a stage-of-completion basis are met in this situation. Drexel is making monthly payments, so the criterion of probable in" ow of economic bene! ts is met. Because this is a ! xed-fee contract, the amount of revenue to be earned is known with certainty, and Seese is able to reliably esti- mate the stage of completion on the basis of total costs to be incurred. In Year 1, the

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200 Chapter Five

company has incurred 60 percent [$90,000/$150,000] of the total estimated costs and therefore would recognize service revenue of $108,000 [$180,000 3 60%] with the following journal entry:

Cash [$10,000 3 12] . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,000         Service Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $108,000         Deferred Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Interest, Royalties, and Dividends If it is probable that the economic bene! ts of interest, royalties, and dividends will " ow to the enterprise and the amounts can be measured reliably, revenue should be recognized on the following bases:

• Interest income is recognized on an effective yield basis. • Royalties are recognized on an accrual basis in accordance with the terms of the

relevant agreement. • Dividends are recognized when the shareholders’ right to receive payment is

established.

Exchanges of Goods or Services In an exchange of goods or services, if the exchanged items are similar in nature and value, no revenue (i.e., no gain or loss) is recognized. If the exchanged goods or services are dissimilar in nature, revenue is recognized at the fair value of the goods or services received, adjusted for the amount of any cash paid or received. When the fair value of the goods or services received cannot be measured reliably, revenue should be measured as the fair value of the goods or services given up, adjusted for the amount of any cash paid or received.

IAS 18, Part B The IASB document published to accompany IAS 18 (IAS 18, Part B) provides examples illustrating the application of the standard to major types of revenue- generating transactions. Most of the examples are self-explanatory, and the relation- ships of the examples to the underlying provisions of the standard are straightfor- ward. The examples accompany IAS 18 but technically are not part of the standard. Issues covered in the examples include:

• Sales transactions: Bill-and-hold sales, goods shipped subject to conditions, lay- away sales, sale and repurchase agreements, subscription sales, installment sales, and real estate sales.

• Service transactions: Installation fees; servicing fees included in the price of a product; advertising commissions; insurance agency commissions; ! nancial service fees; admission fees; initiation, entrance, and membership fees; fran- chise fees; and fees from the development of customized software.

• Interest, royalties, and dividends: License fees and royalties.

We summarize the guidance provided in two of these examples next.

Bill-and-Hold Sales The ! rst illustrative example describes a “bill-and-hold sale” as a sale “in which delivery is delayed at the buyer’s request but the buyer takes title and accepts billing.” Bill-and-hold sales have been used by entities (such as Sunbeam) to shift

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International Financial Reporting Standards: Part II 201

sales to be made in future periods into the current period—a type of earnings man- agement. To make sure that a bill-and-hold sale is truly a sale in substance, IAS 18, Part B suggests that revenue may be recognized by the seller when the buyer takes title only if four conditions are met:

1. It is probable that delivery will be made. 2. The item is on hand, identi! ed, and ready for delivery to the buyer at the time

the sale is recognized. 3. The buyer speci! cally acknowledges the deferred delivery instructions. 4. The usual payment terms apply.

Servicing Fees Included in the Price of the Product The sales price of a product sometimes includes an identi! able amount for sub- sequent servicing. An example is after-sales support provided by a software company for a speci! ed period of time. In such a case, IAS 18, Part B indicates a portion of the sales price should be deferred and recognized as revenue over the period during which the service is performed. The amount deferred must be suf- ! cient to cover the expected costs of the services under the agreement and provide a reasonable pro! t on those services. Judgment must be applied in determining the amount to be deferred, since a reasonable amount of pro! t is not de! ned in the standard.

Customer Loyalty Programs A growing number of entities use customer loyalty programs to provide custom- ers with incentives to buy their goods and services. In many of these programs, “points” are awarded at the time a customer makes a purchase. The question arises as to whether the entity’s obligation to provide a free or discounted good or service should be recognized and measured by (1) allocating a portion of the consideration received from the sale transaction or (2) establishing a provision for the estimated future costs of providing the award.

IFRIC 13, Customer Loyalty Programmes, stipulates that award credits should be treated as a separately identi! able component of the sales transaction in which they are granted. The fair value of the consideration received on the sale must be allocated between the award credits and the other components of the sale. The amount allocated to the award credits is based on their fair value. If the entity supplies the award itself, it recognizes the amount allocated to award credits as revenue when award credits are redeemed and the obligation to provide a free or discounted good or service is ful! lled. The amount of revenue to be recognized is based on the number of award credits that have been redeemed, relative to the total number expected to be redeemed.

Example: Frequent-Flyer Awards Program Redjet Airways, a regional air carrier, has a frequent-" yer program in which cus- tomers receive one point for each mile " own on Redjet " ights. Frequent-" yer program members can redeem 30,000 points for a free domestic " ight, which, on average, would otherwise cost $600. During Year 1, Redjet awarded 1,000,000 points to its customers on " ights with total ticket sales of $600,000. Frequent-" yer points expire two years after they are awarded. By the end of Year 1, frequent-" yer program members had redeemed 300,000 points for free tickets. Redjet expects that only 10 percent of points will expire unredeemed.

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202 Chapter Five

Redjet must allocate the $600,000 collected in ticket sales in Year 1 between " ight revenue and frequent-" yer awards (deferred revenue) based on the fair value of the points awarded. The amount to be allocated to the frequent-" yer awards is determined as follows:

Points awarded in Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000

Percentage expected to be redeemed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 90% Points expected to be redeemed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900,000 Points needed for a free fl ight . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 30,000 Expected number of free fl ights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Average value per fl ight . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 $600 Fair value of points awarded . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $18,000

The journal entry to recognize revenue from ticket sales in Year 1 is as follows:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600,000         Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $582,000         Deferred Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000

During Year 1, 300,000 points were redeemed for 10 free " ights, with a value of $6,000. The journal entry to recognize revenue from providing free " ights under the awards program is:

Deferred Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,000         Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,000

Construction Contracts IAS 11, Construction Contracts, identi! es two types of construction contracts: a ! xed-price contract and a cost-plus contract. Revenues and expenses related to both types of contracts should be recognized using the percentage-of-completion method when the outcome of the contract can be estimated reliably. The outcome of a cost-plus contract can be estimated reliably when (1) it is probable that the economic bene! ts associated with the contract will " ow to the entity and (2) the contract costs can be clearly identi! ed and reliably measured. Two additional cri- teria must be met for a ! xed-price contract to qualify for percentage-of-completion accounting treatment: (1) total contract revenues must be reliably measurable and (2) the costs to complete the contract and the stage of completion at the balance sheet date must be reliably measurable. If the outcome of a construction contract cannot be estimated reliably, a cost recovery method should be used to recognize revenue. Under this method, contract costs are expensed as incurred and revenue is recognized to the extent that contract costs incurred are likely to be recovered. If, during the construction period, the uncertainties that prevented the outcome of the contract from being estimated reliably no longer exist, then the accounting for the contract should be changed to the percentage-of-completion method.

U.S. GAAP also requires use of the percentage-of-completion method when certain criteria are met. When the percentage-of-completion method is not appro- priate, the completed contract method is used, which is a departure from IAS 11. Under both IAS 11 and U.S. GAAP, when the outcome of a construction contract is expected to be a loss, the loss should be recognized immediately.

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International Financial Reporting Standards: Part II 203

IASB–FASB Revenue Recognition Project Revenue recognition is an issue for which neither the IASB nor the FASB believes it has adequate authoritative literature that is coherent and comprehensive. In 2002, the two boards began work on a joint project to develop a single standard to deal with this important issue. The main reasons for undertaking this project are to (1) eliminate weaknesses in existing concepts and standards and (2) converge IFRS and U.S. GAAP.

In June 2010, the IASB and FASB published a joint Exposure Draft, Revenue from Contracts with Customers, which proposes a contract-based revenue recognition model to be applied across a wide range of transactions and industries. The boards published a revised Exposure Draft in November 2011. The proposed model requires an entity to apply the following ! ve steps in the recognition of revenue:

1. Identify the contract with a customer. It might be appropriate to treat a single con- tract with a customer as two or more contracts when the single contract con- tains multiple elements that are priced independently. On the other hand, it might be appropriate to treat two or more separate contracts that are priced interdependently as a single contract.

2. Identify the separate performance obligations in the contract. Performance obligation is de! ned as “an enforceable promise (whether explicit or implicit) in a contract with a customer to transfer a good or service to the customer.” The entity must evaluate all of the goods and/or services promised in a contract to determine whether there are separate performance obligations.

3. Determine the transaction price. If material, the time value of money should be considered in determining the transaction price in a deferred payment contract. When future payments for goods or services are not ! xed in amount, the ex- pected value should be used to determine the transaction price. A probability- weighted approach should be used to adjust the transaction price to re" ect the customer’s credit risk. In effect, the customer’s credit risk affects how much, but not whether, revenue should be recognized.

4. Allocate the transaction price to the separate performance obligations. The transaction price should be allocated to the separate performance obligations in proportion to the stand-alone selling price of each element of the contract. When goods or services are not sold separately, the transaction price must be allocated to the separate performance obligations using a reasonable approach.

5. Recognize the revenue allocated to each performance obligation when the entity satis- ! es each performance obligation. An entity satis! es a performance obligation and recognizes revenue when control of a promised good or service is transferred to the customer. The general principle is that a customer obtains control of a good or service when the customer has the ability to direct the use of, and re- ceive the bene! t from, the good or service. For many revenue-generating trans- actions, transfer of control will occur at a speci! c point in time, often when the good or service is delivered to the customer. However, transfer of control also can occur over a period of time. In this latter case, use of a percentage- of-completion method to recognize revenue will be acceptable when certain conditions are met.

In mid-2013, the boards announced that if approved, the proposed revenue rec- ognition standard would not become effective until reporting periods beginning on or after January 1, 2017. Early application of the new standard would not be allowed.

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204 Chapter Five

FINANCIAL INSTRUMENTS

Current IFRS guidance for the ! nancial reporting of ! nancial instruments is located in the following three standards:

IAS 32, Financial Instruments: Presentation IAS 39, Financial Instruments: Recognition and Measurement IFRS 7, Financial Instruments: Disclosure

In addition, the IASB issued IFRS 9, Financial Instruments, in November 2009 to begin the process of replacing IAS 39; IFRS 9 becomes effective in 2015.

It should be noted that the adoption of IAS 39 met with considerable resistance in the European Union. The European Commission ultimately decided in 2004 to endorse IAS 39, but with exceptions. The Commission modi! ed the version of IAS 39 to be applied by publicly traded companies in the EU with respect to certain provisions on the use of a full fair value option and on hedge account- ing. According to the European Commission, these “carve-outs” are temporary, in effect only until the IASB modi! es IAS 39 in line with European requests. 2

Defi nitions IAS 32 de! nes a ! nancial instrument as any contract that gives rise to both a ! nan- cial asset of one entity and a ! nancial liability or equity instrument of another entity. A ! nancial asset is de! ned as any asset that is:

• Cash. • A contractual right

• to receive cash or another ! nancial asset. • to exchange ! nancial assets or ! nancial liabilities under potentially favorable

conditions. • An equity instrument of another entity. • A contract that will or may be settled in the entity’s own equity instruments and

is not classi! ed as an equity instrument of the entity.

Examples of ! nancial assets include cash, receivables, loans made to other enti- ties, investments in bonds and other debt instruments, and investments in equity instruments of other entities. Investments in equity instruments that are accounted for under the equity method (associates, joint ventures), or are consolidated [sub- sidiaries and special-purpose entities (SPEs)] do not fall within the scope of IAS 32 and IAS 39. Only those investments in equity instruments that result in less than signi! cant in" uence over the other entity (sometimes labeled as “marketable secu- rities”) are accounted for in accordance with IAS 32 and IAS 39.

A ! nancial liability is de! ned as:

• A contractual obligation • to deliver cash or another ! nancial asset. • to exchange ! nancial assets or ! nancial liabilities under potentially unfavor-

able conditions. • A contract that will or may be settled in the entity’s own equity instruments.

2 Ernst & Young, “The Evolution of IAS 39 in Europe,” Eye on IFRS Newsletter, November 2004, pp. 1–4.

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International Financial Reporting Standards: Part II 205

Examples of ! nancial liabilities include payables, loans from other entities (includ- ing banks), issued bonds and other debt instruments, and obligations to deliver the entity’s own shares for a ! xed amount of cash. Derivative ! nancial instruments also are ! nancial assets or ! nancial liabilities.

An equity instrument is de! ned as:

• Any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

Liability or Equity IAS 32 requires ! nancial instruments to be classi! ed as ! nancial liabilities or eq- uity or both in accordance with the substance of the contractual arrangement and the de! nitions of ! nancial liability and equity. If an equity instrument contains a contractual obligation that meets the de! nition of a ! nancial liability, it should be classi! ed as a liability even though its legal form is that of an equity instrument. For example, if an entity issues preferred shares that are redeemable by the share- holder and the entity cannot avoid the payment of cash to shareholders if they redeem their shares, the preferred shares should be accounted for as a liability. Preferred shares that are contingently redeemable based on future events outside the control of either the issuer or the shareholder also would be classi! ed as a ! nancial liability.

Example: Redeemable Preferred Shares On October 29, Year 1, Griglia Company issued $1,000,000 of 5 percent preferred shares at par value. The preferred shareholders have the right to force the com- pany to redeem the shares at par value if the Federal Reserve Bank interest rate rises above 5 percent. On December 10, Year 3, the Federal Reserve Bank interest rate reaches that level.

Because the future event that triggers redemption of the preferred shares is out- side the control of both the company and the shareholders, the 5 percent preferred shares must be classi! ed as a liability under IFRS. The journal entry to record issu- ance of the shares on October 29, Year 1, is:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000         Redeemable Preferred Shares Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000

Under U.S. GAAP, the preferred shares initially would be classi! ed as equity. On December 10, Year 3, when the event triggering redemption occurs, the preferred shares would be reclassi! ed as a liability.

Compound Financial Instruments If a ! nancial instrument contains both a liability element and an equity element, it is a compound ! nancial instrument and should be split into two components that are reported separately. This is referred to as “split accounting.” For example, a bond that is convertible into shares of common stock at the option of the bondholder is a compound ! nancial instrument. From the perspective of the issuer, the bond is comprised of two components:

1. A contractual obligation to make cash payments of interest and principal as long as the bond is not converted. This meets the de! nition of a ! nancial liability.

2. A call option that grants the bondholder the right to convert the bond into a ! xed number of common shares. This meets the de! nition of an equity instrument.

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206 Chapter Five

Under split accounting, the initial carrying amounts of the liability and eq- uity components are determined using what can be called the with-and-without method. The fair value of the ! nancial instrument with the conversion feature is determined (i.e., the selling price of the instrument). Then the fair value of the ! nancial instrument without the conversion feature is determined. This becomes the carrying amount of the ! nancial liability component. The difference between the fair value of the instrument as a whole and the amount separately determined for the liability component is allocated to the equity component. Note that a com- pound ! nancial instrument is a ! nancial asset for the holder of the instrument.

Example: Convertible Bonds Sharma Corporation issued $2 million of 4 percent convertible bonds at par value. The bonds have a ! ve-year life with interest payable annually. Each bond has a face value of $1,000 and is convertible at any time up to maturity into 250 shares of common stock. At the date of issue, the interest rate for similar debt without a conversion feature is 6 percent.

The fair value of the convertible bonds is their selling price of $2 million. The fair value of the liability is calculated using the prevailing interest rate for noncon- vertible bonds:

Present value of $2,000,000, n 5 5, i 5 6% . . . . . . . $2,000,000 3 0.7473 5 $1,494,516

Present value of ordinary annuity of $80,000, n 5 5, i 5 6% . . . . . . . . . . . . . . . . . . . . $80,000 3 4.2124 5 336,989

Fair value of liability . . . . . . . . . . . . . . . . . . . . . . . . . . $1,831,505

The present value of the bond at 6 percent is $1,831,505; this is the fair value of the liability component of the compound ! nancial instrument. The remain- ing $168,495 from the proceeds of the bond issuance is allocated to the equity component.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000,000         Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,831,505         Additional Paid-in Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168,495

Classifi cation of Financial Assets and Financial Liabilities IAS 39 establishes categories into which all ! nancial assets and liabilities must be classi! ed. The classi! cation of a ! nancial asset or ! nancial liability determines how the item will be measured. A ! nancial asset must be classi! ed into one of the following four categories:

• Financial assets at fair value through pro! t or loss (FVPL): This includes ! nancial assets that an entity either (1) holds for trading purposes or (2) has elected to classify into this category under the so-called fair value option (discussed in more detail later).

• Held-to-maturity investments: This category includes ! nancial assets with ! xed or determinable payments and ! xed maturity that the entity has the intention and ability to hold to maturity. If an entity sells or reclassi! es more than an in- signi! cant amount of held-to-maturity investments prior to maturity, the entity normally will be disquali! ed from using this classi! cation during the following two-year period. The entity’s intentions are said to be “tainted” in this case.

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International Financial Reporting Standards: Part II 207

• Loans and receivables: This includes ! nancial assets with ! xed or determinable payments that do not have a price that is quoted in an active market.

• Available-for-sale ! nancial assets: This category includes all ! nancial assets that (1) are not classi! ed in one of the other categories or (2) the entity has elected to classify as available-for-sale. Financial assets held for trading purposes may not be classi! ed as available-for-sale.

A ! nancial liability must be classi! ed as one of the following:

• Financial liabilities at fair value through pro! t or loss (FVPL): This includes ! nancial liabilities that are held for trading or that the entity has opted to classify into this category under the “fair value option.” An example of a liability held for trading is a debt instrument that the issuer intends to repurchase in the short term to make a gain from short-term changes in interest rates.

• Financial liabilities measured at amortized cost: This is the default category for most ! nancial liabilities, including accounts payables, notes payable, bonds payable, and deposits from customers.

Fair Value Option According to IAS 39, the option to designate ! nancial assets or ! nancial liabilities as FVPL may be applied only if one of the following conditions is met:

1. It eliminates or signi! cantly reduces a measurement or recognition inconsis- tency (sometimes referred to as “an accounting mismatch”) that would oth- erwise arise from measuring assets or liabilities or recognizing the gains and losses on them on different bases.

2. A group of ! nancial assets, ! nancial liabilities, or both that is managed and its performance is evaluated on a fair value basis, in accordance with a docu- mented risk management or investment strategy, and information about the group of instruments is provided internally on that basis to the entity’s key management personnel.

Example: Fair Value Option St. John’s Inc. issued $1,000 in 5 percent bonds at par value on January 1, Year 1. The cash proceeds were used to invest in $1,000 of corporate bonds (at a ! xed rate of 6 percent). The bond investment is classi! ed as FVPL. By year-end, interest rates have increased. As a result, the fair value of the investment in bonds is $900 and the fair value of the bonds payable is $900.

The bonds payable and investment in bonds are linked. As interest rates change, the economic loss on the asset will be offset by a gain on the liability, and vice versa. However, for accounting purposes, without a fair value option, there would be a mismatch because the bonds payable are carried at amortized cost and are not revalued, whereas the bond investment is classi! ed as FVPL and, therefore, is car- ried at fair value with gains/losses recognized in net income. The company would prepare the following journal entries in Year 1:

January 1

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000         Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000 Investment in Bonds (FVPL) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000         Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000

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208 Chapter Five

December 31

Interest Expense [$1,000 3 5%] . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50         Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60         Interest Income [$1,000 3 6%] . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60 Loss on Investment in Bonds [$1,000 − $900]. . . . . . . . . . . . . . . . . . . . . . . . . $100         Investment in Bonds (FVPL) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100

The company’s Year 1 income statement would report the following:

Interest income (expense), net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 10

Gain (loss) on fi nancial instruments, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (100) Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (90)

Under IAS 39, St. John’s may use the fair value option to designate the bonds payable as FVPL to remove the accounting mismatch. If the fair value option is used, both the asset and the liability will be measured at fair value with gains/ losses on both recognized in income. The company would prepare the following additional journal entry on December 31:

Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100         Gain on Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100

As a result, the company’s Year 1 income statement would re" ect the following:

Interest income (expense), net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 10 Gain (loss) on fi nancial instruments, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(10)

A net increase in income of $10 more accurately re" ects the economic substance of holding these two ! nancial instruments at the same time.

Transfers between Categories of Financial Assets and Financial Liabilities To reduce the ability to “manage earnings,” IAS 39 severely restricts the ability to reclassify ! nancial assets and liabilities. Financial instruments may not be reclas- si! ed into or out of the FVPL category. Reclassi! cation between the available-for- sale and held-to-maturity categories is possible, but as noted above, reclassi! cation of more than an insigni! cant amount of held-to-maturity investments results in a two-year ban on its use.

Measurement of Financial Instruments

Initial Measurement Financial assets and ! nancial liabilities are initially recognized on the balance sheet at their fair value, which normally will be equal to the amount paid or received. Except for FVPL assets and liabilities, transaction costs are capitalized as part of the fair value of a ! nancial asset or as a reduction in the fair value of a liability. Trans- action costs associated with FVPL assets and liabilities are expensed as incurred.

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International Financial Reporting Standards: Part II 209

Subsequent Measurement Subsequent to initial recognition, ! nancial assets and liabilities are measured using one of three values: (1) cost, (2) amortized cost, or (3) fair value. The only ! nancial asset measured at cost is an unquoted investment in equity instruments that can- not be reliably measured at fair value. This type of asset affects income only when dividends are received (dividend income is recognized) or the asset is sold (gain or loss is realized and recognized). Unrealized gains and losses are not recognized.

Three types of ! nancial assets and liabilities are measured at amortized cost: held-to-maturity investments, loans and receivables, and liabilities measured at amortized cost. Amortized cost is the cost of an asset or liability adjusted to achieve a constant effective interest rate over the life of the asset or liability. The effective interest rate is the internal rate of return of the cash " ows of the asset or liability. Equity investments cannot be measured at amortized cost because there are no ! xed cash " ows; therefore, there is no constant effective interest rate.

Three categories of ! nancial assets and liabilities normally are measured at fair value: (1) FVPL ! nancial assets, (2) FVPL ! nancial liabilities, and (3) available-for- sale ! nancial assets. The carrying amount of these items is adjusted to fair value at each balance sheet date. The unrealized gains and losses (changes in fair value) on FVPL assets and liabilities are recognized in net income. The unrealized gains and losses on available-for-sale ! nancial assets are deferred as a separate component of equity until they are realized (or impairment occurs).

IFRS 9 (effective January 1, 2015) IFRS 9, Financial Instruments, issued in November 2009, simpli! es the classi! cation of ! nancial assets into two categories:

1. Financial assets measured at amortized cost: Financial assets that are held with the objective to collect contractual cash " ows that are solely in the form of principal and interest.

2. Financial assets measured at fair value: All other ! nancial assets.

IFRS 9 does not affect the classi! cation of ! nancial liabilities.

Example: Financial Liabilities Measured at Amortized Cost (Bonds Payable) On January 1, Year 1, Keane Corp. issued $1,000,000 of 5 percent bonds at face value. The bonds pay interest annually and mature on December 31, Year 2. The company incurred bank and legal fees of $70,000 in conjunction with issuing the bonds.

Under IFRS, the debt issuance costs reduce the fair value of the liability. The fair value of the bonds payable at the date of issuance is $930,000 [$1,000,000 2 $70,000]. The entry to initially recognize the liability is:

January 1, Year 1

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $930,000         Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $930,000

Subsequent to initial recognition, the bonds payable are measured at amortized cost. The difference between the fair value of the bonds at the date of issuance and their face value is amortized to expense over the life of the bonds using the effec- tive interest rate method. The effective interest rate is 8.98 percent, calculated as the internal rate of return of the following stream of payments:

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210 Chapter Five

January 1, Year 1: Proceeds from debt issuance $930,000 December 31, Year 1: Interest payment [$1,000,000 3 5%] ($50,000) December 31, Year 2: Interest and principal payment ($1,050,000)

The following journal entries are made over the life of the bonds:

December 31, Year 1

    Interest Expense [$930,000 3 8.98%] . . . . . . . . . . . . . . . . . . . . . $83,496         Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50,000         Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,496

December 31, Year 2     Interest Expense [$963,496 3 8.98%] . . . . . . . . . . . . . . . . . . . . . $86,504         Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50,000         Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,504

Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000     Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   $1,000,000

Under U.S. GAAP, debt issuance costs are deferred as an asset and amortized on a straight-line basis over the life of the debt. Total expense in Year 1 and in Year 2 would be determined as follows:

Interest expense [$1,000,000 3 5%] . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50,000

Amortization of debt issuance costs [$70,000/2] . . . . . . . . . . . . . . . . . . . . . . . 35,000

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $85,000

Available-for-Sale Financial Asset Denominated in a Foreign Currency Financial assets classi! ed as available for sale are measured at fair value on each balance sheet date, with changes in fair value recognized as part of other compre- hensive income. When an entity holds an available-for-sale ! nancial asset that is denominated in a foreign currency, the asset’s fair value in foreign currency must be translated into fair value in the entity’s reporting currency. The change in fair value in the entity’s reporting currency is comprised of two components, which must be accounted for separately. The two components are (1) the change in fair value in the foreign currency and (2) a foreign exchange gain or loss from changes in the exchange rate over time. IAS 39 indicates that these components are deter- mined by treating the ! nancial asset as if it were carried at amortized cost in the foreign currency. The foreign exchange gain or loss resulting from changes in the translated value of the amortized cost of the asset is recognized in net income, and the remaining change in fair value on the available-for-sale ! nancial asset is recog- nized in other comprehensive income.

Example: Foreign Currency Financial Asset Classi! ed as Available- for- Sale On October 29, Year 1, Jacob Industries Inc., a U.S.-based company, purchased a Swiss treasury bond for 10,000 Swiss francs (CHF) when the exchange rate was $1.80 per Swiss franc. The bond investment has a cost of $18,000 [CHF 10,000 3 $1.80] and is classi! ed as available for sale. On December 31, Year 1, the bond has a fair

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International Financial Reporting Standards: Part II 211

value of 10,200 Swiss francs, and the exchange rate is $1.92 per Swiss franc. The bond investment now has a fair value of $19,584 [CHF 10,200 3 $1.92]. Jacob must determine how to account for the $1,584 [$19,584 − $18,000] increase in the U.S. dollar fair value of this ! nancial asset.

A foreign exchange gain or loss is recognized for the change in exchange rate applied to the amortized cost of the bond: CHF 10,000 3 ($1.92 2 $1.80) 5 $1,200 foreign exchange gain. The change in fair value in the foreign currency is then translated using the current exchange rate: (CHF 10,200 2 CHF 10,000) 3 $1.92 5 $384 fair value gain. The journal entry recorded at December 31, Year 1, is:

Investment in Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,584         Foreign Exchange Gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,200         Other Comprehensive Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 384

Impairment IAS 39 requires an entity, at each balance sheet date, to assess whether there is any objective evidence that a ! nancial asset is impaired. For available-for-sale equity investments, a signi! cant or prolonged decline in the fair value below the original cost is objective evidence of impairment. FVPL ! nancial assets are not subject to impairment testing because they already are measured at fair value, with unreal- ized gains and losses recognized in net income.

When an investment in a loan is determined to be impaired, the creditor writes down its ! nancial asset for the difference between (1) the investment in the loan (principal and interest) and (2) the expected future cash " ows discounted at the loan’s historical effective interest rate. If the loan is secured, the expected future cash " ows can be estimated as the fair value of the collateral securing the loan. The investment in the loan can be written down either directly or through an al- lowance account. The write-down is recognized as an impairment loss in net in- come. If in a subsequent period, the impairment loss decreases, the ! nancial asset (investment in loan) is written back up to what its carrying amount would have been if the impairment had not been recognized. The reversal of the impairment loss is recognized as a gain in net income. (Note that the counterparty debtor is not allowed to reduce the carrying amount of its ! nancial liability due to its inability to pay unless its contractual obligation has been legally reduced by the creditor.)

Derecognition Derecognition refers to the process of removing an asset or liability from the bal- ance sheet. Under IAS 39, derecognition of a ! nancial asset is appropriate if either of the following criteria is met:

1. The contractual rights to the cash " ows of the ! nancial asset have expired. 2. The ! nancial asset has been transferred and the transfer quali! es for derecogni-

tion based on an evaluation of the extent to which risks and rewards of owner- ship have been transferred.

Application of the second criterion is often complex. IAS 39, Appendix A, Ap- plication Guidance, provides a " owchart to be followed in evaluating whether a ! nancial asset may be derecognized.

IAS 39 also provides speci! c guidance with respect to a so-called pass-through arrangement, which is a contractual arrangement in which an entity continues to collect cash " ows from a ! nancial asset it holds, but immediately transfers those

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212 Chapter Five

payments to other parties. This arrangement can qualify for derecogniton of the ! nancial asset when certain conditions listed in IAS 39 are met. If a ! nancial asset meets the criteria for derecognition, its carrying amount is removed from the bal- ance sheet and any difference between that amount and consideration received, if any, is recognized as a gain or loss in net income. Application of IAS 39’s derecog- nition requirements to receivables is described in more detail later.

Derecognition of a ! nancial liability is appropriate only when the obligation is extinguished—that is, when the obligation is paid, canceled, or expired. The differ- ence between the carrying amount of the debt and the amount paid to extinguish it is recognized as a gain or loss in net income. Costs incurred in the extinguishment of debt are included as part of the gain or loss. A so-called troubled debt restructur- ing, in which a debtor is relieved of its obligation to the creditor due to ! nancial hardship, is treated as a debt extinguishment.

A substantial modi! cation of the terms of existing debt should be treated as an extinguishment of old debt and the issuance of new debt. A less-than-sub- stantial modi! cation of the terms of existing debt is not treated as an extinguish- ment, but instead the modi! cation is handled prospectively. An example would be the renegotiation of the interest rate on existing debt. Costs associated with a less-than-substantial debt modi! cation that is not treated as an extinguishment are subtracted from the carrying amount of the debt and are amortized over the remaining term of the debt.

Under U.S. GAAP, debt modi! cation costs are expensed as incurred. Debt ex- tinguishment costs also are expensed as incurred, except when new debt is issued for old debt, in which case the costs are deferred and amortized over the term of the new debt.

Example: Debt Extinguishment/Modi! cation Champaign Company issued $10 million in 12 percent bonds several years ago at a discount. The bonds currently have a carrying amount of $9.8 million. The bond agreement allows for early extinguishment by Champaign beginning in the cur- rent year. Champaign’s investment bank has arranged for the company to issue $10 million of new 10 percent bonds at face value to a group of European inves- tors. The proceeds will be used to extinguish the 12 percent bonds. The investment banking, legal, and accounting costs to execute the transaction total $400,000.

This is a debt extinguishment. The costs associated with issuing the new debt are re" ected in the calculation of the gain or loss on extinguishment of the old debt as follows:

Carrying amount of old debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,800,000

Fair value of new debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (10,000,000) Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (200,000) New debt issuance costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (400,000) Loss on extinguishment of old debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (600,000)

The debt extinguishment is recognized as follows:

Bonds Payable—12% (old debt) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,800,000 Loss on Extinguishment of 12% Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000         Bonds Payable—10% (new debt) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000,000         Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000

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International Financial Reporting Standards: Part II 213

Now assume the investment bank has negotiated a reduction in the interest rate with the 12 percent bondholder, who agrees to lower the interest rate to 10 percent based on current market conditions. Fees for the reduction in interest rate total $250,000. This is a less- than-substantial debt modi! cation. The costs incurred adjust the carrying amount of the debt and are amortized prospectively to interest expense over the remaining life of the bonds.

Bonds Payable—12% (now 10%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $250,000         Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $250,000

Derivatives Derivatives are ! nancial instruments such as options, forwards, futures, and swaps whose value changes in response to the change in a speci! ed interest rate, ! nancial instrument price, commodity price, foreign exchange rate, index, credit rating, or other variable. IFRS 39 requires derivatives to be measured at fair value. Whether the change in fair value over time is recognized in net income or deferred in stockholders’ equity (i.e., other comprehensive income) depends on whether the derivative is designated as a hedge or not, and if so, what kind of a hedge. If a derivative is not designated as a hedge, the change in fair value must be recog- nized in net income when the fair value change occurs.

Hedge accounting results in the change in fair value on the derivative being rec- ognized in net income in the same accounting period as gains and losses on the un- derlying hedged item are recognized in net income. Hedge accounting is optional and is only permitted when certain conditions are met. Similar to U.S. GAAP, IAS 39 identi! es three types of hedging relationships: (1) fair value hedge, (2) cash " ow hedge, and (3) hedge of a net investment in a foreign operation. We discuss fair value hedges and cash " ow hedges in the context of foreign currency risks in Chapter 7 and hedges of a net investment in a foreign operation in Chapter 8.

Receivables The accounting for receivables is governed by IAS 39, which identi! es “loans and receivables” as one of four categories of ! nancial assets. Receivables are measured initially at fair value. Subsequently, they are measured at amortized cost using an effective interest method.

Impairment of Receivables If there is objective evidence that receivables are impaired, a loss should be recog- nized. Individually signi! cant receivables should be tested for impairment indi- vidually. Individually insigni! cant receivables are assessed for impairment as a portfolio group. A bad debt loss and provision (allowance) for uncollectible receiv- ables is estimated. IAS 39 states that the loss should be measured as the difference between the carrying amount of the portfolio of receivables and the present value of future cash " ows expected to be received. Implementation guidance in IAS 39 suggests that the aging method of estimating the provision for uncollectible receivables is not appropriate.

Sale of Receivables When an entity sells receivables to a third party, there is a question as to whether the sale is truly a sale of an asset or simply a borrowing secured by the accounts receiv- able. In the former case, it is appropriate to recognize a sale and derecognize the receivables—that is, remove them from the accounting records. In the latter case,

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214 Chapter Five

the receivables are not derecognized and the transaction is accounted for as a bor- rowing. The general principle in IAS 39 is that a ! nancial asset may be derecognized when the signi! cant risks and rewards associated with ownership of the asset have been transferred to another entity. In some cases, the seller of receivables retains signi! cant risks, for example, by guaranteeing the collectibility of the receivables through right of recourse, and derecognition of the receivables is not appropriate. Instead, the cash received from the sale of receivables is treated as a loan payable.

A so-called pass-through arrangement exists when an entity retains the right to collect cash " ows from a receivable but is obligated to transfer those cash " ows to a third party. In this type of arrangement, derecognition is appropriate only if each of the following criteria is met:

1. The entity has no obligation to pay cash to the buyer of the receivables unless it collects equivalent amounts from the receivables.

2. The entity is prohibited by the terms of the transfer contract from selling or pledging the receivables.

3. The entity has an obligation to remit any cash " ows it collects on the receivables to the eventual recipient without material delay. In addition, the entity is not entitled to reinvest such cash " ows. An exception exists for investments in cash equivalents during the short settlement period from the collection date to the date of remittance to the eventual recipients, as long as interest earned on such investments also is passed to the eventual recipients.

The following excerpt from Fiat Group’s notes to the 2009 consolidated ! nan- cial statements demonstrates the impact of IAS 39’s derecognition requirements with respect to receivables:

At 31 December 2009, Current receivables include receivables sold and ! nanced through both securitization and factoring transactions of €6,588 million (€6,190 million at 31 December 2008) which do not meet IAS 39 derecognition requirements. These receivables are recognized as such in the Group ! nancial statements even though they have been legally sold; a corresponding ! nancial liability is recorded in the consoli- dated statement of ! nancial position as Asset-backed ! nancing (see Note 27).

Example: Derecognition of Receivables Edwards Inc. has receivables from unrelated parties with a face value of $1,000. Edwards transfers these receivables to Main Street Bank for $900, without recourse. The discount re" ects the fact that the bank has assumed the credit risk. Edwards will continue to collect the receivables, depositing them in a non-interest-bearing bank account with the cash " ows remitted to the bank at the end of each month. Edwards is not allowed to sell or pledge the receivables to anyone else and is under no obligation to repurchase the receivables from Main Street Bank.

This is a pass-through arrangement, and Edwards appears to meet the three cri- teria required for derecognition: (1) the company is under no obligation to pay any more than it collects, (2) it may not pledge or resell the receivables, and (3) it has agreed to remit the money collected in a timely manner. There is no interest earned on the short-term bank deposits, so there is no question whether Edwards passes on the interest to Main Street Bank. The receivables may be derecognized, as follows:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $900 Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100         Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000

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International Financial Reporting Standards: Part II 215

Now assume that Edwards collects the receivables and deposits collections in its interest-bearing bank account. At the end of each month, Edwards remits to Main Street Bank only the amount collected on the receivables; interest earned on the short-term deposits is retained by Edwards. Because Edwards retains the inter- est on short-term bank deposits, the third pass-through criterion has not been met. Edwards would not be allowed to derecognize the accounts receivable. Instead, the cash received from Main Street Bank would be treated as a secured borrowing.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $900 Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100         Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000

Summary 1. IAS 1 requires liabilities to be classi! ed as current or noncurrent. The classi! - cation and accounting for current liabilities under IFRS is very similar to U.S. GAAP. Differences relate to re! nancing short-term debt, amounts payable on demand due to debt covenant violations, and bank overdrafts.

2. IAS 37 de! nes a provision as a liability of uncertain timing or amount. A pro- vision is recognized when there is a present obligation that can be reliably estimated and for which it is probable (more likely than not) that an out" ow of resources will be made. U.S. GAAP has similar requirements but does not provide guidance for the degree of likelihood needed to meet the threshold of being probable.

3. A provision should be recognized for an onerous contract, which is a contract in which the unavoidable costs of ful! lling the contract exceed the bene! t ex- pected to be received. A provision should be recognized for a restructuring when an entity has created a constructive obligation—that is, when it has raised a valid expectation in those affected by the plan that it will carry out the restruc- turing. U.S. GAAP does not allow recognition of a restructuring until a liability has been incurred.

4. IFRS and U.S. GAAP differ in the accounting for de! ned post-retirement bene! t plans with respect to the periods of time over which past service cost and actu- arial gains and losses are recognized, and measurement of the amount of bene! t liability or asset reported on the balance sheet.

5. Under IAS 19, the amount reported on the balance sheet related to a de! ned post-employment bene! t plan is equal to the present value of the de! ned ben- e! t obligation (PVDBO) minus the fair value of plan assets minus unrecognized past service cost plus (minus) unrecognized actuarial gains (losses). Under U.S. GAAP, the amount recognized is PVDBO minus the fair value of plan assets.

6. IFRS 2 distinguishes between three types of share-based payments. Equity- settled share-based payments are treated as equity transactions; cash-settled and choice-of-settlement share-based payment transactions result in the recog- nition of a liability. The standard applies a fair value approach to all three types of share-based payment.

7. In a stock option plan that vests in installments, compensation cost associated with each installment is amortized over that installment’s vesting period under IFRS. This approach also is acceptable under U.S. GAAP, but a simpler straight- line method also may be used.

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216 Chapter Five

8. Similar to U.S. GAAP, IAS 12 uses an asset-and-liability approach that requires recognition of deferred tax assets and liabilities for temporary differences and for operating loss and tax credit carry-forwards. A deferred tax asset is recog- nized only if it is probable that a tax bene! t will be realized.

9. IFRS contain two standards speci! cally related to revenue recognition: IAS 18 and IAS 11. U.S. GAAP, on the other hand, has many more separate pieces of authoritative guidance that are now codi! ed in FASB Accounting Standards Codi! cation Topic 605. The IASB and FASB jointly issued an Exposure Draft in 2010, which was revised in 2011, with the intent to converge their rules with regard to revenue recognition.

10. IAS 18 provides general principles for the recognition and measurement of revenue generated from the sale of goods; rendering of services; and inter- est, royalties, and dividends. The general measurement principle is that rev- enue should be measured at the fair value of the consideration received or receivable.

11. Five conditions must be met before revenue may be recognized from the sale of goods, including the criterion that the signi! cant risks and rewards of own- ership of the goods have been transferred to the buyer.

12. IAS 18 allows use of the stage-of-completion method for recognition of service revenue when several criteria are met. This method of revenue recognition is not used for service transactions under U.S. GAAP.

13. Entities that use customer loyalty programs to provide customers with incen- tives to purchase their goods and services must treat the award credits as a separate component of the sale transaction and recognize a portion of the sales price as deferred revenue.

14. The accounting for ! nancial instruments is covered by IAS 32, IAS 39, IFRS 7, and IFRS 9 (which goes into effect in 2015). Financial instruments are contracts that give rise to both a ! nancial asset for one party and either a ! nancial li- ability or equity for another party.

15. IAS 32 requires ! nancial instruments to be classi! ed as ! nancial liabilities or equity or both in accordance with the substance of the contractual arrange- ment. If an equity instrument contains a contractual obligation that meets the de! nition of a ! nancial liability, it should be classi! ed as such. Preferred shares that are redeemable at the option of the shareholders are an example of a ! nancial liability.

16. Compound ! nancial instruments, such as convertible bonds, must be split into a liability element and an equity element. This so-called split accounting is not followed under U.S. GAAP.

17. IAS 39 establishes four categories of ! nancial assets and two categories of ! nancial liabilities; both categories include the classi! cation “at fair value through pro! t or loss” (FVPL). Financial assets and liabilities that otherwise would be classi! ed in a different category may be classi! ed as FVPL under certain conditions, such as to eliminate an accounting mismatch.

18. Financial assets and ! nancial liabilities are initially measured at their fair value. Subsequent to initial recognition, they are measured at one of three pos- sible values: (a) cost (unquoted equity investments), (b) amortized cost (loans and receivables, held-to-maturity investments, and liabilities measured at am- ortized cost), or (c) fair value (FVPL ! nancial assets, FVPL ! nancial liabilities, and available-for-sale ! nancial assets).

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International Financial Reporting Standards: Part II 217

19. Under IFRS, costs associated with the issuance or modi! cation of debt are sub- tracted in determining the carrying amount of the related liability. These costs are then allocated over the life of the debt as part of interest expense. Under U.S. GAAP, debt issuance costs are treated as an asset that is amortized over the life of the debt, and debt modi! cation costs are expensed immediately.

20. According to IAS 39, the sale of receivables can be recognized as such and the receivables may be derecognized only if the signi! cant risks and rewards from owning the receivables are transferred to the buyer. If this is not the case, the sale of receivables is treated as a borrowing with the accounts receivable act- ing as collateral.

Questions Answer questions based on IFRS unless indicated otherwise. 1. What is a provision, and when must a provision be recognized? 2. What is a contingent liability? What is the ! nancial reporting treatment for

contingent liabilities? 3. What is a constructive obligation? 4. What is an onerous contract? How are onerous contracts accounted for? 5. How does a company measure the net pension bene! t liability (asset) to report

on the balance sheet under IFRS and U.S. GAAP? 6. In accounting for post-employment bene! ts, when are past service costs and

actuarial gains and losses recognized in income? 7. What is the basis for determining compensation cost in an equity-settled

share-based payment transaction with nonemployees? With employees? 8. What is the difference in measuring compensation expense associated with

stock options that vest on a single date (cliff vesting) and in installments (graded vesting)?

9. How does an entity account for a choice-of-settlement share-based payment transaction?

10. Which income tax rates should be used in accounting for income taxes? 11. What are the rules related to the recognition of a deferred tax asset? 12. What approaches are available for disclosing the relationship between tax

expense and accounting pro! t? 13. How are deferred taxes classi! ed on the balance sheet? 14. What are the criteria that must be met in order to recognize revenue from the

sale of goods? 15. What approaches are used to recognize revenue from the rendering of ser-

vices? Under what conditions is each of these approaches used? 16. How is an exchange of goods that are similar in nature and value accounted

for? 17. Under what conditions may revenue be recognized on a “bill-and-hold” sale? 18. What is a customer loyalty program, and how is such a program accounted

for? 19. What are the ! ve steps to follow in revenue recognition as proposed in the

IASB/FASB Exposure Draft on revenue from contracts with customers?

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218 Chapter Five

20. What are the four classes of ! nancial assets? 21. Under what conditions should preferred shares be recognized as a liability on

the balance sheet? 22. How are convertible bonds measured initially on the balance sheet? 23. How can use of the “fair value option” solve the problem of an accounting

mismatch? 24. What happens if a signi! cant amount of held-to-maturity investments is

reclassi! ed as available- for-sale? 25. How are costs associated with the issuance of bonds payable accounted for? 26. What is the accounting treatment for debt extinguishment costs? Debt modi! -

cation costs? 27. In a sale of receivables described as a pass-through arrangement, under what

conditions can receivables be derecognized?

Exercises and Problems

Solve exercises and problems based on IFRS unless indicated otherwise.

1. Halifax Corporation has a December 31 ! scal year-end. As of December 31, Year 1, the company has a debt covenant violation that results in a 10-year note pay- able to Nova Scotia Bank becoming due on March 1, Year 2. Halifax will be re- quired to classify the 10-year note payable as a current liability unless it obtains a waiver from the bank a. Prior to issuance of its Year 1 ! nancial statements that gives the company

until January 1, Year 3, to rectify the debt covenant violation. b. Prior to December 31, Year 1, that gives the company until January 1, Year 3,

to rectify the debt covenant violation. c. Prior to issuance of its Year 1 ! nancial statements, that gives the company

until June 30, Year 2, to rectify the debt covenant violation. d. Prior to December 31, Year 1, that gives the company until June 30, Year 2, to

rectify the debt covenant violation.

2. Bull Arm Company has the following items at December 31, Year 1: • $200,000, 5 percent note payable, due March 15, Year 2. The company has

reached an agreement with the bank to re! nance the note for two years, but the re! nancing has not yet been completed.

• $1,000,000, 4 percent bonds payable, due December 31, Year 5. The company has violated an agreement with the bondholders to maintain a minimum bal- ance in retained earnings, which causes the bonds to come due on January 31, Year 2.

• $50,000 overdraft on a bank account. Overdrafts are a normal part of the company’s cash management plan.

Required: Related to these items, what amount should Bull Arm Company report as cur- rent liabilities on its December 31, Year 1, balance sheet? a. $50,000. b. $250,000. c. $1,050,000. d. $1,200,000.

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International Financial Reporting Standards: Part II 219

3. Melbourne Inc. became involved in a tax dispute with the national tax author- ity. Melbourne’s legal counsel indicates that there is a 70 percent likelihood that the company will lose this dispute and estimates that the amount the company will have to pay is between $500,000 and $700,000, with all amounts in that range being equally likely. What amount, if any, should Melbourne recognize as a provision related to this tax dispute? a. $0. b. $500,000. c. $600,000. d. $700,000.

4. Which of the following is not a criterion that must be met before an entity rec- ognizes a provision related to a restructuring program? a. The entity has a detailed formal plan for the restructuring. b. The entity has begun implementation of the restructuring. c. The restructuring plan indicates that the restructuring will be carried out in

a reasonable period of time. d. The cost of the restructuring is reasonably estimable.

5. Past service cost related to nonvested employees should be recognized as expense a. In the period the cost is incurred. b. Over the nonvested employees’ remaining vesting period. c. Over the nonvested employees’ estimated remaining working life. d. Over the nonvested employees’ estimated life expectancy.

6. When stock options are granted to employees, what is the basis for de- termining the amount of compensation cost that will be recognized as expense? a. The fair value of the service provided by the employees receiving the options

at the grant date. b. The fair value of the stock options at the exercise date. c. The fair value of the stock options at the grant date. d. There is no recognition of expense related to stock options.

7. Which of the following types of share-based payment (SBP) transactions always results in the recognition of a liability? a. Equity-settled SBP transaction with employees. b. Equity-settled SBP transaction with nonemployees. c. Cash-settled SBP transaction with employees. d. Choice-of-settlement SBP transaction in which the entity chooses the form of

settlement.

8. Sandoval Company operates in a country in which distributed pro! ts are taxed at 25 percent and undistributed pro! ts are taxed at 30 percent. In Year 1, Sandoval generated pre-tax pro! t of $100,000 and paid $20,000 in divi- dends from its Year 1 earnings. In Year 2, Sandoval generated pre-tax pro! t of $120,000 and paid dividends of $40,000 from its Year 1 earnings. What amounts should Sandoval recognize as current tax expense in Years 1 and 2, respectively?

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220 Chapter Five

a. $29,000 and $34,000. b. $30,000 and $34,000. c. $25,000 and $30,000. d. $30,000 and $36,000.

9. Which of the following is not a criterion that must be met to recognize revenue from the sale of goods? a. The amount of revenue can be measured reliably. b. The signi! cant risks and rewards of ownership of the goods have been

transferred to the buyer. c. The costs incurred or to be incurred with respect to the sale of the goods can

be measured reliably. d. It is certain that the economic bene! ts associated with the sale will " ow to

the seller.

10. Manometer Company sells accounts receivable of $10,000 to Eck Bank for $9,000 in cash. The sale does not qualify for derecognition of a ! nancial asset. As a result, Manometer’s balance sheet will be different in which of the follow- ing ways? a. $1,000 more in assets than under derecognition. b. $9,000 more in assets than under derecognition. c. $9,000 more in liabilities than under derecognition. d. $10,000 less in equity than under derecognition.

11. Sinto Bem Company issues a two-year note paying 5 percent interest on January 1, Year 1. The note sells for its par value of $1,000,000, and the com- pany incurs issuance costs of $22,000. Which of the following amounts best approximates the amount of interest expense Sinto Bem will recognize in Year 1 related to this note? a. $48,900. b. $50,000. c. $58,680. d. $60,670.

12. Costs incurred to accomplish a less- than-substantial debt modi! cation, such as an interest rate adjustment, are treated in which of the following ways? a. Expensed immediately. b. Increase the carrying amount of the debt that has been modi! ed. c. Decrease the carrying amount of the debt that has been modi! ed. d. Decrease the gain on the debt modi! cation.

13. On December 31, Year 1, Airways Corp. issued $1 million in bonds at 5 percent annual interest, due December 31, Year 6, at a discount of $100,000. Airways incurred bank fees of $100,000, legal fees of $50,000, and salaries of $25,000 for its employees in conjunction with issuing the bonds. What is the original car- rying amount for these bonds? a. $725,000. b. $750,000. c. $850,000. d. $900,000.

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International Financial Reporting Standards: Part II 221

14. In Year 1, Better Sleep Company began to receive complaints from physicians that patients were experiencing unexpected side effects from the company’s sleep apnea drug. The company took the drug off the market near the end of Year 1. During Year 2, the company was sued by 1,000 customers who had had a severe allergic reaction to the company’s drug and required hospitalization. At the end of Year 2, the company’s attorneys estimated a 60 percent chance the company would need to make payments in the range of $1,000 to $5,000 to settle each claim, with all amounts in that range being equally likely. At the end of Year 3, while none of the cases had been resolved, the company’s attorneys now estimated an 80 percent probability the company would be required to make payments in the range of $2,000 to $7,000 to settle each claim. In Year 4, 400 claims were settled at a total cost of $1.2 million. Based on this experi- ence, the company believes 30 percent of the remaining cases will be settled for $3,000 each, 50 percent will be settled for $5,000, and 20 percent will be settled for $10,000.

Required: Prepare journal entries for Years 1–4 related to this litigation.

15. On June 1, Year 1, Charley Horse Company entered into a contract with Good Feed Company to purchase 1,000 bales of organic hay on January 30, Year 2, at a price of $30 per bale. The hay will be grown especially for Charley Horse and is needed to feed the company’s herd of buffalos. On December 1, Year 1, Charley Horse sells its herd of buffalos. As a result, the company no longer has a need for the organic hay that will be delivered on January 30, Year 2, and the company does not believe it will be able to sell the hay to a third party. Charley Horse is able to cancel the contract with Good Feed for a cancellation fee of $20,000.

Required: Determine what accounting entries, if any, Charley Horse Company should make on December 31, Year 1, related to the contract to purchase 1,000 bales of hay on January 30, Year 2.

16. The board of directors of Chestnut Inc. approved a restructuring plan on November 1, Year 1. On December 1, Year 1, Chestnut publicly announced its plan to close a manufacturing division in New Jersey and move it to China, and the company’s New Jersey employees were noti! ed that their jobs would be eliminated. Also on December 1, Year 1, to ensure an orderly transition, management promised a termination bonus of $10,000 to any employee who remains with the company until his or her position is terminated in the fourth quarter of Year 2. Chestnut estimates it will pay termination bonuses to 120 employees at the end of Year 2, for a total of $1,200,000. The present value of the estimated termination bonus is $1,000,000.

Required: Determine the provision that should be recognized for Chestnut’s restructur- ing plan. Identify the dates on which journal entries should be made and the amounts to be recorded.

17. The Kissel Trucking Company Inc. has a de! ned bene! t pension plan for its employees. At December 31, Year 1, the following information is available regarding Kissel’s plan:

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222 Chapter Five

Fair value of plan assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $30,000,000 Present value of defi ned benefi t obligation . . . . . . . . . . . . . . . . . . . . . . . 38,000,000 Service costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000,000 Interest costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200,000 Actuarial gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 Past service costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375,000

Required: Determine the amount that Kissel will report on the balance sheet as of December 31, Year 1, for this pension plan under IFRS.

18. On January 1, Year 1, the Hoverman Corporation made amendments to its de- ! ned bene! t pension plan, resulting in $150,000 of past service costs. The plan has 100 active employees with an average expected remaining working life of 10 years. There currently are no retirees under the plan.

Required: Determine the amount of past service costs to be amortized in Year 1 and sub- sequent years under (a) IFRS and (b) U.S. GAAP.

19. The Baton Rouge Company compiled the following information for the cur- rent year related to its de! ned bene! t pension plan:

Present value of defi ned benefi t obligation, beginning of year . . . . . . . . . $1,000,000 Fair value of plan assets, beginning of year . . . . . . . . . . . . . . . . . . . . . . . 800,000 Service cost, current year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 Actuarial gain, current year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 Actual return on plan assets, current year . . . . . . . . . . . . . . . . . . . . . . . . 55,000 Effective yield on high-quality corporate bonds, current year . . . . . . . . . . 5%

Required: Determine the amount of de! ned bene! t cost for the current year to be re- ported in (a) net income and (b) other comprehensive income.

20. White River Company has a de! ned bene! t pension plan in which the fair value of plan assets (FVPA) exceeds the present value of de! ned bene! t obliga- tions (PVDBO). The following information is available at December 31, Year 1 (amounts in millions):

PVDBO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,200

FVPA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,700

Because the FVPA exceeds the PVDBO, White River will be able to reduce future contributions to the plan for several years. The present value of reduc- tions in future contributions is $100 million.

Required: Determine the amount at which White River Company will report a de! ned pension bene! t asset on its December 31, Year 1, balance sheet under (a) IFRS and (b) U.S. GAAP.

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International Financial Reporting Standards: Part II 223

21. On January 2, Year 1, Argy Company’s board of directors granted 12,000 stock options to a select group of senior employees. The requisite service period is three years, with one-third of the options vesting at the end of each calendar year (graded vesting). An option-pricing model was used to calculate a fair value of $5 for each option on the grant date. The company assumes all 12,000 options will vest (i.e., there will be no forfeitures).

Required: Determine the amount to be recognized as compensation expense in Year 1, Year 2, and Year 3 under (a) IFRS and (b) U.S. GAAP. Prepare the necessary journal entries.

22. SC Masterpiece Inc. granted 1,000 stock options to certain sales employees on January 1, Year 1. The options vest at the end of three years (cliff vesting) but are conditional upon selling 20,000 cases of barbecue sauce over the three-year service period. The grant-date fair value of each option is $30. No forfeitures are expected to occur. The company is expensing the cost of the options on a straight-line basis over the three-year period at $10,000 per year (1,000 options 3 $30 4 3 5 $10,000).

On January 1, Year 2, the company’s management believes the original sales target of 20,000 units will not be met because only 5,000 cases were sold in Year 1. Management modi! es the sales target for the options to vest to 15,000 units, which it believes is reasonably achievable. The fair value of each option at January 1, Year 2, is $28.

Required: Determine the amount to be recognized as compensation expense in Year 1, Year 2, and Year 3 under (a) IFRS and (b) U.S. GAAP. Prepare the necessary journal entries.

23. Updike and Patterson Investments Inc. (UPI) holds equity investments with a cost basis of $250,000. UPI accounts for these investments as available-for- sale securities. As such, the investments are carried on the balance sheet at fair value, with unrealized gains and losses reported in other comprehensive income.

At the end of Year 1, the fair value of these investments has declined to $220,000. Consequently, UPI reports an unrealized loss for ! nancial reporting purposes of $30,000 in other comprehensive income, which creates a tempo- rary tax difference. As of December 31, Year 1, UPI management determines that it is more likely than not that the company will be able to deduct capital losses on these investments for tax purposes if they are realized.

As of December 31, Year 2, UPI management evaluates its assessment of tax position and determines that it is more likely than not that the company will not be able to take a deduction for any capital loss on these investments. UPI’s tax rate is 40 percent.

Required: Prepare journal entries to account for income taxes in Year 1 and Year 2.

24. Gotti Manufacturing Inc., a U.S.-based company, operates in three countries in addition to the United States. The following table reports the company’s pre- tax income and the applicable tax rate in these countries for the year ended December 31, Year 1. Gotti does not have any temporary tax differences, but it does have two permanent differences: (1) nontaxable municipal bond interest

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224 Chapter Five

of $20,000 in the United States and (2) nondeductible expenses of $5,000 in the United States.

Country Pre-tax Income

Applicable Tax Rate

United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,450,000 35%

Country One . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000 40%

Country Two . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000 20%

Country Three . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000 25%

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,950,000

Permanent differences . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

Book income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,965,000

Required: Prepare the numerical reconciliation between tax expense and accounting pro! t that would appear in Gotti’s income tax note in the Year 1 ! nancial statements. Show two different ways in which this reconciliation may be presented.

25. Mishima Technologies Company introduced Product X to the market on December 1. The new product carries a one-year warranty. In its ! rst month on the market, Mishima sold 1,000 units of the new product for a total of $1,000,000. Customers have an unconditional right of return for 90 days if they are not completely satis! ed with the product. During the month of December, customers returned 200 units of the new product that they had purchased for $200,000.

Required: Determine when it would be appropriate for Mishima Technologies Company to recognize revenue from the December sales of the new product.

26. Ultima Company offers its customers discounts to purchase goods and take title before they actually need the goods. The company offers to hold the goods for the customers until they request delivery. This relieves the customers from making room in their warehouses for merchandise not yet needed. The goods are on hand and ready for delivery to the buyer at the time the sale is made. Ultima Company pays the cost of storage and insurance prior to shipment. Customers are billed at the time of sale and are given the normal credit period (90 days) to pay.

Required: Determine whether Ultima Company should recognize revenue from the sale of goods at the time title passes to the customer or whether it should defer revenue recognition until the goods are delivered to the customer.

27. The Miller-Porter Company sells powder coating equipment at a sales price of $50,000 per unit. The sales price includes delivery, installation, and initial test- ing of the equipment, as well as a monthly service call for one year in which a technician checks to make sure that the equipment is working properly and makes adjustments as needed. After the ! rst year, customers are given the

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International Financial Reporting Standards: Part II 225

opportunity to enter into an extended service agreement; Miller-Porter prices these extended service agreements to earn an expected gross pro! t of 50 per- cent. Given the wages paid to technicians and the time required to make a service call, the company estimates that the cost of providing each monthly service call is $200.

Required: Develop a revenue recognition policy consistent with IAS 18 for The Miller- Porter Company for its sales of power coating equipment.

28. Cypress Company enters into a ! xed-fee contract to provide architectural ser- vices to the Gervais Group for $240,000. The Gervais Group, which will make monthly payments of $40,000, is a new client for Cypress Company. Cypress has agreed to provide Gervais with plans and drawings for a new manufac- turing facility that will qualify for a LEED (Leadership in Energy and Envi- ronmental Design) green building certi! cation. Cypress has no experience in designing green buildings, but it has guaranteed Gervais that the plans and drawings will be completed in six months.

Required: Evaluate whether it would be appropriate for Cypress Company to account for its contract with Gervais Group on a stage-of-completion basis.

29. Phil’s Sandwich Company sells sandwiches at several locations in the north- eastern part of the country. Phil’s customers receive a card on their ! rst visit that allows them to receive one free sandwich for every eight sandwiches purchased in a three-month period. Customers must redeem their cards in the month after the three-month period is completed. Each time a customer purchases a sandwich, his or her card is stamped. Past experience shows that only 50 percent of customers accumulate enough stamps within a three-month period to qualify for a free sandwich, and only 80 percent of those customers actually redeem their card to receive a free sandwich. In the ! rst quarter of the current year, Phil’s sold 12,000 sandwiches at an average price of $7.00. Phil’s only accepts payment in cash.

Required: Prepare the summary journal entry Phil’s Sandwich Company should make to recognize revenue from the sale of sandwiches for the ! rst quarter of the current year.

30. Saffron Enterprises Inc., a U.S.-based company, purchases a 4 percent bond denominated in euros for $1,500 on January 1, Year 1, when the exchange rate is $1.50 per euro. (In other words, the purchase price was 1,000 euros.) The bond was purchased at par value. At December 31, Year 1, the fair value of the bond in the marketplace is 1,050 euros and the exchange rate is $1.40 per euro. Saffron classi! es its investment in bonds as available for sale.

Required: Prepare the journal entries that Saffron Enterprises should record in Year 1 related to its investment in euro-denominated bonds.

31. On January 1, Year 1, Spectrum Fabricators Inc. issues $20 million of convert- ible bonds at par value. The bonds have a stated annual interest rate of 6 per- cent, pay interest annually, and come due December 31, Year 5. The bonds

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226 Chapter Five

are convertible at any time after issuance at the rate of 10 shares of common stock for each $1,000 of the face value of the convertible bonds. Issuance costs total $100,000. The current market interest rate for nonconvertible bonds is 8 percent.

Required: Prepare the journal entries to record the issuance of the convertible bonds (round to the nearest dollar). Determine the amount of expense related to the convertible bonds that the company should recognize each year (round to the nearest dollar). [Note: You will need to calculate the effective interest rate on the bonds to determine interest expense. One way to do this is to solve for the internal rate of return (IRR) of the cash " ows using Excel.]

32. The Bockster Company issues $20 million of preferred shares on January 1, Year 1, at par value. The preferred shares have a 5 percent ! xed annual cash dividend.

Part A. The preferred shareholders have the option to redeem the preferred shares for cash equal to par value any time after January 1, Year 2.

Required: Discuss how Bockster should account for these redeemable preferred shares.

Part B. The preferred shareholders do not have the option to redeem the pre- ferred shares, but instead have the option to convert the preferred shares into a ! xed number of shares of common stock any time after January 1, Year 2.

Required: Discuss how Bockster should account for these convertible preferred shares.

33. On January 1, Year 1, Tempe extinguishes $10 million of 10 percent bonds pay- able due December 31, Year 2, that were originally issued at a discount by calling them at par value. The current carrying amount of the bonds payable is $9,950,000. To ! nance the debt extinguishment, management issues new debt at par with a new lender in the amount of $10 million. The new debt matures on December 31, Year 2, and has a 9 percent annual interest rate. Management incurs $100,000 in legal costs to negotiate the issuance of the new long-term bonds payable.

Required: Prepare the journal entries to record the extinguishment of the debt and inter- est expense for Year 1.

34. Five years ago, Macro Arco Corporation (MAC) borrowed $12 million from Friendly Neighbor Bank (FNB) to ! nance the purchase of a new factory to be able to meet an expected increase in demand for its products. The ex- pected increase in demand never materialized, and due to a downturn in the economy, MAC is no longer able to make its monthly payments to FNB. After a lengthy negotiation process, which cost MAC $50,000 in legal fees, MAC will transfer the factory to the bank, along with a cash payment of $1.5 mil- lion. This will discharge MAC from the debt. The carrying amount and fair value of the factory is $8 million, and the current balance due to the bank is $10 million.

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International Financial Reporting Standards: Part II 227

Required: Prepare the journal entries to be recorded by MAC and FNB related to this troubled debt restructuring.

35. On November 1, Year 1, Farley Corporation sells receivables due in six months with a carrying amount of $100,000 to Town Square Bank for a cash payment of $95,000, subject to full recourse. Under the right of recourse, Farley Cor- poration is obligated to compensate Town Square Bank for the failure of any debtor to pay when due. In addition to the recourse, Town Square Bank is entitled to sell the receivables back to Farley Corporation in the event of unfa- vorable changes in interest rates or credit rating of the underlying debtors.

Required: Determine the appropriate accounting by Farley Corporation for the sale of receivables. Prepare any necessary journal entries for Year 1.

36. On December 1, Year 1, Traylor Company sells $100,000 of short-term trade receivables to Main Street Bank for $98,000 in cash by guaranteeing to buy back the ! rst $15,000 of defaulted receivables. Traylor’s historic rate of noncol- lection on receivables is 5 percent. Traylor noti! es the customers affected that they should make payment on their accounts directly to Main Street Bank.

Required: Determine whether the sale of receivables by Traylor Company quali! es for derecognition.

37. The Campolino Company has a de! ned bene! t post-retirement health-care plan for its employees. To fund the plan, Campolino makes an annual cash contribution to a health-care bene! t fund on December 31 of each year. At the beginning of Year 5, Campolino amended the plan to provide additional ben- e! ts to all employees. Assume that the health-care bene! t fund pays bene! ts to employees on December 31 of each year.

The following facts apply to the plan for the year ended December 31, Year 5:

Present value of defi ned benefi t obligation (PVDBO) on January 1 . . . . . . . . $650,000 Plan assets at fair value (FVPA) on January 1 . . . . . . . . . . . . . . . . . . . . . . . . . 420,000 Service cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46,000 Past service cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000 Actual return on plan assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,000 Employer cash contribution to post-retirement benefi t fund . . . . . . . . . . . . . 50,000 Benefi t paid by post-retirement benefi t fund . . . . . . . . . . . . . . . . . . . . . . . . 42,000 Discount rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 percent Plan assets at fair value (FVPA) on December 31 . . . . . . . . . . . . . . . . . . . . . . 456,000

Required: Use the following template to determine the post-retirement de! ned bene! t cost to be recognized in (a) net income and (b) other comprehensive income for the year ended December 31, Year 5, and the post-retirement de! ned ben- e! t liability (asset) at December 31, Year 5, to be reported by Campolino Com- pany under IFRS. Prepare a summary journal entry to re" ect the recognition of these amounts.

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228 Chapter Five

(Amounts in parentheses represent credits.)

Campolino Company

General Ledger Benefi t Fund

General Ledger

Defi ned benefi t cost recognized

in net income

Defi ned benefi t cost

recognized in OCI Cash

Defi ned benefi t asset

(liability) PVDBO FVPA

Balance at January 1 $(230,000) $(650,000) $420,000

Service cost

Interest expense

Interest income

Net interest

Excess of actual return on plan assets over interest income

Past service costs

Actuarial loss

Contributions

Benefi ts paid

Balance at December 31 $456,000

38. This problem consists of two parts.

Part A. On January 1, Year 1, Stone Company issued 100 stock options with an exercise price of $38 each to 10 employees (1,000 options in total). The em- ployees can choose to settle the options either (a) in shares of stock ($1 par value) or (b) in cash equal to the intrinsic value of the options on the vesting date. The options vest on December 31, Year 3, after the employees have com- pleted three years of service. Stone Company expects that only seven employ- ees will remain with the company for three years and vest in the options. Two employees resign in Year 1, and the company continues to assume an overall forfeiture rate of 30 percent at December 31, Year 1. In Year 2, one more em- ployee resigns. As expected, seven employees vest on December 31, Year 3, and exercise their stock options.

The following represents the share price and fair value at the relevant dates:

Date Share Price

Fair Value of Cash Alternative

Fair Value of Stock Alternative

January 1, Year 1 . . . . . . . . . . . . . . $43 $6.00 $6.00

December 31, Year 1, Year 2 . . . . . $45 $8.00 $8.00

December 31, Year 3 . . . . . . . . . . . $47 $9.00 $9.00

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International Financial Reporting Standards: Part II 229

Required: Determine the fair value of the stock options at the grant date and the amount to be recognized as compensation expense in Year 1, Year 2, and Year 3. Pre- pare journal entries assuming that the vested employees choose (a) the cash alternative and (b) the stock alternative.

Part B. Now assume that if the employees choose to settle the stock options in shares of stock, the employees receive a 10 percent discount on the exercise price (i.e., the exercise price would be $34.20). As a result, the fair value of the share alternative on the grant date is $8.80.

Required: Determine the fair value of the stock options at the grant date and the amount to be recognized as compensation expense in Year 1.

39. Indicate whether each of the following describes an accounting treatment that is acceptable under IFRS, U.S. GAAP, both, or neither by checking the appro- priate box.

Acceptable Under

IFRS U.S. GAAP Both Neither

• Bank overdrafts are netted against cash rather than being recognized as a liability when overdrafts are a normal part of cash management.

• Uncertain legal obligations, but not constructive obligations, contingent upon a future event are recognized as liabilities when certain criteria are met.

• A defi ned benefi t pension liability is measured as the excess of the present value of the defi ned benefi t obligation (PVDBO) over the fair value of plan assets (FVPA).

• Actuarial gains and losses in a defi ned benefi t pension plan are amor- tized to net income over a period of time.

• The compensation cost associated with graded-vesting stock options is amortized to expense on a straight-line basis over the vesting period.

• The minimum amount recognized as compensation expense on a stock option plan is the compensation cost as measured at the grant date, even if a subsequent modifi cation to the plan decreases the total compensation cost.

• Deferred taxes are classifi ed as current or noncurrent based on the classifi cation of the related asset or liability.

• The stage-of-completion method is used to recognize revenue from service transactions when specifi ed criteria are met.

• Nonredeemable preferred shares are classifi ed as a liability on the balance sheet.

• Costs associated with the issuance of debt are amortized on a straight-line basis over the life of the debt.

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230 Chapter Five

Case 5-1

S. A. Harrington Company S. A. Harrington Company is a U.S.-based company that prepares its consoli- dated ! nancial statements in accordance with U.S. GAAP. The company reported income in 2015 of $5,000,000 and stockholders’ equity at December 31, 2015, of $40,000,000.

The CFO of S. A. Harrington has learned that the U.S. Securities and Exchange Commission is considering requiring U.S. companies to use IFRS in preparing consolidated ! nancial statements. The company wishes to determine the impact that a switch to IFRS would have on its ! nancial statements and has engaged you to prepare a reconciliation of income and stockholders’ equity from U.S. GAAP to IFRS. You have identi! ed the following ! ve areas in which S. A. Harrington’s accounting principles based on U.S. GAAP differ from IFRS.

1. Restructuring 2. Pension plan 3. Stock options 4. Revenue recognition 5. Bonds payable

The CFO provides the following information with respect to each of these accounting differences.

Restructuring Provision The company publicly announced a restructuring plan in 2015 that created a valid expectation on the part of the employees to be terminated that the company will carry out the restructuring. The company estimated that the restructuring would cost $300,000. No legal obligation to restructure exists as of December 31, 2015.

Pension Plan In 2013, the company amended its pension plan, creating a past service cost of $60,000. The past service cost was attributable to already vested employees who had an average remaining service life of 15 years. The company has no retired employees.

Stock Options Stock options were granted to key of! cers on January 1, 2015. The grant date fair value per option was $10, and a total of 9,000 options were granted. The options vest in equal installments over three years: one-third vest in 2014, one-third in 2015, and one-third in 2016. The company uses a straight-line method to recognize compensation expense related to stock options.

Revenue Recognition The company entered into a contract in 2015 to provide engineering services to a long-term customer over a 12-month period. The ! xed price is $250,000, and the company estimates with a high degree of reliability that the project is 30 percent complete at the end of 2015.

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International Financial Reporting Standards: Part II 231

Bonds Payable On January 1, 2014, the company issued $10,000,000 of 5 percent bonds at par value that mature in ! ve years on December 31, 2018. Costs incurred in issuing the bonds were $500,000. Interest is paid on the bonds annually.

Required Prepare a reconciliation schedule to reconcile 2015 net income and December 31, 2015, stockholders’ equity from a U.S. GAAP basis to IFRS. Ignore income taxes. Prepare a note to explain each adjustment made in the reconciliation schedule.

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232

Chapter Six

Comparative Accounting Learning Objectives

After reading this chapter, you should be able to

• Describe some aspects of the environment in which accounting operates in fi ve countries: China, Germany, Japan, Mexico, and the United Kingdom.

• Explain the nature of the accounting profession in the selected countries. • Discuss the mechanisms in place for regulating accounting and fi nancial reporting

in the selected countries. • Examine some of the accounting principles and practices used by companies in

these countries. • Identify the areas where national accounting practices in these countries differ

from International Financial Reporting Standards (IFRS).

INTRODUCTION

This chapter describes the accounting environments in ! ve countries: China, Germany, Japan, Mexico, and the United Kingdom. We selected these countries because they are economically important and they represent a cross-section of the different accounting systems used around the world. Further, their accounting systems re" ect their unique historical and cultural backgrounds. Exhibit 6.1 pro- vides comparative demographic and economic data for these countries. Germany, Japan, and the United Kingdom are among the wealthiest nations in the world, whereas China and Mexico are developing economies. China, with a population of over 1.4 billion, has been one of the fastest-growing economies in recent years. As a result of recent economic reforms, Chinese accounting is experiencing a period of rapid evolution. Germany is one of the economic powerhouses in Europe, and its accounting system is undergoing change from the Continental European ap- proach to accounting. Japan became a major economic power within a short period after World War II, focusing on high-tech industries. Its unique system of business interrelationships has had a profound impact on accounting. Mexico is representa- tive of Latin American countries. As a member of the North American Free Trade Agreement (NAFTA), Mexico has been under external pressure to change its accounting system. The United Kingdom represents the Anglo-Saxon model of ac- counting. Recently, accounting in the United Kingdom has been strongly affected by the country’s membership in the European Union.

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233

EXHIBIT 6.1 Country Pro! les

Source: http://news.bbc.co.uk/2/hi/country_pro! les/default.stm

China Germany Japan Mexico United Kingdom

Area 9.6 million sq. km (3.7 million sq. miles)

357,027 sq. km (137,849 sq. miles)

377,864 sq. km (145,894 sq. miles)

1.96 million sq. km (758,449 sq. miles)

242,514 sq. km (93,638 sq. miles)

Population 1.34 billion (UN 2009)

82.2 million (UN 2009)

127.2 million (UN 2009)

109.6 million (UN 2009)

61.6 million (UN 2009)

Capital City Beijing Berlin Tokyo Mexico City London

Life Expectancy 71 years (men) 75 years (women) (UN)

77 years (men) 82 years (women)

79 years (men) 86 years (women)

74 years (men) 79 years (women)

77 years (men) 82 years (women)

Currency Renminbi (Yuan) (1 = 10 jiao = 100 fen)

Euro (1 = 100 cents) Yen Peso (1 = 100 centavos)

Pound Sterling (1 = 100 pence)

GNI Per Capita US$2,940 (World Bank, 2008)

US$42,440 (World Bank, 2008)

US$38,210 (World Bank, 2008)

US$9,980 (World Bank, 2008)

US$45,390 (World Bank, 2008)

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234 Chapter Six

The discussion related to each country’s accounting system is organized into four parts: (1) background, (2) accounting profession, (3) accounting regulation, and (4) accounting principles and practices. We discuss the countries in alphabeti- cal order.

PEOPLE’S REPUBLIC OF CHINA (PRC) Background The ultimate legislative authority in China rests with the National People’s Con- gress, the highest organ of state power. It is elected for a term of ! ve years and has the power to amend the constitution; make laws; select the president, vice presi- dent, and other leading of! cials of the state; approve the national economic plan, the state budget, and the ! nal state accounts; and decide on questions of war and peace. The State Council is the highest organ of the state administration. It is com- posed of the premier, the vice premiers, the state councillors, heads of ministries and commissions, the auditor general, and the secretary-general.

With the formation of the People’s Republic of China (PRC) in 1949, the government adopted a policy of establishing a single public ownership economy with centralized management of businesses and control of all economic resources. By 1956, all private companies had been transformed into state or collective ownership. However, these state-owned enterprises (SOEs) eventually proved to be economic failures. For example, during 1995–1997, more than half of them were in the red, and the losses in 1995 alone were close to 100 billion renminbi (US$12 billion). 1 Restructuring the loss-making SOEs was a major part of the sub- sequent economic reforms, which aimed at transforming the centrally planned economy into a socialist market economy, that is, a market economy based on so- cialist principles. Under the reform agenda, private enterprises, cooperatives, and joint ventures coexist and compete with state-run entities. The radical economic changes implemented over the last decade have made China one of the fastest- growing and largest economies, with annual economic growth rates among the highest in the world. Currently, in terms of gross domestic product (GDP), China ranks second behind the United States.

To carry out its reform program, China needed capital and advanced technol- ogy. This led to an open-door policy of attracting foreign direct investment (FDI), which emphasized the importance of developing a capital market. With nearly 500,000 FDI enterprises, China is now the world’s number one recipient of foreign direct investment. Today there are about half a million foreign investment entities in China, with parent entities in more than 170 countries. Foreign direct invest- ment started to move into China in 1979, when the Equity Joint Venture Law was issued. In 2004, China received $60.6 billion worth of FDI, accounting for more than one-third of total FDI in" ows in developing countries and about 15 percent of FDI in" ows worldwide. The FDI in" ows into China are mainly through large-scale transnational corporations, in high-tech areas and capital-intensive projects, such as petroleum, automobiles, and large-scale integrated circuits, and a tertiary sector including securities, banking, telecommunications, transportation, and tourism. 2

1 C. J. Lee, “Financial Restructuring of State Owned Enterprises in China: The Case of Shanghai Sunve Pharmaceutical Corporation,” Accounting, Organizations and Society 26 (2001), p. 673. 2 T. Xiaowen, Managing International Business in China (Cambridge: Cambridge University Press, 2007), p. 7.

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Comparative Accounting 235

Chinese companies were encouraged to raise funds on international capital markets as well as on the domestic one by issuing shares and bonds. For China to maintain the momentum in its development as a player in the foreign invest- ment market, it needed to update its business practices, which had often been considered out of sync with the rest of the world. For example, China’s accounting practices were often criticized for falling somewhat short of those set out by the IASB. An accounting practice aimed at measuring how well production targets are met in a planned economy was largely at odds with what was required in a market economy. Chinese accounting statements provided no measure of pro! t and loss; there was no recording of the debts of a company; and managers were unable to determine from where the ! rm was making a loss. This caused problems for foreign investors, for example, when looking to perform due diligence work on domestic Chinese ! rms. Further, foreign investors in the developing Chinese stock market had dif! culty interpreting the ! nancial statements of Chinese ! rms, and the restatement of the ! nancial statements into “Western terms” was a costly process. The rapid market development and the desire to attract domestic and overseas capital provided direct incentives and pressures for both the Chinese government and listed ! rms to improve the quality of ! nancial reporting.

During the early 1990s, the government introduced nongovernmental own- ership in state-owned enterprises and organized stock exchanges in Shanghai (SHSE) and Shenzhen (SZSE). The government took steps to develop its domes- tic capital market. Shanghai’s municipal government approved the ! rst securi- ties regulation in China in 1984. Share dealings did not become popular until the beginning of the next decade, when the Shanghai Stock Exchange (SHSE) was reactivated in December 1990 and a second stock exchange, the Shenzhen Stock Exchange (SZSE), was established in April 1991. 3 The capital market in China is controlled by the government. In July 1992, the Chinese Security Regulatory Com- mission (CSRC) was set up as China’s equivalent of the U.S. Securities and Ex- change Commission to monitor and regulate the stock market. This provided an encouragement for investors to engage in capital market activities. The number of companies listed on the two stock exchanges increased from 50 in 1992 to 1,831 at the end of April 2010. By the end of April 2010, according to the World Federation of Exchange, the Shanghai stock exchange had emerged as the sixth largest ex- change in the world, with a market capitalization of US$2,704,778 million (market capitalization of Shenzhen stock exchange is US$868,374 million; NYSE Euronext US$11,839,793 million; Tokyo stock exchange US$3,306,082 million; NASDAQ OMX US$3,239,492  million; London stock exchange US$2,796,444 million; and Hong Kong stock exchange US$2,305,143 million). The capital market in China has now become one of the largest such markets in Asia, second only to that in Tokyo. It was originally designed to offer opportunities for state-owned enterprises to raise capital, and even today nearly 90 percent of the companies listed on the two stock exchanges are still state-owned. Chinese companies also trade on exchanges outside China (about 100 companies), including the New York Stock Exchange (NYSE) (about 20 companies).

Recently, the government announced its plans to allow foreign companies to list in China, which re" ects the government’s desire to open up the country’s ! nancial sector and transform Shanghai into an international ! nancial center. Further, the Minister of Finance and the CSRC have jointly issued an announcement that CPA

3 I. Haw, D. Qi, and W. Wu, “The Nature of Information in Accruals and Cash Flows in an Emerging Capital Market: The Case of China,” International Journal of Accounting 36 (2001), pp. 391–406.

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! rms in mainland China will be allowed to audit companies listed on the Hong Kong Stock Exchange. By the end of 2009, there were 54 accounting ! rms in China licensed to audit listed company ! nancial statements.

Long-term investment in China’s highly speculative stock market is still an ex- ception to the rule. Stock holdings typically range from days to a few months. Investors basically strive for short-term stock price gains, which are not necessar- ily based on fundamental company data. The validity and reliability of ! nancial disclosure are therefore of limited importance to investors.

Companies in China issue four categories of shares:

1. “A” shares, which can be owned only by Chinese citizens and are traded on the two stock exchanges.

2. “B” shares (introduced in 1992), which can be owned by foreigners. 3. “C” shares, which are nontradable and held mainly by the government and

other SOEs. 4. “H” shares, which can be owned only by foreigners and are traded in Hong

Kong.

The market capitalization of A shares on the two stock exchanges accounts for more than 90 percent of the total market capitalization. B shares are for foreign individuals, institutional investors, and Chinese nationals able to trade in for- eign currency. As of late 2001, only 112 out of China’s 1,160 listed ! rms issued B shares; approximately 50 were listed in Hong Kong, and another 20 were listed in New York. 4 Companies listed on the local capital market have a distinctive capital structure in which a large portion is made up of C shares, which cannot be traded publicly.

The categories of shares issued by Chinese companies are very different from those in the United States or Europe, and they have different in" uences on the ! rm. Further, the dynamics in the Chinese boardrooms are quite different from those of Western companies. For example, chairs are full-time executives, and they wield signi! cant power. Senior managers are most likely to be former government bureaucrats, and so they may have a different mind-set than top executives in U.S. ! rms.

With the introduction of the Quali! ed Foreign Institutional Investor (QFII) scheme in 2002, which was designed to allow “quali! ed” foreign institutional in- vestors to purchase a limited amount of securities using Chinese currency, includ- ing the A shares of any Chinese companies listed on the share market, foreign companies can now purchase the shares of Chinese companies listed on the stock market. For example, in October 2003, Kodak succeeded in purchasing 20  per- cent of the shares of Lucky Films, a local company listed on the Shanghai Stock Exchange. By September 2006, 40 foreign ! nancial institutions had been granted QFII status, including Morgan Stanley, Goldman Sachs, HSBC, Deutsche Bank, JP Morgan, Chase Bank, and Merrill Lynch International.

Accounting Profession Accounting has a long history and a close association with the development of Chinese culture. Its roots can be found in the teachings of the philosopher and educator Confucius, which highlight the imperative to keep history and view ac- counting records as part of that history. The word accounting is noted as far back as

4 China Securities Regulatory Commission China Securities and Futures Statistical Yearbook, (Beijing: CSRC, 2002).

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the Hsiu Dynasty, around 2200 BC, when the stewardship function of accounting was emphasized. Later, in the Xia Dynasty (2000–1500 BC), the concept of measur- ing wealth and accomplishment was mentioned. In China, through thousands of years under a feudal social structure, people respected court and scholarly of! cials and looked down upon merchants. Accounting for business was viewed as being a nonskilled profession. More recently, the master–apprentice system was used to train accountants up until the 1900s. The ! rst professional accounting legislation was enacted by the Northern Warloads government in 1918. Also, in the early 1900s, university study in accounting became an accepted way to understand and advance the principles and practice of accounting. The ! rst local professional body, the Chinese Chartered Accountants’ Society of Shanghai, was established in 1925. By 1947, there were 2,619 certi! ed accountants in China. Since 1949, Chinese scholars returning home after completing their accounting studies abroad, mainly in the Soviet Union, pioneered the development of a body of new knowledge in China, which resulted in existing practices. 5 After the revolution, accountants be- came totally subject to bureaucracy.

However, until the 1980s, those who carried out accounting work were not held in high regard in Chinese society compared with their Western counterparts. This was partly due to the traditional Chinese culture of “respecting the peasants and despising the merchants.” 6 Consequently, accounting education has never been well developed in China and was particularly disrupted during the Cultural Revolution (beginning in the mid-1960s). Graham explains some aspects of the accounting environment in China as follows:

Accounting became focused on reporting compliance with State economic plans, using a speci! ed structure of accounts and following a sources and uses of funds concept. But it is commonly agreed the period of the Cultural Revolution (1966– 1976) marks a dark period for the profession, as accounting was overly simpli! ed with the objective of making accounting accessible and understandable to the “masses.” University professors were ousted and occasionally brutalized, and ac- counting theory all but abandoned. . . . The consequence of this simpli! cation on top of an already crude Soviet-based system was the loss of a generation or so of true accounting thought, and the absence of any need to re" ect the nature of modern transactions or business concepts in the accounting system. 7

The economic reform and the open-door policy introduced in the 1980s brought about a large number of Sino–foreign joint ventures in China. This resulted in the reemergence of a private auditing profession, supported by the Accounting Law issued in 1985 and the CPA Regulations in 1986. The CPA Regulations, promul- gated by the State Council, prescribed the scope of practice for certi! ed public accountants (CPAs) and some working and ethical rules. These developments led to the formation of the Chinese Institute of Certi! ed Public Accountants (CICPA) in 1988, the ! rst professional accounting body in China since the establishment of the PRC in 1949.

Unlike in the United States, accounting and auditing in China took different paths in their development processes. For many years, auditing ! rms mainly

5 L. E. Graham and C. Li, “Cultural and Economic Infl uences on Current Accounting Standards in the People’s Republic of China,” International Journal of Accounting 32, no. 3 (1997), pp. 247–78. 6 Y. Chen, P. Jubb, and A. Tran, “Problems of Accounting Reform in the People’s Republic of China,” International Journal of Accounting 32, no. 2 (1997), pp. 139–53. 7 L. E. Graham, “Setting a Research Agenda for Auditing Issues in the People’s Republic of China,” International Journal of Accounting 31, no. 1 (1996), p. 22.

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audited domestic companies, whereas accounting ! rms focused on companies using foreign investments. Accounting ! rms were sponsored by the Ministry of Finance (MoF), and auditing ! rms were under the State Administration of Audit (SAA), a department within the State Council responsible for government audits. In 1991, the SAA, in competition with the CICPA, issued its “Tentative Rules on Certi! ed Public Auditors” to regulate auditors employed in audit ! rms. In 1992, the Chinese Association of Certi! ed Practicing Auditors (CACPA) was formed under the auspices of the SAA. 8

The competition between accountants and auditors with their own rules is- sued by different government departments was confusing, particularly to interna- tional accounting ! rms. Consequently, steps were taken to merge the CICPA and CACPA. In 1993, the CPA Regulations were upgraded to become the CPA Law. 9 As a result, the MoF was given the authority to regulate both the accounting and the auditing ! rms. The CICPA became a member of the IASC (and IFAC) in 1997. The merger between the CICPA and the CACPA was completed in 1998.

By way of comparison, there are some clear differences between the evolution of the accounting profession in China and in other countries such as the United Kingdom. For example, in the United Kingdom, auditors enjoyed a good legisla- tive and judicial environment during the early stages of development, whereas a market-oriented legal and judicial infrastructure is still emerging in China. Further, UK auditors were able to establish and maintain high quality because they had the support of their professional accounting bodies, which emphasized professional education, training, and examinations. By contrast, these support mechanisms are still lacking in China. 10 Finally, unlike in the United Kingdom, accounting and au- diting ! rms in China have been treated separately. This is evident from the coexis- tence of the CICPA and the CACPA, with their admission requirements governed by the respective sponsoring agencies (i.e., the MoF and the SAA). By the end of 1997, there were 62,460 practicing CPAs and 6,900 accounting and auditing ! rms in China. 11

The economic reform program, with its open-door policy, has stimulated the growth of accounting and related activities in China in many ways. Prior to re- forms, the accounting system was no more than a way to provide information to the government. The economic reforms rapidly changed, among other things, the ownership structure of organizations. 12 The joint stock company was recognized by the state as the desired organizational structure to reform the SOEs. This cre- ated new demands for ! nancial information from investors and other interested parties. The establishment of the two stock exchanges aiming to develop capital market activities led to major changes in China’s accounting system. For example, companies that issue B shares are now required to restate their earnings accord- ing to International Financial Reporting Standards, and to provide two annual

8 J. Z. Xiao, Y. Zhang, and Z. Xie, “The Making of Independent Auditing Standards in China,” Accounting Horizons 14, no. 1 (2000), pp. 69–89. 9 In China, laws have a higher legal status than regulations, as laws are stipulated by the National Peoples’ Congress, whereas regulations are promulgated by the State Council (ibid.). 10 Xiao, Zhang, and Xie, “The Making. . . .” 11 Y. Tang, “Bumpy Road Leading to Internationalization: A Review of Accounting Development in China,” Accounting Horizons 14, no. 1 (2000), pp. 93–102. 12 Z. Xiao and A. Pan, “Developing Accounting Standards on the Basis of a Conceptual Framework by the Chinese Government,” International Journal of Accounting 32, no. 3 (1997), pp. 279–99.

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Comparative Accounting 239

reports—one prepared by an international auditing ! rm, and one certi! ed by a local accounting ! rm.

Many aspects of the reform program rely on accounting and auditing services to assist the market to work in an orderly manner. Various government regulations on the implementation of economic reform measures require the involvement of independent auditors. The post-Enron era has witnessed a growing concern with the issues of auditor independence and audit quality. Legislators, regulators, and professional bodies have suggested mandatory auditor rotation at both the part- ner and the ! rm level after a ! xed period of tenure, as a method to enhance audi- tor independence. Unlike in the United States, auditors in China (normally two CPAs) are required to sign their names on audit reports. In October 2003, the CSRC and the MoF jointly issued a policy requiring auditors who sign the audit report of a listed company to be rotated off after ! ve years. Given the close relationship between audit partners and their listed clients, this policy was aimed at ensuring auditor independence and audit quality. The laws on Sino–foreign joint ventures require the audit of annual statements and income tax returns and the veri! cation of capital contributions by registered Chinese CPAs. These additional demands for accounting services created new opportunities for international accounting ! rms to enter the Chinese market. In the past, because only certi! ed public accountants (CPAs) licensed by the Chinese authorities would be allowed to establish partner- ships or limited liability accounting ! rms in China, to be able to operate in China, foreign accounting ! rms needed to af! liate with local ! rms.

Recently, Beijing has of! cially announced its plan to allow foreign companies to list in China. This re" ects the government’s ambitions to open up the country’s ! nancial sector and transform Shanghai into an international ! nancial center. Fur- ther, in the process of globalization, it is necessary for investors and accountants over the world to both celebrate common ground achieved and understand the deeply rooted differences.

By providing services to foreign investors, the international accounting ! rms have assisted in the implementation of the open-door policy. They also have as- sisted in the development of the Chinese capital market by, for example, undertak- ing ! nancial audits of Chinese companies that offer shares to overseas investors and that wish to obtain a foreign stock exchange listing. In addition, the interna- tional ! rms have been involved in training Chinese auditors and setting audit- ing standards. More than 200 of the world’s top 500 companies have invested in China. All of the leading international accounting ! rms, following their clients, have moved into China by opening representative of! ces.

The Practice of “Hooking Up” The practice of “hooking up” refers to an af! liate relationship between an ac- counting/auditing ! rm and its sponsoring organization, normally a government body. 13 The hooking-up relationship is rooted in the circumstances in which these professional accounting ! rms were originally established. At the beginning of the reform process, the Chinese government required all newly established profes- sional accounting ! rms to af! liate themselves with a government agency or a government-run institute. Before 1996, all Chinese audit ! rms were af! liated with government agencies, government-sponsored bodies, or universities and research

13 X. Dai, A. H. Lav, and J. Yang, “Hooking-up: A Unique Feature of China’s Public Accounting Firms,” Managerial Finance 26, no. 5 (2000), pp. 21–30.

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240 Chapter Six

institutions. Aiming at ensuring ! nancial and operational independence for audi- tors, the CICPA and the MoF launched the disaf! liation program in 1996. This program required all auditors to sever their links with their sponsoring bodies. The CICPA and the MoF had also been engaged in establishing a new set of Inde- pendent Auditing Standards since 1995 which were in line with the International Standards on Auditing promulgated by the IFAC. However, it was dif! cult for them to be independent because of the historical connections. As a result, most domestic professional accounting ! rms continued to have some government con- nection, and truly independent private accounting ! rms are rarely seen in China. Further, some of the clients of these organizations are themselves directly or in- directly related to the “hooked” organization because of complex ownership and control arrangements.

Guanxi Guanxi refers to connections or tight, close-knit networks. It can be considered an important feature of Chinese business culture. With guanxi, it is possible to ac- complish almost anything, but without it, life is likely to be a series of long lines and tightly closed doors, and a maze of administrative and bureaucratic hassles. 14 Although it is common practice in China, it is likely to create an ethical dilemma for foreign investors because if they do not practice guanxi , they are unlikely to succeed in China, but if they do practice guanxi , they may be doing something ethically wrong or against the law of their own country, for example, the Foreign Corrupt Practices Act of 1977 in the United States.

The prevalence of guanxi may be contributing to the large-scale corruption in China. Under its in" uence, guanxi -related considerations often prevail over ethics- related considerations in accounting and auditing practice. Accountants and ! nancial managers often have to use guanxi to do business with business partners or government of! cials in a way that is in violation of their professional ethics. 15

This shows the importance of understanding the environment in which ac- counting is practiced in a country. In China, civil litigation is very rare, and thus the CSRC is the prime discipliner of ! rms and their managements. Further, the relatively young Chinese auditing profession provides insuf! cient support for accounting standards, because auditors lack both professional training and in- dependence. 16 Until recently, accounting education in China has been based on “Uniform Accounting Systems” (UAS) and lacked a conceptual underpinning and an international outlook. Furthermore, as a result of the absence of sophis- ticated users and providers of accounting information, Chinese auditors have enjoyed an almost litigation-free environment.

China is said to have a set of collectivism-oriented societal values and a rela- tively low degree of professionalism. 17 Independence, belief in individual deci- sions, and respect for individual endeavor are not emphasized. People do not take responsibility for something that has not been approved by systems and rules.

14 S. D. Seligman, “ Guanxi: Grease for the Wheels of China,” China Business Review 26, no. 5 (1999), pp. 34–38. 15 M. Islamand and M. Gowing, “Some Empirical Evidence of Chinese Accounting System and Business Management Practices from an Ethical Perspective,” Journal of Business Ethics 42, no. 4 (2003), p. 358. 16 B. Xiang, “Institutional Factors Infl uencing China’s Accounting Reforms and Standards,” Accounting Horizons 12, no. 2 (1998). 17 L. M. Chow, G. K. Chua, and S. J. Gray, “Accounting Reforms in China: Cultural Constraints on Implementation and Development,” Accounting and Business Research 26, no. 1 (1995).

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Comparative Accounting 241

Collectivism thus supports devising uniform accounting systems and making ac- counting policy at the national level. This mentality is widely re" ected in account- ing and auditing practices in China.

Accounting professionalization in China over the past 60 years, particularly in recent years, has been dramatic. The public practice of accountants was suspended immediately after the communist government came into power in 1949. The ac- counting system in the country was reformed following the Soviet Union model. As stated earlier, accountants became totally subject to bureaucracy. China revived the public practice of accountants in 1980. Since then, there has been rapid growth in the professionalization of accounting. For example, the CICPA was established in 1988. In 1991, the ! rst national CPA quali! cation examination was held. The Law on Certi! ed Public Accountants was enacted in 1993, raising the legal status of certi! ed public accountants. However, there are many issues associated with the process of professionalization, and a lack of autonomy might be regarded as the most critical hurdle in that respect. The CICPA is under the direct control of the Ministry of Finance, which has the authority to appoint the leader ship. In re- sponse to numerous accounting scandals, the CICPA has set up the accounting ethics code with “independence, integrity, and objectivity” at the core. However, the spirit of “professional autonomy” is not necessarily encouraged by the existing institutional structure.

In October 2007, the ICAEW in the UK and CICPA set up a joint project to facili- tate and promote cooperation between the accounting professions in both coun- tries. As a result, preparers and users of ! nancial statements in China bene! ted from the ICAEW certi! cate in IFRS. Developed by experts and focused on an un- derstanding of all International Standards, the Chinese edition of learning materi- als aims to help China strengthen its commitment to applying rigorous accounting and auditing standards. This speeded up the process of international convergence of accounting standards.

China’s Ministry of Finance has issued Draft Interpretation 3 for Chinese new accounting standards, which are consistent with IFRS, to ensure their appropriate application. According to the Chinese Certi! ed Public Accountant, the of! cial journal of the CICPA, China had more than 7,200 accounting ! rms by the end of 2008. This number is 36 times more than in 1988, the year the CICPA came into being. By De- cember 2008, China had registered more than 83,000 CPAs (population 1.34 billion). The Minister of Finance (MoF) and the China Securities Regulatory Commission (CSRC) have jointly issued an announcement that CPA ! rms in mainland China will be allowed to audit H-share companies (i.e., those listed on the Hong Kong Stock Exchange) after January 2010. The MoF also provided guidance at the end of 2009 on further improving accounting practice and ! nancial reporting quality for 2010, including additional guidance on ! rst-time adoption, appropriate use of professional judgment, elimination of the difference in A-share and H-share listed ! rms, and adoption of the concept of “other comprehensive income” in IFRS.

Accounting Regulation The government continues to act as the accounting regulator in order to retain political control. Through the MoF it issues IFRS-based accounting standards mainly to meet external pressures but retains a UAS-based approach in parallel as a means of detailed regulatory control. The UAS has the bene! t of familiarity, both for the regulator and for those subject to regulation. Direct government involve- ment in accounting regulation in China is a political tradition that originated in the era of central planning.

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In Anglo-American countries, for example, setting authoritative accounting standards is the responsibility of accounting societies or independent bodies cre- ated for that purpose, whereas in China, it is the responsibility of the Ministry of Finance, rather than the Accounting Society of China (ASC) or the CICPA or any independent body.

In recent years, accounting regulation in China has been in" uenced mainly by China’s desire to harmonize domestic accounting practices (the various uniform accounting systems used in different industries produced inconsistent practices across industries), harmonize Chinese accounting with IFRS, and meet the re- quirements of economic reforms. As new forms of business (such as Sino– foreign joint ventures and joint stock companies) emerged, they created a need for in- ternational accounting harmonization. This prompted the Ministry of Finance to issue pronouncements to achieve it. These pronouncements include the following:

1. The Accounting Systems for Sino–Foreign Joint Ventures (1985). 2. Accounting Systems for Companies Experimenting with a Shareholding System and

the Accounting Standard for Business Enterprises (ASBE) (1992) (the ASBE is simi- lar to a conceptual framework).

3. The Accounting Regulations for Selected Joint Stock Limited Companies, issued in 1991 and revised in 1998.

4. Accounting Law (1999). 5. The Regulations on Financial Reporting of Enterprises (2000). 6. The Accounting Systems for Business Enterprises (2001). 7. Accounting Standards for Business Enterprises (2006) (it replaced the 1992 ASBE,

and CASs previously issued).

As these laws and regulations draw heavily on regulations and practices in Western countries, the current accounting concepts and practices in China mirror, to an extent, those in the mature market economies. Following are examples: the Accounting Law (1999) stressed the importance of “true and complete” accounting information; the Regulations on Financial Reporting of Enterprises (2000) rede! ned the elements of ! nancial statements in line with the conceptual framework of the IASC and stipulated responsibilities and liabilities for parties involved in account- ing, auditing, and reporting.

However, the Chinese government has retained a uniform accounting system in the Enterprise Accounting System, issued in 2000 to accommodate the special circumstances of a transforming government, strong state ownership, a weak ac- counting profession, a weak equity market, and the inertial effect of accounting tradition and cultural factors.

The movement toward private ownership has required a revision of China’s accounting and disclosure standards. Several major Chinese ! nancial scandals in the early 1990s highlighted the problems associated with the accounting system, which was modeled on the system that existed in the former Soviet Union. One of the most notorious was the Great Wall fund-raising scandal, which implicated the Zhongchen accounting ! rm.

In this case, the Great Wall Electrical Engineering Science and Technology Co. illegally raised one billion Yuan in a few months between 1992 and 1993 by issuing very high coupon securities to over 100,000 private investors in 17 large cities in China. The money raised was partly embezzled and partly used to establish over 20 subsidiaries and more than 100 branches all over the country. A branch of the

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Comparative Accounting 243

Zhongchen accounting ! rm played a key role in the fraud: its three CPAs provided an unfounded certi! cate con! rming 0.3 billion Yuan capital after just one day’s work with only 25 pages of working papers. . . . Five CPAs from the accounting ! rm were disquali! ed and the whole ! rm was dismantled. The president of the client company received the death penalty, a deputy minister was jailed for bribery, and the president of the People’s Bank of China was terminated. 18

The MoF establishes accounting standards and regulations, while the CSRC issues disclosure requirements for listed companies. The MoF began setting ac- counting standards in 1988 (the same year in which the CICPA was established). The MoF adopted a policy of following international accounting practice in set- ting Chinese standards. To this end, it developed ASBE in 1992. In 1993, it ap- pointed an international accounting ! rm (with technical assistance funds from the World Bank) as consultants to the MoF’s standard-setting program and es- tablished two advisory committees, one consisting of international accounting experts and the other consisting of Chinese accounting experts. 19 The promulga- tion of a conceptual framework by the MoF in 1992 was a landmark event in the recent accounting reforms in China. It was a clear signal that Anglo-American accounting principles were to replace the rigid Soviet accounting model practiced in China since 1949.

However, extensive false reporting and earnings management by companies have discredited accounting information and hampered the development of the capital market. As a result, the Accounting Law amendment in 1999 stressed the importance of “true and complete” accounting information. In 2000, the State Council issued an Enterprise Financial Reporting Regulation, rede! ning the ele- ments of ! nancial statements in line with the conceptual framework of the IASC and stipulating responsibilities and liabilities for parties involved in accounting, auditing and reporting. 20

The CPA Law requires auditors to audit Chinese enterprises’ ! nancial state- ments; verify the enterprises’ capital contribution; engage in the audit work of the enterprises’ merger, demerger, and liquidation; and provide professional services speci! ed by the law and regulations. 21 The accounting regulations applicable to a Chinese listed ! rm depend on the type of security issued, A or B shares or both. The IFRS-based annual report must be audited by an internationally recognized auditor, but not necessarily a Big Four ! rm, while the Chinese GAAP-based an- nual report may be audited by local accounting ! rms. Both sets of annual reports must be released to the public simultaneously, and any difference in net incomes between Chinese GAAP and IFRS must be reconciled and presented in the ! nan- cial statement footnotes. Accountants who intentionally provide false certi! cates may be sentenced to up to ! ve years of ! xed-term imprisonment or criminal de- tention and a ! ne. The law requires a CPA to refuse to issue any relevant report where (1) the client suggests, overtly or covertly, that a false or misleading re- port or statement be issued; (2) the client intentionally fails to provide relevant

18 Xiao, Zhang, and Xie, “The Making. . . .” 19 Y. Tang, “Bumpy Road. . . .” 20 B. Xiang, “Institutional Factors Infl uencing China’s Accounting Reforms and Standards,” Accounting Horizons 12, no. 2 (1998). 21 K. Z. Lin and K. H. Chan, “Auditing Standards in China: A Comparative Analysis with Relevant International Standards and Guidelines,” International Journal of Accounting 35, no. 4 (2000), pp. 559–77.

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accounting material and documents; and (3) the report to be issued by a certi! ed public accountant cannot correctly represent all material information due to the client’s unreasonable behavior.

The China Accounting Standards Committee (CASC)—comprising government experts, academics, and members of accounting ! rms—was established within the MoF in 1998. China has not adopted IFRS, but it has stated that it will develop its own standards based on IFRS. However, different types of companies are required to comply with different sets of standards; for example, companies with B shares must follow IFRS, companies with A shares must follow Chinese GAAP, and com- panies with H shares must follow either Hong Kong GAAP or IFRS.

In June 2002, the CICPA issued new guidelines on professional ethics as a sup- plement to the General Standard on Professional Ethics. The guidelines stress the importance of a CPA’s independence and also contain extensive discussion on change in a professional appointment, service fees charged to clients, practice promotion, and con! dentiality. 22

The CSRC requires companies listed on the two stock exchanges to post their annual reports on the exchanges’ respective Web sites. 23 The CSRC and the two stock exchanges have also adopted new corporate governance rules that require listed companies to disclose detailed related-party transaction information re- lating to intangible assets. 24 However, both internal and external corporate gov- ernance mechanisms are weak in China. For example, externally the market for corporate control and the managerial labor market are seriously underdevel- oped, while internally it was not until 2002 that independent directors and audit committees appeared in listed companies. 25 The CSRC has recently moved to require more outside directors on the boards of companies, as companies with a high proportion of nonexecutive directors on the board are less likely to engage in fraud.

In November 2003 (effective January 2004), the CSRC and the MoF issued a joint document requiring companies to rotate their auditors every ! ve years and to take a two-year break before auditing the same client again. China is follow- ing the international trend toward tighter regulation of auditing practices, which has gained momentum following the collapse of Arthur Andersen in the after- math of the Enron scandal. The CSRC seems to follow the recommendations of the Sarbanes-Oxley Act in the United States. Convergence of Chinese GAAP with international standards can be summarized as follows:

1992 Chinese GAAP (1992–1997) The 1992 Chinese GAAP marked a radical change in China’s accounting rules and regulations, representing a shift in focus from providing information for a central government-planned economy to a socialist-market economy. The 1992 Chinese GAAP was comprised of the Accounting Systems for Companies Experimenting with a Shareholding System and the Accounting Standard for Business Enterprises (ASBE). The ASBE (1992) is similar to a conceptual framework.

22 For more details, see IAS PLUS, July 2002, at www.iasplus.com. 23 The Shanghai Stock Exchange Web site ( www.sse.com.cn ) and the Shenzhen Stock Exchange Web site ( www.cninfo.com.cn ). 24 See IAS PLUS, January 2001, at www.iasplus.com . 25 G. Chen, M. Firth, D. N Gao, and O. M. Rui, “Ownership Structure, Corporate Governance and Fraud: Evidence from China,” Journal of Corporate Finance 12 (2006), pp. 424–48.

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Comparative Accounting 245

1998 Chinese GAAP (1998–2000) The second stage of regulatory development is characterized by the adoption of the Accounting System for Joint Stock Limited Enterprises by the MoF in 1998. This regulation replaced the 1992 Chinese GAAP and aimed at eliminating discrepan- cies between Chinese GAAP and IAS, which existed in the 1992 regulation. In ad- dition, 10 speci! c Chinese Accounting Standards (CAS) were issued by the MoF.

2001 Chinese GAAP (2001–2006) The third stage of development was characterized by the issuance of the Account- ing System for Business Enterprises by the MoF in 2001, which replaced the 1998 Chi- nese GAAP. Inventory valuation at lower of cost or market (LCM) was optional in 1998 GAAP but required in 2001 GAAP. Further, recognition of impairment losses was required only for investments in 1998 GAAP, but it was also required for prop- erty, plant, and equipment (PP&E); intangible assets; construction in process; and investment property in 2001 GAAP.

2006 Chinese GAAP This stage is characterized by the issuance in February 2006 of the Accounting Standards for Business Enterprises (ASBE). It replaced the 1992 ASBE and CASs previously issued. The ASBE became mandatory for all PRC listed companies in January 2007. Other PRC enterprises were encouraged to apply the ASBE.

Instead of phasing them in gradually over time, China chose to adopt the main standards essentially in one go in the convergence process. With the introduction of the ASBE, China adopted a signi! cant number of the accounting standards laid out by the IASB. The ASBE cover almost all of the major topics included in IFRS, albeit with some notable exceptions.

Convergence occurred through both the direct import of standards from IFRS and progressive changes to Chinese GAAP. Direct import was observed for items either re" ective of traditional Chinese accounting practice or that addressed situ- ations not considered or not relevant under the previous accounting model. Pro- gressive changes to Chinese GAAP were observed on items substantially different from traditional practice. Currently, the CAS is comprised of Basic Standard, 38 speci! c standards, and application guidance.

CAS are unique because they originated in a socialist period in which the state was the sole owner of industry. Therefore, unlike Western accounting standards, they were less a tool of pro! t and loss than an inventory of assets available to a company. In contrast to a Western balance sheet, CAS did not include an ac- counting of a company’s debts, and were less suitable for management control than for accounting for tax purposes. The differences that do exist represent China’s unique position in the global economy. This includes a prohibition on re- versing an asset impairment decision; ! nancial statements incorporating certain government grants; and related-party disclosures between certain state-owned enterprises.

Prior to the reforms, Chinese companies which offered shares for sale in the United States used to be required to prepare three sets of statements, one using Chinese GAAP, one using IFRS, and one using U.S. GAAP. However, since 2008, the SEC has allowed foreign private issuers to use ! nancial statements prepared in accordance with IFRS.

The pressure is on for China to harmonize its accounting standards and prac- tices with international standards. As a result, international harmonization has been recognized as a priority for the development of the profession. China’s desire

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246 Chapter Six

to join the World Trade Organization (WTO) was a major incentive for the push toward international harmonization. WTO membership, granted in 2002, was con- ditional upon, among other things, the adoption of internationally acceptable ac- counting and ! nancial reporting practices, and the opening up of the accounting and auditing markets.

The problem of corruption and the involvement of accountants in corruption became so alarming that in 2004, the Chinese government launched a nationwide “auditing storm” campaign to check on accounting misconduct in government agencies, institutions, and enterprises. According to the report that was submitted to the National Congress, serious fraud and embezzlement of public funds were found in many government agencies and government-funded projects and often implicated accounting malpractice.

Accounting Principles and Practices In the prereform period, the aim of the accounting system in China was to help the government plan its economic activities and manage the various government funds, and it was therefore called the “fund accounting system.” All accounting bodies and personnel were closely linked with the government at the central or the local level, and there were no independent accountants and independent account- ing institutions. Furthermore, China’s accounting system was completely closed to the outside world. The reliance on UASs was reinforced because many Chinese accountants and auditors lacked professional education and training. 26 Further, it was also supported by the Chinese culture.

With the economic reform, which aimed at opening up the economy, Chinese enterprises began to operate independently, foreign companies moved in, and a stock market emerged. All these developments required fundamental changes in the accounting system. The reform of the system gained momentum in the 1990s, following the establishment of the two stock exchanges. However, although the capital market has played an important role in accounting standard-setting in China, its continued structural weaknesses and signi! cant imperfections have se- riously restricted the supply of, and demand for, decision-useful accounting infor- mation and IAS-type accounting standards.

State ownership is present in more than 90 percent of listed companies, 27 and the government remains an important in" uence on corporate governance by way of personnel control and resource allocation. Consequently the government is re- garded as the main user of accounting information.

China is an economy in transition, and its market-based systems are still at an early stage of development. Traditionally in China, there has been a close link between taxation and accounting, and the calculation of taxable income has been a major purpose of accounting. Further, under China’s communist ideological in- " uences, accounting conservatism has long been criticized as a tool used to ma- nipulate accounting numbers and maximize the pro! ts of capitalists in exploiting workers. Accounting conservatism is the principle that stipulates that, in a situ- ation where there are acceptable accounting alternatives, the one that produces lower current amounts for net income and net assets ought to be chosen. This accounting convention has virtually been prohibited in China since 1949. 28 A lack

26 Xiang, “International Factors. . . .” 27 Q. Sun, W. Tong, and J. Tong, “How Does Government Ownership Affect Firm Performance? Evidence from China’s Privatization Experience,” Journal of Business Finance and Accounting 29, no.1/2 (2002). 28 Lin and Chan, “Auditing Standards in China.”

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Comparative Accounting 247

of conservatism in Chinese accounting standards and practices continues to be a major difference between Chinese GAAP and IFRS.

The ! nancial statements published by Chinese companies typically include a balance sheet, an income statement, a cash " ow statement, notes to ! nancial state- ments, and other supporting schedules. One of the major problems associated with accounting practices adopted by enterprises in China is the lack of coherent interpretation of the relevant requirements. Regulations are subject to different interpretations and applications on the part of government agencies in different locations. As a result, the formal harmonization of accounting and auditing stan- dards that has occurred within China has not brought about a harmonization of accounting practices. China, being a transitional economy, is only beginning to de- velop the infrastructure required to support credible ! nancial reporting. As China intensi! es its integration into the global economy and ful! lls its obligations agreed on in the WTO accession treaty, for example, to open up its market to foreign audi- tors, 29 market forces in the accounting and auditing sector undoubtedly will be- come more active, which should strengthen the effectiveness of private safeguard mechanisms.

The conceptual framework, ! rst issued in 1992, has since been superseded by 16 Chinese Accounting Standards (see Exhibit 6.2 ) and other regulations, such as the Accounting System for Business Enterprises (ASBE) issued in 2001. The ASBE aims, among other things, to enhance comparability of ! nancial information, separate accounting and taxation treatments, and ensure harmonization with internation- ally accepted accounting practices.

The ASBE de! nes fundamental principles (going concern, accounting period, substance over form, consistency, timeliness, understandability, accrual basis, matching, impairment recognition, prudence, materiality, and measurement cur- rency vs. presentation currency) and ! nancial statement elements (assets, liabili- ties, owners’ equity, revenues, expenses, and pro! ts), which are similar to those found in IFRS . It also speci! es the contents of ! nancial reports (which ! nancial statements are to be presented annually, semiannually, quarterly, and monthly), minimum notes to the ! nancial statements, and how soon after the end of the accounting period reports should be published.

The ASBE also includes

1. Classi! cations within the asset, liability, and equity elements, as well as recog- nition and measurement principles for a wide variety of assets and liabilities.

2. Revenue recognition principles for goods, services, royalties, and interest. 3. Expense recognition principles for bad debts, cost of goods sold, depreciation,

major overheads, and impairment of assets. 4. Accounting principles for nonmonetary transactions, assets contributed by in-

vestors, accounting for income taxes, foreign currency transactions, changes in accounting policies, changes in estimates, corrections of errors, post–balance sheet events, contingencies, and related-party transactions.

5. Principles for consolidated ! nancial statements and accounting for investments in joint ventures.

29 Foreign fi rms that have obtained CPA licenses are permitted to affi liate with Chinese fi rms and enter into contractual agreements to provide accounting, auditing and bookkeeping services. (World Trade Organization, Report of the Working Party on the Accession to China, Addendum, Schedule of Specifi c Commitment on Services, October 1, 2001, available at www.wto.org/english/thewto_e/completeacc_e.htm .)

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248 Chapter Six

Accounting Standard Effective Date Applicability

1 Disclosure of Related Party January 1, 1997 Listed enterprises Relationships and Transactions

2 Cash Flow Statements (minor revision in 2001)

January 1, 2001 All enterprises

3 Events Occurring After the Balance Sheet Date

January 1, 1998 Listed enterprises

4 Debt Restructuring (revised signifi cantly in 2001)

January 1, 2002 All enterprises

5 Revenue January 1, 1999 Listed enterprises

6 Investments (minor revision in 2001)

January 1, 2001 Joint stock limited enterprises (prior to

January 1, 2001, listed enterprises only)

7 Construction Contracts January 1, 1999 Listed enterprises

8 Changes in Accounting Policies and Estimates and

Corrections of Accounting Errors (minor revision in 2001)

January 1, 2001 All enterprises (prior to January 1, 2001,

listed enterprises only)

9 Non-monetary Transactions (revised signifi cantly in 2001)

January 1, 2001 All enterprises

10 Contingencies July 1, 2000 All enterprises

11 Intangible Assets January 1, 2001 Joint stock limited enterprises

12 Borrowing Costs January 1, 2001 All enterprises

13 Leases January 1, 2001 All enterprises

14 Interim Financial Reporting January 1, 2002 Listed enterprises

15 Inventories January 1, 2002 Joint stock limited enterprises

16 Fixed Assets January 1, 2002 Joint stock limited enterprises

EXHIBIT 6.2 Chinese Accounting Standards as at January 1, 2002

In addition, it requires that expenses be classi! ed as operating, administrative, or ! nancing expenses and that pro! t be classi! ed between operating pro! t, invest- ment income, subsidy income, and several other nonoperating income categories. Finally, its requirement to include management discussion of ! nancial condition is similar to requirements in the United States. Further, with economic reforms, a new auditing system has emerged under which the purpose of auditing has changed from ascertaining a company’s tax liabilities to ascertaining the truthful- ness and fairness of a company’s ! nancial statements. Currently most companies in China are subject to the annual audit carried out by certi! ed public accounting ! rms registered in China.

Nearly half a million enterprises in China, including all listed companies, now follow one uni! ed ASBE. The MoF required all 170,000 SOEs to adopt the ASBE in 2005. The ASBE and Chinese Accounting Standards together form the structure of

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Comparative Accounting 249

! nancial reporting in modern China. Since 1978 China has introduced measures to reform its accounting system, which is now converging with standard accounting practices in mature market economies. Initially, ! rms undergoing the transition to the new system found it dif! cult to present a true picture of the impact of the change, and hence tended to provide misleading information to shareholders in the form of incorrect ! nancial reporting, damaging share values. This was mainly because they did not seem to fully contemplate the amount of ! nancial informa- tion that was needed, since most of it had not been collected in the past. As a result, signi! cant differences remain with respect to those practices and the accounting institutional environment between China and mature market economies, for ex- ample, and fair value is not recognized for accounting purposes.

Chinese accounting practices differ in some respects from those required under IFRS. In some areas covered by IFRS, there are no speci! c rules in China. In other areas, transactions are treated differently under the two sets of rules. For example, there are no speci! c rules in the areas of business combinations, including provi- sions in the context of acquisitions (IAS 22); impairment of assets, particularly as (except for investments) diminutions in value are not allowed (IAS 36); the de! nitions of operating and ! nance leases (IAS 17); employee bene! ts obliga- tions (IAS 19); and accounting for an issuer’s ! nancial instruments (IAS 32). Fur- ther, there are no speci! c rules requiring disclosures of discontinuing operations (IAS 35), segment liabilities (IAS 14), or diluted earnings per share (IAS 33). The methods of treating certain transactions are different from those required under IFRS. In China, proposed dividends are accrued before being approved (IAS 10); preoperating expenses are deferred and amortized (IAS 38); a wider de! nition of extraordinary items is used (IAS 8); and in segment reporting, the line of business basis is always treated as primary (IAS 14). Each of these practices is inconsistent with IFRS. Exhibit 6.3 presents some of the differences between IFRS and Chinese GAAP.

Several Chinese companies provide ! nancial statements prepared in accor- dance with both Chinese (PRC) GAAP and IFRS. Exhibit 6.4 provides an excerpt from Sinopec Shanghai Petrochemical Company Ltd.’s Form 20-F for the year ended December 31, 2012.

The unique features in the Chinese environment include the following:

• Civil litigation is very rare, and thus the CSRC is the prime discipliner of ! rms and their managements.

• In the ownership structure of listed ! rms, blockholders are usually the state and quasi-state institutions such as SOEs. (These are very different from the companies in Anglo-American countries, and they have different in" uences on the ! rm.)

• The dynamics in Chinese boardrooms are likely to be different from those of their counterparts in Anglo-American countries. For example, chairs are full- time executives and they wield signi! cant power; and senior management typi- cally started their careers as government bureaucrats.

• The auditing profession in China is relatively new, and it has faced a steep learning curve.

• State ownership still has an important in" uence on the organization and devel- opment of accounting standards.

• Wholly foreign-owned large multinational corporations competing against weaker and smaller domestic ! rms are becoming a major concern.

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250 Chapter Six

• Due to contextual differences, Chinese regulators view harmonization between Chinese GAAP and IFRS as a two-way process that should permit differences and local innovation.

• The capital market in China is controlled by government. It is characterized by weak equity outsiders, strong market speculation, weak form ef! ciency, ex- tensive earnings management and deceptive reporting, and large-scale market manipuIation.

In recent years, Chinese regulators have taken signi! cant steps to reform Chinese accounting standards in line with IFRS.

EXHIBIT 6.3 Differences between Chinese GAAP and IFRS

Issue IFRS Chinese GAAP

Profi t or loss on disposal of fi xed assets

IAS 16: Included in operating profi t or loss.

Presented as a nonoperating gain or loss.

Requirement to provide segment information

IAS 14: Listed companies only. Listed companies and other enterprises applying the system.

Measurement of property, plant, and equipment

IAS 16: May use either fair value or historical cost.

Generally required to use historical cost.

Borrowing costs related to self-use assets that take a substantial time to complete

IAS 23: May either capitalize as part of the asset’s cost or charge to expenses.

Must capitalize as part of the asset’s cost.

Impairment of assets that do not generate cash fl ows individually

IAS 36: An asset is impaired when its book value exceeds its recoverable amount, which is the greater of net realizable value and the net present value of future net cash fl ows expected to arise from continued use of the asset.

Specifi c guidance is not provided.

Research and development costs

IAS 38: Expense all research costs. Capitalize development costs if certain criteria are met.

Expense all research and development costs (except patent registration and legal costs, which are capitalized).

Preoperating expenses IAS 38: Charged to expenses when incurred.

Deferred until the entity begins operations, then charged to expenses.

Land use rights IAS 38: Accounted for as an operating lease. Cost of land use rights is treated as prepaid lease payments.

Accounted for as a purchased intangible asset until the construction or development commences, then accounted for as fi xed assets under construction or property development costs until the construction or development is complete; on completion, total costs are transferred to property held for use.

Amortization of intangible assets

IAS 38: Amortize over the estimated useful life, which is presumed to be 20 years or less.

Amortized over the shorter of the estimated useful life and the contractual or legal life; if no contractual or legal life, amortize over the estimated useful life, but not more than 10 years.

Revaluation of intangible assets

IAS 38: Permitted only if the intangible asset trades in an active market.

Prohibited.

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Comparative Accounting 251

EXHIBIT 6.4

SINOPEC SHANGHAI PETROCHEMICAL COMPANY LTD. Excerpts from Form 20-F

2012

1. ORGANIZATION, PRINCIPAL ACTIVITIES AND BASIS OF PREPARATION

Sinopec Shanghai Petrochemical Company Limited (“the Company”), formerly Shanghai Petrochemical Company Limited, was established in the People’s Republic of China (“the PRC” or “the State”) on June 29, 1993 as a joint stock limited company to hold the assets and liabilities of the production divisions and certain other units of the Shanghai Petrochemical Complex (“SPC”). SPC was established in 1972 and owned and managed the production divisions as well as the related housing, stores, schools, hotels, transportation, hospitals and other municipal services in the community of Jinshanwei.

The Company’s former controlling shareholder, China Petrochemical Corporation (“CPC”) completed its reorganization on February 25, 2000 in which its interests in the Company were transferred to its subsidiary, China Petroleum & Chemical Corporation (“Sinopec Corp”). In connection with the reorganization, CPC transferred the ownership of its 4,000,000,000 of the Company’s state owned legal shares, which represented 55.56 percent of the issued share capital of the Company, to Sinopec Corp. On October 12, 2000, the Company changed its name to Sinopec Shanghai Petrochemical Company Limited.

The principal activity of the Company and its subsidiaries (the “Group”) is the processing of crude oil into petrochemical products for sale. The Group is one of the largest petrochemical enterprises in the PRC, with a highly integrated petrochemical complex which processes crude oil into a broad range of synthetic fi bers, resins and plastics, intermediate petrochemicals and petroleum products. Substantially all of its products are sold in the PRC domestic market.

These fi nancial statements have been approved by the Board of Directors on March 27, 2013. At December 31, 2012, the following list contains the particulars of subsidiaries, all of which are limited companies established

and operating in the PRC, which principally affected the results and assets of the Group.

Company Registered

Capital

Percentage of equity

held by the Company

%

Percentage of equity

held by sub- sidiaries

% Principal activities

Shanghai Petrochemical Investment Development Company Limited . . . . . . RMB 1,000,000 100 — Investment management

China Jinshan Associated Trading Corporation . . . . . . . . . . . . . . . . . . . . . RMB 25,000 67.33 —

Import and export of petrochemical products and equipment

Shanghai Jinchang Engineering Plastics Company Limited . . . . . . . . . . . US$ 9,154 — 74.25

Production of polypropylene compound products

Shanghai Golden Phillips Petrochemical Company Limited. . . . . . US$ 50,000 — 60

Production of polyethylene products

Zhejiang Jin Yong Acrylic Fibre Company Limited . . . . . . . . . . . . . . . . . RMB 250,000 75 — Production of acrylic fi ber products

Shanghai Golden Conti Petrochemical Company Limited . . . . . . . . . . . . . . . . . RMB 545,776 — 100

Production of petrochemical products

None of the subsidiaries have issued any debt securities.

The consolidated fi nancial statements have been prepared in accordance with International Financial Reporting Standards (“IFRS”) as issued by the International Accounting Standards Board (“IASB”).

The consolidated fi nancial statements are prepared on the historical cost basis except for available-for-sale fi nancial assets (see note 2(b)) which are stated at fair value.

The preparation of fi nancial statements in conformity with IFRS requires management to make judgments, estimates and assumptions that affect the application of policies and reported amounts of assets and liabilities, income and expenses. The estimates and associated assumptions are based on historical experience and various other factors that are believed to be reasonable under the circumstances, the results of which form the basis of making the judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.

Continued

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252 Chapter Six

The estimates and underlying assumptions are reviewed on an ongoing basis. Revisions to accounting estimates are recognized in the period in which the estimate is revised if the revision affects only that period, or in the period of the revision and future periods if the revision affects both current and future periods.

Judgments made by management in the application of IFRS that have signifi cant effect on the fi nancial statements and major sources of estimation uncertainty are disclosed in note 27.

2. PRINCIPAL ACCOUNTING POLICIES

(a) Basis of consolidation (i) Subsidiaries and non-controlling interests

The consolidated fi nancial statements of the Group include the fi nancial statements of the Company and all of its principal subsidiaries. Subsidiaries are entities controlled by the Group. Control exists when the Group has the power to govern the fi nancial and operating policies of an entity so as to obtain benefi ts from its activities. In assessing control, potential voting rights that presently are exercisable are taken into account.

An investment in a subsidiary is consolidated into the consolidated fi nancial statements from the date that control commences until the date that control ceases. Intra-group balances and transactions and any unrealized profi ts arising from intra-group transactions are eliminated in full in preparing the consolidated fi nancial statements. Unrealized losses resulting from intra-group transactions are eliminated in the same way as unrealized gains but only to the extent that there is no evidence of impairment.

Non-controlling interests represent the equity in a subsidiary not attributable directly or indirectly to the Company, and in respect of which the Group has not agreed any additional terms with the holders of those interests which would result in the Group as a whole having a contractual obligation in respect of those interests that meets the defi nition of a fi nancial liability. For each business combination, the Group can elect to measure any non-controlling interests either at fair value or at their proportionate share of the subsidiary’s net identifi able assets.

Non-controlling interests are presented in the consolidated balance sheet within equity, separately from equity attributable to the equity shareholders of the Company. Non-controlling interests in the results of the Group are presented on the face of the consolidated statements of operations and the consolidated statements of comprehensive income as an allocation of the total profi t or loss and total comprehensive income for the year between non-controlling interests and the equity shareholders of the Company. Loans from holders of non-controlling interests and other contractual obligations towards these holders are presented as fi nancial liabilities in accordance with notes 2(i) or 2(j) depending on the nature of the liability.

Changes in the Group’s interests in a subsidiary that do not result in a loss of control are accounted for as equity transactions, whereby adjustments are made to the amounts of controlling and non-controlling interests within consolidated equity to refl ect the change in relative interests, but no adjustments are made to goodwill and no gain or loss is recognized.

When the Group loses control of a subsidiary, it is accounted for as a disposal of the entire interest in that subsidiary, with a resulting gain or loss being recognized in profi t or loss. Any interest retained in that former subsidiary at the date when control is lost is recognized at fair value and this amount is regarded as the fair value on initial recognition of a fi nancial asset (see note 2(b)) or, when appropriate, the cost on initial recognition of an investment in an associate or jointly controlled entity (see note 2(a)(ii)).

(ii) Associates and jointly controlled entities An associate is an entity in which the Group has signifi cant infl uence, but not control or joint control, over its management,

including participation in the fi nancial and operating policy decisions. A jointly controlled entity is an entity which operates under a contractual arrangement between the Group and other

parties, where the contractual arrangement establishes that the Group and one or more of the other parties share joint control over the economic activity of the entity.

An investment in an associate or a jointly controlled entity is accounted for in the consolidated fi nancial statements under the equity method. Under the equity method, the investment is initially recorded at cost, adjusted for any excess of the Group’s share of the acquisition-date fair values of the investee’s identifi able net assets over the cost of the investment (if any). Thereafter, the investment is adjusted for the post acquisition change in the Group’s share of the investee’s net assets and any impairment loss relating to the investment (see note 2(s)). Any acquisition-date excess over cost, the Group’s share of the post-acquisition, post-tax results of the investees and any impairment losses for the year are recognized in the consolidated statements of operations, whereas the Group’s share of the post-acquisition post-tax items of the investees’ other comprehensive income is recognized in the consolidated statements of comprehensive income. For the periods presented, no adjustments have been made (or are necessary) to conform the associate’s or jointly controlled entity’s accounting policies to those of the Group as there are no material differences between the accounting policies adopted by the associate and the jointly controlled entity and the Group.

EXHIBIT 6.4 (Continued)

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Comparative Accounting 253

When the Group’s share of losses exceeds its interest in the associate or the jointly controlled entity, the Group’s interest is reduced to nil and recognition of further losses is discontinued except to the extent that the Group has incurred legal or constructive obligations or made payments on behalf of the investee. For this purpose, the Group’s interest is the carrying amount of the investment under the equity method together with the Group’s long term interests that in substance form part of the Group’s net investment in the associate or the jointly controlled entity.

Unrealized profi ts and losses resulting from transactions between the Group and its associates and jointly controlled entities are eliminated to the extent of the Group’s interest in the investee, except where unrealized losses provide evidence of an impairment of the asset transferred, in which case they are recognized immediately in profi t or loss.

When the Group ceases to have signifi cant infl uence over an associate or joint control over a jointly controlled entity, it is accounted for as a disposal of the entire interest in that investee, with a resulting gain or loss being recognized in profi t or loss. Any interest retained in that former investee at the date when signifi cant infl uence or joint control is lost is recognized at fair value and this amount is regarded as the fair value on initial recognition of a fi nancial asset (see note 2(b)) or, when appropriate, the cost on initial recognition of an investment (see note 2(b)).

(b) Other investments The Group’s policies for other investments, other than investments in associates and jointly controlled entities, are as follows:

Investments in available-for-sale fi nancial assets are carried at fair value with any change in fair value recognized in other comprehensive income and accumulated separately in equity in the fair value reserve. When these investments are derecognized or impaired, the cumulative gain or loss is reclassifi ed from equity to profi t or loss. Investments in equity securities that do not have a quoted market price in an active market and whose fair value cannot be reliably measured are recognized in the balance sheet at cost less impairment losses (see note 2(s)).

(c) Property, plant and equipment Property, plant and equipment are stated at cost less accumulated depreciation and impairment losses (see note 2(s)).

The cost of self-constructed assets includes the cost of materials, direct labor, the initial estimate, where relevant, of the costs of dismantling and removing the items and restoring the site on which they are located, and an appropriate proportion of production overheads and borrowing costs.

Gains or losses arising from the retirement or disposal of items of property, plant and equipment are determined as the difference between the net disposal proceeds and the carrying amount of the items and are recognized in profi t or loss on the date of retirement or disposal.

Depreciation is calculated to write off the costs of property, plant and equipment over their estimated useful lives on a straight-line basis, after taking into account their estimated residual values, as follows:

Buildings 12 to 40 years

Plant and machinery 5 to 20 years

Vehicles and other equipment 4 to 20 years

Where parts of an item of property, plant and equipment have different useful lives, the cost of the item is allocated on a reasonable basis between the parts and each part is depreciated separately. The depreciation method, useful life and the residual value of an asset are reviewed annually.

(d) Investment property Investment properties are properties which are owned or held under a leasehold interest either to earn rental income and/or for

capital appreciation. Investment properties are stated in the balance sheet at cost less accumulated depreciation and impairment losses (see note

2(s)). Depreciation is provided over their estimated useful lives on a straight-line basis, after taking into account their estimated residual values. Estimated useful life of the investment property is 40 years.

(e) Lease prepayments and other assets Lease prepayments and other assets mainly represent prepayments for land use rights and catalysts used in production. The

assets are carried at cost less accumulated amortization and impairment losses (see note 2(s)). Lease prepayments and other assets are written off on a straight-line basis over the respective periods of the rights and the estimated useful lives of the catalysts.

(f) Construction in progress Construction in progress represents buildings, various plant and equipment under construction and pending installation, and

is stated at cost less government grants that compensate the Group for the cost of construction, and impairment losses (see note 2(s)). Cost comprises direct costs of construction as well as interest charges, and foreign exchange differences on related borrowed funds to the extent that they are regarded as an adjustment to interest charges, during the period of construction.

Construction in progress is transferred to property, plant and equipment when the asset is substantially ready for its intended use.

No depreciation is provided in respect of construction in progress.

Continued

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254 Chapter Six

(g) Inventories Inventories, other than spare parts and consumables, are carried at the lower of cost and net realizable value. Cost is calculated

using the weighted average cost formula and comprises all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. Costs of conversion of inventories include cost directly related to the units of production as well as allocation of production overheads. The allocation of fi xed production overhead to the costs of conversion is based on normal operating capacity of the production facilities, whereas variable production overheads are allocated to each unit of production on the basis of the actual use of the production facilities. Net realizable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.

When inventories are sold, the carrying amount of the inventories is recognized as an expense in the period in which the related revenue is recognized. The amount of any write-down of inventories to net realizable value and all losses of inventories are recognized as an expense in the period the write-down or loss occurs. The amount of any reversal of any write-down of inventories is recognized as a reduction in the amount of inventories recognized as an expense in the period in which the reversal occurs.

Spare parts and consumables are stated at cost less any provision for obsolescence. (h) Trade receivables, bills and other receivables Trade receivables, bills and other receivables are initially recognized at fair value and thereafter stated at amortized cost using

the effective interest method less allowance for impairment of doubtful debts (see note 2(s)), except where the receivables are interest-free loans made to related parties without any fi xed repayment terms or the effect of discounting would be immaterial. In such cases, the receivables are stated at cost less allowance for impairment of doubtful debts.

Trade receivables, bills and other receivables are derecognized if the Group’s contractual rights to the cash fl ows from these fi nancial assets expire or if the Group transfers these fi nancial assets to another party without retaining control or substantially all risks and rewards of the assets.

(i) Interest-bearing borrowings Interest-bearing borrowings are recognized initially at fair value less attributable transaction costs. Subsequent to initial

recognition, interest-bearing borrowings are stated at amortized cost with any difference between the amount initially recognized and redemption value being recognized in profi t or loss over the period of the borrowings, together with any interest and fees payable, using the effective interest method.

(j) Trade and other payables Trade and other payables are initially recognized at fair value and thereafter stated at amortized cost unless the effect of

discounting would be immaterial, in which case they are stated at cost. (k) Cash and cash equivalents Cash and cash equivalents comprise cash at bank and on hand and time deposits with banks and other fi nancial institutions with

an initial term of less than three months at acquisition. Cash equivalents are stated at cost, which approximates fair value. (l) Translation of foreign currencies Foreign currency transactions during the year are translated into Renminbi at the applicable exchange rates ruling at the

transaction dates. Monetary assets and liabilities denominated in foreign currencies are translated into Renminbi at rates quoted by the People’s

Bank of China at the balance sheet date. Non-monetary assets and liabilities denominated in foreign currencies, which are stated at historical cost, are translated into Renminbi at the closing foreign exchange rate ruling at the date of the transaction.

Foreign currency translation differences relating to funds borrowed to fi nance the construction of property, plant and equipment to the extent that they are regarded as an adjustment to interest costs are capitalized during the construction period. All other exchange gains and losses are dealt with in profi t or loss.

(m) Revenue recognition Revenues associated with the sale of petroleum and chemical products are recognized in profi t or loss when the signifi cant

risks and rewards of ownership have been transferred to the buyer. Revenue excludes value added tax and is after deduction of any trade discounts and returns. No revenue is recognized if there are signifi cant uncertainties regarding recovery of the consideration due to the possible return of goods, or when the amount of revenue and the costs incurred or to be incurred in respect of the transaction cannot be measured reliably.

The Group provides pipeline transportation services to customers. Revenues associated with transportation services are recognized by reference to the stage of completion (that is, when the services are rendered) of the transaction at the end of the reporting period and when the outcome of the transaction can be estimated reliably. The outcome of the transaction can be estimated reliably when the amount of revenue, the costs incurred and the stage of completion can be measured reliably and it is probable that the economic benefi ts associated with the transaction will fl ow to the Group.

EXHIBIT 6.4 (Continued)

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Comparative Accounting 255

Dividend income is recognized in profi t or loss on the date the shareholder’s right to receive payment is established. Gains or losses arising from the disposal of unlisted investments are determined as the difference between the net disposal

proceeds and the carrying amount of the investment and are recognized in profi t or loss on the date of disposal. Rental income from investment property is recognized in profi t or loss on a straight-line basis over the term of the lease.

(n) Government grants Government grants are recognized in the balance sheet initially when there is reasonable assurance that they will be received

and that the Group will comply with the conditions attaching to them. Grants that compensate the Group for expenses incurred are recognized as revenue in profi t or loss on a systematic basis in the same periods in which the expenses are incurred. Grants that compensate the Group for the cost of an asset are deducted from the carrying amount of the asset and consequently are effectively recognized in profi t or loss over the useful life of the asset by way of reduced depreciation expense.

(o) Net fi nancing (costs)/income Net fi nancing (costs)/income comprise interest payable on borrowings calculated using the effective interest rate method, interest

income on bank deposits, foreign exchange gains and losses and bank charges. Interest income from bank deposits is recognized in profi t or loss as it accrues using the effective interest method. All interest and other costs incurred in connection with borrowings are expensed as incurred and included as part of net

fi nancing costs, except to the extent that they are capitalized as being directly attributable to the acquisition or construction of an asset which necessarily takes a substantial period of time to get ready for its intended use or sale.

(p) Repairs and maintenance expenses Repairs and maintenance expenses are charged to profi t or loss as and when they are incurred. (q) Research and development costs Research and development costs comprise all costs that are directly attributable to research and development activities or

that can be allocated on a reasonable basis to such activities. Because of the nature of the Group’s research and development activities, no development costs satisfy the criteria for the recognition of such costs as an asset. Both research and development costs are therefore recognized as expenses in the period in which they are incurred.

(r) Employee benefi ts The contributions payable under the Group’s retirement plans are charged to the profi t or loss on an accrual basis according to

the contribution determined by the plans. Further information is set out in note 24. Termination benefi ts are recorded as employee reduction expenses in the profi t or loss, and are recognized when, and

only when, the Group demonstrably commits itself to terminate employment or to provide benefi ts as a result of voluntary redundancy by having a detailed formal plan which is without realistic possibility of withdrawal.

(s) Impairment loss (i) Trade accounts receivable, bills and other receivables and investments in equity securities other than investments in

associates and jointly controlled entities, that do not have a quoted market price in an active market are reviewed at each balance sheet date to determine whether there is objective evidence of impairment. If any such evidence exists, an impairment loss is determined and recognized.

The impairment loss is measured as the difference between the asset’s carrying amount and the estimated future cash fl ows, discounted at the current market rate of return for a similar fi nancial asset where the effect of discounting is material, and is recognized as an expense in the profi t or loss. Impairment losses for trade accounts receivable, bills and other receivables are reversed through the profi t or loss if in a subsequent period the amount of the impairment loss decreases. Impairment losses for investments in equity securities carried at cost are not reversed.

For investments in associates and jointly controlled entities recognized using the equity method (note 2(a)(ii)), the impairment loss is measured by comparing the recoverable amount of the investment as a whole with its carrying amount in accordance with note 2(s)(ii). The impairment loss is reversed if there has been a favourable change in the estimates used to determine the recoverable amount in accordance with note 2(s)(ii).

(ii) Impairment of other long-lived assets is accounted for as follows: The carrying amounts of other long-lived assets, including property, plant and equipment, construction in progress, lease

prepayments, other assets and investments in associates and jointly controlled entities, are reviewed at each balance sheet date to identify indications that the asset may be impaired. These assets are tested for impairment whenever events or changes in circumstances indicate that their recorded carrying amounts may not be recoverable. When such a decline has occurred, the carrying amount is reduced to the recoverable amount.

The recoverable amount is the greater of the fair value less costs to sell and the value in use. In determining the value in use, expected future cash fl ows generated by the asset are discounted to their present value using a pre-tax discount rate that refl ects current market assessments of the time value of money and the risks specifi c to the asset. Where an asset does not generate cash infl ows largely independent of those from other assets, the recoverable amount is determined for the smallest group of assets that generates cash infl ows independently (i.e. a cash-generating unit).

Continued

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256 Chapter Six

The amount of the reduction is recognized as an expense in the profi t or loss. Impairment losses recognized in respect of cash-generating units are allocated fi rst to reduce the carrying amount of any goodwill allocated to the cash-generating unit and then, to reduce the carrying amount of the other assets in the unit on a pro rata basis, except that the carrying value of an asset will not be reduced below its individual fair value less costs to sell, or value in use, if determinable.

Management assesses at each balance sheet date whether there is any indication that an impairment loss recognized for an asset, except in the case of goodwill, in prior years may no longer exist. An impairment loss is reversed if there has been a favorable change in the estimates used to determine the recoverable amount. A subsequent increase in the recoverable amount of an asset, when the circumstances and events that led to the write-down or write-off cease to exist, is recognized in profi t or loss. The reversal is reduced by the amount that would have been recognized as depreciation had the write-down or write-off not occurred. An impairment loss in respect of goodwill is not reversed.

(t) Dividends payable Dividends are recognized as a liability in the period in which they are declared. (u) Income tax Income tax expense comprises current and deferred tax. Income tax expense is recognized in profi t or loss except to the extent

that it relates to items recognized in other comprehensive income or directly in equity, in which case the relevant amounts of tax are recognized in other comprehensive income or directly in equity, respectively.

Current tax is the expected tax payable on the taxable income for the year, using tax rates enacted or substantially enacted at the balance sheet date, and any adjustment to tax payable in respect of previous years.

Deferred tax is provided using the balance sheet liability method, providing for temporary differences between the carrying amounts of assets and liabilities for fi nancial reporting purposes and the amounts used for taxation purposes, except differences relating to goodwill not deductible for tax purposes and the initial recognition of assets or liabilities which affect neither accounting nor taxable income. The amount of deferred tax provided is based on the expected manner of realization or settlement of the carrying amount of assets and liabilities, using tax rates enacted or substantially enacted at the balance sheet date. The effect on deferred tax of any changes in tax rates is charged or credited to the profi t or loss, except for the effect of a change in tax rate on the carrying amount of deferred tax assets and liabilities which were previously charged or credited directly to equity upon initial recognition, in such case the effect of a change in tax rate is also charged or credited to equity.

A deferred tax asset is recognized only to the extent that it is probable that future taxable income will be available against the assets which can be realized or utilized. Deferred tax assets are reduced to the extent that it is no longer probable that the related tax benefi t will be realized.

(v) Provisions and contingent liabilities Provisions are recognized for liabilities of uncertain timing or amount when the Group has a legal or constructive obligation

arising as a result of a past event, it is probable that an outfl ow of economic benefi ts will be required to settle the obligation and a reliable estimate can be made. Where the time value of money is material, provisions are stated at the present value of the expenditure expected to settle the obligation.

Where it is not probable that an outfl ow of economic benefi ts will be required, or the amount cannot be estimated reliably, the obligation is disclosed as a contingent liability, unless the probability of outfl ow of economic benefi ts is remote. Possible obligations, whose existence will only be confi rmed by the occurrence or non-occurrence of one or more future events are also disclosed as contingent liabilities unless the probability of outfl ow of economic benefi ts is remote.

(w) Related parties (i) A person, or a close member of that person’s family, is related to the Group if that person: (1) has control or joint control over the Group; (2) has signifi cant infl uence over the Group; or (3) is a member of the key management personnel of the Group or the Group’s parent. (ii) An entity is related to the Group if any of the following conditions applies: (1) The entity and the Group are members of the same group (which means that each parent, subsidiary and fellow

subsidiary is related to the others). (2) One entity is an associate or joint venture of the other entity (or an associate or joint venture of a member of a group of

which the other entity is a member). (3) Both entities are joint ventures of the same third party. (4) One entity is a joint venture of a third entity and the other entity is an associate of the third entity. (5) The entity is a post-employment benefi t plan for the benefi t of employees of either the Group or an entity related to the

Group. (6) The entity is controlled or jointly controlled by a person identifi ed in (i). (7) A person identifi ed in (i)(1) has signifi cant infl uence over the entity or is a member of the key management personnel of

the entity (or of a parent of the entity).

EXHIBIT 6.4 (Continued)

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Comparative Accounting 257

Close members of the family of a person are those family members who may be expected to infl uence, or be infl uenced by, that person in their dealings with the entity.

(x) Segment reporting Operating segments, and the amounts of each segment item reported in the fi nancial statements, are identifi ed from the

fi nancial information provided regularly to the Group’s chief operating decision maker for the purposes of allocating resources to, and assessing the performance of the Group’s various lines of business.

3. CHANGES IN ACCOUNTING POLICIES

The IASB has issued a few amendments to IFRS that are fi rst effective for the current accounting period of the Group. None of the developments are relevant to the accounting policies applied in the fi nancial statements for the years presented.

The Group has not applied any new standard or interpretation that is not yet effective for the current accounting period.

The Chinese government has been active in developing accounting standards in harmony with international accounting standards due to self-motivation and external pressure. However, it has retained a uniform accounting system in the Enterprise Accounting System, issued in 2000 to accommodate the special circum- stances of a transforming government, strong state ownership, a weak accounting profession, a weak equity market, and the inertial effect of accounting tradition and cultural factors. 30

At the end of 2009, the Ministry of Finance provided guidance on how to fur- ther improve ! nancial reporting quality, which included ! rst-time adoption of IFRS, appropriate use of professional judgment, elimination of the difference be- tween A-share and H-share listed ! rms, and adoption of “other comprehensive income.”

GERMANY Background After the Second World War, Germany was divided into American, French, British, and Soviet zones of occupation. In 1949, the Federal Republic of Germany was created out of the western zones, and the communist-led German Democratic Republic was established in the Soviet zone. After reuni! cation in October 1990, Germany became a federal republic composed of 16 Länder (states): 10 from the former West, 5 from the former East, and Berlin, the capital city. The constitution provides for a president, elected by a federal convention for a ! ve-year term; the Bundestag (Lower House) of 667 members elected by direct universal suffrage for a four-year term of of! ce; and the Bundesrat (Upper House), composed of 69 mem- bers appointed by the governments of the Länder in proportion to their popula- tions, without a ! xed term of of! ce.

There are eight stock exchanges in Germany: Berliner Börse, Börse Hamburg, Börse Hannover, Börse München, Börse Stuttgard, Börse Düsseldorf, Eurex (Frankfurt-based), and Frankfurt Stock Exchange (FSE). The origins of the FSE go back to the ninth century. By the sixteenth century, Frankfurt had developed into

30 J. Z. Xiao, P. Weetman, and M. Sun, “Political Infl uence and Coexistence of a Uniform Accounting System and Accounting Standards: Recent Developments in China,” Abacus 40, no. 2 (2004), pp. 193–218.

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258 Chapter Six

a wealthy and busy city with an economy based on trade and ! nancial services. In 1574, a Börse was established to set up ! xed currency exchange rates. During the following centuries, Frankfurt developed into one of the world’s ! rst stock exchanges, next to London and Paris. In 1949, after World War II, the FSE became established as the leading stock exchange in Germany. However, unlike in the United States, traditionally the primary source of ! nance for German companies is bank loans, rather than equity raised through the capital market. In Germany, banks not only provide loans to companies but also control major proportions of their equity capital, either directly or as trustees for their customers. This deter- mines to a large extent the purpose for ! nancial reporting by companies.

Since reuni! cation, German accounting has been greatly affected by the increas- ing internationalization of the German economy and the growing integration of the world’s capital markets. In 1993, the Frankfurt Stock Exchange became the German Stock Exchange—GSE (Deutsche Börse AG). In early 1997, the GSE formed the Neuer Markt (New Market) for young, high-tech enterprises, and required those companies, most of which were German, to use U.S. GAAP or IAS, but not German GAAP. The FSX was Börse for the Neuer Markt. Currently the FSE is by far the largest in Germany, and the world’s tenth-largest stock exchange by market capitalization. The FSE accounts for over 90 percent of the turnover in the Ger- man market. In recent years, an increasing number of German companies, such as DaimlerChrysler and Deutsche Telekom, have been raising capital on interna- tional markets, particularly the New York Stock Exchange.

The most common legal forms of business enterprise are the Aktiengesellschaft (AG), which is a publicly traded stock corporation, and the Gesellschaft mit be- schränkter Haftung (GMBH), which is a limited liability company that is not pub- licly traded.

Historically, Germany has had a considerable in" uence on the accounting sys- tems in many countries, especially Japan, Austria, Switzerland, and some Nordic countries such as Denmark and Sweden. These countries adapted the ideas and concepts developed in Germany to suit their conditions. This is re" ected in the intellectual basis of accounting and auditing education and in the source of the various laws in those countries. For example, the Commercial Code in Japan was modeled on the German Commercial Code.

Accounting Profession Auditing dominates the ! nancial reporting related professional activities in Germany. The title for certi! ed auditors, Wirtschaftsprüfer (WP) (economic or en- terprise examiner), was created by the Companies Act of 1931. The Institut der Wirtschaftsprüfer (Institute of Auditors) is a private association of public auditors and public audit ! rms. It comprises approximately 10,800 public auditors and over 900 public audit ! rms, and represents about 85 percent of the profession. It pro- vides for education and continuing professional development. Stock corporations and other large companies must be audited by WPs. Stringent requirements to become a WP are found in the Wirtschaftsprüferordnung (Auditors Law). These gen- erally include obtaining a university degree in business administration, econom- ics, law, engineering, or agriculture; passing examinations covering accounting, auditing, business administration, law, taxation, and general economics; and four years of practical experience, including two years in auditing. The German audit- ing profession is much smaller than its counterpart in the United States (about 11,000 WPs—population 82.2 million—vs. more than 250,000 CPAs— population 307.2 million).

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Comparative Accounting 259

The auditing profession is headed by the Wirtschaftsprüferkammer (WPK) (Chamber of Auditors), an independent organization responsible for the super- vision of its members and for the representation of the profession to other parties. It is a state-supervised organization. All public accountants are mandatory mem- bers of the WPK. A second important organization is the Institute of Auditors, whose main task is to publish statements on accounting and auditing questions, which usually serve as generally accepted accounting and auditing standards.

There also is a second-tier body of certi! ed accountants, vereidigte Buchprüfer (VB). The requirements to become a VB are less onerous than those to become a WP. VBs are allowed to perform only voluntary audits and audits of medium- sized limited liability companies (GMBHs). A third type of professional accoun- tant in Germany are the Steuerberater (tax advisers), who focus on offering tax services to their clients.

Accounting Regulation Financial reporting in Germany is dominated by commercial law, tax law, and pronouncements issued by the profession. Traditionally, Germany has not used a system of independent institutional oversight. 31 The German Commercial Code contains most of the country’s ! nancial reporting principles, which include the general accounting and auditing rules applicable to all companies, together with a special section relating to stock corporations and limited liability companies. It also speci! es sanctions for noncompliance, such as punitive measures, penalties, and ! nes to be imposed by the courts. Unlike in the United States, partnership account- ing is regulated in Germany. The German Stock Exchange listing requirements have much less in" uence on ! nancial reporting compared to those in the United States.

A stock corporation (AG) is required to prepare statutory nonconsolidated an- nual ! nancial statements comprising a balance sheet, income statement, and the notes to the ! nancial statements, along with a management report. These ! nancial statements should (1) be prepared in accordance with the German principles of proper accounting applicable to all commercial business and (2) provide a true and fair view of the net assets, ! nancial position, and results of operations of the corporation. In addition, parent companies are required to prepare statutory con- solidated annual ! nancial statements and a group management report. A parent company may be exempted from this requirement if, for example, it is itself a sub- sidiary of another parent company. Further, the executive board of a stock corpo- ration is required to ! le at the Commercial Registrar the nonconsolidated (and consolidated, if applicable) ! nancial statements, the management report, the audi- tor’s report, and the proposed, and resolved, appropriation of retained earnings and net income (including any dividend proposal or resolution). These documents are also published in the of! cial federal gazette, the Bundesanzeiger.

In Germany, the predominance of the principle of prudence (conservatism) is clearly established in the law. Accordingly, pro! ts must be recognized only when they have been realized, but losses should be recorded as soon as they appear pos- sible. During the worldwide economic crisis of the late 1920s and early 1930s (the Great Depression), the existing accounting practices failed to protect adequately the creditors of German companies in cases of insolvency. As a consequence, the principle of prudence was incorporated in the 1937 Stock Corporation Law, which also speci! cally required that the compulsory audits of public corporations be performed by WPs.

31 D. Ordelheide, “Germany,” in Accounting Regulation in Europe, ed. S. McLeary (London: Macmillan, 1999), pp. 99–146.

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260 Chapter Six

In the mid-1960s, there were signs of a change in ! nancial reporting in Germany from a creditor orientation towards a shareholder orientation. The Companies Act of 1965 can be regarded as the initiator of this change, and for the ! rst time it required greater ! nancial disclosures from companies, including preparation of consolidated statements and disclosure of the valuation bases used. For two de- cades, the Companies Act provided the primary source of accounting regulation for listed companies, supplemented by provisions in the Commercial Code and income tax law.

More recently, German accounting regulation has been heavily in" uenced by the EU directives. The Accounting Act of 1985 implemented the EU’s Fourth, Sev- enth, and Eighth Directives, and transformed them into German Commercial Law. The act speci! es different ! nancial reporting requirements according to company size. Since then, the Financial Statement Directives Law, which amended the Com- mercial Code, has been the legal basis for ! nancial reporting in Germany. In line with the European IAS regulation, Germany enacted the Financial Reporting Con- trol Act (Bilanzkontrollgesetz) and the Accounting Law Reform Act (Bilanzrechts- formgesetz) in 2004, allowing the entities providing debt instruments to postpone the changeover to IFRS for two years, and noncapital market-oriented companies to prepare their consolidated ! nancial statements in conformity with IFRS for ! nancial years which commence on or after January 1, 2005. However, individ- ual ! nancial statements still needed to be consistent with the German accounting principles of the German Commercial Code because of their role in the calculation of dividend payments and income tax.

Until 1998 the Federal Ministry of Justice coordinated the accounting rule devel- opment process, and the accounting profession played only a relatively minor role in that process. In May 1998, German law was amended to allow a private-sector body to develop accounting standards. Accordingly, the German Accounting Standards Committee (GASC) was created in May 1998. It was charged with the responsibility of developing accounting standards for consolidated ! nancial reporting, represent- ing German interests in international fora, and advising the Ministry of Justice on the development of accounting legislation. The GASC is a private standard-setting body that is supported and funded by 137 German companies and individual mem- bers, and managed by an executive board of up to 14 members.

The GASC has two standing committees, the German Accounting Standards Board (GASB) and the Accounting Interpretations Committee (AIC). The GASB is solely responsible for the preparation and adoption of its pronouncements, which may consist of accounting standards, comments on accounting issues ad- dressed to national and international bodies, working papers, and other com- ments and publications considered appropriate by the GASB. The main objective of the AIC is to promote international convergence of interpretations of core accounting issues in close cooperation with the IASB’s International Financial Reporting Interpretations Committee (IFRIC). The GASB develops its account- ing standards through a due process of public consultation, which includes the following steps:

1. Publication of exposure drafts of standards with a call for comments to be sub- mitted within 45 days.

2. Publication of comments received (unless the party submitting the comments requests otherwise), along with an analysis and discussion of material objec- tions and proposed amendments.

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Comparative Accounting 261

3. Publication of a revised exposure draft with a call for comments to be submit- ted within 30 days (in those cases where the GASB determines the comments received warrant material amendments of the original exposure draft).

4. Public discussion on the draft standard, which must be announced at least 14 days in advance; minutes of the public discussion must be published within 30 days.

5. Adoption of standards at meetings open to the public. 6. Publication of adopted standards including, where applicable, dissenting votes,

with a brief basis for conclusion.

In recent years, in addition to companies affected by the legal requirements, the IFRS have gained popularity in Germany among companies in general. The ben- e! ts of adopting IFRS are widely seen as being based in the fact that they are likely to result in increased transparency. The strong international acceptance of inter- national accounting principles also seems to have put growing pressure on na- tional standard-setters and legislators. The GASB was given the task of adapting German accounting principles to international norms by 2004. The establishment of this committee also provided a vehicle for the German accounting profession to participate formally in the activities of international bodies such as the IASB. The GASB, modeled on the FASB, is staffed by independent experts—three from industry, two auditors, one ! nancial analyst, and one academic.

Adoption of IFRS in Germany:

Listed companies Companies that have applied for listing

Nonlisted companies

Consolidated fi nancial statements

Mandatory adoption of IFRS starting January 1, 2005

Mandatory adoption of IFRS starting January 1, 2007

Option to choose between HGB and IFRS starting January 1, 2003

Individual fi nancial statements

All companies must prepare fi nancial statements in accordance with HGB. For informative purposes, they may also prepare fi nancial statements in accordance with IFRS. Starting January 1, 2005, large corporations may use IFRS instead of HGB for publishing their individual fi nancial statements in the Federal Gazette.

All other parent companies (excluding companies whose shares were admitted in any member state for trading on a regulated exchange, and all parent compa- nies which had applied for admission of securities for trading on an organized exchange in Germany) may choose to apply the IFRS for compiling their consoli- dated ! nancial statements at their discretion. If they choose to do so, they should comply fully with IFRS. Still, the German legislators require individual ! nancial statements to be consistent with the German accounting principles of the German Commercial Code because of their role in the calculation of dividend payments and income tax.

Germany has created a new legal code for ! nancial accounting. Accordingly, enforcement of ! nancial reporting is performed in Germany in two stages; the ! rst stage involves a government-appointed privately organized institution, the Financial Reporting Enforcement Panel (FREP) (Deutsche Prüfstelle für Rechnungsle- gung), while the second stage is performed by the Federal Financial Supervisory

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262 Chapter Six

Authority (FFSA) (Bundesanstalt für Finanzdienstleistungsaufsicht, or BaFin), which is the ! nancial regulatory authority for Germany.

FREP has been examining ! nancial reporting of companies listed in the regu- lated market in Germany since July 2005. They publish the results of their work in an annual activity report (available in English), which includes statistics on the number of ! nancial statements found to be wanting, and analysis of the types of errors found. In its annual activity report for 2012, FREP mentions that it com- pleted 113 examinations. At 16 percent, the rate of ! nancial statements found to be wanting was signi! cantly lower than last year’s rate of 25 percent. The FREP has identi! ed two main causes of errors in 2012, namely, (1) insuf! cient reporting in the management report and in the notes, and (2) range and challenging ap- plication of certain IFRS. The accounting treatment of business combinations was found to be the main cause of the latter type of errors.

The FREP established the following main focus areas for 2013 in October 2012:

1. Impairments of assets, including goodwill. 2. Consistency of cash " ow projections for cash-generating units with related

operating budgets/forecasts, particularly with respect to the forecasting period. 3. Reasonableness of forecasted cash " ows during the detailed forecasting period,

particularly if forecasts were not achieved in the past or if assumptions differ from market data.

4. Reasonableness of growth rate and discount rate (determination of the peer group in calculating the cost of capital; derivation of the discount rate accord- ing to the timing of the underlying cash " ows).

5. Suf! ciently precise disclosure of valuation methods and underlying assumptions.

The FFSA, established in May 2002 with the aim of creating one integrated ! nan- cial regulator that covered all ! nancial markets, is an independent federal institu- tion and falls under the supervision of the Ministry of Finance. It has the right, when it discovers a crime or even the suspicion of a crime, such as insider trading, market manipulation, illegal operation of banking, or ! nancial fraud, to forward the perpetrators to law enforcement authorities.

At the European Commission level, the European Securities and Markets Authority (ESMA), founded in 2011, is responsible for coordinating the work of the national enforcement institutions in order to promote consistency in apply- ing IFRS. In 2012, the ESMA and national enforcers, for the ! rst time, agreed on European common enforcement priorities with respect to separate and consoli- dated ! nancial statements of publicly listed companies for the ! scal year ended December 31, 2012. Accordingly, the ESMA report entitled “European Enforcers’ Review of Impairment of Goodwill,” released in January 2013, analyzed the ac- counting practices of 235 European issuers related to impairment testing of goodwill and intangible assets. The report shows that, although the consolidated ! nancial statements reviewed did provide the major disclosures related to impair- ment testing, in many cases these disclosures were not informative enough.

In November 2007, the German Federal Ministry of Justice published a draft bill of the German Accounting Law Modernization Act (BilMoG). 32 The German Federal Council approved BilMoG in May 2009. The new regulations introduced

32 For details, see www.standardsetter.de/drsc/docs/press_releases/071108-RefEBilMoG.pdf (only available in German).

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Comparative Accounting 263

far-reaching changes to German GAAP, mandatory for all ! nancial years from January 1, 2010, with early adoption permitted. All companies that prepare Ger- man GAAP ! nancial statements, irrespective of whether they are SMEs or publicly traded, are affected.

For the ! rst time ever, BilMoG incorporated IFRS-related elements into Ger- man GAAP. For example, as a result of BilMoG, the capitalization of internally generated intangible assets such as self-created patents is a permissible option, while prohibited under previous rules, and tax accounting for external ! nancial reporting is abolished. However, BilMoG is not “IFRS light”; instead, it is “German GAAP complex.”

Following the major accounting reforms introduced to the German Commer- cial Code (Handelsgesetzbuch—HGB) by the BilMoG, a question has been raised whether Germany can still be classi! ed within the Continental European model of accounting [e.g., Hellmann, Perera, and Patel (2013)]. The BilMoG incorporates some attributes of IFRS into the HGB, affecting both consolidated ! nancial state- ments and individual company ! nancial statements of all companies. However, the HGB still remains the primary law for ! nancial reporting in Germany, and it is mandatory for individual ! nancial statements of all German companies by pro- viding the legal basis for dividends and other related matters. Hellmann, Perera, and Patel (2013) argue that, as a result of these changes, the current German ap- proach to ! nancial reporting separates Germany from the traditional Continental European model of accounting and moves it to somewhere on the spectrum be- tween the traditional Continental European model of accounting and the Anglo- American model of accounting.33

DRSC/GASB have released their annual report for the year 2009 (in both German and English), which provides a comprehensive overview of the national and the international activities of these bodies. According to the annual report, in 2009, the work of the GASB was essentially characterized by IASB projects relat- ing to the ! nancial crisis. Further, the Accounting Interpretation Committee (AIC) developed or amended interpretations and application advice on different topics in 2009.

DRSC provided comments on IASCF constitution review proposals for en- hanced public accountability. It is now available for download from the DRSC/ GASB Web site. In particular, the Board takes issue with the lack of explicit ref- erence to a commitment to principles-based standards and urges the Trustees of the IFRS Foundation to review the objective of bringing about convergence with national accounting standards. They argue that as more than 100 countries now follow IFRS, the IASB should focus entirely on the quality of its standards, rather than seek convergence with a few remaining countries.

Accounting Principles and Practices The German ! nancial reporting requirements are mainly based on the Commer- cial Code. The historical cost basis for valuing tangible assets is strictly adhered to. In addition, the approved standards of the GASB must be followed in preparing the consolidated accounts of listed companies. Accordingly, starting from 2005, listed companies are required to use IFRS in their consolidated ! nancial state- ments, so long as these comply with EU directives.

33 A. Hellmann, H. Perera, and C. Patel, “Continental European Accounting Model and Accounting Mod- ernization in Germany,” Advances in Accounting, Incorporating Advances in International Accounting 29 (2013), pp. 124–33.

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264 Chapter Six

Given the traditional role of bank credit in corporate ! nance, the principle of creditor protection plays an important role in German accounting practices. Ac- cordingly, the primary function of ! nancial accounting is the conservative deter- mination of distributable income, which represents that part of the actual income of the company that can be paid out to shareholders without impairing the po- sition of the creditors or the long-term prospects of the ! rm. Consequently, the information needs of investors and presenting a true and fair view in the ! nancial statements have not been the primary focus in ! nancial reporting.

Traditionally, German accounting is heavily in" uenced by tax law. The relation- ship between ! nancial accounting and taxation in Germany is explained by the “authoritative principle,” which basically states that the ! nancial statements are the basis for taxation. There also is a “reverse authoritative principle,” which re- quires an expense to be included in accounting income to be tax deductible. These principles have the effect of minimizing differences between tax and accounting income, thereby reducing the need to account for deferred income taxes.

The reason for the link between ! nancial reporting and taxation in Germany is historical. The duty of bookkeeping and annual accounting was codi! ed in the German Commercial Code in 1862. Corporate income taxation was introduced 12 years later, in 1874. The easiest course of action was to link corporate income taxation to existing ! nancial statements. In contrast, when income tax was intro- duced in the United Kingdom in 1799 and reformed substantially in 1803, there was no set of accounting rules to refer to. The ! rst accounting rules appeared only in 1844. This explains the different traditions followed in Germany and the United Kingdom with regard to the link between taxation and ! nancial reporting. 34

For the average company, ! nancial accounting is in" uenced to a great extent by the desire to minimize taxes. For example, in years with high pro! ts, ! rms will attempt to report a more moderate level of income to reduce taxes by adopting the most conservative options available under the rules. (This is less the case for companies that compete for funds in international capital markets.) In some cases, what is acceptable for tax purposes is not acceptable under German accounting rules. To meet the requirement that tax deductions must be reported in ! nancial statements, German accounting law allows companies to report “special tax items” on the balance sheet, located between accrued liabilities and stockholders’ equity. For example, assume that tax law allows a special depreciation rate of 75 percent in the year in which an asset with a 20-year life that costs 100 euros is acquired. Depreciation of 75 euros (a debit) would be taken in calculating both taxable and accounting income, but accumulated depreciation (a credit) would be re" ected on the balance sheet in the amount of only 5 euros (5 percent annual depreciation). The difference of 70 euros is reported as a special tax item on the equity side (a credit) of the balance sheet.

The conservative measurement of income in Germany is also in" uenced by a desire to mitigate labor unions’ demands for higher wages and to report stable income over time for dividend purposes. 35 Income stability (or smoothing) is ac- complished by estimating liabilities such as provisions for warranties, pensions, and “uncertain future liabilities” at relatively high amounts, with a correspond- ing increase in expenses. The extra amounts accrued as liabilities on the balance

34 E. L. E. Eberhartinger, “The Impact of Tax Rules on Financial Reporting in Germany, France, and the UK,” International Journal of Accounting 34, no. 1 (1999), pp. 93–119. 35 Timothy S. Doupnik, “Recent Innovations in German Accounting Practice Through the Integration of EC Directives,” Advances in International Accounting (1992), p. 80.

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Comparative Accounting 265

sheet are known as hidden or silent reserves. In later, less pro! table years, adjust- ments can be made to these liabilities to release the hidden reserves, with a cor- responding amount of revenue recognized in income. German accounting rules allow ! rms to smooth their pro! ts over time in this fashion. 36 The process of using accounting options available within the accounting law to generate the desired amount of reported pro! t is referred to as Bilanzpolitik (! nancial statement policy).

The EU’s Fourth Directive requires companies to apply the true and fair view principle in preparing ! nancial statements. Some suggest that the German un- derstanding of true and fair view differs from how the concept is understood in Anglo-Saxon countries. Alexander and Archer state:

According to the thinking of the Germans, and to a certain extent of most other member states, the true and fair view is not an operational concept; accounting measurement rules are simply conventions that are agreed on by due democratic process, and if they allow hidden reserves, then such reserves are fair. 37

The German Accounting Act of 1985 increased the required note disclosures. It appears that extensive note disclosures are seen as a way of achieving the true and fair view without changing the tax-based, income-smoothing approach to ! nan- cial reporting.

Globalization has had a dramatic effect on German ! nancial reporting in recent years. Since 1998, parent companies whose shares or other issued securities are publicly traded have been allowed to prepare their consolidated ! nancial state- ments in accordance with IFRS or other internationally accepted accounting stan- dards, such as U.S. GAAP. In 2001, of the 100 blue-chip companies making up the DAX/MDAX stock market index, 39 were using IFRS and 22 used U.S. GAAP. 38 For the 2002 ! nancial year, 53 percent of ! rms listed on the Frankfurt Prime Stan- dard adopted IFRS. 39 Since January 1, 2005, all German listed companies have been required to use IFRS in preparing their consolidated ! nancial statements. German GAAP continue to be used by non-publicly traded companies and by publicly traded companies in preparing their parent company, that is, nonconsoli- dated, ! nancial statements, which serve as the basis for taxation.

The main intention of the German Accounting Law Modernization Act is to modernize the German Accounting Law in line with IFRS. Important changes include:

• Intangible assets have to be recognized. • Deferred tax assets will have to be recognized. • Fair value accounting of ! nancial assets, i.e., valuation above the initially recog-

nized costs, will become possible.

German accounting practices differ in some respects from IFRS, partly because German accounting law contains no speci! c rules in some areas. For example, the law provides no guidance with respect to the translation of foreign cur- rency ! nancial statements of foreign subsidiaries (IAS 21), or annual impairment

36 M. Glaum and U. Mandler, “Global Accounting Harmonization from a German Perspective: Bridging the GAAP,” Journal of International Financial Management and Accounting 7, no. 3 (1996), pp. 215–42. 37 David Alexander and Simon Archer, eds., European Accounting Guide, 5th ed. (New York: Aspen, 2004), p. 1.15. 38 Ibid., p. 7.09. 39 P. Brown and A. Tarca, “A Commentary on Issues Relating to the Enforcement of International Financial Reporting Standards in the EU,” European Accounting Review 14, no. 1 (2005), p. 198.

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266 Chapter Six

reviews when a useful life in excess of 20 years is used for intangible assets (IAS 38). Further, there are no speci! c rules requiring disclosures of a primary statement of changes in equity (IAS 1); fair values of ! nancial assets and liabili- ties (IAS 32); related-party transactions other than those with equity participants (IAS 24); and earnings per share (IAS 33). There are also inconsistencies between German rules and IFRS in some areas; for example, goodwill arising on consoli- dation can be deducted immediately against equity (IFRS 3); foreign-currency payables and receivables are generally translated at the worse of transaction and closing rates so as to avoid the recognition of gains on unsettled balances (IAS 21); leases are normally classi! ed according to tax rules and are therefore seldom rec- ognized as ! nance leases (IAS 17); and inventories can be valued at replacement cost (IAS 2). Exhibit 6.5 summarizes some of the differences between IFRS and German GAAP.

EXHIBIT 6.5 Differences between German GAAP and IFRS

Issue IFRS German GAAP

Business combinations IFRS 3: Must use purchase method; pooling of interests prohibited.

Certain business combinations may be accounted for as pooling of interests even though an acquirer can be identifi ed.

Goodwill on consolidation IFRS 3: Not amortized, but tested for impairment annually (effective March 31, 2004).

Goodwill arising on consolidation can be deducted immediately against equity.

Internally generated intangible assets IAS 38: Internally generated goodwill can be recognized as an asset under certain conditions.

Internally generated intangible assets, which are expected to provide ongoing service to the enterprise, must not be recognized.

Foreign-currency translation IAS 21: Foreign-currency monetary items should be reported using the closing rate.

Foreign-currency monetary balances are generally translated at the worse of transaction and closing rates so as to avoid the recognition of gains on unsettled balances.

Leases IAS 17: Distinguishes between fi nance leases and operating leases, and provides guidance for classifying them.

Leases are normally classifi ed according to tax rules; therefore, leases are seldom recognized as fi nance leases.

Inventory valuation IAS 2: Requires inventories to be stated at the lower of cost or net realizable value.

Inventories can be stated at the lowest of cost, net realizable value, or replacement cost.

Construction contracts IAS 11: The stage of completion of the contract activity at the balance sheet date should be used to recog- nize contract revenue.

In general, the completed contract method is used for the recognition of revenue on construction contracts and services.

Exclusion of subsidiaries from consolidation

IAS 27: Subsidiaries whose activities are dissimilar to those of its parent must be consolidated.

Certain subsidiaries with dissimilar activities should be excluded from consolidation.

Start-up costs IAS 38: Start-up costs must be charged to expenses when incurred.

Start-up costs may be capitalized and amortized over four years.

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Comparative Accounting 267

40 In early February 2005, it was reported that more than half of German companies which were in the FTSEurofi rst 300 index had adopted IFRSs. Due to globalization pressures, German companies are now competing in a worldwide capital market where the quality of the information provided to investors has to match up to that of international competitors. 41 In February 2005, the Federal Ministry of Justice published German Accounting Standard 15, Management Reporting, and subsequently the GASB reported that it adopted GAS 15.

Another area where German GAAP differs from IFRS is in the management report, which is, according to the German tradition, an important part of a com- pany’s ! nancial statements. The IFRS do not include speci! c requirements regard- ing the management report. However, even companies that publish their ! nancial statements according to IFRS 40 still have to provide a management report provid- ing information on a company’s future situation, for example, regarding research and development or exposure to ! nancial or operating risks. 41

In August 2010, only about 10 German companies were listed on the New York Stock Exchange (NYSE), mainly due to overregulation of the NYSE. Prior to the adoption of IFRS in the European Union in 2005, BASF AG was one of the few NYSE-listed German companies that prepared its consolidated ! nancial state- ments on the basis of German GAAP; the others used either IFRS (e.g., Bayer and Schering) or U.S. GAAP (e.g., DaimlerChrysler and Siemens). We can gain some insight into the differences that exist between German GAAP and U.S. GAAP by investigating the reconciliation to U.S. GAAP prepared by BASF in its Form 20-F annual report ! led with the U.S. Securities and Exchange Commission. Exhibit 6.6 presents excerpts from Form 20-F for the year ended December 31, 2012. Note that BASF has adopted accounting policies consistent with U.S. GAAP to the extent that these practices are permissible under German GAAP. Nonethe- less, BASF’s accountants have determined that there are 11 accounting issues in which U.S. GAAP and German GAAP are incompatible and for which an adjust- ment must be made. The largest adjustments relate to the accounting for goodwill and the accrual of provisions. The adjustment related to provisions reverses ac- cruals of liabilities (and expenses) that were made under German GAAP in 2003 that would not have met the de! nition of a liability under U.S. GAAP in that period.

Issues related to the adoption of IFRS in Germany

• Still, many companies in Germany have not addressed the full effects of BilMoG, as it introduced major changes to German GAAP.

• IFRS are said to be superior because they are perceived as being more transpar- ent, with greater public accountability, whereas German GAAP had been char- acterized by con! dentiality and restriction of ! nancial disclosure to those that were closely involved in the management of the business;

• IFRS re" ect the concept of a “true and fair view,” which would lead to a much greater scope of reporting obligations, whereas the German GAAP has tradi- tionally emphasized creditor protection and prudence in its conservative mea- surement approaches.

• IFRS requires extensive use of judgments by professional accountants, whereas in German GAAP, there is less exercise of professional accountants’ judgments and a greater focus on legal form and statutory control.

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268 Chapter Six

EXHIBIT 6.6

BASF GROUP Form 20-F

2012 Excerpt from Notes to the Consolidated Financial Statements

1—Summary of accounting policies

1.1—Group accounting principles

Accounting standards applied: The Consolidated Financial Statements of BASF SE as of December 31, 2012, have been prepared in accordance with International Financial Reporting Standards (IFRS) and Section 315a (1) of the German Commercial Code (HGB). BASF SE is a publicly-listed corporation based in Ludwigshafen am Rhein. Its offi cial address is Carl-Bosch-Str. 38, 67056 Ludwigshafen am Rhein, Germany.

The individual fi nancial statements of the companies included in the Consolidated Financial Statements of the BASF Group (hereinafter referred to as “consolidated companies”) are prepared as of the balance sheet date of the Consolidated Financial Statements. All of the binding IFRSs in the fi scal year 2012 as well as the pronouncements of the International Financial Reporting Interpretations Committee (IFRIC) were applied. IFRSs are applied as soon as they have been endorsed by the European Union.

The accounting policies that have been applied are the same as those in 2011, with the exception of any changes required by the application of new or revised standards and interpretations. In 2012, there were no signifi cant changes for BASF in this regard.

The Consolidated Financial Statements are prepared in euros, and all amounts, including the fi gures for previous years, are given in million euros unless otherwise indicated.

On February 18, 2013, the Consolidated Financial Statements were prepared and authorized for release by the Board of Executive Directors and will be submitted for approval by the Audit Committee to the Supervisory Board of BASF SE at its meeting on February 21, 2013.

Scope of consolidation: The Consolidated Financial Statements include BASF SE as well as all material subsidiaries. BASF controls these companies or exercises a majority of the voting rights, either directly or indirectly.

Material, jointly controlled entities are included on a proportional consolidation basis. Associated companies are accounted for using the equity method. These are companies over which the Company can exercise a

signifi cant infl uence over the operating and fi nancial policies, and are neither subsidiaries nor jointly controlled entities. In general, this applies to companies in which BASF has an interest of 20% to 50%.

Subsidiaries whose business is dormant or of low volume and that are insignifi cant for the presentation of a true and fair view of the net assets, fi nancial position and results of operations as well as the cash fl ows are not consolidated. These companies are carried at amortized cost and are written down in the case of an impairment. The aggregate assets and equity of these subsidiaries amount to less than 1% of the corresponding value at Group level.

Consolidation methods: Assets and liabilities of consolidated companies are accounted for and valued uniformly in accordance with the principles described herein. For companies accounted for using the equity method, material deviations from our accounting policies are adjusted for.

Transactions between consolidated companies as well as intercompany profi ts resulting from sales and services rendered between consolidated companies are eliminated in full; for jointly controlled entities, they are proportionally eliminated. Material intercompany profi ts related to companies accounted for using the equity method are eliminated.

Capital consolidation at the acquisition date is based on the purchase method. Initially, all assets, liabilities and additional intangible assets that are to be capitalized are valued at fair value. Finally, the acquisition cost is compared with the proportional share of the net assets acquired at fair value. The resulting positive differences are capitalized as goodwill. Negative differences are reviewed once more, then recognized directly in profi t or loss.

The incidental acquisition costs of a business combination are recognized in the income statement. Translation of foreign currency fi nancial statements: The translation of foreign currency fi nancial statements depends on

the functional currency of the consolidated companies. For companies whose functional currency is not the euro, translation into the reporting currency is based on the closing rate method: Balance sheet items are translated into euros at closing rates on the balance sheet date; expenses and income are translated into euros at monthly average rates and accumulated for the year. The translation adjustments due to the use of the closing rate method are shown under currency translation adjustments as a component of other comprehensive income in equity and are recognized in income only upon the disposal of a company.

For certain companies outside the eurozone or U.S. dollar zone, the euro or U.S. dollar is the functional currency.

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Comparative Accounting 269

Selected exchange rates (1 EUR equals)

Closing rates Average rates Dec. 31, Dec. 31,

2012 2011 2012 2011

Brazil (BRL). . . . . . . . . . . . . . . . 2.70 2.42 2.51 2.33 China (CNY). . . . . . . . . . . . . . . 8.22 8.16 8.11 9.00 Great Britain (GBP). . . . . . . . . . 0.82 0.84 0.81 0.87 Japan (JPY). . . . . . . . . . . . . . . . 113.61 100.20 102.49 110.96 Malaysia (MYR) . . . . . . . . . . . . 4.03 4.11 3.97 4.26 Mexico (MXN) . . . . . . . . . . . . . 17.18 18.05 16.90 17.29 Russia (RUB). . . . . . . . . . . . . . . 40.33 41.77 39.93 40.88 Switzerland (CHF) . . . . . . . . . . 1.21 1.22 1.21 1.23 South Korea (KRW) . . . . . . . . . 1,406.23 1,498.69 1,447.69 1,541.23 United States (USD) . . . . . . . . . 1.32 1.29 1.28 1.39

1.2—Accounting policies

Assets Goodwill is only written down if there is an impairment. Impairment testing takes place once a year and whenever there is an indication of an impairment. The goodwill impairment test is based on cash-generating units and compares the recoverable amount of the unit with the respective carrying amount. At BASF, the cash-generating units are predominantly the business units, or in certain cases, the divisions. The recoverable amount is the higher of fair value less costs to sell and the value in use. Value in use is generally determined using the discounted cash fl ow method. Impairment testing relies upon the cash-generating unit’s long-term earnings forecasts, which are based on economic trends.

The weighted average cost of capital (WACC) based on the Capital Asset Pricing Model plays an important role in impairment testing. The WACC is made up of the risk-free interest rate, the country-specifi c tax rates, the beta of the BASF share as well as assumptions as to the spread for credit risk and the market risk premium for the cost of equity. Additional important assumptions are the forecasts for the detailed planning period and the terminal growth rates used.

For more information, see Note 13 from page 178 onward

If the impairment loss is equal to or exceeds the carrying amount of goodwill, the goodwill is written off completely. Any impairment loss left over is allocated to the remaining assets of the cash-generating unit. Goodwill impairments are reported under other operating expenses.

Acquired intangible assets are valued at cost less scheduled straight-line amortization, except for goodwill and intangible assets with indefi nite useful lives. The useful life is determined using the period of the underlying contract and the period of time over which the intangible asset is expected to be used. Impairments are recognized if the recoverable amount of the asset is lower than the carrying amount. The recoverable amount is the higher of either fair value less costs to sell and the value in use. Impairments are reversed if the reasons for the impairment no longer exist.

Depending on the type of intangible asset, the amortization expense is recorded as cost of sales, selling expenses, research and development expenses or other operating expenses.

Intangible assets with indefi nite useful lives are trade names and trademarks that have been acquired as part of acquisitions. They are tested for impairment annually.

Internally generated intangible assets primarily comprise internally developed software. Such software and other internally generated assets for internal use are valued at cost and amortized over their useful lives. Impairments are recognized if the carrying amount of an asset exceeds the recoverable amount.

In addition to those costs directly attributable to the asset, costs of internally generated intangible assets also include an appropriate allocation of overhead costs. Borrowing costs are capitalized if they relate to the period over which the asset is generated and they are material.

Continued

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270 Chapter Six

The weighted-average useful lives of intangible assets amounted to:

Average amortization in years

2012 2011 Distribution, supply and similar rights. . . . . . . . . . . . . . . . . . . . 13 13

Product rights, licenses and trademarks . . . . . . . . . . . . . . . . . . 17 17 Know-how, patents and production technologies . . . . . . . . . . 13 13 Internally generated intangible assets. . . . . . . . . . . . . . . . . . . . 5 5 Other rights and values . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 6

The estimated useful lives and amortization methods chosen are based on historical values, plans and estimates. These estimates also consider the period and distribution of future cash infl ows. The depreciation methods, useful lives and residual values are reviewed at each balance sheet date.

Emission rights: Emission right certifi cates, granted free-of-charge by the German Emissions Trading Authority (Deutsche Emissionshandelsstelle) or a similar authority in other European countries, are recognized at fair value at the time they are credited to the electronic register run by the relevant governmental authority. Purchased emission rights are recorded at cost. Subsequently, they are measured at fair value, up to a maximum of cost. If the fair value is lower than the carrying amount on the balance sheet date, the emission rights are written down.

Property, plant and equipment are carried over their useful lives at acquisition or production cost less scheduled depreciation and impairments. The revaluation method is not used. Low-value assets are fully written off in the year of acquisition and are shown as disposals.

The cost of self-constructed plants includes direct costs, appropriate allocations of material and manufacturing costs, and a share of the general administrative costs of the divisions involved in the construction of the plants. Borrowing costs that are incurred during the period of construction are capitalized.

Expenditures related to scheduled maintenance turnarounds of large-scale plants are separately capitalized as part of the asset and depreciated using the straight-line method over the period until the next planned turnaround. The costs for the replacement of components are recognized as assets when an additional future benefi t is expected. The book value of the replaced components is derecognized. The costs for maintenance and repair as part of normal business operations are recognized as an expense.

Both movable and immovable fi xed assets are usually depreciated using the straight-line method. The weighted-average depreciation periods were as follows:

Average depreciation in years

2012 2011 Buildings and structural installations. . . . . . . . . . . . . . . . . . . . . 20 22

Machinery and technical equipment. . . . . . . . . . . . . . . . . . . . . 10 10 Long-distance natural gas pipelines . . . . . . . . . . . . . . . . . . . . . 25 25 Miscellaneous equipment and fi xtures . . . . . . . . . . . . . . . . . . . 7 7

The estimated useful lives and amortization methods applied are based on historical values, plans and estimates. These estimates also consider the period and distribution of future cash infl ows. The depreciation methods, useful lives and residual values are reviewed at each balance sheet date.

Impairments are recognized if the recoverable amount of the asset is lower than the carrying amount. The evaluation is based on the present value of the expected future cash fl ows. An impairment is recognized for the difference between the carrying amount and the value of discounted future cash fl ows. If the reasons for the impairment no longer exist, the write-downs are reversed accordingly.

Investment properties held to realize capital gains or rental income are immaterial. They are valued at the lower of fair value or acquisition cost less scheduled depreciation.

Leases: In accordance with IAS 17, leasing contracts are classifi ed as either fi nance or operating leases. Assets subject to operating leases are not capitalized. Lease payments are charged to income in the year they are incurred.

A lease is classifi ed as a fi nance lease if it substantially transfers all of the risks and rewards related to the leased asset. Assets subject to a fi nance lease are recorded at the present value of the minimum lease payments. A leasing liability is recorded in the same amount. The periodic lease payments must be divided into principal and interest components. The principal component reduces the outstanding liability, while the interest component represents an interest expense. Depreciation takes place over the shorter of the useful life of the asset or the period of the lease.

Leases can be embedded within other contracts. If IFRS requires separation, then the embedded lease is recorded separately from its host contract and each component of the contract is carried and measured in accordance with the applicable regulations.

EXHIBIT 6.6 (Continued)

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Comparative Accounting 271

BASF acts as a lessor for fi nance leases in a minor capacity only. Borrowing costs: If the production phase of intangible assets or the construction phase of property, plant and equipment

extends beyond a period of one year, the interest incurred on borrowed capital directly attributable to that asset is capitalized as part of the cost of that asset. Borrowing costs are capitalized up to the date the asset is ready for its intended use. The borrowing costs are calculated based on a rate of 4.5%, which is adjusted on a country-specifi c basis. All other borrowing costs are recognized as an expense in the period in which they are incurred.

Investment subsidies: Government grants related to the acquisition or construction of property, plant and equipment reduce the acquisition or construction cost of the respective assets. Other government grants or government assistance are treated as deferred income and recognized as income over the underlying period.

Investments accounted for using the equity method: The carrying amounts of these companies are adjusted annually based on the pro rata share of net income, dividends and other changes in equity. Should there be indications of a permanent reduction in the value of an investment, an impairment is recognized in the income statement.

Inventories are carried at cost. If the listed, market or fair value of the sales product which forms the basis for the net realizable value is lower, then this is applied and an impairment is recognized. The net realizable value is based on the selling price in the ordinary course of business less the estimated costs of completing and selling the product.

In addition to direct costs, cost of conversion includes an appropriate allocation of production overhead costs based on normal utilization rates of the production plants, provided that they are related to the production process. Pensions, social services and voluntary social benefi ts are also included, as well as allocations for administrative costs, provided they relate to the production. Borrowing costs are not included in cost of conversion.

Valuation adjustments on inventories result from price declines in sales products and age of inventory. For the valuation of inventories in the precious metals trading business, the Company applies the exception for commodity broker-

traders under IAS 2. Accordingly, inventories held exclusively for trading purposes are to be measured at fair value. Changes in value are recognized in profi t or loss.

Deferred taxes: Deferred taxes are recorded for temporary differences between the carrying amount of assets and liabilities in the fi nancial statements and the carrying amounts for tax purposes as well as for tax loss carryforwards and unused tax credits. This also comprises temporary differences arising from business combinations, with the exception of goodwill. Deferred tax assets and liabilities are calculated according to country-specifi c tax rates. Any changes to the tax rate enacted or substantively enacted on or before the balance sheet date are taken into consideration. The tax rate for corporations based in Germany is 29%. Deferred tax assets are offset against deferred tax liabilities provided they are related to the same taxation authority. Surpluses of deferred tax assets are only recognized provided that the tax benefi ts are likely to be realized. The valuation of deferred tax assets depends on the estimated probability of a reversal of the temporary differences and the ability to utilize tax loss carryforwards and unused tax credits. This depends on whether future taxable profi ts will exist during the period in which temporary differences are reversed and in which tax loss carryforwards and unused tax credits can be claimed. Based on experience and the expected development of taxable income, it is assumed that the benefi t of deferred tax assets recognized will be realized. The valuation of deferred tax assets is based on internal projections of the future earnings of the particular Group company.

Changes made to deferred tax assets or liabilities are recorded as deferred tax expense or income if the transaction or event on which they are based is not recognized directly in equity. Deferred tax assets and liabilities for those effects which have been recognized in equity are also recorded outside profi t and loss.

No deferred tax liabilities are recognized for differences between the proportional IFRS equity and the taxable book value of participations when a reversal of these differences is not expected in the foreseeable future. Deferred tax liabilities are recognized for dividend distributions which are planned for the following year if these distributions lead to a reversal of the temporary differences.

For more information, see Note 10 from page 175 onward

Financial instruments

Financial assets and fi nancial liabilities are recognized in the balance sheet when the BASF Group becomes a party to a fi nancial instrument. Financial assets are derecognized when the contractual rights to the cash fl ows from the fi nancial asset expire or when the fi nancial asset, with all risks and rewards of ownership, is transferred. Financial liabilities are derecognized when the contractual obligation expires, is discharged or cancelled. Regular way purchases and sales of fi nancial instruments are accounted for using the settlement date; in precious metals trading, the day of trading is used.

The fair value of a fi nancial instrument is the amount for which an instrument could be exchanged in an arm’s length transaction between two knowledgeable, willing parties. When pricing on an active market is available, for example on a stock exchange, this price is used for the measurement. Otherwise, the measurement is based on internal valuation models using current market parameters or external valuations, for example, from banks. These internal valuations predominantly use the net present value method and option pricing models.

If there is objective evidence of a permanent impairment of a fi nancial instrument that is not measured at fair value through profi t or loss, an impairment loss is recognized.

If the reason for the impairment of loans and receivables as well as held-to-maturity fi nancial instruments no longer exists, the impairment is reversed up to the amortized cost and recognized in profi t or loss. Impairments on fi nancial instruments are booked in separate accounts.

Continued

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272 Chapter Six

Financial assets and liabilities are divided into the following valuation categories: – Financial assets and liabilities at fair value through profi t or loss consist of derivatives and other trading instruments. At

BASF, this valuation category only includes derivatives. Derivatives are reported in miscellaneous assets or other liabilities. BASF does not make use of the fair value option under IAS 39. The calculation of fair values is based on market parameters or valuation models based on such parameters. In some exceptional cases, the fair value is calculated using parameters which are not observable on the market.

– Loans and receivables comprise fi nancial assets with fi xed or determinable payments, which are not quoted on an active market and are not derivatives or classifi ed as available-for-sale. This valuation category includes trade accounts receivable, loans classifi ed under other fi nancial assets as well as other receivables and loans classifi ed under other receivables and miscellaneous assets. Initial valuation is done at fair value, which generally matches the nominal value of the receivable or loan. Interest-free and low- interest long-term loans and receivables are recorded at present value. Subsequent valuations recognized in income are generally made at amortized cost using the effective interest method.

If there is objective evidence for an impairment of a receivable or loan, an individual valuation allowance is made. When assessing the need for a valuation allowance, regional and sector-specifi c conditions are considered. In addition, use is made of internal and external ratings as well as the assessments of debt collection agencies and credit insurers, when available. A substantial portion of receivables is covered by credit insurance. Bank guarantees and letters of credit are used to a limited extent. Valuation allowances are only recognized for those receivables which are not covered by insurance or other collateral. The valuation allowances for receivables whose insurance includes a deductible cannot exceed the amount of the deductible. Impairments are based on historical values relating to customer solvency and the age, period overdue, insurance policies and customer-specifi c risks. In addition, a valuation allowance must be recognized when the contractual conditions which form the basis for the receivable or loan are changed through renegotiation in such a way that the present value of the future cash fl ows decreases.

Receivables for which no objective indication for an impairment exists may be impaired based on historical default rates. In addition, valuation allowances are made on receivables based on transfer risks for certain countries.

If, in a subsequent period, the amount of the valuation allowance decreases and the decrease can be related objectively to an event occurring after the impairment was recognized, the previously recognized write-down is to be reversed through profi t or loss. Reversals of valuation allowances may not exceed amortized cost. Loans and receivables are derecognized when they are defi nitively found to be uncollectible.

– Held-to-maturity fi nancial assets consist of non-derivative fi nancial assets with fi xed or determinable payments and a fi xed term, for which there is the ability and intent to hold until maturity, and which do not fall under other valuation categories. Initial valuation is made at fair value, which matches the nominal value in most cases. Subsequent measurement is carried out at amortized cost, using the effective interest method.

For BASF, there are no material fi nancial assets that fall under this category. – Available-for-sale fi nancial assets comprise fi nancial assets which are not derivatives and do not fall under any of the

previously stated valuation categories. This valuation category comprises participations not accounted for using the equity method as well as short- and long-term securities reported under the item other fi nancial assets.

The valuation is carried out at fair value. Changes in fair value are recognized directly in equity under the item other comprehensive income and are only recorded in profi t or loss when the assets are disposed of or have been impaired. Subsequent reversals are recognized directly in equity (other comprehensive income). Only in the case of debt instruments are reversals up to the amount of the original impairment recognized in profi t or loss; reversals above this amount are recognized directly in equity. If the fair value of available-for-sale fi nancial assets drops below acquisition costs, the assets are impaired if the decline in value is signifi cant and can be considered lasting. The fair values are determined using market prices. Participations whose fair value cannot be reliably determined are carried at acquisition cost and are written down in the case of an impairment. When determining the value of these participations, the acquisition costs constitute the best estimate of their fair value. This category of participations includes investments in other affi liated companies, investments in other associated companies and shares in other participations, provided that these shares are not publicly traded. There are no plans to sell signifi cant stakes in these participations.

– Financial liabilities which are not derivatives are initially measured at fair value, which normally corresponds to the amount received. Subsequent measurement is carried out at amortized cost, using the effective interest method.

– Cash and cash equivalents consist primarily of cash on hand and bank balances.

There were no reclassifi cations from one valuation category to another in 2012 and 2011. Revenue from interest-bearing assets is recognized on the outstanding receivables on the balance sheet date using interest rates

calculated by means of the effective interest method. Dividends from participations not accounted for under the equity method are recognized when the shareholders’ right to receive payment is established.

Derivative fi nancial instruments can be embedded within other contracts. If IFRS requires separation, then the embedded derivative is recorded separately from its host contract and shown at fair value.

Financial guarantees of the BASF Group are contracts that require compensation payments to be made to the guarantee holder if a debtor fails to make payment when due under the terms of the fi nancial guarantee. Financial guarantees are measured at fair value upon initial recognition. In subsequent periods, fi nancial guarantees are carried at the higher of amortized cost or the best estimate of the present obligation on the fi nancial reporting date.

EXHIBIT 6.6 (Continued)

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Comparative Accounting 273

Cash fl ow hedge accounting is applied for selected deals to hedge future transactions. The effective portion of the change in fair value of the derivative is thereby recognized directly in equity under other comprehensive income, taking deferred taxes into account. The ineffective portion is recognized immediately in profi t or loss. In the case of future transactions that will lead to a non-fi nancial asset or a non-fi nancial debt, the cumulative fair value changes in equity are either charged against the acquisition costs on initial recognition or recognized in profi t or loss in the reporting period in which the hedged item is recorded in the income statement. For hedges based on fi nancial assets or debts, the cumulative fair value changes of the hedges are transferred from equity to the income statement in the reporting period in which the hedged item is recognized in the income statement. The maturity of the hedging instrument is determined based on the effective date of the future transaction.

To hedge the translation risk from the net investment in a foreign subsidiary, BASF uses hedge accounting in individual cases (hedge of a net investment in a foreign operation). The effective portion of the hedge is recognized in equity. If the foreign operation is disposed of, these amounts are reclassifi ed to profi t and loss. The ineffective portion of the hedge is immediately recognized in profi t or loss.

When fair value hedges are used, the asset or liability is hedged against the risk of a change in fair value, with changes in the market value of the derivative fi nancial instruments recognized in the income statement. Furthermore, the book value of the underlying transaction is adjusted by the profi t or loss resulting from the hedged risk, offsetting the effect in the income statement.

The derivatives employed by BASF for hedging purposes are effective hedges from an economic point of view. Changes in the fair value of the derivatives almost completely offset the changes in the value of the underlying transactions.

Debt

Provisions for pensions and similar obligations: Provisions for pensions are based on actuarial computations made according to the projected unit credit method, which applies valuation parameters that include: future developments in compensation, pensions and infl ation, the expected performance of plan assets, employee turnover and the life expectancy of benefi ciaries. The resulting obligations are discounted on the balance sheet date using the market yields on high-quality corporate fi xed-rate bonds with an AA rating. Actuarial gains and losses are recognized directly in retained earnings. They result from the difference between the actual development in pension obligations and pension assets and the assumptions made at the beginning of the year as well as from the updating of actuarial assumptions.

Similar obligations, especially those arising from commitments by North American Group companies to pay the healthcare costs and life insurance premiums of retired staff and their dependents, are included in pension provisions.

The calculation of pension provisions is based on actuarial reports.

For more information on provisions for pensions and similar obligations, see Note 21 from page 187 onward

Other provisions: Other provisions are recognized when there is a present obligation as a result of a past event and when there is a probable outfl ow of resources whose amount can be reliably estimated. Provisions are recognized at the probable settlement value.

Provisions for German trade income tax, German corporate income tax and similar income taxes are determined and recognized in the amount necessary to meet the expected payment obligations less any prepayments that have been made. Other taxes to be assessed are considered accordingly.

Provisions are established for certain environmental protection measures and risks if the measures are considered likely as a result of present legal or constructive obligations arising from a past event. Provisions for restoration obligations primarily concern the fi lling of wells and the removal of production facilities upon the termination of production in the Oil & Gas segment. The present value of the obligation increases the cost of the respective asset when it is initially recognized.

Other provisions also include expected charges for the rehabilitation of contaminated sites, the recultivation of landfi lls, the removal of environmental contamination at existing production or storage facilities and other similar measures. If BASF is the only responsible party that can be identifi ed, the provision covers the entire expected claim. At sites operated together with one or more partners, the provision covers only BASF’s share of the expected claim. The determination of the amount of the provision is based on the available technical information on the site, the technology used, legal regulations, and offi cial obligations.

The estimation of future costs is subject to uncertainties. This refers in particular to rehabilitation measures that involve several parties and extend over longer time periods.

Provisions are recognized for expected severance payments or similar personnel expenses as well as for demolition expenses and other charges related to the closing of operations that have been planned and publicly announced by management.

Provisions for long-service and anniversary bonuses are predominantly calculated based on actuarial principles. For contracts signed under the early retirement programs, provisions for the supplemental payments are recognized in their full amount and the wage and salary payments due during the passive phase of agreements are accrued in installments.

For more information on provisions for the long-term incentive program, see Note 29 from page 205 onward

Other provisions also cover risks resulting from legal disputes and proceedings. In order to determine the amount of the provisions, the Company takes into consideration the facts related to each case, the size of the claim, claims awarded in similar cases and independent expert advice as well as assumptions regarding the probability of a successful claim and the range of possible claims. The actual costs can deviate from these estimates. For more information, see Note 25 on page 196

Continued

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274 Chapter Six

The probable amount required to settle long-term provisions is discounted if the effect of discounting is material. In this case, the provision is recognized at present value. Assumptions must be made in determining the discount rate used for calculating long- term provisions. Financing costs related to the compounding of provisions in subsequent periods are shown in other fi nancial results.

Other accounting policies

Revenue recognition: Revenues from the sale of goods or the rendering of services are recognized upon the transfer of ownership and risk to the buyer. They are valued at the fair value of the consideration received. Sales are reported without sales tax. Expected rebates and other trade discounts are either accrued or deducted. Provisions are made according to the principle of individual valuation to cover probable risks related to the return of products, estimated future warranty obligations and other claims.

Revenues from the sale of precious metals to industrial customers as well as some revenues from natural gas trading are recognized at the time of shipment and the corresponding purchase price is recorded at cost of sales. In the trading of precious metals and their derivatives with broker-traders, where there is usually no physical delivery, revenues are recorded on a net basis. Revenues from the natural gas trading activities of a project company consolidated by BASF are also recorded on a net basis.

In certain cases, customer acceptance is required on delivery. In these cases, revenue is recognized after customer acceptance occurs. Payments relating to the sale or licensing of technologies or technological expertise are recognized in income according to the

contractually agreed transfer of the rights and obligations associated with those technologies. Foreign currency transactions: The cost of assets acquired in foreign currencies and revenue from sales in foreign currencies are

recorded at the exchange rate on the date of the transaction. Foreign currency receivables and liabilities are valued at the exchange rates on the balance sheet date. Foreign exchange gains or losses resulting from the translation of assets and liabilities are reported as other operating expenses or other operating income under other fi nancial income or expenses; for available-for-sale fi nancial assets, they are reported in other comprehensive income.

Oil and gas exploration: Exploration and development expenditures are accounted for using the successful efforts method. Under this method, costs of successful exploratory drilling as well as successful and dry development wells are capitalized.

An exploration well is a well located outside of an area with proven oil and gas reserves. A development well is a well which is drilled to the depth of a reservoir of oil or gas within an area with proven reserves.

Production costs include all costs incurred to operate, repair and maintain the wells as well as the associated plant and ancillary production equipment, including the associated depreciation.

Exploration expenses relate exclusively to the Oil & Gas segment and include all costs related to areas with unproven oil or gas deposits. These include costs for the exploration of areas with possible oil or gas deposits, among others. Costs for geological and geophysical investigations are always reported under exploration expenses. In addition, this item includes write-offs for exploration wells which did not encounter proven reserves. Scheduled depreciation of successful exploratory drilling is reported under cost of sales.

Exploratory drilling is generally reported under construction in progress until its success can be determined. When the presence of hydrocarbons is proven such that the economic development of the fi eld is probable, the costs remain capitalized as suspended well costs. At least once a year, all suspended wells are assessed from an economic, technical and strategic viewpoint to see if development is still intended. If this is not the case, the well in question is written off. When reserves are proven and the development of the fi eld begins, the exploration wells are reclassifi ed as machinery and technical equipment.

An Exploration and Production Sharing Agreement (EPSA) is a type of contract in crude oil and gas concessions whereby the expenses and profi ts from the exploration, development and production phases are divided between the state and one or more exploration and production companies using defi ned keys. The revenue BASF is entitled to under such contracts is reported as sales.

Provisions for required restoration obligations associated with oil and gas operations concern the fi lling of wells and the removal of production facilities upon the termination of production. When the obligation arises, the provision is initially measured at the present value of the future restoration costs. An asset of the same value is capitalized as part of the carrying amount of the plant concerned and is depreciated along with the plant. Interest on the provision is accrued annually until the time of the planned restoration.

The unit of production method is used to depreciate assets from oil and gas exploration at the fi eld or reservoir level. Depreciation is generally calculated on the basis of proven, developed reserves in relation to the production of the period.

In the natural gas trading business, long-distance natural gas pipelines are depreciated using the straight-line method. The weighted-average depreciation period amounted to 25 years in 2012 and 2011. The intangible asset from the marketing contract for natural gas from the Yuzhno Russkoye natural gas fi eld is amortized based on BASF’s share of the produced and distributed volumes.

Intangible assets in the Oil & Gas segment relate primarily to exploration and drilling rights. During the exploration phase, these are not subject to scheduled amortization but are tested for impairment annually. When economic success is determined, the rights are amortized in accordance with the unit of production method.

Groups of assets and liabilities held for sale and disposal groups: These comprise those assets and directly associated liabilities shown on the balance sheet whose sale in the context of a single transaction is highly probable. The assets and liabilities of disposal groups are recognized at the lower of the sum of their carrying amounts or fair value less costs to sell; this does not apply to assets which do not fall under the valuation principles of IFRS 5. Scheduled depreciation of long-term assets is suspended.

Further information on the assets and liabilities of the disposal group can be found in Note 2 on page 165

EXHIBIT 6.6 (Continued)

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Comparative Accounting 275

Use of estimates and assumptions in the preparation of the Consolidated Financial Statements

The carrying amount of assets, liabilities and provisions, contingent liabilities and other fi nancial obligations in the Consolidated Financial Statements depends on the use of estimates and assumptions. Specifi c estimates or assumptions used in individual accounting or valuation methods are disclosed in their respective sections. They are based on the circumstances and estimates on the balance sheet date and affect the reported amounts of income and expenses during the reporting periods. These assumptions affect the determination of useful lives of property, plant and equipment and intangible assets, the measurement of provisions, the carrying amount of investments, and other similar valuations of assets and obligations. Although uncertainty is appropriately incorporated in the valuation factors, actual results can differ from these estimates.

In business combinations, the acquired assets and liabilities are recognized at fair value on the date the acquirer effectively obtains control. Assumptions are used to determine the fair value of the acquired intangible assets, property, plant and equipment and liabilities assumed at the date of exchange as well as the useful lives of the acquired intangible assets and property, plant and equipment. The measurement is largely based on projected cash fl ows. The actual cash fl ows can differ signifi cantly from the cash fl ows used to determine the fair values. External appraisals are used for the purchase price allocation of material acquisitions. Valuations in the course of business combinations are based on existing information as of the acquisition date.

Impairment tests on assets are carried out whenever certain triggering events indicate that an impairment may be necessary. External triggering events include, for example, changes in customer industries, technologies used and economic downturns. Internal triggering events for an impairment include lower product profi tability, planned restructuring measures or physical damage to assets.

Impairment tests are based on a comparison of the carrying amount and the recoverable amount. The determination of value in use requires the estimation and discounting of cash fl ows. The estimation of cash fl ows and the assumptions used consider all information available on the respective balance sheet date on the future development of the operating business. Actual future developments may vary.

IFRSs and IFRICs not yet to be considered in the preparation of the Consolidated Financial Statements The effects on the BASF Group of the IFRSs and IFRICs not yet in force or not yet endorsed by the European Union in the fi scal year 2012 were reviewed, and are shown in the overview on the following page. Other new standards or interpretations and amendments of existing standards and interpretations will have no material impact on BASF. Implementing the standards before endorsement by the European Union is not planned.

Overview of impact of IFRSs and IFRICs not yet to be considered in the preparation of the Consolidated Financial Statements

Standard/ Interpretation

Published by IASB

Implemen- tation date stipulated by IASB

E.U. endorse-

ment published Anticipated impact on BASF

IFRS 9 Financial Instruments

Nov. 12, 2009

Jan. 1, 2015

Postponed As the fi rst phase of the project to replace IAS 39 Financial Instruments - Recognition and Measurement, this standard introduces new classes, classifi cation criteria and assessment criteria for fi nancial instruments. In addition, on October 28, 2010, new requirements under IFRS 9 were published on the accounting for fi nancial liabilities and the derecognition of fi nancial instruments. In particular, these changes will affect those fi nancial liabilities that were optionally measured at fair value. On November 28, 2012, a draft of the limited changes under IFRS 9 Recognition and Measurement was published. Furthermore, a staff draft of the hedge accounting section was published on September 7, 2012, which contains the future accounting rules for hedging transactions. The potential impact on BASF is currently being analyzed.

IFRS 10 Consolidated Financial Statements

May 12, 2011

Jan. 1, 2013

Dec. 29, 2012

IFRS 10 replaces the provisions of IAS 27 Consolidated and Separate Financial Statements, which regulates the preparation of consolidated fi nancial statements, as well as SIC-12 Consolidation – Special Purpose Entities. In contrast to IAS 27, this standard is geared more strongly towards the economic situation as opposed to the legal conditions. IFRS 10 contains a new defi nition of “control,” which is to be applied in determining the companies to be consolidated. “Control” now comprises three elements: decision-making power, variable returns and the ability to use decision-making power to affect the variable returns. The new defi nition of control as well as the rules regarding principal-agent relationships will also lead to a change in the scope of consolidation at BASF. Upon the application of the new standard by BASF from January 1, 2013, four companies, including Wintershall AG, will be accounted for using the equity method rather than fully consolidated. The impact on BASF Group is described below under IFRS 11.

Continued

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276 Chapter Six

Standard/ Interpretation

Published by IASB

Implemen- tation date stipulated by IASB

E.U. endorse-

ment published Anticipated impact on BASF

IFRS 11 Joint Arrangements

May 12, 2011

Jan. 1, 2013

Dec. 29, 2012

The standard regulates the accounting of joint arrangements. Depending on the type of rights and obligations resulting from the arrangements, IFRS 11 differentiates between joint ventures and joint operations. While shares in joint ventures are accounted for using the equity method, for joint operations the proportional share of assets, liabilities, income and expenses are reported. BASF currently consolidates joint ventures proportionally. BASF will apply the standard from January 1, 2013, and report the equity result as part of EBIT. Upon the application of the new standard, 14 companies will be accounted for using the equity method rather than proportionally consolidated. Applying IFRS 10 and 11 to the fi gures from the year 2012 would have resulted in a decrease in sales of €6,600 million (of which Wintershall AG: €2,741 million) and a decline in EBIT of €2,404 million (of which Wintershall AG: €2,331 million). The reclassifi cation of the equity income of associated companies would have partially offset this, leading to an increase in EBIT of €171 million. Net income would have remained nearly unchanged.

For fi nancial information on proportionally consolidated companies, see Note 2 from page 161 onward

IFRS 12 Disclosure of Interests in Other Entities

May 12, 2011

Jan. 1, 2013

Dec. 29, 2012

This new standard, which BASF has applied since January 1, 2013, requires more extensive disclosures with respect to fully consolidated companies and companies which are not included in the Consolidated Financial Statements, i.e., the reasons why they were fully consolidated or excluded. This change will impact the Notes to the Consolidated Financial Statements of the BASF Group.

IFRS 13 Fair Value Measurement

May 12, 2011

Jan. 1, 2013

Dec. 29, 2012

IFRS 13 will replace the individual regulations governing the determination of fair value. This standard does not introduce any signifi cant new valuation requirements but does require additional notes. The potential impact on BASF is currently being analyzed.

Amendments to IAS 28 Investments in Associates and Joint Ventures

May 12, 2011

Jan. 1, 2013

Dec. 29, 2012

The provision of IAS 28 governing the use of the equity method will be expanded by the adoption of IFRS 11; in the future, it will also have to be used on shares in jointly controlled entities.

Amendments to IAS 1 Presentation of Items of Other Comprehensive Income

June 16, 2011

July 1, 2012

June 6, 2012

Components of other comprehensive income (OCI) that under certain circumstances are to be reclassifi ed in the profi t and loss statement will have to be shown separately from those components which can never be reclassifi ed. If the change to IAS 1 were applied to the 2012 annual fi nancial statements, the income and expenses recognized in equity would include minus €201 million in items which in the future will be reclassifi ed to the income statement – of which minus €11 million would be deferred taxes.

“Statement of income and expense recognized in equity” on page 147

EXHIBIT 6.6 (Continued)

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Comparative Accounting 277

Standard/ Interpretation

Published by IASB

Implemen- tation date stipulated by IASB

E.U. endorse-

ment published Anticipated impact on BASF

IAS 19 (revised) Employee Benefi ts

June 16, 2011

Jan. 1, 2013

June 6, 2012

The most signifi cant change of IAS 19 requires that experience-based adjustments and effects from changes of actuarial assumptions, reported as actuarial gains and losses, will have to be recognized immediately in other comprehensive income. The previous option between immediate reporting in profi t and loss, reporting in equity or delayed reporting according to the corridor method will be abolished. The amendment will not have an effect on BASF because actuarial gains and losses are already recorded directly in equity. Changes in the benefi t levels with retroactive effect on past service which result from plan amendments are no longer to be amortized over the vesting period; instead they are to be recognized immediately in profi t or loss in the year of the plan amendment. The application of this accounting policy will lead to a reduction of around €3 million in BASF’s EBIT in 2013. Additionally, asset returns on plan assets recognized in profi t or loss will no longer be calculated according to expectations but will instead be equal to the discount rate applied for pension obligations. The application of this accounting method will lead to a reduction of around €100 million in BASF’s fi nancial result in 2013. Due to the changed defi nition of termination benefi ts and the resulting change in accounting policy for early-retirement agreements, a reduction in EBIT of around €7 million is expected in 2013.

For more information, see Note 21 from page 187 onward The revised IAS 19 also requires more detailed disclosure.

JAPAN

Background Legislative authority in Japan rests with the Kokkai, the bicameral diet, which con- sists of a 480-member House of Representatives and a 247-member House of Coun- cillors. Members of the House of Representatives serve a four-year term. The House of Councillors elects half of its members every three years for a six-year term.

In 1868, groups of feudal lords, known as samurai, and aristocrats overthrew the military government and installed an imperial government under the Meiji Empire. This ended Japan’s self-isolation policy and led to rapid economic change. Prior to World War II, the Japanese economy was dominated by zaibatsu (family ! nancial combines). They derived their power from both economic strength and political af! liations. Each of these conglomerates usually included a major bank as the source of ! nance for the group. During the postwar occupation of Japan by the allied forces, zaibatsu were dissolved by the Anti-Monopoly Law of 1947. However, when the allied forces left Japan in 1952, the old conglomerates started to reappear under a different name, keiretsu. Douthett and Jung describe the disap- pearance of zaibatsu and the reappearance of keiretsu as follows:

An interesting aspect of Japanese ownership structure is the industrial groupings known as the keiretsu. The keiretsu is a successor of pre-war zaibatsu, which origi- nated as family-controlled concerns such as Yasuda banking complex, Mitsubishi shipping conglomerate, and Mitsui trading company, and existed as early as the 1870s. After the zaibatsu were dissolved by the Anti-Monopoly Law (1947) during the occupation of Japan by the allied forces following World War II, the pre-existing inter-! rm relations gradually re-emerged as keiretsu through coordination by the previous zaibatsu banks and other large commercial banks.

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278 Chapter Six

After the occupation forces left Japan in April 1952, Ministry of International Trade and Industry (MITI) began to permit formation of cartels among the small businesses as an exception to the anti-Monopoly Law. . . . As a result, the old zaibatsu names were restored and MITI encouraged the formation of keiretsu. Banks contin- ued to be the major nexus of inter-locking shareholding ties in these “! nancial keiretsu. ” The main banking groups of Mitsubishi, Sumitomo, Mitsui and Fuyo as well as the newer groups of Sanwa and Dai-ichi Kangyo Group (DKB) were the initial six ! nancial keiretsu. These ! nancial keiretsu are referred to as horizontal keiretsu since the member ! rms have common ties with a main bank, including shared stockholdings as well as normal banking relations. In contrast, a vertical keiretsu normally involves a very large trading company with many small, subservient companies such as Toyota Motor Corporation. 42

A unique aspect of Japanese business is cross-corporate ownership. About 70 percent of the equity shares of listed ! rms in Japan are cross-owned by corporate shareholders such as ! nancial institutions and other companies. Keiretsu control about a half of the top 200 ! rms in Japan through cross-corporate shareholdings, which amount to more than 25 percent of all the assets in Japan. 43 The manner in which business is organized in Japan re" ects its cultural value of collectivism.

The ways in which businesses are ! nanced in" uences ! nancial reporting and attitudes of interested parties toward accounting information. The main sources of ! nance for Japanese business are through bank credit and cross-corporate own- ership. Unlike in the United States, outside equity ! nancing is relatively minor. In addition to providing credit, banks also have control over major portions of cor- porate equity capital. As “insiders,” banks have access to their clients’ ! nancial information, so there is less pressure for public disclosure. This helps to explain the relatively low level of information disclosure in the annual reports of Japa- nese companies. The heavy reliance on bank credit and the long-term nature of cross-corporate equity ownership also lead to a weaker emphasis on short-term earnings in Japanese companies compared to those in the United States. Corpo- rate earnings are regarded as the source of funds that can be distributed, at the discretion of the shareholders, and not as a measure of corporate performance.

In the 1990s, however, as their ability to raise capital from domestic sources contracted signi! cantly, Japanese companies were compelled to look beyond the national borders to raise capital. This was due to the major recessionary pressures experienced by the Japanese economy during this period, involving large-scale capital losses among Japanese banks and other ! nancial companies, as well as the collapse of Japanese asset prices, including stock prices. 44 As the need to attract foreign investment grew, Japanese businesses and regulators found it necessary to respond to the demands of the international capital markets.

Accounting Profession The ! rst group of professional accountants in Japan is said to have emerged around 1907 under the Commercial Code of 1890, but it was not until 1927 that the Institute of Professional Accountants came into existence with the enactment of the Accountants Law. Currently, members of the accounting/auditing profession

42 E. B. Douthett and K. Jung, “Japanese Corporate Groupings ( Keiretsu ) and the Informativeness of Earnings,” Journal of International Financial Management and Accounting 12, no. 2 (2001), pp. 135–36. 43 L. Jiang and J. Kim, “Cross-Corporate Ownership, Information Asymmetry and the Usefulness of Accounting Performance Measures in Japan,” International Journal of Accounting 35, no. 1 (2000), p. 96. 44 W. R. Singleton and S. Globerman, “The Nature of Financial Disclosure in Japan,” International Journal of Accounting 37 (2002), pp. 95–111.

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in Japan practice with the title of Certi! ed Public Accountant (CPA) under the Certi! ed Public Accountants Law, legislated in 1948. The CPA Act was designed primarily to establish professional standards comparable to those in the United States, and to establish a publicly recognized status for CPAs. The CPA law es- tablished the Japanese Institute of Certi! ed Public Accountants (JICPA). This can be considered the beginning of the modern accounting profession in Japan. The JICPA has been heavily involved in the international harmonization process, being one of the nine founding members of the IASC. The JICPA was patterned after the AICPA, with the difference that it was to be closely supervised and guided by the Ministry of Finance (MoF). Further, compared to the AICPA in the United States, the in" uence of the JICPA on ! nancial reporting in Japan has been minor. Its tra- ditional role has been basically to implement the decisions made by the MoF. In this traditional role, it has issued recommendations on minor accounting issues, guidelines, and interpretations of accounting and auditing standards. 45

The CPA law deals with issues such as examinations, quali! cations, registra- tion, duties, and responsibilities of CPAs; audit corporations; the CPA board; JICPA; and disciplinary procedures. Because of the cultural value of collectivism, an independent auditor in Japan does not ! t the role of someone to be trusted or relied on, and the auditor has dif! culty being accepted by clients. Japanese corporations do not typically trust outsiders, and that includes (Japanese) audi- tors. 46 This explains why, even though audits by CPAs began in 1951, it was not until 1957 that full-scope audits were introduced. In order to promote the system- atic and standardized audit of ! nancial statements, the CPA Act was amended in 1966, which encouraged and facilitated the CPAs to organize into corporations. An audit corporation is similar to a partnership in Western countries, in that all partners have unlimited liability. However, prior to the amendment in 2004, every partner of an audit corporation was jointly and severally liable for liabilities with- out limitation.

Prior to 2004, the CPA Act allowed CPAs to provide their audit clients such ser- vices as preparation of ! nancial statements, researching or planning on ! nancial matters, and providing consultation on ! nancial matters, to the extent that it did not impede the performance of the audit. The amended CPA Act in 2004, following the U.S. Sarbanes-Oxley Act of 2002, prohibits an audit corporation from provid- ing certain nonaudit services to any audit client, in addition to tax services, which had been prohibited by the prior act. However, under the amended CPA Act, a new category of “designated partner” was created to alleviate the legal burdens of partners who are not designated as engagement partners. The audits must be conducted in accordance with the Auditing Standards codi! ed by the Business Accounting Council (BAC) and with the JICPA implementation guidance. These two pronouncements are deemed to be the generally accepted auditing standards (GAAS) in Japan. The Audit Practice Monitoring Board was established as a per- manent body in 2001 in order to ensure the objectivity and transparency of JICPA’s monitoring activities concerning audit practices. In terms of disciplinary action against auditors, in addition to the traditional “information-based” approach, JICPA adopts a “complaints-based” approach to investigate potential misconduct by auditors.

Even though the basic standards are set by the BAC, an advisory body to the MoF, the role of the JICPA in setting standards has become increasingly important

45 Tax experts have their own separate profession, and it is much larger in terms of membership. 46 J. Aono, “The Auditing Environment in Japan,” in International Auditing Environment, ed. I. Shiobara (Tokyo: Zeimukeiri-Kyokai, 2001), pp. 199–211.

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because of continued international pressure; for example, the JICPA was autho- rized to decide on the details of auditing standards. In 1992, the JICPA established the Auditing Standards Committee. Since then, this committee has issued stan- dards to guide auditing practices. In 2010, the requirements for an auditor’s report under the Auditing Standards were revised in response to the clarity project of the International Auditing and Assurance Standards Board (IAASB) of the IFAC.

Further, the process of setting accounting standards, previously driven by the MoF and the FSA, was changed with the establishment of the Financial Accounting Standards Foundation (FASF) in 2001. The Accounting Standards Board of Japan (ASBJ) was established under the FASF as an independent, private-sector entity to develop accounting standards in Japan. In January 2005, the ASBJ announced the launch of a joint project with the IASB aimed at achieving convergence between Japanese GAAP and IFRS.

In December 2008, the European Commission (EC) decided that Japanese GAAP was equivalent to IFRS adopted by the EU. Consequently, Japanese com- panies could continue to be listed in European capital markets after 2009, by using the ! nancial statements based on Japanese GAAP.

In December 2009, the Japanese FSA permitted certain qualifying domestic companies to apply IFRS for ! scal years start on or after March 31, 2010.

In July 2012, the BAC published an interim discussion paper, which announced its intention to continue with deliberations over the best approach for the pos- sible application of IFRS in Japan. The relatively low status of the accounting pro- fession within Japanese society is re" ected in the fact that very few CPAs hold top positions in industry and commerce. Instead, such positions are often held by people with engineering and science backgrounds. Japan has only about 15,000 CPAs (population 127.2 million), compared to about 250,000 in the United States (population 307.2 million).

The relatively small number of CPAs in Japan is caused partially by the rigor- ous requirements one must meet to become an accountant. The preliminary re- quirement includes a series of general examinations, but university graduates are exempt from this requirement. A candidate then must pass intermediate exams covering topics such as economics, bookkeeping, ! nancial and cost accounting, the Commercial Code, and auditing theory. The pass rates for these exams are relatively low, but a candidate who does pass is considered to be a junior CPA. A three-year apprenticeship then is required, which includes one year in training and two years of practical experience. Upon completion of the apprenticeship, the CPA candidate must take a ! nal technical exam and submit a written thesis. The ! nal exam also has a very low pass rate. The JICPA recently reformed the certi! cation process. Under this reform, the three levels of examinations have been reduced to one, the three-year internship has been reduced to two years, and the notion of junior CPA has been eliminated.

In 1961, Sony Corporation offered, for the ! rst time, a new stock issue for sale in the United States, and it had to hire an American accounting ! rm to certify its ! nancial statements for ! ling with the U.S. SEC. This example was soon fol- lowed by a number of other Japanese companies offering stocks and bonds in the United States and European countries. Further, the ! rst foreign company was listed on the Tokyo Stock Exchange in 1973, and a number of other foreign com- panies followed, engaging Japanese CPAs to examine their ! nancial statements. Consequently, the need for international audit capabilities became crucial, and Japanese audit corporations started to enter into associations or af! liation agree- ments with foreign accounting ! rms, mainly the Big Eight at the time. The ! rst formal af! liation took place in 1975.

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Being a founding council member of the IFAC, the JICPA sends its members to committees and commentaries on the exposure drafts by IFAC committees. The JICPA is also a founding member of the IASC, and it comments on the exposure drafts issued by the IASB. Further, as the founding and key executive member of the Confederation of Asian and Paci! c Accountants (CAPA), the JICPA has played an important role in developing the accountancy profession in the region.

Accounting Regulation Accounting and ! nancial reporting in Japan are regulated primarily through a tri- angle of laws: the Commercial Code, the Securities and Exchange Law (SEL), and the Corporate Income Tax Law. The Commercial Code of Japan is administered by the Ministry of Justice. It was enacted in 1890, as mentioned earlier, borrow- ing heavily from the German Commercial Code. This law requires kabushiki kaisha (joint stock corporations) to prepare an annual report for submission to the gen- eral meeting of shareholders. The annual report must include a balance sheet, an income statement, and a statement of proposed appropriation of earnings. These must be accompanied by a number of supplementary schedules, including sched- ules detailing the acquisition and disposal of ! xed assets, transactions with direc- tors and shareholders, and details of changes to share capital and reserves. Recent amendments to the code also require certain “large corporations” (as de! ned by the code) to include a consolidated balance sheet and income statement in annual reports for the business years ending in or after 2004. Prior to this, there was no legal requirement for consolidated ! nancial statements in Japan.

Japan has six stock exchanges, the most important being the Tokyo Stock Ex- change. From the early 1990s, while the total number of listings on the Japanese exchanges has increased rapidly, the number of foreign companies listed on Japanese stock exchanges has gradually fallen. From 1991 to 2003, the total num- ber of companies listed on the Tokyo Stock Exchange increased from 1,532 to 2,194; during the same period, the number of foreign listings fell from 127 to 32.

Stock exchanges in Japan are government-regulated rather than self-regulated. The SEL for listed companies was enacted in 1948 and is administered by the MoF. In 1951 the SEL required that ! nancial statements of stock-exchange-listed com- panies should be audited by CPAs. This requirement also was added to the Com- mercial Code in 1974. However, there were dif! culties in implementing the SEL, particularly during its ! rst two decades. CPA ! rms at the time were relatively small, often with fewer than 10 assistants, and therefore did not have the capacity to undertake audits of major corporations such as Mitsubishi, Toyota, and Sumi- tomo. Understandably, these small CPA ! rms were not able to ensure compliance with the SEL, and independence was an issue. As a result, the 1966 revision to the CPA Law allowed many smaller audit companies to merge to form kansa hajin, large corporations that operate like partnerships in terms of their liability and au- diting activities and often are af! liated with large international accounting ! rms. Modeled on the U.S. SEC regulations, the ! nancial reporting requirements under SEL are more demanding compared to those of the Commercial Code. In addition to SEL requirements, the stock exchanges have their own listing requirements.

Some Japanese companies, including well-known companies such as Honda Motor Company, Sony Corporation, and Pioneer Corporation, have listed on for- eign stock exchanges, in particular the New York Stock Exchange. Foreign com- panies that list their shares on the U.S. stock market must register with the U.S. Securities and Exchange Commission (SEC). Japanese companies are the fourth- largest group of foreign SEC registrants. From 2007, foreign companies, including Japanese companies, that used IFRS in preparing their ! nancial statements could

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282 Chapter Six

! le their 20-F forms with the SEC without reconciliation to U.S. GAAP. However, most Japanese companies with U.S. stock listings use U.S. GAAP in preparing the consolidated ! nancial statements included in their SEC ! lings.

Unlike in the United States, and as in Germany, ! nancial reporting in Japan is strongly in" uenced by tax law. The corporate income tax law in Japan provides methods for calculating taxable income and requires revenues and expenses to be recognized in the books of account in accordance with the tax law. The tax law is considered to be less vague than the Commercial Code and the SEL, so it is often referred to for more detailed regulations. Depreciation, allowance for bad debts, and pro! t from installment sales are examples of accounting issues that are gener- ally reported in ! nancial statements in conformity with the tax law.

In addition to the three laws just discussed, all listed companies are required to comply with Business Accounting Principles issued by the MoF. Business Ac- counting Principles consist of a set of seven general guidelines that form the equiv- alent of a conceptual framework in Japan:

1. True and fair view. Financial statements should provide a true and fair view of a company’s ! nancial situation.

2. Orderly bookkeeping. A company must use an orderly system in accounting for its activities.

3. Distinction between capital and earnings. A company should clearly distinguish earnings from capital, earnings being the amount that can be distributed to stockholders as a dividend.

4. Clear presentation. Financial statements must be presented in a manner that is straightforward and logical.

5. Continuity. A company should follow the same accounting principles from year to year, unless a speci! c and understandable reason to change arises.

6. Conservatism. A company should use cautious judgment in applying accounting principles.

7. Consistency. A company should prepare only one set of ! nancial statements to be used by various users of ! nancial statements.

In the 1990s, the Business Accounting Principles increasingly came under criti- cism, mainly from international investors, for lacking a requirement of transpar- ency in corporate reporting.

The Business Accounting Principles are developed by the Business Account- ing Deliberation Council (BADC), an advisory body to the MoF. Members of the BADC have a wide variety of backgrounds. They include accountants who work in industry, public accounting, government, and higher education. The BADC has been the primary standard-setting body in Japan.

Japan’s economy experienced unprecedented growth from the mid-1950s to the 1980s. In the late 1980s, however, exports and stock prices began to fall, and eco- nomic growth ground to a halt. In November 1996, the Japanese government an- nounced its strategy for ! nancial reforms, and the prime minister commissioned the BADC to reform the ! nancial reporting system. This triggered a series of major changes to the regulation of ! nancial reporting in Japan. These changes have been referred to as the Big Bang. 47 One of the major objectives of the Big Bang is to

47 T. Ravlic, “Japan Looks to Higher Standards,” Australian CPA 69, no. 10 (1999), pp. 48–49.

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Comparative Accounting 283

ensure that Japanese accounting standards fall into line with international stan- dards. As a result of the Big Bang, companies in Japan were required to

• Publish consolidated accounts, including those for all associates over which they have in" uence.

• Disclose the market value of pension liabilities and whether they have shortfalls. • Report tradable ! nancial securities, such as derivatives and equities, at market

values, not historical cost. 48

Another outcome of the Big Bang was the creation, in 2001, of the Financial Ac- counting Standards Foundation (FASF) and a new private-sector standard- setting body modeled on the FASB, the Accounting Standards Board of Japan (ASBJ). The FASF oversees the ASBJ. The ASBJ was established by a joint committee of the Fi- nancial Services Agency, the JICPA, and the Keidanren (Federation of Economic Organizations). Similar to the manner in which the FASB obtains its authority to establish U.S. GAAP from the U.S. SEC, the FASF and ASBJ derive standard-setting authority from the BADC. The BADC reserves the right, however, to override any ASBJ pronouncement that is considered to be inconsistent with the “true and fair view” principle. The FASF was established partly to facilitate harmonization with international accounting standards. The JICPA takes part in setting accounting stan- dards by sending board members to the FASF and the ASBJ. Additionally, many CPAs participate in various technical committees at the ASBJ as technical staff.

In May 2002, the FASF con! rmed that accounting standards issued by the ASBJ are considered to set forth standards for ! nancial accounting and, together with other pronouncements such as Financial Accounting Standards Implementation Guidance and Report of Practical Issues, constitute a coherent set of standards that must be complied with or otherwise referred to by members of the founding organizations and other concerned parties. 49

In terms of accounting regulation, Japanese tradition differs in several respects from the approach taken in Anglo-American countries. The government has the strongest in" uence on accounting through the Commercial Code, the Securities Law, and the Tax Law and Regulations. Further, until recently, the Japanese ac- counting profession, represented by the JICPA, had only a relatively minor in- " uence on determining standards for accounting and ! nancial reporting. Finally, stock exchanges are government-regulated rather than self-regulated.

International in" uences have played a major role in shaping accounting regula- tion in Japan. The Commercial Code re" ects a German in" uence on the Japanese company legislation, including ! nancial reporting requirements. The Securities and Exchange Law clearly re" ects the in" uence of U.S. securities and exchange regulations. Indications are that the forces of globalization are having a signi! cant impact on accounting and ! nancial reporting in Japan and will continue to do so in the future. 50

48 N. Yamori and T. Baba, “Japanese Management Views on Overseas Exchange Listings: Survey Results,” Journal of International Financial Management and Accounting 12, no. 3 (2001), pp. 312–14. 49 FASF, “Concerning Treatment (Compliance) of Accounting Standards and other Pronouncements Issued by the Accounting Standards Board of Japan,” May 2002. For details, go to www.jicpa.or.jp/ n_eng/e200201.html . 50 For information on developments in Japanese accounting activity, go to www.jicpa.or.jp/n_eng/ e-jicpa.html .

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284 Chapter Six

Accounting Principles and Practices As mentioned earlier, Japanese disclosure requirements are based on the Commer- cial Code, the SEL, and ASBJ accounting standards. Accounting periods ending on March 31 are the most common in Japan. Corporate net income tends to be used as a measure of funds available for distribution to shareholders, and not as a mea- sure of corporate performance. Financial reporting practices in Japan re" ect some of the inherent cultural values in Japanese society, such as group consciousness. Prior to the U.S. occupation of Japan following World War II, there was no outside auditing profession. Many Japanese corporations viewed the introduction of the CPA law in 1949 as unnecessary, and the audit as a necessary inconvenience. 51

In general, companies are not under pressure from their main providers of ! - nance to disclose information publicly, and Japanese companies are reluctant to provide information voluntarily. Research has found that Japanese ! nancial ana- lysts are concerned that Japanese ! rms do not de! ne segments meaningfully and consistently and are arbitrary in the allocation of common costs, 52 and that there is a general reluctance on the part of Japanese ! rms to disclose segment and other information, particularly to nonshareholders. 53

Efforts are being made to bring Japanese accounting principles and prac- tices closer to international standards. In January 2005, the IASB and the ASBJ announced that they had agreed to launch a joint project to reduce differences between IFRS and Japanese accounting standards. Speci! c elements of the agree- ment include the following:

• Identi! cation and assessment of differences in their existing standards on the basis of their respective conceptual frameworks or basic philosophies with the aim of reducing those differences where economic substance or market envi- ronments such as legal systems are equivalent.

• Addressing the differences in their respective conceptual frameworks. • Considering their respective due process requirements in arriving at agreement. • Undertaking a study by the ASBJ to get an overall picture of major differences

between Japanese accounting standards and IFRS with a view to identifying topics to be discussed.

Under this project, ! ve topics would be considered by both boards for the ! rst phase:

• Measurement of inventories (IAS 2). • Segment reporting (IAS 14). • Related-party disclosures (IAS 24). • Uni! cation of accounting policies applied to foreign subsidiaries (IAS 27). • Investment property (IAS 40).

The differences between Japanese accounting standards and IFRS can be identi- ! ed in many areas. There are no speci! c Japanese rules in some areas covered by

51 Aono, “The Auditing Environment. . . .” 52 V. Mande and R. Ortman, “Are Recent Segment Disclosures of Japanese Firms Useful? Views of Japanese Financial Analysts,” International Journal of Accounting 37 (2002), pp. 27–46. 53 C. Ozu and S. Gray, “The Development of Segment Reporting in Japan: Achieving International Harmonization Through a Process of National Consensus,” Advances in International Accounting 14 (2001), pp. 1–13; and J. L. McKinnon and G. L. Harrison, “Cultural Infl uence on Corporate and Governmental Involvement in Accounting Policy Determination in Japan,” Journal of Accounting and Public Policy, Autumn (1985), pp. 201–23.

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Comparative Accounting 285

IFRS, such as classi! cation of business combinations as acquisitions or poolings of interest (IAS 22), impairment of assets (IAS 36), and accounting for employee bene! ts other than severance indemnities (IAS 19). Further, there are no speci! c rules requiring disclosures of a primary statement of changes in equity (IAS 1), discontinuing operations (IAS 35), and segment liabilities (IAS 14). In some other areas, there are inconsistencies between Japanese GAAP and IFRS. For example, under Japanese GAAP, leases, except those that transfer ownership to the lessee, are treated as operating leases (IAS 17); inventories generally can be valued at cost rather than at the lower of cost or net realizable value (IAS 2); proposed dividends can be accrued in consolidated ! nancial statements (IAS 10); and extraordinary items are de! ned more broadly (IAS 8). Exhibit 6.7 shows some of the differences between IFRS and Japanese GAAP.

Nineteen Japanese companies were listed on the New York Stock Exchange in June 2004. Each of these companies uses U.S. GAAP to prepare the ! nancial statements included in the Form 20-F annual report ! led with the U.S. Securities and Exchange Commission. However, in its 2003 Form 20-F, Nidec Corporation (a Japanese motor manufacturer) provided the following information related to dif- ferences between Japanese and U.S. GAAP:

There are differences between Japanese GAAP and U.S. GAAP. They primarily relate to the statement of cash " ows, disclosure of segment information, the scope of consolidation, accounting for derivatives, deferred income taxes, accounting for investments in certain equity securities, accounting for lease transactions, accrued compensated absences, accounting for employee retirement and severance bene! ts, accounting for the impairment of long-lived assets, earnings per share and compre- hensive income. Also, under Japanese GAAP, a restatement of prior years’ ! nancial statements re" ecting the effect of a change in accounting policies is not required.

Our results of operations for the year ended March 31, 2003, as reported in our U.S. GAAP and Japanese GAAP consolidated ! nancial statements differ substan- tially mainly because of the difference in the scope of consolidation. For that year, we consolidated 18 more entities in our Japanese GAAP consolidated ! nancial state- ments than in our U.S. GAAP consolidated ! nancial statements. We were required to consolidate these additional entities in our Japanese GAAP consolidated ! nancial statements because, with respect to each of those entities: (i) we were regarded as possessing a majority of the entity’s voting shares because of the existence of a suf! cient number of shareholders of the company that did not exercise their voting rights at the shareholders’ general meetings; or (ii) our current or former executives or employees comprised a majority of the board of directors of the entity. These 18 entities had combined net sales of ¥86 billion in the year ended March 31, 2003. (p. 4)

Nidec Corporation, in its 2010 Form 20-F, provides a description of the account- ing standards adopted in preparing ! nancial statements (see Exhibit 6.8 ).

Tokyo Agreement In August 2007, the ASBJ and IASB jointly announced an agreement (known as the Tokyo Agreement) to accelerate the process of convergence between Japanese GAAP and IFRS, which began in March 2005. As part of the agreement, by 2008 the two boards would seek to eliminate major differences between the two sets of standards identi! ed in 2005, with the remaining differences being removed by June 2011. The target date of 2011 does not apply to any major new IFRS that will become effective after 2011, and both boards will work closely to ensure the acceptance of the international approach in Japan when new standards become effective.

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286 Chapter Six

In September 2009, at a meeting held in London, the chairs of the ASBJ and IASB reaf! rmed their ongoing cooperation in achieving convergence of Japa- nese GAAP and IFRS and reported that good progress was being made toward convergence of IFRS and Japanese GAAP. In February 2010, the JICPA joined the Global Accounting Alliance (GAA), the largest global accounting network. As a further step toward adopting IFRS in Japan, the regulatory changes an- nounced by the Japan Financial Services Agency (FSA) in December 2009 per- mitted domestic use of IFRS and established an operational framework for the voluntary application of IFRS in Japan, starting from the ! scal year ending on or after March 31, 2010.

EXHIBIT 6.7 Differences between Japanese GAAP and IFRS

Issue IFRS Japanese GAAP

Accounting policies for overseas subsidiaries

IAS 27: Consolidated fi nancial statements should be prepared using uniform accounting policies for like transactions and other events in similar circumstances. If it is not practicable to use uniform accounting policies, that fact should be disclosed together with the proportions of the items in the consolidated fi nancial statements to which the different accounting policies have been applied.

It is acceptable that overseas subsidiaries apply different accounting policies if they are appropriate under the requirements of the country of those subsidiaries.

Revaluation of land IAS 16: Revaluations should be made with suffi cient regularity such that the carrying amount does not differ materially from that which would be determined using fair value at the balance sheet date.

Land can be revalued, but the revaluation does not need to be kept up to date.

Preoperating costs IAS 38: Start-up costs should be recognized as an expense when incurred.

Preoperating costs can be capitalized.

Inventory valuation IAS 2: Inventories should be measured at the lower of cost or net realizable value.

Inventories can be valued at cost rather than at the lower of cost and net realizable value.

Construction contracts IAS 11: The stage of completion of the contract activity at the balance sheet date should be used to recognize contract revenue.

The completed contract method can be used for the recognition of revenue on construction contracts.

Provisions IAS 37: Provisions can be made only if an enterprise has a present obligation as a result of a past transaction.

Provisions can be made on the basis of decisions by directors before an obligation arises.

Segment reporting IAS 14: Disclosure requirements for segments are provided in terms of primary and secondary reporting formats.

Segment reporting does not use the primary/secondary basis.

Financial statements of hyperinfl ationary subsidiaries

IAS 21: The fi nancial statements of a foreign entity that reports in the currency of a hyperinfl ationary economy should be restated before they are translated into the reporting currency of the reporting entity.

There are no requirements concerning the translation of the fi nancial statements of hyperinfl ationary subsidiaries.

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Comparative Accounting 287

EXHIBIT 6.8

NIDEC CORPORATION Form F-20

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the fi scal year ended March 31, 2012

1. Nature of operations:

NIDEC Corporation (the “Company”) and its subsidiaries (collectively “NIDEC”) are primarily engaged in the design, development, manufacture and marketing of i) small precision motors, which include spindle motors for hard disk drives, motors for optical disk drives, small precision fans and other small motors; ii) general motors, which are used in various electric household appliances, industrial equipment and automobiles; iii) machinery, which includes, test systems, measuring equipment, power transmission equipment, factory automation systems, card readers and industrial robots; iv) electronic and optical components, which include camera shutters, camera lens units, switches, trimmer potentiometers, motor driven actuator units, processing and precision plastic mold products; and v) other products, which include auto parts, pivot assemblies, other components and other services. Manufacturing operations are located primarily in Asia (China, Thailand, Vietnam and the Philippines), Japan and North America, and sales subsidiaries are primarily located in Asia, North America and Europe. The main customers for NIDEC are manufacturers of hard disk drives. NIDEC also sells its products to the manufacturers of various electric household appliances, automation equipment, automotive components, home video game consoles, telecommunication equipment and audio-visual equipment.

2. Summary of signifi cant accounting policies:

The Company and its subsidiaries in Japan maintain their records and prepare their fi nancial statements in accordance with accounting principles generally accepted in Japan, and its foreign subsidiaries in conformity with those of their countries of domicile. Certain adjustments and reclassifi cations have been incorporated in the accompanying consolidated fi nancial statements to conform with accounting principles generally accepted in the United States of America. Signifi cant accounting policies after refl ecting adjustments for the above are as follows:

Estimates - The preparation of NIDEC’s consolidated fi nancial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and contingent assets and liabilities at the date of the fi nancial statements, as well as the reported amounts of revenues and expenses during the reporting period. Some of the more signifi cant estimates include the allowance for doubtful accounts, depreciation and amortization of long-lived assets, valuation allowance for deferred tax assets, fair value of fi nancial instruments, uncertain tax positions, pension liabilities, the recoverability of long-lived assets and goodwill, and fair value of assets acquired and liabilities assumed. Actual results could differ from those estimates.

Basis of consolidation and accounting for investments in affi liated companies - The consolidated fi nancial statements include the accounts of the Company and those of its majority-owned subsidiary companies. All signifi cant intercompany transactions and accounts have been eliminated. Companies over which NIDEC exercises signifi cant infl uence, but which it does not control, are classifi ed as affi liated companies and accounted for using the equity method. Consolidated net income includes NIDEC’s equity in current earnings (losses) of such companies, after elimination of unrealized intercompany profi ts. On occasion, NIDEC may acquire additional shares of the voting rights of a consolidated subsidiary or dispose of a part of those shares or a Nidec consolidated subsidiary may issue its shares to third parties. With respect to such transactions, all transactions for changes in a parent’s ownership interest in a subsidiary that do not result in the subsidiary ceasing to be a subsidiary are recognized as equity transactions. The FASB Accounting Standards Codifi cation™(ASC) 810, “Consolidation” requires the consolidation or disclosure of variable interest entities. NIDEC does not hold any variable interests in a variable interest entity.

Translation of foreign currencies - Non monetary asset and liability accounts of foreign subsidiaries and affi liates are translated into Japanese yen at the year-end exchange rates and all income and expense accounts are translated at exchange rates that approximate those prevailing at the time of the transactions. The resulting translation adjustments are included as a component of accumulated other comprehensive income in shareholders’ equity. Monetary assets and liabilities denominated in foreign currencies are translated at the year-end exchange rates and the resulting transaction gains or losses are taken into income. Continued

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288 Chapter Six

Cash and cash equivalents - Cash and cash equivalents include all highly liquid investments, with original maturities of three months or less that are readily convertible to known amounts of cash and are so near maturity that they present insignifi cant risk of changes in value because of changes in interest rates.

Inventories - Inventories are stated at the lower of cost or market. Cost is determined principally on the weighted average cost basis. Cost includes the cost of materials, labor and applied factory overhead. Projects in progress, which mainly relate to production of factory automation equipment based on contracts with customers, are stated at the lower of cost or market, cost being determined as the accumulated production cost.

Marketable securities - Marketable securities consist of equity securities that are listed on recognized stock exchanges and debt securities. Equity securities designated as available-for-sale are carried at fair value with changes in unrealized gains or losses included as a component of accumulated other comprehensive income in shareholders’ equity, net of applicable taxes. Realized gains and losses are determined on the average cost method and are refl ected in the statement of income. Other than temporary declines in market value of individual securities classifi ed as available-for-sale are charged to income in the period the loss occurs. Debt securities designated as held-to-maturity securities are recorded at amortized cost, adjusted for the amortization or accretion of premiums or discounts.

Derivative fi nancial instruments - NIDEC manages the exposures of fl uctuations in interest rate, foreign exchange rate, and commodity prices movements through the use of derivative fi nancial instruments which include foreign exchange forward contracts, interest rate currency swap and commodities agreements. NIDEC does not hold derivative fi nancial instruments for trading purposes. Derivatives are accounted for under ASC 815, “Derivatives and Hedging.” All derivatives are recorded as either assets or liabilities on the balance sheet and measured at fair value. Changes in the fair value of derivatives are charged in current earnings. However certain derivatives may qualify for hedge accounting as a cash fl ow hedge, if the hedging relationship is expected to be highly effective in achieving offsetting of cash fl ows of the hedging instruments and hedged items. Under hedge accounting, changes in the fair value of the effective portion of these derivatives designated as cash fl ow hedge derivatives are deferred in accumulated other comprehensive income and charged to earnings when the underlying transaction being hedged occurs. NIDEC designates certain foreign exchange forward contracts and commodities agreements as cash fl ow hedges. NIDEC formally documents all relationships between hedging instruments and hedged items, as well as its risk management objective and strategy for undertaking various hedge transactions. This process includes linking all derivatives designated as cash fl ow hedges to specifi c assets and liabilities on the balance sheet or forecasted transactions. NIDEC also formally assesses, both at the hedge’s inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting cash fl ows of hedged items. When it is determined that a derivative is not a highly effective hedge or that it has ceased to be a highly effective hedge, NIDEC discontinues hedge accounting prospectively. When a cash fl ow hedge is discontinued, the previously recognized net derivative gains or losses remain in accumulated other comprehensive income until the hedged transaction occurs, unless it is probable that the forecasted transaction will not occur at which point the derivative gains or losses are reclassifi ed into earnings immediately.

Property, plant and equipment and Change in Accounting Estimate - Property, plant and equipment are stated at cost. Major renewals and improvements are capitalized; minor replacements, maintenance and repairs are charged to expense in the year incurred. Effective April 1, 2011, NIDEC changed the depreciation method from the declining-balance method to the straight-line method as a result of taking business situation into consideration. NIDEC believes that the straight-line method better refl ects the pattern of consumption of the future benefi ts to be derived from those assets being depreciated. Under the new provisions of ASC 250, “Accounting Changes and Error Corrections,” a change in depreciation method is treated as a change in accounting estimate. The effect of the change in depreciation method has been refl ected on a prospective basis beginning April 1, 2011, and prior period results were not restated. The change in depreciation methods caused an increase in Income from continuing operations before income taxes by ¥1,241 million, Income from continuing operations by ¥813 million and Earning per share by ¥5.92 respectively for the year ended March 31, 2012. Depreciation of property, plant and equipment is mainly computed on the straight-line method at rates based on the estimated useful lives of the assets. Estimated useful lives range from 10 to 20 years for most spindle motor factories, from 7 to 47 years for factories to produce other products, 50 years for the head offi ce and sales offi ces, from 3 to 18 years for leasehold improvements, and from 2 to 15 years for machinery and equipment. Depreciation expense amounted to ¥29,185 million, ¥32,981 million, and ¥31,511 million for the years ended March 31, 2010, 2011 and 2012, respectively.

EXHIBIT 6.8 (Continued)

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Comparative Accounting 289

Lease - NIDEC capitalizes leases and related obligations when any of the four criteria are met within the guidance of ASC 840 “Leases”. Under ASC840, these leases and related obligations are capitalized at the commencement of the lease at the lower of the fair value of the leased property and the present value of the minimum lease payments.

Goodwill and other intangible assets - Goodwill and other intangible assets are accounted for under ASC350, “Intangibles—Goodwill and Other”. Goodwill acquired in business combinations is not amortized but tested annually for impairment. NIDEC tests for impairment at the reporting unit level on January 1st of each year. In addition, NIDEC tests for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. This test is a two-step process. The fi rst step of the goodwill impairment test, used to identify potential impairment, compares the fair value of the reporting unit with its carrying amount, including goodwill. If the fair value, which is based on discounted future cash fl ows, exceeds the carrying amount, goodwill is not considered impaired. If the carrying amount exceeds the fair value, the second step must be performed to measure the amount of the impairment loss, if any. The second step compares the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill. Other intangible assets include patent rights, proprietary technology and customer relationships, as well as software and other intangible assets acquired in business combinations. Intangible assets with an indefi nite life are not subject to amortization and are tested for impairment once on January 1st of each year or more frequently if an event occurs or circumstances change. Intangible assets with a defi nite life are amortized on a straight-line basis over their estimated useful lives. The weighted average amortization period for patent rights, proprietary technology, customer relationships and software are 9 years, 11 years, 19 years and 5 years, respectively.

Long-lived assets - NIDEC reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. An impairment loss would be recognized when the carrying amount of an asset group exceeds the estimated undiscounted future cash fl ows expected to result from the use of the asset group and its eventual disposition. The amount of the impairment loss to be recorded is calculated as the excess of the assets group’s carrying value over its fair value. Long-lived assets that are to be disposed of other than by sale are considered to be held and used until the disposal. Long-lived assets that are to be disposed of by sale are reported at the lower of their carrying value or fair value less costs to sell. Reductions in carrying value are recognized in the period in which long-lived assets are classifi ed as held for sale.

Revenue recognition - NIDEC recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fi xed or determinable and collectibility is reasonably assured. For small precision motors, general motors and electronic and optical components, these criteria are generally met at the time a product is delivered to the customers’ site which is the time the customer has taken title to the product and the risk and rewards of ownership have been substantively transferred. These conditions are met at the time of delivery to customers in domestic sales (FOB destination) and at the time of shipment for export sales (FOB shipping point). Revenue for machinery sales is recognized upon receipt of fi nal customer acceptance. At the time the related revenue is recognized, NIDEC makes provisions for estimated product returns.

Research and development expenses- Research and development expenses, mainly consisting of personnel and depreciation expenses at research and development branches, are charged to operations as incurred.

Advertising costs - Advertising and sales promotion costs are expensed as incurred. Advertising costs were ¥156 million, ¥246 million, and ¥228 million for the years ended March 31, 2010, 2011 and 2012, respectively.

Income taxes - The provision for income taxes is computed based on the pretax income included in the consolidated statement of income. The asset and liability approach is used to recognize deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not that a tax benefi t will not be realized. NIDEC recognizes the fi nancial statement effects of tax positions when it is more likely than not, based on the technical merits, that the tax positions will be sustained upon examination by the tax authorities. Benefi ts from tax positions that meet the more-likely- than-not recognition threshold are measured at the largest amount of benefi t that is greater than 50 percent likely of being realized upon settlement. Interest and penalties accrued related to unrecognized tax benefi ts are included in other, net in the consolidated statements of income.

Continued

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290 Chapter Six

Earnings per share - Basic net income per common share is calculated by dividing net income by the weighted-average number of shares outstanding during the reported period. The calculation of diluted net income per common share is similar to the calculation of basic net income per share, except that the weighted-average number of shares outstanding includes the additional dilution from potential common stock equivalents such as convertible bonds and options.

Other comprehensive income - NIDEC’s other comprehensive income is primarily comprised of unrealized gains and losses on marketable securities designated as available-for-sale, foreign currency translation adjustments, adjustments to recognize pension liabilities associated with NIDEC’s defi ned benefi t pension plans and unrealized gains (or losses) from derivative instruments qualifying cash fl ow hedge.

Reclassifi cation Certain reclassifi cations of previously reported amounts have been made to the consolidated statements of income and cash fl ows for the years ended March 31, 2010 and 2011 to conform to the current year presentation. As of September 30, 2009, NIDEC discontinued its semiconductor manufacturing equipment business. The results of the semiconductor manufacturing equipment business were previously recorded in the Nidec Tosok reporting segments. As of March 31, 2011, NIDEC discontinued its specialty lens unit business. The results of the specialty lens unit business were previously recorded in the Nidec Copal reporting segments. As of March 31, 2012, NIDEC discontinued its lens actuator business and its tape drive and disk drive mechanism business included within the Nidec Sankyo reportable segment, and its compact digital camera lens unit business included within the Nidec Copal reportable segment. The operating results of the discontinued businesses and exit costs with related taxes were recorded as “Loss on discontinued operations” in the consolidated statement of income in accordance with ASC 205-20, “Presentation of Financial Statements-Discontinued Operations”.

Accounting Changes As of April 1, 2011, NIDEC adopted FASB Accounting Standards Codifi cation™ (ASC) 350 “Intangibles—Goodwill and Other” updated by Accounting Standards Update (ASU) No. 2010-28 “When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts.” ASU 2010-28 modifi es Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. The adoption of this standard did not have a material impact on NIDEC’s consolidated fi nancial position, results of operations or liquidity. As of April 1, 2011, NIDEC adopted FASB ASC 805 “Business Combinations” updated by ASU No.2010-29 “Disclosure of Supplementary Pro Forma Information for Business Combinations.” ASU 2010-29 requires a public entity that enters into business combination(s) to disclose pro forma revenue and earnings of the combined entity in the comparative fi nancial statements as though the business combination(s) that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. ASU 2010-29 also expands the supplemental pro forma disclosures to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. ASU2010-29 is a provision for disclosure. The adoption of ASU2010-29 did not have any impact on NIDEC’s consolidated fi nancial position, results of operations or liquidity. As of January 1, 2012, NIDEC adopted FASB ASC 820 “Fair Value Measurement” updated by ASU No.2011-04 “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” ASU 2011-04 amends current U.S. GAAP to create more commonality with IFRS by changing some of the wording used to describe requirements for measuring fair value and for disclosing information about fair value measurements. The adoption of this standard did not have a material impact on NIDEC’s consolidated fi nancial position, results of operations or liquidity.

Recent Accounting Pronouncements to be adopted in future periods In June 2011, the FASB issued ASU No. 2011-05, “Comprehensive Income (Topic 220): Presentation of Comprehensive Income.” ASU 2011-05 eliminates the option to report other comprehensive income and its components in the consolidated statement of changes in equity and requires an entity to report components of comprehensive income in either a continuous statement of comprehensive income or two separate but consecutive statements. Additionally, in December 2011, the FASB issued ASU No. 2011-12, “Comprehensive Income (Topic 220): Deferral of the Effective Date for Amendments to the Presentation of Reclassifi cations of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05” which indefi nitely defers the requirement in ASU 2011-05 to present reclassifi cation adjustments out of accumulated other comprehensive income by component in both the statement in which net income is presented and the statement in which other comprehensive income is presented. During the deferral period, the existing requirements in U.S. GAAP for the presentation of reclassifi cation adjustments must continue to be followed. These standards are effective for fi scal years, and interim periods within those fi scal years, beginning after December 15, 2011. Early adoption is permitted. These standards are provisions for disclosure. The adoption of these standards will not have any impact on NIDEC’s consolidated fi nancial position, results of operations or liquidity.

EXHIBIT 6.8 (Continued)

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Comparative Accounting 291

In September 2011, the FASB issued ASU No. 2011-08, “Intangibles-Goodwill and Other (Topic 350): Testing Goodwill for Impairment.” ASU 2011-08 allows an entity the option of performing a qualitative assessment before calculating the fair value of a reporting unit. If an entity determines, on the basis of qualitative factors, that the fair value of the reporting unit is more likely than not less than the carrying amount, the two-step impairment test would be required. ASU 2011-08 is effective for annual and interim goodwill impairment tests performed for fi scal years beginning after December 15, 2011. Early adoption is permitted. NIDEC is currently evaluating the potential impact of adopting ASU 2011-08 on its consolidated fi nancial position, results of operations or liquidity.

MEXICO

Background Mexico was conquered by the Spanish in 1519 and became an independent nation in 1821. It is one of the most populated of the Latin American countries. According to the of! cial population census of 2005, the population was estimated at 107,029,000. The total area of Mexico is 1,972,550 square kilometers (758,249 square miles), bor- dering to the north with the United States and to the south with Guatemala and Belize. Mexico is the northernmost and the westernmost country of Latin America. The of! cial name of the country is United Mexican States (Estados Unidos Mexicanos). The of! cial language of the country is Spanish, and there are over 60 native dialects which are still used by small sections of the population. Mexico is a federal republic consisting of 31 states and a federal district (Mexico City). The Mexican states do not have separate and different laws, as is the case in the United States. The legislative authority in Mexico rests with the president and the Congress. The chief executive of the government is the president, who is elected for a six-year term and may not be reelected. The Mexican Congress consists of a Senate, with 128 members, elected for six years, and a Chamber of Deputies, with 500 members, elected for three years.

Until about two decades ago, a substantial proportion of the Mexican business sector was government-controlled, and a large number of business enterprises were government-owned. The Constitution grants the federal government the right to own certain industries which are considered “basic,” for example, the exploration for and re! nement of oil and its by-products and the production and distribution of electrical energy. There are no price or currency controls, but a minimum wage for employees is established by each state and the federal district. From the mid-1970s until the late 1980s, Mexico faced persistent balance-of-payments problems result- ing from the government’s efforts to defend the overvalued peso while incurring massive external debt. These and other economic problems were attributed largely to government acquisition and control of private enterprises. In recent years, there has been a major effort to privatize state-owned enterprises as part of a new eco- nomic program designed to accelerate long-term economic growth. Many of the restrictions on investment by foreigners have been removed, opening the door to external capital. This process has been further encouraged by Mexico’s joining the United States and Canada under the North American Free Trade Agreement (NAFTA) in 1993. Among other things, NAFTA aims to reduce most barriers to trade in goods, liberalize the cross-border " ow of services and capital, and open up new areas of opportunity in each country to conduct business in the other two

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countries. Mexico represents one of the largest trading partners of the United States, which accounts for three-quarters of Mexico’s imports, more than 80 per- cent of Mexico’s exports, and 60 percent of all direct foreign investment.

In December 1994, Mexico devalued the peso and plunged into a ! nancial crisis (known as the Tequila crisis) as billions in short-term, dollar-denominated bonds held largely by foreigners came due. Unable to pay, Mexico accepted a $40 billion bailout from the U.S. Treasury and the International Monetary Fund. The bailout was accompanied by some tough conditions. For example, Mexico’s Central Bank and Finance Secretariat had to shed light on all of their ! nancial transactions and start communicating better with investors and creditors. Within seven months, Mexico managed to take measures aimed at rectifying its economic ills and raise money on international ! nancial markets once again. Currently, Mexico has a largely free-market economy. According to the World Bank, Mexico ranks twelfth in the world in terms of GDP. Mexico experienced several years of record-low in" ation, low interest rates, a low external debt, and a strong peso. However, the economic collapse in 2009 had a devastating effect.

Mexico has one stock exchange, the Bolsa Mexicana de Valores, located in Mex- ico City. Historically, the Mexican business sector has been predominantly family- owned. Firms prefer to raise capital through debt rather than equity, although this is gradually changing. Commercial banks are still the most important suppliers of funds to businesses. The in" ux of foreign capital and the return of Mexican capital previously invested abroad in the late 1980s and early 1990s have stimulated the growth of the Mexican stock market. The stock exchange is a private institution jointly owned by 32 brokerage houses. Prior approval of the National Banking and Securities Commission (NBSC) is required for listing on the stock exchange. Mexican companies can issue three categories of shares: Series A, Series B, and Series N. Se- ries A shares can be held only by Mexican nationals, and these shares account for at least 51 percent of voting rights; Series B shares are open to foreigners and may account for only up to 49 percent of ownership; and Series N shares, called neutral shares and created under the Foreign Investment Law in January 1994, involve a trust mechanism designed for foreign investors. They have no voting rights and limited corporate rights.

There are ! ve major forms of business organization in Mexico, namely, a ! xed capital corporation (Sociedad Anónima—S. A.), variable capital corporation (So- ciedad Anónima de Capital Variable—S.A. de C.V.), limited liability corporation (Sociedad de Responsabilidad Limitada—S. de R. L.), branch of a foreign corpo- ration, and partnership. At inception, a ! xed capital corporation is required to be registered in the Public Register of Commerce, with the name followed by the letters S.A. It must have at least two stockholders, with a minimum ! xed capital of 50,000 Mexican pesos. Stockholders are liable only to the extent of their invest- ment. The ! xed capital is speci! ed in the articles of incorporation and the bylaws. Any subsequent change to capital requires the modi! cation of the articles of in- corporation and the bylaws. A variable capital corporation is the most commonly used by foreign investors. Its capital stock is also divided into nominal shares, and the stockholders are liable only to the extent of their investment. It must have at least two stockholders, with a minimum ! xed portion of the capital of 50,000 pesos and an unlimited variable portion. To increase or decrease the variable por- tion of the capital, there is no need to modify the articles of incorporation and the bylaws. In all other aspects, this form is identical to the ! xed capital corpora- tion. A limited liability corporation is similar to the ! xed capital corporation. The

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54 For an excellent discussion of the early development of Mexican accounting, see S. A. Zeff, Forging Accounting Principles in Five Countries: A History and Analysis of Trends (Champaign, IL: Stipes, 1972), pp. 91–109. 55 Certain regulated enterprises, such as government-owned banks, may follow special accounting rules and thus depart from GAAP.

responsibility is limited to the investment of the stockholders. There is a maxi- mum limit to the number of shareholders, which should not exceed 50. This type of organization requires only 3,000 pesos of capital investment, which is divided into “participation units” instead of shares. This type of organization is used more frequently by U.S. investors than by Mexicans. A foreign corporation may establish a Mexican branch, which has to be incorporated in a similar manner as a domestic corporation. Branches of foreign corporations also compute income tax in the same manner as corporations in Mexico. Partnerships in Mexico are civil organizations that usually associate professionals for the purpose of render- ing a professional service, such as accountants, lawyers, architects, and the like. Partnerships are incorporated in the same manner as corporations, may have any number of partners, and require a minimum capital of 50,000 pesos. Partners are jointly responsible for the partnership’s operations and have unlimited personal liability.

There are about 200 companies listed on the Mexican Stock Exchange, 80 per- cent of which are audited by the Big Four accounting ! rms; the remainder are audited by about 10 accounting ! rms that are associated with the second-tier international accounting ! rms.

Accounting Profession The ! rst professional organization of public accountants in Mexico, the Aso- ciación de Contadores Publicos, was established in 1917. 54 This organization was replaced by the Mexican Institute of Public Accountants (MIPA) in 1964. MIPA was of! cially recognized in 1977 as a federation of state and local associations of registered public accountants in Mexico. An independent, nongovernmental professional association, it is governed by three bodies, the General Conference of Members, the Governance Group, and the National Executive Committee (NEC). The ! rst two bodies mainly perform sponsoring and oversight functions, whereas the NEC’s major responsibilities relate to overseeing the day-to-day activities of MIPA. MIPA’s primary responsibility used to be to establish and communicate, in the public interest, the accounting principles to be followed in preparing ! nan- cial information for external users and to promote their acceptance and obser- vance throughout the nation. 55 Since 2004, the Mexican Board for Research and Development of Financial Reporting Standards (CINIF in Spanish) assumed the duties and responsibilities for issuance of Mexican accounting standards. MIPA is empowered to conduct an investigation in response to complaints against its members and impose sanctions; oversee the professional conduct of its members; and establish continuing professional education requirements. MIPA’s Code of Ethics for professional accountants was recently revised toward alignment with IFAC’s code. It includes, among other things, the adoption of a framework and principles-based approach, and additional guidance for implementation of the principles.

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Public accounting services in Mexico mainly consist of bookkeeping, tax, and audit. The number of public accountants in Mexico is about 200,000, with the ma- jority working in business or government. As stipulated in the law regulating the practice of professions, a professional diploma is required to practice as a pub- lic accountant in Mexico. Under the arrangement introduced in 1999, the MIPA organizes the quali! fying examination for those public accountants who intend to obtain the title of Contador Publico Certi! cado (CPC); i.e., Certi! ed Public Ac- countant. The title CPC is considered equivalent to the CPA in the United States. Consequently, the Mexican CPCs can practice accountancy in the United States and Canada, subject to passing examinations on national legislation and standards in accordance with provisions of the Professional Mutual Recognition Agreement (PMRA) signed in September 2002 by the representatives of the U.S. NASBA/ AICPA International Quali! cations Appraisal Board, the CICA’s International Quali! cations Appraisal board, and Mexican Institute of Public Accountants and Mexican Committee for the International Practice of Accounting, agreeing on the principal elements for granting accounting certi! cation and licenses, which in- clude education, examination, and experience. NAFTA’s Free Trade Commission af! rmed the PMRA in October 2003. The implementation of the NAFTA PMRA is an example of converging national licensing requirements into an international framework. Mexico has made the most signi! cant changes in the process and has improved the ability of Mexican CPAs to practice across national boundar- ies. In the past, a person would obtain a Public Accountant undergraduate degree from an approved Mexican university and would be able to practice as a Public Accountant without passing a uniform examination. Currently, Public Accoun- tants must successfully complete the uniform examination and be certi! ed as a Certi! ed Public Accountant to give an audit opinion. Those who sit for the Uni- form Certi! cation Exam are required to possess the title “accountant,” granted by an approved university when an individual successfully completes the Public Accountant degree.

Accounting Regulation Regulation of accounting and ! nancial reporting in Mexico is through legisla- tion, stock exchange listing requirements, and bulletins (accounting standards). Mexican law requires all companies incorporated in Mexico to appoint one or more statutory auditors. Annual ! nancial statements of listed companies must be audited by a Mexican CPA and be published in a nationally circulated me- dium. The statutory audit report must include, at a minimum, the auditor’s opinion as to whether the accounting and reporting policies followed by the company are appropriate and adequate in the circumstances and have been con- sistently applied, and whether the information presented by management gives a true and adequate picture of the company’s ! nancial position and operating results.

The NBSC is the most important federal agency that oversees information dis- closure by publicly owned companies in Mexico. It is a semi-independent entity within the Ministry of Finance that administers Mexico’s securities law and regu- lates the operation of securities markets. The current Mexican Securities Law was enacted in 1975, with some amendments introduced in 1993, mainly to accommo- date the foreign investment requirements under NAFTA.

Mexico’s legal system is based on civil law; however, accounting standard- setting takes an Anglo-American approach rather than a Continental European

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Comparative Accounting 295

one. Accounting in Mexico is oriented toward fairness, not legal compliance. A due process is followed in developing standards, which includes issuance of exposure drafts of proposed standards for public comment.

Until 2004, accounting standards were promulgated by the Accounting Principles Commission (CPC) of MIPA. Since June 2004, the CINIF assumed the duties and responsibilities for issuance of Mexican accounting standards. The standards previously issued by MIPA were called “Generally Accepted Ac- counting Principles in Mexico,” and the standards issued by CINIF are called Financial Reporting Standards. The Mexican FRS framework requires compa- nies to follow IFRS as supplementary, when no speci! c guidance is provided by Mexican FRS for a particular transaction or event. Mexican FRS, which are very similar to U.S. GAAP and IFRS, are widely recognized and supported by the CNBV, the tax authorities, banks, and other lending institutions. Beginning in 2012, all public companies are required to apply IFRS. Accounting standards are recognized as authoritative by the government, in particular the NBSC. Mexican accounting principles apply to all business entities, large and small. In some cases, the NBSC issues rules for listed companies. All companies incorporated under Mexican law must appoint at least one statutory auditor to report to the shareholders on the annual ! nancial statements. MIPA also has developed a Code of Ethics, which, among other things, prohibits media advertising for pub- lic accountants.

Mexican FRS are known as bulletins. There are four kinds of bulletins. Series A bulletins deal with the basic accounting principles that de! ne the framework of accounting principles. For example, Bulletin A-8 requires companies to apply IFRS for issues that are not covered by Mexican generally accepted accounting principles. MIPA has translated and published IFRS into Spanish. Series B bul- letins deal with the accounting principles that are pervasive to all ! nancial state- ments. For example, Bulletin B-1 states the objectives of ! nancial statements, B-2 deals with revenue recognition, and so on. Bulletin B-10 deals with the rec- ognition of the effects of in" ation in the ! nancial statements. Series C bulletins provide guidance with respect to speci! c balance sheet and income statement accounts, such as cash and short-term investments (Bulletin C-1), inventories (Bulletin C-4), liabilities (Bulletin C-9), and contingencies and commitments (Bulletin C-12). Series D bulletins deal with speci! c topics that are key to de- termining the net income of an enterprise, such as accounting for income taxes (Bulletin D-4) and leasing (Bulletin D-5). With few exceptions, bulletins are similar to U.S. GAAP.

The Mexican law governing commercial companies (Ley General de Sociedades Mercantiles—LGSM) requires that shareholders appoint a comisario. As per the requirement of the LGSM, a comisario is appointed at the annual general meet- ing of shareholders and is given responsibility to protect shareholder interests. This individual, for whom no professional title of any kind is required, attends board meetings without a voting right, is authorized to call a shareholders’ meet- ing, and has full access to company information. At each annual general meeting, the comisario is required to deliver a report with respect to the accuracy, adequacy, and rationality of ! nancial and other information presented by the board of directors, including an opinion on whether appropriate accounting policies were followed in preparing the ! nancial statements.

The Mexican Stock Exchange, Bolsa Mexicana de Valores (BMV), located in Mexico City, is the only stock exchange in Mexico. It is privately owned by a few

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Mexican brokerage houses. Currently, institutional investors do not play as big a role in equity markets in Mexico as they do in the United States. For example, the pension fund laws of Mexico do not allow pension funds to invest in equity securities. The BMV operates with an authority granted by the Ministry of Finance and Public Credit, under the Law of Securities Market. Trading on the BMV " oor began in October 1895. Mexico’s securities market is signi! cantly smaller than that of the United States. Unlike in the United States, the Mexican capital market is controlled by families. Since 1975, the BMV has been regulated by the Securities Market Act.

Companies listed on the Mexican Stock Exchange must submit annual, Decem- ber 31 year-end, consolidated ! nancial statements, audited by a Mexican public accountant, to the BMV and to the NBSC. Compliance with tax regulations re- quires a report prepared in accordance with Mexican FRS and audited in accor- dance with Mexican generally accepted auditing standards.

The enactment of the Securities Market Law (LMV) of 2001 and of the CN- BV’s Circular Única provides the basis for enforcement of the accounting and auditing requirements in listed companies. The Securities and Banking Na- tional Commission (Comisión Nacional Bancaria y de Valores—CNBV) is the federal agency that regulates the offerings of the securities market in Mexico. All companies whose shares are listed on the stock exchange are required to ! le periodic reports with the CNBV. The ! nancial statements of these companies must be audited annually and reviewed by independent public accountants on a quarterly basis. The CNBV also requires companies to comply with its rules and regulations, including the Mexican FRS. The tax authorities also rely on the generally accepted accounting principles for the determination of the basic elements that are taken into account to determine taxes payable, except when otherwise indicated in the applicable tax laws. The CNBV conducts re- views of ! nancial statements of listed companies and other participants in the securities markets, which include brokerage ! rms and investment funds, as well as banks, aimed at determining compliance with applicable accounting and disclosure requirements. Similar to Sarbanes-Oxley recommendations, the CNBV issued a new circular in March 2003 which states that the chief executive of! cer and chief ! nancial of! cer must certify the completeness and accuracy of quarterly and annual ! nancial statements. In Mexico, the board of directors is also legally responsible for the ! nancial statements. Also similar to the require- ments of the Sarbanes-Oxley Act, insiders are required to inform the CNBV and BMV of their shareholdings so that the information can be disclosed. The CNBV also visits audit ! rms, selected on a random basis, to perform reviews of audit work and ensure compliance with applicable standards. For violations of account- ing and auditing requirements, the CNBV is authorized under the Securities Ex- change Law to impose administrative sanctions, including ! nes, suspension, and deprivation of the right to practice as advisers, directors, management, comisarios, and external auditors.

However, the enforcement mechanisms in Mexico are not very effective. For ex- ample, although the NBSC is responsible for enforcing insider-trading laws, these laws are rarely implemented.

Mexico is different from the United States and Canada in that a single na- tional body, the Ministry of Education, has the authority by law to set the re- quirements for accounting professionals’ public practice rights. The Mexican states do not have separate and different laws, as is the case in the United States and Canada.

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Comparative Accounting 297

Accounting Principles and Practices Mexico has a conceptual framework for ! nancial reporting, which is basically in- cluded in three bulletins: A-1, Structure of the Basic Theory of Financial Accounting; A-11, De! nition of Basic Concepts Integrating Financial Statements; and B-1, Objectives of Financial Statements. The generally accepted accounting principles in Mexico consist of the following, in order of importance:

1. CINIF (formerly MIPA) bulletins. 2. CINIF (formerly MIPA) circulars or interpretations. These are opinions relating

to speci! c topics on which there may or may not be a speci! c standard. Compli- ance with these is not mandatory, but highly recommended.

3. International Financial Reporting Standards. 4. Accounting principles of other countries that would be applicable in the cir-

cumstances. In practice, U.S. GAAP are the main source applied.

In recent years, Mexican accounting principles have been heavily in" uenced by U.S. accounting practice because of Mexico’s membership in NAFTA. The U.S. in" uence is through the presence of subsidiaries of U.S. companies and the promi- nence of local representatives of the Big Four international accounting ! rms. As a result, although there are differences in accounting between the two countries, Mexican and U.S. accounting standards are generally consistent. In those areas where Mexican accounting principles do not exist, such as earnings per share or line-of-business disclosures, it is common for companies to use the corresponding U.S. standard.

In addition to the basic balance sheet and income statement, a statement of changes in ! nancial position also is prepared. This latter statement is very similar to the U.S. statement of cash " ows in appearance but re" ects sources and uses of funds, rather than cash. Notes to the ! nancial statements and a report from the stat- utory auditor are attached to the ! nancial statements. Mexican parent companies are required to prepare consolidated ! nancial statements. In doing so, Mexican companies use both the purchase method and the pooling of interests method. Note that IFRS 3 eliminated the option to use the pooling of interests method. Goodwill is amortized over a period not exceeding 20 years.

Accounting in Mexico shares many features of accounting with other Latin American countries. In the 1980s and 1990s, in" ation accounting information was being produced in several South American countries, generally using a general price index for adjustment purposes, mainly because of the absence of satisfactory speci! c asset indexes.

One of the unique features of Mexican accounting practice, and the greatest dif- ference from U.S. accounting, is the treatment of the effects of in" ation in ! nancial statements by using general purchasing power accounting. Mexico has a history of high rates of in" ation, often exceeding 20 percent per year. Bulletin B-10, Rec- ognition of the Effects of In" ation in Financial Information, became compulsory for all Mexican companies in 1984. The bulletin has been amended and re! ned several times. This is an example of how accounting practices re" ect speci! c needs of the local environment, in this case, the economic environment.

Bulletin B-10 required all nonmonetary assets and liabilities to be restated for changes in the purchasing power of the peso using the National Consumer Price Index (NCPI) published by the Central Bank. Prior to the Fifth Amendment to B-10 in 1996, estimated replacement costs were acceptable for restating inven- tory and ! xed assets, but later this was only permissible for inventory. Equity

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298 Chapter Six

accounts also had to be restated using the NCPI to re" ect paid-in capital at con- stant purchasing power. The third important element of the Mexican in" ation accounting system was the recognition in income of the gain or loss from the net monetary asset or liability position. All comparative ! nancial statements from prior years also should be restated to constant pesos as of the date of the most recent balance sheet. Both large and small enterprises followed the same set of accounting standards.

Bulletin B-10 also introduced a novel concept called the integral result of ! nanc- ing, which was reported as a separate line item on the income statement. This is calculated by adding the nominal interest expense, the gain or loss due to price- level changes on the company’s net monetary position, and the gains and losses due to exchange rate " uctuations on the company’s monetary assets and liabilities denominated in foreign currencies.

Before 1996, current replacement cost based on appraisals or speci! c price in- dexes was also acceptable. This approach was eliminated because it was viewed as less reliable and less in line with international standards based on historical cost.

MIPA, being one of the nine founding members of the IASC, has shown a keen interest in international harmonization of accounting standards. The United States has a dominant in" uence on accounting standards in Mexico. For example, many of the pioneers of the Mexican accounting profession grew up on “American ac- counting.” 56 However, the standards issued by the FASB did not always meet the Mexican requirements; for example, Latin American ! nancial reports are prepared for creditors, owner-managers, and tax collectors, while accounting standards and ! nancial reports in the United States are directed toward the investor as the intended subject. As a result, the national standard-setters in Mexico have also looked at “principles-based” IFRS as a reference for upgrading Mexican GAAP. There are signs of convergence with IFRS in recent years. For example, in line with IAS 29, Mexico has given up on in" ation accounting recently. Bulletin B-10 require that nonmonetary items of the ! nancial statements be restated for the effects of in" ation, irrespective of the level of in" ation. However, as a result of low in" ation rates in Mexico in recent years, it does not seem to satisfy the conditions set out in IAS 29, Financial Reporting in Hyperin" ationary Economies, for such statements. However, Mexican stakeholders strongly expressed the view that even though price levels have been stabilized in the recent period, it is still more bene! cial to the business community to maintain the practice of restating the effects of in" a- tion in the country. In the past, the effects of in" ation were recorded for accounting and tax purposes in Mexico. However, more recent amendments to Mexico’s FRS B-10 require corporations to include the effects of in" ation in ! nancial statements only if such in" ation exceeds 26 percent (the combined in" ation of the last three years). In" ation continues to be taken into account in the determination of taxes to be paid.

Mexican accounting rules require research and development costs to be expensed as incurred, and leases to be classi! ed into ! nancial and operating categories. Mexican GAAP differs from IFRS in the following areas: IFRS prohibit, whereas Mexican FRS permit (and U.S. GAAP also permit) the use of the last-in, ! rst-out inventory-costing methodology; the de! nition of an associate is based on a threshold of an investment of 10 percent of voting shares (IAS 28); preoperating and setup costs can be capital- ized (IAS 38); a statement of changes in ! nancial position is required instead of a

56 Stephen A. Zeff, Forging Accounting Principles in Five Countries: A History and an Analysis of Trends (Champaign, IL: Stipes Publishing, 1972), pp. 96–97.

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Comparative Accounting 299

EXHIBIT 6.9 Some Differences between Mexican GAAP and IFRS

Issue IFRS Mexican GAAP

Defi nition of an associate IAS 28: An associate is an enterprise in which the investor has signifi cant infl uence and which is neither a subsidiary nor a joint venture of the investor.

The defi nition of an associate is based on a threshold of an investment of 10 percent of voting shares.

Preoperating and setup costs IAS 38: Charge to expenses when incurred. Preoperating and setup costs can be capitalized.

Calculation of impairment of fi xed assets

IAS 36: Impairment is calculated when the book value of an asset exceeds its recoverable amount, which is the greater of net realizable value and the net present value of future net cash fl ows expected to arise from continued use of the asset.

For the calculation of impairment, assets for sale are valued at net selling price and assets for continued use are valued at value in use.

Statement of cash fl ows IAS 7: A statement of cash fl ows is required. A statement of changes in fi nancial position is required instead of a statement of cash fl ows.

Infl ation accounting IAS 29: Required for hyperinfl ationary countries.

Restatement for infl ation is mandatory if the combined infl ation rate of the last three years exceeds 26 percent.

Infl ation accounting method

IAS 29: Adjust the subsidiary fi nancial statements for general effects of infl ation, with the gain or loss on net monetary position in net income.

Companies can follow either the general price-level method or that method combined with the current cost method for restatement for infl ation, and if the current cost method is followed, the results of holding nonmonetary assets (difference between indexed cost and current cost) is recorded in equity.

Negative goodwill IFRS 3: Recognized in profi t and loss immediately.

Negative goodwill is shown as a deferred credit and amortized over a period of up to fi ve years.

statement of cash " ows (IAS 7); and restatement of in" ation is mandatory, irrespec- tive of the in" ation rate (IAS 29). Exhibit 6.9 summarizes some of the differences between IFRS and Mexican GAAP.

CEMEX SA de CV is one of more than 20 Mexican companies listed on the New York Stock Exchange. Note 25 to the consolidated ! nancial statements included in the company’s 2010 annual report provides a detailed description about the dif- ferences between Mexican GAAP and U.S. GAAP (see Exhibit 6.10 ). In November 2008, the Mexican Securities and Exchange Commission (Comision Nacional Ban- caria y de Valores, or CNBV) announced that all companies listed on the Mexican Stock Exchange will be required to use IFRS starting in 2012. Listed companies will have the option to use IFRS earlier—starting as early as 2008—subject to require- ments that will be established by the CNBV.

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300 Chapter Six

EXHIBIT 6.10

CEMEX, S.A.B. DE C.V. AND SUBSIDIARIES Notes to Consolidated Financial Statements

As of December 31, 2012 (Millions of Mexican pesos)

1. Description of Business

CEMEX, S.A.B. de C.V., a public stock corporation with variable capital (S.A.B. de C.V.) organized under the laws of the United Mexican States, or Mexico, is a holding company (parent) of entities whose main activities are oriented to the construction industry, through the production, marketing, distribution and sale of cement, ready-mix concrete, aggregates and other construction materials.

CEMEX, S.A.B. de C.V. was founded in 1906 and was registered with the Mercantile Section of the Public Register of Property and Commerce in Monterrey, N.L., Mexico in 1920 for a period of 99 years. In 2002, this period was extended to the year 2100. The shares of CEMEX, S.A.B. de C.V. are listed on the Mexican Stock Exchange (“MSE”) as Ordinary Participation Certifi cates (“CPOs”). Each CPO represents two series “A” shares and one series “B” share of common stock of CEMEX, S.A.B. de C.V. In addition, CEMEX, S.A.B. de C.V.’s shares are listed on the New York Stock Exchange (“NYSE”) as American Depositary Shares (“ADSs”) under the symbol “CX.” Each ADS represents ten CPOs.

The terms “CEMEX, S.A.B. de C.V.” and/or the “Parent Company” used in these accompanying notes to the fi nancial statements refer to CEMEX, S.A.B. de C.V. without its consolidated subsidiaries. The terms the “Company” or “CEMEX” refer to CEMEX, S.A.B. de C.V. together with its consolidated subsidiaries. The issuance of these consolidated fi nancial statements was authorized by the management of CEMEX, S.A.B. de C.V. on January 31, 2013. These consolidated fi nancial statements were authorized by the Stockholders’ Meeting of CEMEX, S.A.B. de C.V. on March 21, 2013.

2. Signifi cant Accounting Policies (2a) Basis of Presentation and Disclosure

In November 2008, the CNBV issued regulations requiring registrants whose shares are listed on the MSE, to begin preparing their consolidated fi nancial statements using International Financial Reporting Standards (“IFRS”), as issued by the International Accounting Standards Board (“IASB”), no later than January 1, 2012 and to stop using Mexican Financial Reporting Standards (“MFRS”). In connection with this requirement, CEMEX’s consolidated fi nancial statements as of December 31, 2012 and 2011 and for the years ended December 31, 2012, 2011 and 2010, were prepared in accordance with IFRS as issued by the IASB.

On January 26, 2012, CEMEX issued its last consolidated fi nancial statements under MFRS, which were as of December 31, 2011 and 2010 and for the years ended December 31, 2011, 2010 and 2009. These fi nancial statements were used to comply with CEMEX’s fi nancial information requirements before April 2012 issuance of its 2011 annual report with the Mexican National Banking and Exchange Commission (“Comisión Nacional Bancaria y de Valores” or “CNBV”) and its 2011 annual report on Form 20-F with the U.S. Securities and Exchange Commission (“SEC”). In addition, for purposes of preparing its 2011 annual reports with the CNBV and the SEC, on April 27, 2012, CEMEX issued its fi rst fi nancial statements under IFRS, which were as of December 31, 2011 and 2010 and as of January 1, 2010 and for the years ended December 31, 2011 and 2010 (not included in this report), in which CEMEX described the options it made in the migration to IFRS and the effects that such migration had on (i) CEMEX’s opening balance sheet as of January 1, 2010, according to IFRS 1, First time adoption (“IFRS 1”), (ii) CEMEX’s balance sheets as of December 31, 2011 and 2010, and (iii) CEMEX’s statements of operations, statements of comprehensive loss and statements of cash fl ows for the years ended December 31, 2011 and 2010, in each case, as compared to CEMEX’s previously reported amounts under MFRS.

Defi nition of terms

When reference is made to pesos or “Ps,” it means Mexican pesos. The amounts in the fi nancial statements and the accompanying notes are stated in millions, except when references are made to loss per share and/or prices per share. When reference is made to “US$” or dollars, it means millions of dollars of the United States of America (“United States”). When reference is made to “£” or pounds, it means millions of British pounds sterling. When reference is made to “€” or Euros, it means millions of the currency in circulation in a signifi cant number of European Union (“EU”) countries. When it is deemed relevant, certain amounts presented in the notes to the fi nancial statements include between parentheses a convenience translation into dollars, into pesos, or both, as applicable. These translations should not be construed as representations that the amounts in pesos or dollars, as applicable, actually represent those peso or dollar amounts or could be converted into pesos or dollars at the rate indicated. As of

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Comparative Accounting 301

December 31, 2012 and 2011, translations of pesos into dollars and dollars into pesos, were determined for balance sheet amounts using the closing exchange rates of Ps12.85 and Ps13.96 pesos per dollar, respectively, and for statements of operations amounts, using the average exchange rates of Ps13.15, Ps12.48 and Ps12.67 pesos per dollar for 2012, 2011 and 2010, respectively. When the amounts between parentheses are the peso and the dollar, the amounts were determined by translating the foreign currency amount into dollars using the closing exchange rates at year-end, and then translating the dollars into pesos as previously described.

Statements of operations

In CEMEX’s statements of operations for the years ended December 31, 2012, 2011 and 2010, the line item currently titled “Operating earnings before other expenses, net” was previously titled “Operating income,” and the line item currently titled “Operating earnings” was previously titled “Operating income after other expenses, net.” CEMEX made these changes to comply with industry practice when fi ling fi nancial statements under IFRS with the SEC based on the guidance set forth in paragraph 56 of the Basis for Conclusions of IAS 1, Presentation of Financial Statements (“IAS 1”). However, such changes in line-item titles do not represent any change in CEMEX’s accounting practices, policies or methodologies under IFRS as compared to prior years. Consequently, the line item “Operating earnings before other expenses, net” is directly comparable with the line item “Operating income” presented in prior years and the line item “Operating earnings” is directly comparable with the line item “Operating income after other expenses, net” presented in prior years.

The line item “Other expenses, net” in the statements of operations consists primarily of revenues and expenses not directly related to CEMEX’s main activities, or which are of an unusual and/or non-recurring nature, including impairment losses of long-lived assets, results on disposal of assets and restructuring costs, among others (note 6).

Statements of other comprehensive income (loss) For the years ended December 31, 2012, 2011 and 2010, CEMEX adopted amendments to IAS 1, which, among other things, require entities to present line items for amounts of other comprehensive income (loss) in the period grouped into those that, in accordance with other IFRSs: a) will not be reclassifi ed subsequently to profi t or loss; and b) will be reclassifi ed subsequently to profi t or loss when specifi c conditions are met.

Statements of cash fl ows The statements of cash fl ows present cash infl ows and outfl ows, excluding unrealized foreign exchange effects, as well as the following transactions that did not represent sources or uses of cash:

• In 2012, the exchange of approximately US$452 (48%) of CEMEX’s then outstanding perpetual debentures and of approximately €470 (53%) of CEMEX’s then outstanding Euro-denominated 4.75% notes due 2014, for new Euro-denominated notes for €179 and new Dollar-denominated notes for US$704. In 2011, the exchange of a portion of CEMEX’s perpetual debentures for new notes for US$125, and in 2010, the exchange of a portion of CEMEX’s perpetual debentures for new notes for US$1,067 and new notes for €115 (note 16A). These exchanges represented net increases in debt of Ps4,111 in 2012, Ps1,486 in 2011 and Ps15,361 in 2010, reductions in equity’s non controlling interest of Ps5,808 in 2012, Ps1,937 in 2011 and Ps20,838 in 2010 and increases in equity’s controlling interest of Ps1,680 in 2012, Ps446 in 2011 and Ps5,401 in 2010;

• In 2012 and 2011, the increases in property, plant and equipment for approximately Ps2,025 and Ps1,519, respectively, and in debt for approximately Ps1,401 and Ps1,558, respectively, associated with the negotiation of capital leases during the year (note 16B);

• In 2011, the increase in debt for Ps1,352 related mainly to the acquisition of Ready Mix USA LLC (note 15B); • In 2011, the decrease in debt and in perpetual debentures within non-controlling interest for approximately Ps239 and Ps1,391,

respectively, in connection with the gains resulting from the difference between the notional amount and the fair value of CEMEX’s debt and perpetual instruments held by subsidiaries (note 16A); and

• In 2012, 2011 and 2010, the increases in common stock and additional paid-in capital associated with: (i) the capitalization of retained earnings for Ps4,138, Ps4,216 and Ps5,481, respectively (note 20A); and (ii) CPOs issued as part of the executive stock- based compensation for Ps486, Ps495 and Ps312, respectively (note 20A).

(2b) Principles of Consolidation

According to IAS 27, Consolidated and separate fi nancial statements (“IAS 27”), the consolidated fi nancial statements include those of CEMEX, S.A.B. de C.V. and the entities in which the Parent Company holds, directly or through subsidiaries, more than 50% of their common stock and/or has control. Control exists when CEMEX, S.A.B. de C.V. has the power, directly or indirectly, to govern the administrative, fi nancial and operating policies of an entity in order to obtain benefi ts from its activities. The fi nancial statements of Special Purpose Entities (“SPEs”) are consolidated if, based on an evaluation of the substance of the agreements and the SPE’s risks and rewards, CEMEX concludes that it controls the SPE. Balances and operations between related parties are eliminated in consolidation.

Continued

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302 Chapter Six

EXHIBIT 6.10 (Continued )

Pursuant to IAS 28, Investments in associates and joint ventures (“IAS 28”), investments in associates are accounted for by the equity method when CEMEX has signifi cant infl uence, which is generally presumed with a minimum equity interest of 20%, unless it is proven in unusual cases that CEMEX has signifi cant infl uence with a lower percentage. The equity method refl ects in the fi nancial statements the investment’s original cost and the proportional interest of the holding company in the associate’s equity and earnings after acquisition, considering, if applicable, the effects of infl ation. The fi nancial statements of joint ventures, which are those entities in which CEMEX and other third-party investors have agreed to exercise joint control, are also recognized under the equity method. The equity method is discontinued when the carrying amount of the investment, including any long-term interest in the associate or joint venture, reaches zero, unless CEMEX has incurred or guaranteed additional obligations of the associate or joint venture.

Other investments of a permanent nature where CEMEX holds equity interests of less than 20% and/or there is no signifi cant infl uence are carried at their historical cost.

(2c) Use of Estimates and Critical Assumptions

The preparation of fi nancial statements in accordance with IFRS principles requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the fi nancial statements, as well as the reported amounts of revenues and expenses during the period. These assumptions are reviewed on an ongoing basis using available information. Actual results could differ from these estimates.

The main items subject to estimates and assumptions by management include, among others, impairment tests of long-lived assets, allowances for doubtful accounts and inventories, recognition of deferred income tax assets, as well as the measurement of fi nancial instruments at fair value, and the assets and liabilities related to employee benefi ts. Signifi cant judgment by management is required to appropriately assess the amounts of these assets and liabilities.

There is an element of secrecy in ! nancial reporting, given the tradition of family- controlled business and the cultural orientation of Mexican society. Exhibit 6.11 shows that Mexican society is characterized by low individualism (collectivism), high masculinity, large power distance, and strong uncertainty avoidance, com- pared to the United Kingdom. These cultural characteristics are likely to lead to a high level of secrecy in accounting and ! nancial reporting. 57

57 S. J. Gray, “Towards a Theory of Cultural Infl uence on the Development of Accounting Systems Internationally,” Abacus, March 1988, pp. 1–15.

EXHIBIT 6.11 Work-Related Cultural Value Orientation of Mexico

Source: G. Hofstede, Cultures and Organizations: Software of the Mind (London: McGraw-Hill, 1991).

Individualism vs. Collectivism

Masculinity vs. Femininity

Large vs. Small Power Distance

Strong vs. Weak Uncertainty Avoidance

United Kingdom 89 66 35 35

Germany 67 66 35 65

Japan 46 95 54 92

Mexico 30 69 81 82

Median score 38 49 60 68

Range 6–91 5–95 11–104 8–112

Scores above the median are considered high.

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Comparative Accounting 303

UNITED KINGDOM Background The United Kingdom consists of four constituent regions: England, Wales, Scotland, and Northern Ireland. The legislative authority lies with Parliament, which includes the House of Commons and the House of Lords. The House of Commons has 659 directly elected members, whose term of of! ce is a maximum of ! ve years. The House of Lords is appointed and consists of 92 hereditary peers, over 500 life peers, certain senior judges, and 26 bishops of the Church of England.

The limited liability company is the main form of business organization in the United Kingdom, and the capital market provides the main source of fund- ing for business. Consequently, facilitating the ef! cient working of the capital market is the primary purpose of accounting. There are approximately 15,000 private limited companies (PLCs), of which about 2,500 are listed on the London Stock Exchange. 58 The United Kingdom has by far the greatest number of com- panies listed on a regulated market in the European Union. Listed companies and other large companies ! le a full set of audited annual ! nancial statements with the Registrar of Companies. The annual report of a UK-listed company typi- cally includes, in addition to ! nancial statements, a chairperson’s statement, an operating and ! nancial review, the report of the directors, the report of the re- muneration committee, a statement on corporate governance, and shareholding information.

Accounting Profession Accounting in the United Kingdom grew as an independent discipline, respond- ing to business needs, and has had a signi! cant in# uence on the development of the accounting profession in many countries, including the United States and member countries of the British Commonwealth such as Canada, Australia, and New Zealand. The establishment of the ! rst professional accounting body, the Society of Accountants in Edinburgh, in 1853 can be regarded as the beginning of the modern accounting profession. 59 There are six professional bodies in the United Kingdom. In order of membership size, these are the Institute of Chartered Accountants in England and Wales (ICAEW), the Association of Chartered Certi- ! ed Accountants (ACCA), the Chartered Institute of Management Accountants (CIMA), the Institute of Chartered Accountants in Scotland (ICAS), the Chartered Institute of Public Finance and Accountancy (CIPFA), and the Institute of Char- tered Accountants in Ireland (ICAI). The ICAEW alone has more than 140,000 members. It is the largest professional accounting body in Europe. The UK ac- countancy bodies, enjoying Royal Charters, exercise considerable social power. They act as statutory regulators for the auditing and the insolvency sectors. The activities of the six bodies are coordinated through the Consultative Committee of Accountancy Bodies (CCAB), established in May 1974. Members of CIMA and CIPFA are not allowed to sign audit opinions. Since the formation of the Financial Reporting Council (FRC) as the regulator for accounting matters, CCAB became more focused on auditing and therefore less relevant to CIMA members. In March 2011, CIMA left CCAB.

58 David Alexander and Simon Archer, eds., European Accounting Guide, 4th ed. (New York: Aspen, 2003), p. 14.04. 59 For details about early developments of the accounting profession in the United Kingdom, see Zeff, Forging Accounting Principles; and L. Goldburgh, “The Development of Accounting,” in Accounting Concepts Readings, ed. C. T. Gibson, G. G. Meredith, and R. Peterson (Melbourne: Cassell, 1971), pp. 18–22.

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Professional accounting bodies in the United Kingdom do not require aspiring members to have an undergraduate degree in accounting. However, those who possess an undergraduate degree in accounting would qualify for exemptions from the full examination structure. The three Institutes of Chartered Accountants have been the main training bodies for the members of the big accounting ! rms in the respective regions of the United Kingdom. The membership of ACCA mainly consists of small practitioners and individuals from the corporate sector, while the main foci of CIMA and CIPFA are on management accounting and accounting in government organizations, respectively. All six professional accounting bodies set comprehensive exams for admission to their bodies. The examinations test knowl- edge at the basic, intermediate, and advanced levels. Those aspiring to be mem- bers of the three Institutes of Chartered Accountants are required to enter into training contracts with approved organizations (traditionally accounting ! rms, but now extended to large companies) while completing their examinations.

The ICAEW in September 2000 introduced a new examination structure consist- ing of a professional stage and an advanced stage. The professional stage, which students can take prior to entering a training contract, consists of six subjects and two modules in law whose assessment is devolved to tuition providers. Students can gain exemptions from individual subjects at this stage if they have completed relevant diplomas, degrees, or examinations of other professional bodies. The ad- vanced stage consists of a Test of Advanced Technical Competence (TATC) and an Advanced Case Study. The advanced stage adopts “a multidisciplinary approach, breaking down the old subject by subject ‘tunnel vision,’ integrating tax, audit, ! nancial reporting and business topics, including business strategy, knowledge management and communication, digital economy, ! nancial strategy, mergers and acquisition, change management, and business recovery.” 60 From July 2013, updated syllabi for the two stage modules will be available.

Over the years, there have been several attempts at consolidating the UK ac- countancy profession by a merger of the three chartered bodies (CIMA, CIPFA, and ICAEW). This would create an organization with more than 200,000 mem- bers and become the authoritative voice across the accountancy profession in the United Kingdom. However, this has not materialized as a result of the inability of the three bodies to reach an agreement on some aspects of the merger.

Traditionally, the UK accounting profession has favored a principles-based approach, rather than a rules-based approach, to standard-setting. Peter Wyman, president of the ICAEW in 2002, explained the importance of this approach as follows:

To remain a profession, accountancy must be about the exercise of professional integrity and judgment. If we are driven down the road of simply ticking boxes to show that rules have been complied with, we will end up with a clerical activity that is carried out without thought, and possibly without regard to the special context of the business at hand.

Not only will this fail to attract people with intellect, but will also, inevitably from time to time, produce the wrong answers. No standard setter, no lawmaker is able to predict every likely situation. It is for this reason that we have constantly called for principles rather than rules in our standards. However, such an approach can only operate successfully if the principles are being applied by people with in- tegrity and with the suitable skill, insight and application to do so effectively. 61

60 www.icaew.co.uk/students/newaca/document.asp . 61 Peter Wyman, “The Enron Aftermath—Where Next?” speech delivered October 10, 2002, at a conference held in Brussels (available at www.icaew.co.uk ).

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Comparative Accounting 305

Accounting Regulation Regulation of accounting and ! nancial reporting in the United Kingdom primarily is through legislation (Companies Act), professional pronouncements, and stock exchange listing requirements. The idea that determination of acceptable account- ing principles and standards should be left in the hands of the profession has been part of the UK tradition. Unlike their counterparts in the United States, tradition- ally, UK legislators have never felt the need to have a powerful securities com- mission to regulate accounting and ! nancial reporting with detailed rules. Recent developments, however, suggest a change to this attitude, as the Financial Report- ing Council (FRC) has become the powerful independent regulator responsible for promoting con! dence in corporate reporting and governance in the UK.

The United Kingdom joined the European Union in 1973. Since then, EU di- rectives have had a strong impact on UK accounting regulation. EU directives are transformed into UK legislation through the Companies Act. The EU Fourth Directive was integrated into British law in 1981 through amendments to the Com- panies Act of 1948. These amendments were prescriptive to a degree previously unknown in the United Kingdom. Traditionally, the Companies Act would nor- mally set out the general principles, leaving the speci! c requirements to be devel- oped through other channels, particularly the accounting profession. However, the 1981 amendments to the Companies Act state exactly how certain matters are to be disclosed, with no latitude, for example, in matters of format. Similarly, the Companies Act of 1989 introduced the EU Seventh and Eighth Directives. 62

As a result of the EU Eighth Directive, in order to qualify to practice as an audi- tor in the United Kingdom, a candidate is required to be registered in a statutory register maintained by one of the professional bodies. The 1989 Companies Act also requires companies to state whether the ! nancial statements have been pre- pared in accordance with applicable accounting standards and, if not, give reasons for the departure. This is also an important change, because, prior to the 1989 Com- panies Act, UK accounting standards were not referred to in company legislation.

In 2000, the British government, in partnership with the professional accoun- tancy bodies, established the Accountancy Foundation, to be responsible for the nonstatutory independent regulation of the six professional chartered accountancy bodies comprising the CCAB. The purpose of establishing the Accountancy Foun- dation was to ensure that self-regulation would be conducted in the public interest.

In response to accounting scandals in the United States, such as those related to Enron and WorldCom, several steps have been taken to improve regulation of ! nancial reporting in the United Kingdom. The Department of Trade and Industry initiated a review of the Accountancy Foundation in October 2002 by publishing a consultation document on how the UK accountancy and auditing professions are to be regulated. It highlighted a number of issues:

• Whether the professional organizations should continue to set their own ethical standards and monitor the work and conduct of audit ! rms, or whether there should be stronger independent oversight or intervention.

62 In January 2003, the European Parliament approved amendments to the EU Fourth and Seventh Directives that removed all inconsistencies between the directives and IFRS. In December 2004, the EU adopted a directive on minimum transparency requirements for listed companies, completing a package of measures to establish a common fi nancial disclosure regime across the EU for issuers of listed securities. The text of the directive is at www.europa.eu.int/comm/internal_market/securities/transparency/index_en.htm .

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306 Chapter Six

• Whether the Accountancy Foundation should focus on the company auditor rather than on the regulation of accountants in general.

• Whether the structure and funding of the Accountancy Foundation should be reviewed.

The second main element of the UK regulatory system is professional pro- nouncements. The establishment of the Accounting Standards Steering Committee in 1970 by the ICAEW was the beginning of the development of formal accounting standards in the United Kingdom. The ! rst Statement of Standard Accounting Prac- tice (SSAP 1), on “Accounting for the Results of Associated Companies,” was issued in January 1971. The committee was later redesignated as the Accounting Standards Committee (ASC), which was reconstituted as a joint committee of the six profes- sional bodies in 1976. The ASC standard-setting mechanism came under heavy criticism in the 1980s for a lack of effective means of monitoring compliance and the low quality of its standards. In response, the Dearing Report recommended signi! cant changes to the UK standard-setting process, which included the cre- ation of the following: 63

1. The Accounting Standards Board (ASB), with the authority to issue standards in its own right.

2. The Financial Reporting Council (FRC), given the responsibility of overall pol- icy control over the standard-setting process.

3. The Financial Reporting Review Panel (FRRP), to oversee compliance.

The creation of the ASB in August 1990 marked the beginning of a new era in accounting standard-setting in the United Kingdom. It reduced the direct in# u- ence of the accounting profession on standard-setting, because the ASB, like the U.S. FASB, is institutionally separated from the accounting institutes. The role of the FRC, also created in 1991, was to secure funding for the ASB and FRRP, which functioned under its purview. The FRC also acted as a high-level policy body that provided guidance to the ASB on priorities and work programs, advised the board in broad terms on issues of public concern, and encouraged compliance.

Following the major corporate collapses in the United States, in January 2003, the Secretary of State for Trade and Industry announced a package of reforms to raise standards of corporate governance, strengthen the accountancy and audit professions, and provide for an independent system of regulation for those pro- fessions. Accordingly, the FRC assumed the functions of the Accountancy Foun- dation. As part of the reforms in July 2012, setting accounting standards became the responsibility of the FRC Board, whereas this had previously been done by the ASB. In addition to being responsible for issuing accounting standards and dealing with their enforcement, the FRC is also responsible for promoting high- quality corporate governance and reporting to foster investment. It also monitors and takes action to promote the quality of corporate reporting and auditing, op- erates independent disciplinary arrangements for accountants and actuaries, and oversees the regulatory activities of the accountancy and actuarial professional bodies.

With the assumption of these responsibilities, the FRC became the single, in- dependent regulator of accounting and auditing in the United Kingdom. For ex- ample, it assumed responsibility for setting independence standards for auditors and for monitoring the audit of listed companies, and other signi! cant entities

63 Consultative Committee on Accountancy Bodies, The Making of Accounting Standards: Report of the Review Committee (Dearing Committee) (London: ICAEW, 1988).

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Comparative Accounting 307

were transferred from the accounting professional bodies to the FRC. The FRC also retains its current responsibilities for the work of the ASB and the FRRP. In addition, the FRC represents UK interests in international standard-setting through the IASB, and collaborates with accounting standard-setters from other countries—both in order to in# uence the development of international standards and to ensure that its standards are developed with due regard to international developments.

The Companies Act of 2004, which amended the Companies Acts of 1985 and 1989, made the FRC a uni! ed, independent regulator with the above three key roles. The FRC and its subsidiary bodies are funded equally by government, busi- ness, and the accountancy profession, thereby guaranteeing its independence be- cause no single interest group dominates. The annual report 2008/2009 of the FRC (published in May 2009) comments about its own effectiveness as “an effective, ac- countable and independent regulator, operating in the public interest and actively helping to shape UK, and to in# uence EU and global, approaches to corporate reporting and governance.” The annual report also says,

In view of the importance of the IASB for accounting in the UK, we continued to follow its work carefully, in particular its Memorandum of Understanding with the US FASB. The ASB continued to look for opportunities to promote the merits of reassessing the advantages of further convergence between IFRS and US GAAP. It assessed the accounting implications of current market conditions and the IASB projects related to the global liquidity squeeze, in particular consolidation and the issues around fair value measurements in illiquid markets. We continue to have signi! cant concerns that the EU might adopt its own version of IFRS rather than the standards as published by the IASB. . . . We remain committed in principle to a future UK GAAP which is further converged with IFRS, but the strategy for achiev- ing this remains under consideration. The ASB continued its efforts to ensure that UK converged standards remain in line with their IFRS equivalents, responding to circumstances arising from the current crisis as appropriate. (p. 5)

According to the annual report, the key themes of the FRC’s work for 2009/2010 would be to in# uence (1) market participants to meet high standards of reporting and governance through a combination of measures to raise awareness of major risks, monitor corporate reporting and governance practices, and take enforce- ment action where appropriate; (2) legislators and international standard-setters to encourage a proportionate and principles-based approach that promotes high standards of corporate reporting and governance; and (3) international regulatory authorities to encourage effective cooperation (p. 10).

The ASB, adopting a principles-based approach, develops its standards on the basis of a conceptual framework known as the “Statement of Principles for Finan- cial Reporting.” The ASB makes, amends, and withdraws accounting standards, assisted by four committees: (1) the Urgent Issues Task Force, (2) the Financial Sector and Other Special Industries Committee, (3) the Public Sector and Not-for- pro! t Committee, and (4) the Committee on Accounting for Smaller Entities. The standards issued by the ASB are called Financial Reporting Standards (FRS).

The ASB is one of several national standard-setters that have a formal liaison relationship with the IASB. The ASB is committed to align UK accounting stan- dards with IFRS wherever practicable, by a phased replacement of existing UK standards with new UK standards based on IFRS. 64 According to the FRC annual

64 In July 2003, the Department of Trade and Industry announced that all UK companies will be able to use IFRS as an alternative to UK standards from 2005. (Department of Trade and Industry Press Release, “UK Extends Use of International Accounting Standards,” July 17, 2003.)

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report for 2008/2009, the ASB faces three major challenges. The ! rst challenge is to continue to ensure an appropriate in# uence on the development of IFRS through high-quality submissions to, and communications with, the IASB, arguing the case for accounting standards based on clear principles rather than detailed rules. The second challenge is to work for the timely adoption of IFRS as developed by the IASB for adoption in the EU. As ! nancial reporting has become increasingly politi- cal, the ASB will have to work hard with its European counterparts and EFRAG to maintain the policy of using IFRS in Europe. The ! nal challenge is to develop an appropriate strategy for the future of UK GAAP.

The main purpose of the FRRP, which was established in 1991, is to review companies’ ! nancial statements to ensure fair presentation of information. The FRRP adopts a proactive role for the enforcement of accounting standards in which the Financial Services Authority (FSA), the UK ! nance watchdog, plays an active part. 65 The FRRP can ask directors to explain apparent departures from the accounting requirements. If the panel is not satis! ed by the directors’ explana- tions, it persuades them to adopt a more appropriate accounting treatment. Fail- ing this, the panel can exercise its powers to secure the necessary revision of the original accounts through a court order.

Under the Companies Act of 2004, which came into effect in October 2004, 66 the authority of the FRRP would be extended to cover ! nancial information, other than annual accounts, published by entities that have securities listed on a UK market and where mandatory accounting requirements may apply.

In May 2007, the FRRP issued a consultation paper aimed at improving the quality and credibility of annual ! nancial statements. The panel seeks to ensure that the provision of ! nancial statements by public and large companies complies with the reporting requirements of the Companies Act of 1985. The panel cur- rently relies on users of accounts bringing such reports to its attention, but this often happens some considerable time after publication. The panel proposes that registered audit ! rms disclose voluntarily to the panel any audit report they issue in respect of annual ! nancial statements in which their opinion is quali! ed for failure to comply with the reporting requirements of the Companies Act.

Auditing standards in the United Kingdom are issued by the Auditing Practices Board (APB), an operating body of the FRC. They include Statements of Auditing Standards (SASs), Auditing Guidelines, and Statements of Investment Circular Reporting Standards (SIRs). The APB is funded by the CCAB, and its membership consists of practicing auditors and others from business, academia, law, and the public sector.

The third element of the UK regulatory system is stock exchange listing require- ments. The London Stock Exchange (LSE) requires publication of a semiannual interim report and disclosure of information about corporate governance and di- rectors’ remuneration. Unlike in Germany or Japan, taxation rules are not a major in# uence on ! nancial reporting in the United Kingdom.

65 The FSA is an independent body that regulates the fi nancial services industry in the United Kingdom. It aims to maintain confi dence in the UK fi nancial system, promote public understanding of the fi nancial system, secure the right degree of protection for consumers, and help to reduce fi nancial crime. For details see www.fsa.gov.uk . 66 The Companies (Audit, Investigations, and Community Enterprise) Act of 2004 forms part of the government’s strategy to help restore investor confi dence in companies and fi nancial markets following major corporate failures. The act amends relevant provisions of the Companies Acts of 1985 and 1989.

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Comparative Accounting 309

In July 2012, the Codes & Standards Committee was established to advise the FRC Board on maintaining an effective framework of UK codes and standards. The Ac- counting Council also replaced the Accounting Standards Board (ASB), assuming an advisory role to the Codes & Standards Committee and the FRC Board. The Accounting Council comprises up to 12 members, at least half of whom are prac- ticing members of the relevant profession and the remainder are other stakehold- ers. The revised Corporate Governance Code (formerly the Combined Code) was issued in September 2012, applicable to reporting periods beginning on or after October 1, 2012. One of the new provisions states that FTSE 350 companies should put the external audit contract out to tender at least every 10 years. Listed com- panies are required to report on how they have applied the main principles of the Code, and either to con! rm that they have complied with the Code’s provisions or—where they have not—to provide an explanation, so that their shareholders can understand the reasons for doing so and judge whether they are content with the approach the company has taken. To help companies understand what is ex- pected of them and for shareholders to have a benchmark against which to assess explanations, the FRC published a paper titled “What Constitutes an Explanation under ‘Comply or Explain’.” Companies are also encouraged to state, when they ! rst report against the 2012 Code, whether or not they anticipate putting the audit contract out to tender in due course. These new features have been incorporated in the introductory section of the 2012 edition of the Code. A recent study found that more than half of the companies complied with this requirement.

Accounting Principles and Practices Accounting principles in the United Kingdom emphasize investor needs and the importance of transparency. UK ! nancial statements typically include a pro! t and loss account, a balance sheet, a cash # ow statement, a statement of total gains and losses, a statement of accounting policies, notes to ! nancial statements, and the auditor’s report. The United Kingdom has a differential ! nancial reporting sys- tem in which small and medium-size companies are exempt from many reporting requirements.

The 1985 Companies Act requires corporate ! nancial statements to provide a true and fair view of the ! rm’s ! nancial position and results of operations for the ! nancial year. Auditors are given the corresponding duty to render an opinion on whether a true and fair view is provided. True and fair view is not speci! cally de! ned in law. The legal opinion is that compliance with accounting standards is necessary to meet the true and fair requirement. However, this requirement is overriding and may require more than just compliance with accounting stan- dards. For example, the Companies Act speci! cally stipulates that if compliance with the act “would not be suf! cient to give a true and fair view, the necessary additional information shall be given in the accounts or in a note to them” [Section 226 (2)]. Therefore, while accounting standards are a necessary component of a true and fair view, they may not in themselves be suf! cient in all situations to pro- vide a true and fair view. Professional judgment remains an essential additional component. In incorporating the Fourth and Seventh Directives, which had a more prescriptive approach, into the national law, extensive use was made of options in order to preserve the importance of professional judgment.

In an opinion published in May 2008, the FRC con! rmed the continued rele- vance of the “true and fair” concept to the preparation and audit of ! nancial state- ments following the enactment of the Companies Act of 2006 and the introduction of international accounting standards.

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310 Chapter Six

Since January 1, 2005, UK-listed companies must use European Union–adopted IFRS to prepare their group ! nancial statements. 67 They are permitted, but not required, to use IFRS for their individual accounts. Other companies and limited liability partnerships are permitted, but not required, to use IFRS for both their con- solidated and individual accounts. UK standards will therefore still be available for all ! nancial statements other than the consolidated accounts of listed groups. The Financial Reporting Review Panel in its 2010 annual report states that there has been a continuous improvement in the general quality of IFRS ! nancial reporting.

Financial statements generally are prepared on the basis of historical cost, but companies are allowed to revalue tangible assets. In general, UK accounting stan- dards are very similar to IFRS, as the international standards have been heavily in# uenced by British accounting. However, speci! c differences do exist between IFRS and UK GAAP. (The acronym GAAP stands for “Generally Accepted Accounting Practice” or “Generally Accepted Accounting Principles” or “Gener- ally Accepted Accounting Policies.” GAAP is a term used to describe the rules generally accepted as being applicable to accounting practices as laid down by standards or legislation, or upheld by the accounting profession.) In some areas, there is a difference in requirements under the two sets of standards. For example, segment reporting in the United Kingdom does not follow the primary–secondary reporting format approach found in IAS 14. In other areas, UK rules are more # ex- ible. For example, whereas IFRS 3 requires that goodwill should not be amortized systematically, but instead should be subject to an annual impairment test, UK GAAP allows amortization at the ! rm’s discretion. Exhibit 6.12 provides a sum- mary of several differences that exist between UK GAAP and IFRS.

Recently, the FRC published a discussion paper on reducing complexity in cor- porate reporting. The paper seeks to address growing concerns about the complex- ity of corporate reporting in terms of, for example, increasing length and detail of annual reports and the regulations that govern them. The paper recommends a commonsense approach to reducing complexity based on eight guiding principles divided into two categories.

Guiding Principles for Regulation

1. Regulations should focus on signi! cant problems and be targeted to: • Provide relevant information that meets important user needs. • Reflect the reality of the business while minimizing unintended implementa-

tion consequences. 2. Regulators should limit constant change by intervening only when an area is

high-risk and change will bring obvious bene! t. Intervention should be as cost effective as possible—for example, by using management information already produced for internal purposes.

3. Regulators should understand what other national and international regulators are doing in a particular area. Wherever possible, they should be consistent with one another and work together in a joined-up way.

4. Regulations should be kept simple and user-friendly. They need to be under- stood easily by those who will apply them and those who will bene! t from them. Regulations should emphasize: • A clear articulation of the desired outcome. • Principles and judgment where appropriate.

67 The EU made certain amendments to IAS 39 prior to its adoption. However, the ASB has adopted the unamended version of IAS 39 in the United Kingdom.

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Comparative Accounting 311

EXHIBIT 6.12 Differences between UK GAAP and IFRS

Issue IFRS UK GAAP

Goodwill IFRS 3: Prohibits amortization. Must be tested for impairment annually.

Goodwill can be amortized at the fi rm’s choice.

Proposed dividends IAS 10: Should not be recognized as a liability at the balance sheet date.

Accrued as a liability.

Related-party disclosures IAS 24: Requires transactions to be disclosed by type of related party. Does not require names to be disclosed.

Names of transacting related parties should be disclosed.

Segment reporting IAS 14: More disclosure for primary segments than for secondary segments.

Segment reporting does not use the primary-secondary basis. Reports net assets rather than assets and liabilities separately.

Cash fl ow statements IAS 7: Cash fl ows include both cash and cash equivalents.

Cash fl ow statements reconcile to a narrowly defi ned “cash” rather than to “cash and cash equivalents.”

Translation of profi t and loss account of a foreign subsidiary

IAS 21: The average rate of exchange for the period should be used.

Allows the closing rate to be used.

Reporting on a hyperinfl ationary subsidiary

IAS 21: The fi nancial statements of a foreign entity that reports in the currency of a hyperinfl ationary economy should be restated before they are translated into the reporting currency of the reporting entity.

The fi nancial statements of a hyperinfl ationary subsidiary can be remeasured using a stable currency as the measurement currency.

Revaluation gains/losses on investment properties

IAS 40: Allows the choice of either fair value or depreciated cost as an accounting policy for measuring investment property. Where fair value is used, gains and losses from changes in fair value are recognized in the income statement.

Fair value should be used, but gains on revaluation are taken though the statement of total recognized gains and losses, not through profi t and loss (except for permanent defi cits below cost, or their reversals).

Intangible assets IAS 38: Requires capitalization of development expenditure in R&D. Requires Web site costs, when capitalized, to be treated as intangible asset.

Permits capitalization of development expenditure in R&D.

• Plain language with well-defined terms. • Consistent terminology. • An easy-to-follow structure.

Guiding Principles for Communication

1. Highlight important messages, transactions, and accounting policies, and avoid distracting readers with immaterial clutter.

2. Provide a balanced explanation of the results—the good news and the bad. 3. Use plain language, only well-de! ned technical terms, consistent terminology,

and an easy-to-follow structure. 4. Get the point across with a report that holds the reader’s attention.

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312 Chapter Six

The discussion paper is focused on the activities of UK publicly traded com- panies, but its recommendations could be useful to all companies, and it would stimulate discussions around the world, regarding corporate reporting.

The United Kingdom has the second greatest number of foreign companies listed on the New York Stock Exchange (Canada has the most). Exhibit 6.13 pro- vides useful information about the accounting standards adopted by Vodafone Group in preparing ! nancial statements according to its 2011 annual report. Note that there is no need to reconcile the UK standards and U.S. GAAP, as the ! nancial statements were in compliance with IFRS.

The annual reports of listed companies have become too complex and focused on compliance, rather than providing useful information on the business to inves- tors. In addressing this issue, the Institute of Chartered Accountants of Scotland (ICAS) has provided a document entitled “Making Corporate Reports Readable,” which contains a pro forma short form report that uses the example of a ! ctional universal bank as the underlying business and produces “in less than 30 pages” the key information of interest to investors.

The ASB has issued a Financial Reporting Standard (FRS), Improvements to Financial Reporting Standards 2009, so as to maintain the existing levels of con- vergence between UK and IFRS in 2009.

FRC’s guiding principles for communication to reduce complexity in ! nancial reporting:

1. Highlight important messages, transactions, and accounting policies, and avoid distracting readers with immaterial clutter.

2. Provide a balanced explanation of the results—the good news and the bad. 3. Use plain language, only well-de! ned technical terms, consistent terminology,

and an easy-to-follow structure. 4. Get the point across with a report that holds the reader’s attention.

The FRC developed a suite of three standards, FRC 100, FRC 101, and FRC 102, by taking into account feedback received over many years and with the stated aim of simplifying accounting and reporting for unlisted entities, improving report- ing of ! nancial instruments, and providing cost savings for subsidiaries of listed groups. These standards will be applicable to all companies and entities in the UK and Republic of Ireland, other than listed groups. They will be effective from January 1, 2015, but may be adopted early.

FRS 100 (Published in November 2012) FRS 100 sets out the overall ! nancial reporting requirements, giving many entities a choice of detailed accounting requirements depending on factors such as size and whether or not they are part of a listed group. It does not require any entities to apply international accounting standards that they are not already required to apply; for example, investment entities are allowed not to consolidate, but they should report earnings from investments at fair value. This is effective from January 1, 2014. This standard is expected to be endorsed by the EU in the second half of 2013.

FRS 101 (Expected early 2013) FRS 101, Reduced Disclosure Framework, applies to the individual ! nancial state- ments of subsidiaries and ultimate parents, allowing them to apply the same accounting as in their listed group accounts, but with fewer disclosures. This will reduce the reporting burden on listed groups.

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Comparative Accounting 313

EXHIBIT 6.13

VODAFONE GROUP PLC Form 20-F

2011 Excerpts from Notes to the Consolidated Financial Statements

Notes to the consolidated fi nancial statements

1. Basis of preparation

The consolidated fi nancial statements are prepared in accordance with IFRS as issued by the IASB. The consolidated fi nancial statements are also prepared in accordance with IFRS adopted by the European Union (‘EU’), the Companies Act 2006 and Article 4 of the EU IAS Regulations.

The preparation of fi nancial statements in conformity with IFRS requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the fi nancial statements and the reported amounts of revenue and expenses during the reporting period. For a discussion on the Group’s critical accounting estimates see “Critical accounting estimates” on pages 77 and 78. Actual results could differ from those estimates. The estimates and underlying assumptions are reviewed on an ongoing basis. Revisions to accounting estimates are recognised in the period in which the estimate is revised if the revision affects only that period or in the period of the revision and future periods if the revision affects both current and future periods.

Amounts in the consolidated fi nancial statements are stated in pounds sterling.

Vodafone Group Plc is registered in England (No. 1833679).

2. Signifi cant accounting policies

Accounting convention

The consolidated fi nancial statements are prepared on a historical cost basis except for certain fi nancial and equity instruments that have been measured at fair value.

New accounting pronouncements adopted

IFRS 3 (Revised) “Business Combinations”

The Group adopted IFRS 3 (Revised) on 1 April 2010. The revised standard introduces changes in the accounting for business combinations that impacts the amount of goodwill recognised, the reported results in the period that a business combination occurs and future reported results. The adoption of this standard is likely to have a signifi cant impact on the Group’s accounting for future business combinations.

Amendment to IAS 27 “Consolidated and Separate Financial Statements”

The Group adopted the amendment to IAS 27 on 1 April 2010. The amendment requires that when a transaction occurs with non-controlling interests in Group entities that do not result in a change in control, the difference between the consideration paid or received and the recorded non-controlling interest should be recognised in equity. In cases where control is lost, any retained interest should be remeasured to fair value with the difference between fair value and the previous carrying value being recognised immediately in the income statement. The adoption of this standard may have a signifi cant impact on the Group’s accounting for future transactions involving non-controlling interests.

The adoption of this standard has resulted in a change in presentation within the statement of cash fl ows of amounts paid to acquire non-controlling interests in Group entities that do not result in a change in control. In the year ended 31 March 2011 £137 million related to such transactions was classifi ed as “Other transactions with non-controlling shareholders in subsidiaries” within “Net cash fl ows from fi nancing activities”, whereas these amounts would have previously been recorded in “Purchase of interests in subsidiaries and joint ventures, net of cash acquired” within “Cash fl ows from investing activities”. There is no material impact in the comparative period.

New accounting pronouncements not yet adopted

Phase I of IFRS 9 “Financial Instruments” was issued in November 2009 and is effective for annual periods beginning on or after 1 January 2013. This standard has not yet been endorsed for use in the EU. The standard introduces changes to the classifi cation and measurement of fi nancial assets and the requirements relating to fi nancial liabilities in relation to the presentation of changes in fair value due to credit risks and the removal of an exemption from measuring certain derivative liabilities at fair value. The Group is currently assessing the impact of the standard on its results, fi nancial position and cash fl ows.

Continued

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314 Chapter Six

The Group has not adopted the following pronouncements, which have been issued by the IASB or the IFRIC. These pronouncements have been endorsed for use in the EU, unless otherwise stated. The Group does not currently believe the adoption of these pronouncements will have a material impact on the consolidated results, fi nancial position or cash fl ows of the Group.

• Amendments to IFRS 1, “Severe hyperinfl ation and removal of fi xed dates for fi rst-timer adopters”, effective for annual periods beginning on or after 1 July 2011. This standard has not yet been endorsed for use in the EU.

• Amendments to IFRS 7, “Financial Instruments: Disclosure”, effective for annual periods beginning on or after 1 July 2011. This standard has not yet been endorsed for use in the EU.

• “Improvements to IFRSs”, effective over a range of dates, with the earliest being for annual periods beginning on or after 1 January 2011.

• Amendment to IFRS 1, “Limited Exemption from Comparative IFRS 7 disclosures for fi rst time adopters”, effective for annual periods beginning on or after 1 July 2010.

• Amendment to IAS 12, “Deferred tax: Recovery of Underlying Assets”, effective for annual periods beginning on or after 1 January 2012. This standard has not yet been endorsed for use in the EU.

• Amendment to IAS 24, “Related Party Disclosures—State-controlled Entities and the Defi nition of a Related Party”, effective for annual periods beginning on or after 1 January 2011.

• Amendment to IFRIC 14, “Prepayments on a Minimum Funding Requirement”, effective for annual periods beginning on or after 1 January 2011.

• IFRIC 19, “Extinguishing Financial Liabilities with Equity Instruments”, effective annual periods beginning on or after 1 July 2010 with early adoption permitted.

The Group has also not adopted the following pronouncements, all of which were issued by the IASB on 12 May 2011 and which are effective for annual periods beginning on or after 1 January 2013. These pronouncements have not yet been endorsed for use in the EU. The Group has not completed its assessment of the impact of these pronouncements on the consolidated results, fi nancial position or cash fl ows of the Group. However, the Group currently expects that IFRS 11, “Joint Arrangements”, will have a material impact on the presentation of the Group’s interests in its joint ventures owing to the Group’s signifi cant investments in joint ventures as discussed in note 13.

• IFRS 10, ‘Consolidated Financial Statements’, which replaces parts of IAS 27, ‘Consolidated and Separate Financial Statements and all of SIC-12, ‘Consolidation – Special Purpose Entities’, builds on existing principles by identifying the concept of control as the determining factor in whether an entity should be included within the consolidated fi nancial statements of the parent company. The remainder of IAS 27, ‘Separate Financial Statements’, now contains accounting and disclosure requirements for investments in subsidiaries, joint ventures and associates only when an entity prepares separate fi nancial statements and is therefore not applicable in the Group’s consolidated fi nancial statements.

• IFRS 11, ‘Joint Arrangements’, which replaces IAS 31, ‘Interests in Joint Ventures’ and SIC-13, ‘Jointly Controlled Entities— Non-monetary Contributions by Venturers’, requires a single method, known as the equity method, to account for interests in jointly controlled entities which is consistent with the accounting treatment currently applied to investments in associates. The proportionate consolidation method currently applied to the Group’s interests in joint ventures is prohibited. IAS 28, ‘Investments in Associates and Joint Ventures’, was amended as a consequence of the issuance of IFRS 11. In addition to prescribing the accounting for investment in associates, it now sets out the requirements for the application of the equity method when accounting for joint ventures. The application of the equity method has not changed as a result of this amendment.

• IFRS 12, ‘Disclosure of Interest in Other Entities’, is a new and comprehensive standard on disclosure requirements for all forms of interests in other entities, including joint arrangements, associates, special purpose vehicles and other off balance sheet vehicles. The standard includes disclosure requirements for entities covered under IFRS 10 and lFRS 11.

• IFRS 13, ‘Fair Value Measurement’, provides guidance on how fair value should be applied where its use is already required or permitted by other standards within IFRS, including a precise defi nition of fair value and a single source of fair value measurement and disclosure requirements for use across IFRS.

Basis of consolidation

The consolidated fi nancial statements incorporate the fi nancial statements of the Company and entities controlled, both unilaterally and jointly, by the Company.

Accounting for subsidiaries A subsidiary is an entity controlled by the Company. Control is achieved where the Company has the power to govern the fi nancial and operating policies of an entity so as to obtain benefi ts from its activities.

The results of subsidiaries acquired or disposed of during the year are included in the income statement from the effective date of acquisition or up to the effective date of disposal, as appropriate. Where necessary, adjustments are made to the fi nancial statements of subsidiaries to bring their accounting policies into line with those used by the Group.

All intra-group transactions, balances, income and expenses are eliminated on consolidation.

EXHIBIT 6.13 (Continued )

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Comparative Accounting 315

Non-controlling interests in the net assets of consolidated subsidiaries are identifi ed separately from the Group’s equity therein. Non- controlling interests consist of the amount of those interests at the date of the original business combination and the non-controlling shareholder’s share of changes in equity since the date of the combination. Total comprehensive income is attributed to non- controlling interests even if this results in the non-controlling interests having a defi cit balance.

Business combinations Acquisitions of subsidiaries are accounted for using the acquisition method. The cost of the acquisition is measured at the aggregate of the fair values, at the date of exchange, of assets given, liabilities incurred or assumed, and equity instruments issued by the Group in exchange for control of the acquiree. Acquisition-related costs are recognised in the income statement as incurred. The acquiree’s identifi able assets and liabilities are recognised at their fair values at the acquisition date.

Goodwill is measured as the excess of the sum of the consideration transferred,the amount of any non-controlling interests in the acquiree and the fair value of the Group’s previously held equity interest in the acquiree, if any, over the net amounts of identifi able assets acquired and liabilities assumed at the acquisition date.

The interest of the non-controlling shareholders in the acquiree may initially be measured either at fair value or at the non-controlling shareholders’ proportion of the net fair value of the identifi able assets acquired, liabilities and contingent liabilities assumed. The choice of measurement basis is made on an acquisition-by-acquisition basis.

Acquisition of interests from non-controlling shareholders In transactions with non-controlling parties that do not result in a change in control, the difference between the fair value of the consideration paid or received and the amount by which the non-controlling interest is adjusted is recognised in equity.

Interests in joint ventures A joint venture is a contractual arrangement whereby the Group and other parties undertake an economic activity that is subject to joint control; that is, when the strategic fi nancial and operating policy decisions relating to the activities require the unanimous consent of the parties sharing control.

The Group reports its interests in jointly controlled entities using proportionate consolidation. The Group’s share of the assets, liabilities, income, expenses and cash fl ows of jointly controlled entities are combined with the equivalent items in the results on a line-by-line basis. Any goodwill arising on the acquisition of the Group’s interest in a jointly controlled entity is accounted for in accordance with the Group’s accounting policy for goodwill arising on the acquisition of a subsidiary.

Investments in associates An associate is an entity over which the Group has signifi cant infl uence and that is neither a subsidiary nor an interest in a joint venture. Signifi cant infl uence is the power to participate in the fi nancial and operating policy decisions of the investee but is not control or joint control over those policies.

The results and assets and liabilities of associates are incorporated in the consolidated fi nancial statements using the equity method of accounting. Under the equity method, investments in associates are carried in the consolidated statement of fi nancial position at cost as adjusted for post-acquisition changes in the Group’s share of the net assets of the associate, less any impairment in the value of the investment. Losses of an associate in excess of the Group’s interest in that associate are not recognised. Additional losses are provided for, and a liability is recognised, only to the extent that the Group has incurred legal or constructive obligations or made payments on behalf of the associate.

Any excess of the cost of acquisition over the Group’s share of the net fair value of the identifi able assets, liabilities and contingent liabilities of the associate recognised at the date of acquisition is recognised as goodwill. The goodwill is included within the carrying amount of the investment.

The licences of the Group’s associate in the US, Verizon Wireless, are indefi nite lived assets as they are subject to perfunctory renewal. Accordingly, they are not subject to amortisation but are tested annually for impairment, or when indicators exist that the carrying value is not recoverable.

Intangible assets Identifi able intangible assets are recognised when the Group controls the asset, it is probable that future economic benefi ts attributed to the asset will fl ow to the Group and the cost of the asset can be reliably measured.

Goodwill

Goodwill arising on the acquisition of an entity represents the excess of the cost of acquisition over the Group’s interest in the net fair value of the identifi able assets, liabilities and contingent liabilities of the entity recognised at the date of acquisition.

Goodwill is initially recognised as an asset at cost and is subsequently measured at cost less any accumulated impairment losses. Goodwill is held in the currency of the acquired entity and revalued to the closing rate at each reporting period date.

Goodwill is not subject to amortisation but is tested for impairment.

Negative goodwill arising on an acquisition is recognised directly in the income statement.

On disposal of a subsidiary or a jointly controlled entity, the attributable amount of goodwill is included in the determination of the profi t or loss recognised in the income statement on disposal.

Continued

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316 Chapter Six

Goodwill arising before the date of transition to IFRS, on 1 April 2004, has been retained at the previous UK GAAP amounts, subject to being tested for impairment at that date. Goodwill written off to reserves under UK GAAP prior to 1998 has not been reinstated and is not included in determining any subsequent profi t or loss on disposal.

Finite lived intangible assets

Intangible assets with fi nite lives are stated at acquisition or development cost, less accumulated amortisation. The amortisation period and method is reviewed at least annually. Changes in the expected useful life or the expected pattern of consumption of future economic benefi ts embodied in the asset is accounted for by changing the amortisation period or method, as appropriate, and are treated as changes in accounting estimates. The amortisation expense on intangible assets with fi nite lives is recognised in profi t or loss in the expense category consistent with the function of the intangible asset.

Licence and spectrum fees

Amortisation periods for licence and spectrum fees are determined primarily by reference to the unexpired licence period, the conditions for licence renewal and whether licences are dependent on specifi c technologies. Amortisation is charged to the income statement on a straight-line basis over the estimated useful lives from the commencement of service of the network.

Computer software

Computer software comprises computer software purchased from third parties as well as the cost of internally developed software. Computer software licences are capitalised on the basis of the costs incurred to acquire and bring into use the specifi c software. Costs that are directly associated with the production of identifi able and unique software products controlled by the Group, and are probable of producing future economic benefi ts are recognised as intangible assets. Direct costs include software development employee costs and directly attributable overheads.

Software integral to a related item of hardware equipment is accounted for as property, plant and equipment.

Costs associated with maintaining computer software programs are recognised as an expense when they are incurred.

Internally developed software is recognised only if all of the following conditions are met:

• an asset is created that can be separately identifi ed; • it is probable that the asset created will generate future economic benefi ts; and • the development cost of the asset can be measured reliably.

Amortisation is charged to the income statement on a straight-line basis over the estimated useful lives from the date the software is available for use.

Other intangible assets

Other intangible assets, including brands and customer bases, are recorded at fair value at the date of acquisition. Amortisation is charged to the income statement on either a straight-line or sum of digits basis over the estimated useful lives of intangible assets from the date they are available for use.

Estimated useful lives

The estimated useful lives of fi nite lived intangible assets are as follows:

• Licence and spectrum fees 3–25 years • Computer software 3–5 years • Brands 1–10 years • Customer bases 2–7 years

Property, plant and equipment

Land and buildings held for use are stated in the statement of fi nancial position at their cost, less any subsequent accumulated depreciation and subsequent accumulated impairment losses.

Equipment, fi xtures and fi ttings are stated at cost less accumulated depreciation and any accumulated impairment losses.

Assets in the course of construction are carried at cost, less any recognised impairment loss. Depreciation of these assets commences when the assets are ready for their intended use.

The cost of property, plant and equipment includes directly attributable incremental costs incurred in their acquisition and installation.

Depreciation is charged so as to write off the cost of assets, other than land and properties under construction, using the straight-line method, over their estimated useful lives, as follows:

• Freehold buildings 25–50 years • Leasehold premises the term of the lease

EXHIBIT 6.13 (Continued )

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Comparative Accounting 317

Equipment, fi xtures and fi ttings:

• Network infrastructure 3–25 years • Other 3–10 years

Depreciation is not provided on freehold land.

Assets held under fi nance leases are depreciated over their expected useful lives on the same basis as owned assets or, where shorter, the term of the relevant lease.

The gain or loss arising on the disposal or retirement of an item of property, plant and equipment is determined as the difference between the sale proceeds and the carrying amount of the asset and is recognised in the income statement.

Impairment of assets

Goodwill

Goodwill is not subject to amortisation but is tested for impairment annually or whenever there is an indication that the asset may be impaired.

For the purpose of impairment testing, assets are grouped at the lowest levels for which there are separately identifi able cash fl ows, known as cash-generating units. If the recoverable amount of the cash-generating unit is less than the carrying amount of the unit, the impairment loss is allocated fi rst to reduce the carrying amount of any goodwill allocated to the unit and then to the other assets of the unit pro-rata on the basis of the carrying amount of each asset in the unit. Impairment losses recognised for goodwill are not reversed in a subsequent period.

Recoverable amount is the higher of fair value less costs to sell and value in use. In assessing value in use, the estimated future cash fl ows are discounted to their present value using a pre-tax discount rate that refl ects current market assessments of the time value of money and the risks specifi c to the asset for which the estimates of future cash fl ows have not been adjusted.

The Group prepares and approves formal fi ve year management plans for its operations, which are used in the value in use calculations. In certain developing markets the fi fth year of the management plan is not indicative of the long term future performance as operations may not have reached maturity. For these operations, the Group extends the plan data for an additional fi ve year period.

Property, plant and equipment and fi nite lived intangible assets

At each reporting period date, the Group reviews the carrying amounts of its property, plant and equipment and fi nite lived intangible assets to determine whether there is any indication that those assets have suffered an impairment loss. If any such indication exists, the recoverable amount of the asset is estimated in order to determine the extent, if any, of the impairment loss. Where it is not possible to estimate the recoverable amount of an individual asset, the Group estimates the recoverable amount of the cash-generating unit to which the asset belongs.

If the recoverable amount of an asset or cash-generating unit is estimated to be less than its carrying amount, the carrying amount of the asset or cash-generating unit is reduced to its recoverable amount. An impairment loss is recognised immediately in the income statement.

Where an impairment loss subsequently reverses, the carrying amount of the asset or cash-generating unit is increased to the revised estimate of its recoverable amount, not to exceed the carrying amount that would have been determined had no impairment loss been recognised for the asset or cash-generating unit in prior years. A reversal of an impairment loss is recognised immediately in the income statement.

Revenue

Revenue is recognised to the extent the Group has delivered goods or rendered services under an agreement, the amount of revenue can be measured reliably and it is probable that the economic benefi ts associated with the transaction will fl ow to the Group. Revenue is measured at the fair value of the consideration received, exclusive of sales taxes and discounts.

The Group principally obtains revenue from providing the following telecommunication services: access charges, airtime usage, messaging, interconnect fees, data services and information provision, connection fees and equipment sales. Products and services may be sold separately or in bundled packages.

Revenue for access charges, airtime usage and messaging by contract customers is recognised as services are performed, with unbilled revenue resulting from services already provided accrued at the end of each period and unearned revenue from services to be provided in future periods deferred. Revenue from the sale of prepaid credit is deferred until such time as the customer uses the airtime, or the credit expires.

Revenue from interconnect fees is recognised at the time the services are performed.

Revenue from data services and information provision is recognised when the Group has performed the related service and, depending on the nature of the service, is recognised either at the gross amount billed to the customer or the amount receivable by the Group as commission for facilitating the service.

Continued

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318 Chapter Six

Customer connection revenue is recognised together with the related equipment revenue to the extent that the aggregate equipment and connection revenue does not exceed the fair value of the equipment delivered to the customer. Any customer connection revenue not recognised together with related equipment revenue is deferred and recognised over the period in which services are expected to be provided to the customer.

Revenue for device sales is recognised when the device is delivered to the end customer and the sale is considered complete. For device sales made to intermediaries, revenue is recognised if the signifi cant risks associated with the device are transferred to the intermediary and the intermediary has no general right of return. If the signifi cant risks are not transferred, revenue recognition is deferred until sale of the device to an end customer by the intermediary or the expiry of the right of return.

In revenue arrangements including more than one deliverable, the arrangements are divided into separate units of accounting. Deliverables are considered separate units of accounting if the following two conditions are met: (1) the deliverable has value to the customer on a stand-alone basis and (2) there is evidence of the fair value of the item. The arrangement consideration is allocated to each separate unit of accounting based on its relative fair value.

Commissions Intermediaries are given cash incentives by the Group to connect new customers and upgrade existing customers.

For intermediaries who do not purchase products and services from the Group, such cash incentives are accounted for as an expense. Such cash incentives to other intermediaries are also accounted for as an expense if:

• the Group receives an identifi able benefi t in exchange for the cash incentive that is separable from sales transactions to that intermediary; and

• the Group can reliably estimate the fair value of that benefi t.

Cash incentives that do not meet these criteria are recognised as a reduction of the related revenue.

Inventory

Inventory is stated at the lower of cost and net realisable value. Cost is determined on the basis of weighted average costs and comprises direct materials and, where applicable, direct labour costs and those overheads that have been incurred in bringing the inventories to their present location and condition.

Leasing

Leases are classifi ed as fi nance leases whenever the terms of the lease transfer substantially all the risks and rewards of ownership of the asset to the lessee. All other leases are classifi ed as operating leases.

Assets held under fi nance leases are recognised as assets of the Group at their fair value at the inception of the lease or, if lower, at the present value of the minimum lease payments as determined at the inception of the lease. The corresponding liability to the lessor is included in the statement of fi nancial position as a fi nance lease obligation. Lease payments are apportioned between fi nance charges and reduction of the lease obligation so as to achieve a constant rate of interest on the remaining balance of the liability. Finance charges are recognised in the income statement.

Rentals payable under operating leases are charged to the income statement on a straight-line basis over the term of the relevant lease. Benefi ts received and receivable as an incentive to enter into an operating lease are also spread on a straight-line basis over the lease term.

Foreign currencies

The consolidated fi nancial statements are presented in sterling, which is the parent company’s functional and presentation currency. Each entity in the Group determines its own functional currency and items included in the fi nancial statements of each entity are measured using that functional currency.

Transactions in foreign currencies are initially recorded at the functional currency rate prevailing at the date of the transaction. Monetary assets and liabilities denominated in foreign currencies are retranslated into the respective functional currency of the entity at the rates prevailing on the reporting period date. Non-monetary items carried at fair value that are denominated in foreign currencies are retranslated at the rates prevailing on the initial transaction dates. Nonmonetary items measured in terms of historical cost in a foreign currency are not retranslated.

Changes in the fair value of monetary securities denominated in foreign currency classifi ed as available-for-sale are analysed between translation differences and other changes in the carrying amount of the security. Translation differences are recognised in the income statement and other changes in carrying amount are recognised in equity.

Translation differences on non-monetary fi nancial assets, such as investments in equity securities, classifi ed as available-for-sale are reported as part of the fair value gain or loss and are included in equity.

For the purpose of presenting consolidated fi nancial statements, the assets and liabilities of entities with a functional currency other than sterling are expressed in sterling using exchange rates prevailing at the reporting period date. Income and expense items and cash fl ows are translated at the average exchange rates for the period and exchange differences arising are recognised directly in

EXHIBIT 6.13 (Continued )

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Comparative Accounting 319

equity. On disposal of a foreign entity, the cumulative amount previously recognised in equity relating to that particular foreign operation is recognised in profi t or loss.

Goodwill and fair value adjustments arising on the acquisition of a foreign operation are treated as assets and liabilities of the foreign operation and translated accordingly.

In respect of all foreign operations, any exchange differences that have arisen before 1 April 2004, the date of transition to IFRS, are deemed to be nil and will be excluded from the determination of any subsequent profi t or loss on disposal.

The net foreign exchange gain recognised in the consolidated income statement is £1,022 million (2010: £35 million gain, 2009: £131 million loss).

Research expenditure

Expenditure on research activities is recognised as an expense in the period in which it is incurred.

Post employment benefi ts

For defi ned benefi t retirement plans, the difference between the fair value of the plan assets and the present value of the plan liabilities is recognised as an asset or liability on the statement of fi nancial position. Scheme liabilities are assessed using the projected unit funding method and applying the principal actuarial assumptions at the reporting period date. Assets are valued at market value.

Actuarial gains and losses are taken to the statement of comprehensive income as incurred. For this purpose, actuarial gains and losses comprise both the effects of changes in actuarial assumptions and experience adjustments arising because of differences between the previous actuarial assumptions and what has actually occurred.

Other movements in the net surplus or defi cit are recognised in the income statement, including the current service cost, any past service cost and the effect of any curtailment or settlements. The interest cost less the expected return on assets is also charged to the income statement. The amount charged to the income statement in respect of these plans is included within operating costs or in the Group’s share of the results of equity accounted operations as appropriate.

The Group’s contributions to defi ned contribution pension plans are charged to the income statement as they fall due.

Cumulative actuarial gains and losses at 1 April 2004, the date of transition to IFRS, have been recognised in the statement of fi nancial position.

Taxation

Income tax expense represents the sum of the current tax payable and deferred tax.

Current tax payable or recoverable is based on taxable profi t for the year. Taxable profi t differs from profi t as reported in the income statement because some items of income or expense are taxable or deductible in different years or may never be taxable or deductible. The Group’s liability for current tax is calculated using UK and foreign tax rates and laws that have been enacted or substantively enacted by the reporting period date.

Deferred tax is the tax expected to be payable or recoverable in the future arising from temporary differences between the carrying amounts of assets and liabilities in the fi nancial statements and the corresponding tax bases used in the computation of taxable profi t. It is accounted for using the statement of fi nancial position liability method. Deferred tax liabilities are generally recognised for all taxable temporary differences and deferred tax assets are recognised to the extent that it is probable that taxable profi ts will be available against which deductible temporary differences can be utilised.

Such assets and liabilities are not recognised if the temporary difference arises from the initial recognition (other than in a business combination) of assets and liabilities in a transaction that affects neither the taxable profi t nor the accounting profi t. Deferred tax liabilities are not recognised to the extent they arise from the initial recognition of non tax deductable goodwill.

Deferred tax liabilities are recognised for taxable temporary differences arising on investments in subsidiaries and associates, and interests in joint ventures, except where the Group is able to control the reversal of the temporary difference and it is probable that the temporary difference will not reverse in the foreseeable future.

The carrying amount of deferred tax assets is reviewed at each reporting period date and adjusted to refl ect changes in probability that suffi cient taxable profi ts will be available to allow all or part of the asset to be recovered.

Deferred tax is calculated at the tax rates that are expected to apply in the period when the liability is settled or the asset realised, based on tax rates that have been enacted or substantively enacted by the reporting period date.

Tax assets and liabilities are offset when there is a legally enforceable right to set off current tax assets against current tax liabilities and when they either relate to income taxes levied by the same taxation authority on either the same taxable entity or on different taxable entities which intend to settle the current tax assets and liabilities on a net basis.

Tax is charged or credited to the income statement, except when it relates to items charged or credited directly to equity, in which case the tax is also recognised directly in equity.

Financial instruments

Financial assets and fi nancial liabilities, in respect of fi nancial instruments, are recognised on the Group’s statement of fi nancial position when the Group becomes a party to the contractual provisions of the instrument.

Continued

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320 Chapter Six

Trade receivables

Trade receivables do not carry any interest and are stated at their nominal value as reduced by appropriate allowances for estimated irrecoverable amounts. Estimated irrecoverable amounts are based on the ageing of the receivable balances and historical experience. Individual trade receivables are written off when management deems them not to be collectible.

Other investments

Other investments are recognised and derecognised on a trade date where a purchase or sale of an investment is under a contract whose terms require delivery of the investment within the timeframe established by the market concerned, and are initially measured at cost, including transaction costs.

Other investments classifi ed as held for trading and available-for-sale are stated at fair value. Where securities are held for trading purposes, gains and losses arising from changes in fair value are included in net profi t or loss for the period. For available-for-sale investments, gains and losses arising from changes in fair value are recognised directly in equity, until the security is disposed of or is determined to be impaired, at which time the cumulative gain or loss previously recognised in equity, determined using the weighted average cost method, is included in the net profi t or loss for the period.

Other investments classifi ed as loans and receivables are stated at amortised cost using the effective interest method, less any impairment.

Cash and cash equivalents

Cash and cash equivalents comprise cash on hand and call deposits, and other short-term highly liquid investments that are readily convertible to a known amount of cash and are subject to an insignifi cant risk of changes in value.

Trade payables

Trade payables are not interest bearing and are stated at their nominal value.

Financial liabilities and equity instruments

Financial liabilities and equity instruments issued by the Group are classifi ed according to the substance of the contractual arrangements entered into and the defi nitions of a fi nancial liability and an equity instrument. An equity instrument is any contract that evidences a residual interest in the assets of the Group after deducting all of its liabilities and includes no obligation to deliver cash or other fi nancial assets. The accounting policies adopted for specifi c fi nancial liabilities and equity instruments are set out below.

Capital market and bank borrowings

Interest bearing loans and overdrafts are initially measured at fair value (which is equal to cost at inception), and are subsequently measured at amortised cost, using the effective interest rate method, except where they are identifi ed as a hedged item in a fair value hedge. Any difference between the proceeds net of transaction costs and the amount due on settlement or redemption of borrowings is recognised over the term of the borrowing.

Equity instruments

Equity instruments issued by the Group are recorded at the proceeds received, net of direct issuance costs.

Derivative fi nancial instruments and hedge accounting

The Group’s activities expose it to the fi nancial risks of changes in foreign exchange rates and interest rates.

The use of fi nancial derivatives is governed by the Group’s policies approved by the Board of directors, which provide written principles on the use of fi nancial derivatives consistent with the Group’s risk management strategy. Changes in values of all derivatives of a fi nancing nature are included within investment income and fi nancing costs in the income statement. The Group does not use derivative fi nancial instruments for speculative purposes.

Derivative fi nancial instruments are initially measured at fair value on the contract date and are subsequently remeasured to fair value at each reporting date. The Group designates certain derivatives as either:

• hedges of the change of fair value of recognised assets and liabilities (‘fair value hedges’); or • hedges of net investments in foreign operations.

Hedge accounting is discontinued when the hedging instrument expires or is sold, terminated, or exercised, or no longer qualifi es for hedge accounting, or the Company chooses to end the hedging relationship.

Fair value hedges

The Group’s policy is to use derivative instruments (primarily interest rate swaps) to convert a proportion of its fi xed rate debt to fl oating rates in order to hedge the interest rate risk arising, principally, from capital market borrowings. The Group designates these as fair value hedges of interest rate risk with changes in fair value of the hedging instrument recognised in the income statement for the period together with the changes in the fair value of the hedged item due to the hedged risk, to the extent the hedge is effective. The ineffective portion is recognised immediately in the income statement.

EXHIBIT 6.13 (Continued)

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Comparative Accounting 321

Net Investment hedges

Exchange differences arising from the translation of the net investment in foreign operations are recognised directly in equity. Gains and losses on those hedging instruments (which include bonds, commercial paper and foreign exchange contracts) designated as hedges of the net investments in foreign operations are recognised in equity to the extent that the hedging relationship is effective. These amounts are included in exchange differences on translation of foreign operations as stated in the statement of comprehensive income. Gains and losses relating to hedge ineffectiveness are recognised immediately in the income statement for the period. Gains and losses accumulated in the translation reserve are included in the income statement when the foreign operation is disposed of.

Put option arrangements

The potential cash payments related to put options issued by the Group over the equity of subsidiary companies are accounted for as fi nancial liabilities when such options may only be settled other than by exchange of a fi xed amount of cash or another fi nancial asset for a fi xed number of shares in the subsidiary.

The amount that may become payable under the option on exercise is initially recognised at fair value within borrowings with a corresponding charge directly to equity. The charge to equity is recognised separately as written put options over non-controlling interests, adjacent to non-controlling interests in the net assets of consolidated subsidiaries.

The Group recognises the cost of writing such put options, determined as the excess of the fair value of the option over any consideration received, as a fi nancing cost.

Such options are subsequently measured at amortised cost, using the effective interest rate method, in order to accrete the liability up to the amount payable under the option at the date at which it fi rst becomes exercisable. The charge arising is recorded as a fi nancing cost. In the event that the option expires unexercised, the liability is derecognised with a corresponding adjustment to equity.

Provisions

Provisions are recognised when the Group has a present obligation (legal or constructive) as a result of a past event, it is probable that the Group will be required to settle that obligation and a reliable estimate can be made of the amount of the obligation. Provisions are measured at the directors’ best estimate of the expenditure required to settle the obligation at the reporting date and are discounted to present value where the effect is material.

Share-based payments

The Group issues equity-settled share-based payments to certain employees. Equity-settled share-based payments are measured at fair value (excluding the effect of non market-based vesting conditions) at the date of grant. The fair value determined at the grant date of the equity-settled share-based payments is expensed on a straight-line basis over the vesting period, based on the Group’s estimate of the shares that will eventually vest and adjusted for the effect of non market-based vesting conditions.

Fair value is measured using a binomial pricing model, being a lattice-based option valuation model, which is calibrated using a Black- Scholes framework. The expected life used in the model has been adjusted, based on management’s best estimate, for the effects of non-transferability, exercise restrictions and behavioural considerations.

The Group uses historical data to estimate option exercise and employee termination within the valuation model; separate groups of employees that have similar historical exercise behaviour are considered separately for valuation purposes. The expected life of options granted is derived from the output of the option valuation model and represents the period of time that options are expected to be outstanding. Expected volatilities are based on implied volatilities as determined by a simple average of no less than three international banks, excluding the highest and lowest numbers. The risk-free rates for periods within the contractual life of the option are based on the UK gilt yield curve in effect at the time of grant.

Some share awards have an attached market condition, based on total shareholder return (‘TSR’), which is taken into account when calculating the fair value of the share awards. The valuation for the TSR is based on Vodafone’s ranking within the same group of companies, where possible, over the past fi ve years. The volatility of the ranking over a three year period is used to determine the probable weighted percentage number of shares that could be expected to vest and hence affect fair value.

The fair value of awards of non-vested shares is equal to the closing price of the Vodafone’s shares on the date of grant, adjusted for the present value of future dividend entitlements where appropriate.

3. Segment analysis

The Group has a single group of related services and products being the supply of communications services and products. Segment information is provided on the basis of geographic areas, being the basis on which the Group manages its worldwide interests. Revenue is attributed to a country or region based on the location of the Group company reporting the revenue. Intersegment sales are charged at arm’s length prices.

During the year ended 31 March 2011 the Group changed its organisation structure to enable continued improvement in the delivery of the Group’s strategic goals. The Europe region now consists of all existing controlled businesses in Europe plus the Group’s interests in Czech Republic, Hungary, Romania and Turkey. The Africa, Middle East and Asia Pacifi c region includes the Group’s interests in Egypt, India, Ghana, Kenya, Qatar and Vodacom as well as Australia, New Zealand and Fiji. Non-Controlled Interests

Continued

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322 Chapter Six

and Common Functions includes Verizon Wireless, SFR and Polkomtel as well as central Group functions. The tables below present segment information on the revised basis, with prior years amended to conform to the current year presentation.

Segment revenue

£m

Intra-region revenue

£m

Regional revenue

£m

Inter-region revenue

£m

Group revenue

£m

Adjusted EBITDA(1)

£m 31 March 2011 Germany ....................................................... 7,900 (51) 7,849 (2) 7,847 2,952 Italy .............................................................. 5,722 (31) 5,691 (3) 5,688 2,643 Spain ............................................................ 5,133 (62) 5,071 (2) 5,069 1,562 UK ................................................................ 5,271 (50) 5,221 (7) 5,214 1,233 Other Europe ................................................ 8,253 (70) 8,183 (3) 8,180 2,433

Europe ......................................................... 32,279 (264) 32,015 (17) 31,998 10,823 India ............................................................. 3,855 (1) 3,854 (11) 3,843 985 Vodacom ...................................................... 5,479 — 5,479 (8) 5,471 1,844 Other Africa, Middle East and Asia Pacifi c ..... 3,971 — 3,971 (27) 3,944 1,170

Africa, Middle East and Asia Pacifi c .......... 13,305 (1) 13,304 (46) 13,258 3,999 Non-Controlled Interests and Common Functions .................................................. 659 — 659 (31) 628 (152) Group 46,243 (265) 45,978 (94) 45,884 14,670 Verizon Wireless ........................................... 18,711(2) 7,313 31 March 2010 Germany ....................................................... 8,008 (41) 7,967 (8) 7,959 3,122 Italy .............................................................. 6,027 (40) 5,987 (2) 5,985 2,843 Spain ............................................................ 5,713 (81) 5,632 (2) 5,630 1,956 UK ................................................................ 5,025 (47) 4,978 (10) 4,968 1,141 Other Europe ................................................ 8,357 (88) 8,269 (5) 8,264 2,582

Europe ......................................................... 33,130 (297) 32,833 (27) 32,806 11,644 India ............................................................. 3,114 (1) 3,113 (20) 3,093 807 Vodacom ...................................................... 4,450 — 4,450 (7) 4,443 1,528 Other Africa, Middle East and Asia Pacifi c ..... 3,526 — 3,526 (30) 3,496 977

Africa, Middle East and Asia Pacifi c .......... 11,090 (1) 11,089 (57) 11,032 3,312 Non-Controlled Interests and Common Functions .................................................. 667 — 667 (33) 634 (221) Group .......................................................... 44,887 (298) 44,589 (117) 44,472 14,735

Verizon Wireless ........................................... 17,222(2) 6,689

31 March 2009 Germany ....................................................... 7,847 (59) 7,788 (9) 7,779 3,225 Italy .............................................................. 5,547 (39) 5,508 (3) 5,505 2,565 Spain ............................................................ 5,812 (95) 5,717 (2) 5,715 2,034 UK ................................................................ 5,392 (48) 5,344 (8) 5,336 1,368 Other Europe ................................................ 8,514 (102) 8,412 (3) 8,409 2,920

Europe ......................................................... 33,112 (343) 32,769 (25) 32,744 12,112 India ............................................................. 2,689 (2) 2,687 (18) 2,669 717 Vodacom ...................................................... 1,778 — 1,778 — 1,778 606 Other Africa, Middle East and Asia Pacifi c ..... 3,258 — 3,258 (32) 3,226 1,072 Africa, Middle East and Asia Pacifi c .......... 7,725 (2) 7,723 (50) 7,673 2,395 Non-Controlled Interests and Common Functions .................................................. 614 — 614 (14) 600 (17) Group .......................................................... 41,451 (345) 41,106 (89) 41,017 14,490

Verizon Wireless ........................................... 14,085(2) 5,543

EXHIBIT 6.13 (Continued)

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Comparative Accounting 323

Notes: (1) The Group’s measure of segment profi t, adjusted EBITDA, excludes the Group’s share of results in associates. The Group’s share

of results in associates, by segment, for the year ended 31 March 2011 is Other Europe £nil (2010: £nil; 2009 £(3) million), Vodacom £nil (2010: £(2) million; 2009: £(1) million), Other Africa, Middle East and Asia Pacifi c £51 million (2010: £56 million; 2009: £31 million) and Non-Controlled Interests and Common Functions £5,008 million (2010: £4,688 million; 2009: £4,064 million).

(2) Values shown for Verizon Wireless, which is an associate, are not included in the calculation of Group revenue or adjusted EBITDA.

A reconciliation of adjusted EBITDA to operating profi t is shown below. For a reconciliation of operating profi t to profi t before taxation, see the consolidated income statement on page 80.

2011 £m

2010 £m

2009 £m

Adjusted EBITDA ................................................................................................... 14,670 14,735 14,490 Depreciation, amortisation and loss on disposal of fi xed assets .............................. (7,967) (8,011) (6,824) Share of results in associates ................................................................................. 5,059 4,742 4,091 Impairment losses ................................................................................................. (6,150) (2,100) (5,900) Other income and expense ................................................................................... (16) 114 —

Operating profi t ................................................................................................. 5,596 9,480 5,857

Non-current assets(1)

£m

Capital expenditure(2)

£m

Other expenditure

on intangible

assets £m

Depreciation and

amortisation £m

Impairment (reversal)/

loss £m

31 March 2011 Germany .............................................................. 20,764 824 1,214 1,361 — Italy ..................................................................... 16,645 590 12 732 1,050 Spain ................................................................... 9,596 517 — 641 2,950 UK ....................................................................... 6,665 516 — 874 — Other Europe ....................................................... 11,438 1,230 59 1,406 2,150

Europe ................................................................ 65,108 3,677 1,285 5,014 6,150 India .................................................................... 9,882 870 1,851 973 — Vodacom ............................................................. 7,382 572 19 1,013 — Other Africa, Middle East and Asia Pacifi c ............ 4,797 754 2 793 —

Africa, Middle East and Asia Pacifi c ................. 22,061 2,196 1,872 2,779 — Non-Controlled Interests and Common Functions.. 1,570 346 9 83 — Group ................................................................. 88,739 6,219 3,166 7,876 6,150

31 March 2010 Germany .............................................................. 20,211 766 18 1,422 — Italy ..................................................................... 17,941 610 60 732 — Spain ................................................................... 12,746 543 — 638 — UK ....................................................................... 6,977 494 — 963 — Other Europe ....................................................... 13,883 1,282 228 1,467 (200)

Europe ................................................................ 71,758 3,695 306 5,222 (200) India .................................................................... 8,665 853 — 848 2,300 Vodacom ............................................................. 7,783 520 — 1,005 — Other Africa, Middle East and Asia Pacifi c ............ 5,062 694 — 683 —

Africa, Middle East and Asia Pacifi c ................. 21,510 2,067 — 2,536 2,300 Non-Controlled Interests and Common Functions.. 1,632 430 19 152 — Group ................................................................. 94,900 6,192 325 7,910 2,100

Continued

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324 Chapter Six

31 March 2009 Germany ........................................................................................ 750 16 1,378 — Italy ............................................................................................... 521 — 735 — Spain ............................................................................................. 632 — 606 3,400 UK ................................................................................................. 446 — 1,010 — Other Europe ................................................................................. 1,013 21 1,441 2,250

Europe .......................................................................................... 3,362 37 5,170 5,650 India .............................................................................................. 1,351 — 746 — Vodacom ....................................................................................... 237 — 231 — Other Africa, Middle East and Asia Pacifi c ...................................... 581 1,101 527 250

Africa, Middle East and Asia Pacifi c ........................................... 2,169 1,101 1,504 250 Non-Controlled Interests and Common Functions .......................... 378 — 140 — Group ........................................................................................... 5,909 1,138 6,814 5,900

Notes: (1) Comprises goodwill, other intangible assets and property, plant and equipment. (2) Includes additions to property, plant and equipment and computer software, reported within intangible assets.

4. Operating profi t

Operating profi t has been arrived at after charging/(crediting):

2011 £m

2010 £m

2009 £m

Net foreign exchange losses/(gains) ....................................................................................... 14 (29) 30 Depreciation of property, plant and equipment (note 11): Owned assets .................................................................................................................... 4,318 4,412 4,025 Leased assets ..................................................................................................................... 54 44 36 Amortisation of intangible assets (note 9) ............................................................................. 3,504 3,454 2,753 Impairment of goodwill (note 10) .......................................................................................... 6,150 2,300 5,650 (Reversal of impairment)/impairment of licence and spectrum (note 10) ................................ — (200) 250 Research and development expenditure ................................................................................ 287 303 280 Staff costs (note 31) .............................................................................................................. 3,642 3,770 3,227 Operating lease rentals payable: Plant and machinery .......................................................................................................... Other assets including fi xed line rentals .............................................................................

127 1,761

71 1,587

68 1,331

Loss on disposal of property, plant and equipment ................................................................ 91 101 10 Own costs capitalised attributable to the construction or acquisition of property, plant and equipment ......................................................................................................... (331) (296) (273)

The total remuneration of the Group’s auditor, Deloitte LLP, and its affi liates for services provided to the Group is analysed below:

2011 £m

2010 £m

2009 £m

Audit fees: Parent company ................................................................................................................ 1 1 1 Subsidiaries(1) .................................................................................................................... 7 7 5

8 8 6 Fees for statutory and regulatory fi lings ............................................................................. 1 1 2

Audit and audit-related fees ......................................................................................... 9 9 8

Other fees: Taxation ............................................................................................................................ 1 1 1 Total fees ........................................................................................................................ 10 10 9

EXHIBIT 6.13 (Continued)

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Comparative Accounting 325

Note: (1) The increase in the year ended 31 March 2010 primarily arose from the consolidation of Vodacom Group Limited as a subsidiary

from 18 May 2009.

In addition to the above, the Group’s joint ventures and associates paid fees totalling £1 million (2010: £2 million, 2009: £3 million) and £5 million (2010: £7 million, 2009: £6 million) respectively to Deloitte LLP and other member fi rms of Deloitte Touche Tohmatsu Limited during the year. Deloitte LLP and other member fi rms of Deloitte Touche Tohmatsu Limited have also received amounts totalling less than £1 million in each of the last three years in respect of services provided to pension schemes and charitable foundations associated to the Group.

A description of the work performed by the Audit Committee in order to safeguard auditor independence when non-audit services are provided is set out in “Corporate governance” on page 60.

FRS 102 (Expected in January 2015) FRS 102, Financial Reporting Standard Applicable in the UK and Republic of Ireland, will complete the suite of three new ! nancial reporting standards. Further, in October 2012, in an effort to make narrative reporting simpler, clearer, and more focused, the UK Department for Business, Innovation and Skills (BIS) published draft regulations for narrative reporting. The key points of the draft regulation are:

• A separate strategic report replaces the business review and includes some extra content for quoted companies concerning the business model, human rights, and diversity.

• The directors’ report is retained largely unchanged except that it now excludes the content that is in the new strategic report.

• Shareholders who currently receive only the summary ! nancial statement will in the future receive the strategic report instead.

That is quite a signi! cant change, because it replaces a summarized P&L and bal- ance sheet with what is essentially a narrative discussion about the company’s strategy and performance.

Summary 1. China: a. In China, accounting and auditing have taken different paths in their

deve lopment. b. There is strong government involvement in the activities of the stock market. c. The accounting profession in China has a lower social recognition compared

to its counterparts in Anglo-Saxon countries. d. The recent economic reforms in China have had a major impact on that coun-

try’s accounting standards and practices. e. China became a member of the IASC in 1997, and has expressed commitment

to develop accounting standards based on IFRS. f. A number of steps have been taken toward convergence of the Chinese

! nancial reporting standards with IFRS. 2. Japan:

a. The Japanese economy is dominated by large conglomerates known as keiretsu. b. A unique feature of Japanese companies is cross-corporate ownership,

mutual holding of equity interests among companies. c. In Japan, ! nancial reporting has a creditor orientation, and is strongly in# u-

enced by tax law.

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326 Chapter Six

d. Traditionally, accounting regulation in Japan is heavily in# uenced by gov- ernment, and the accounting profession has only a minor role, compared to its counterpart in the United States.

e. Recent developments indicate a willingness to bring Japanese accounting practices more in line with international best practice.

f. Japan has committed to adopting IFRS through the Tokyo agreement with the IASB.

3. Germany: a. Traditionally, the primary source of ! nance for German companies has been

bank credit, and as a result, ! nancial reporting has a creditor orientation rather than an equity shareholder orientation.

b. Company, commercial, and tax laws and regulations are the main sources of accounting requirements (or “principles of orderly bookkeeping”).

c. Financial reporting is strongly in# uenced by EU directives. d. The German stock exchange has much less in# uence on ! nancial reporting

compared to exchanges in the United Kingdom or the United States. e. Traditionally, the in# uence of the accounting profession on developing

accounting standards has been minor compared to that of its counterpart in the United Kingdom or the United States.

f. The 2010 act to modernize German accounting systems re# ects a willingness to change the traditional accounting practices and, at the same time, retain some accounting practices based on local context.

4. Mexico: a. In recent years, the economy has been transforming from a centrally con-

trolled economy to a market economy. b. The Mexican Stock Exchange is a privately owned institution. c. Mexico has a conceptual framework for ! nancial reporting. d. Until recently, a unique feature of Mexican accounting was the treatment of

the effects of in# ation in ! nancial statements. e. The changes to Mexican accounting standards in recent years highlight,

among other things, the potential con# ict between the pressures for interna- tional harmonization and the need to consider the local circumstances in a given country.

f. In November 2008, the Mexican Securities and Exchange Commission (Comision Nacional Bancaria y de Valores, or CNBV) announced that all com- panies listed on the Mexican Stock Exchange will be required to use IFRS starting in 2012.

5. United Kingdom: a. The main purpose of accounting in the United Kingdom is to facilitate the

effective functioning of the capital market. b. The primary sources of accounting standards are the Companies Act, profes-

sional pronouncements, and stock exchange listing requirements. c. Unlike in Germany or Japan, taxation rules do not have a major in# uence on

! nancial reporting in the United Kingdom. d. The UK Accounting Standards Board uses a statement of principles as a con-

ceptual framework for developing ! nancial reporting standards.

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Comparative Accounting 327

1. How might the liberalization of accounting and auditing services in China result in an improved level of investor protection?

2. How have economic reforms affected the demand for accounting services in China?

3. In what way has the development of accounting and auditing in China dif- fered from that in other countries?

4. What are the main pressures for accounting regulation in modern China? 5. Identify three features of the Chinese accounting profession that are different

from its counterparts in Anglo-American countries. 6. How have cultural factors in# uenced accounting practices in Japan? 7. What was the accounting Big Bang in Japan? 8. What is the Tokyo agreement? 9. Why is the principle of prudence clearly established in the German law? 10. Why does tax law have a strong in# uence on German accounting? 11. What are the main external factors that have in# uenced ! nancial reporting in

Germany in recent years? 12. What was the main focus of the GASB’s work in 2009? 13. “BilMoG is not ‘IFRS light’; instead it is ‘German GAAP complex’.” Do you

agree? Explain. 14. What is the role of the National Banking and Securities Commission in the

area of ! nancial reporting by Mexican companies? 15. What is the Professional Mutual Recognition Agreement (PMRA) signed by

NAFTA participants in September 2002? 16. What is the signi! cance of Bulletin A-8 of the Mexican Institute of Public

Accountants? 17. What are the main external factors that have in# uenced ! nancial reporting in

Mexico in recent years? 18. Brie# y describe the current requirement for companies in Mexico to account

for the effect of in# ation in their annual ! nancial statements. 19. What is an important contribution that Mexican accounting has made to inter-

national accounting? 20. What has been the impact of EU membership on accounting regulation in the

United Kingdom? 21. What is the role of the UK Financial Reporting Council? 22. What are the main features of the approach taken in the United Kingdom in

setting accounting standards?

e. A principles-based approach is taken in setting standards for accounting and ! nancial reporting.

f. Traditionally, there has been no government agency similar to the U.S. SEC in the United Kingdom. However, recent changes to the regulatory structure have strengthened enforcement through the FRC.

g. Recently, the FRC published a discussion paper on reducing complexity in corporate reporting, which includes eight guiding principles.

Questions

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328 Chapter Six

23. What was the main objective of the discussion paper entitled “Louder than Words,” published by the FRC in 2009?

24. Recently, the regulators in the United Kingdom have placed increased em- phasis on the importance of narrative reporting in the ! nancial statements published by companies. Explain.

1. This chapter describes accounting regulation in ! ve countries: China, Germany, Japan, Mexico, and the United Kingdom.

Required: Compare the mechanisms in place to regulate accounting and ! nancial report- ing in your own country with those of any of the ! ve countries mentioned above, and explain the possible reasons for any noticeable differences.

2. The number of professional accountants in a country indicates the status of the accounting profession in that country.

Required: Determine the number of accountants per 100,000 of population in the United Kingdom and Japan. Explain why the numbers are so different. The membership details of professional accounting bodies in different countries are available at www.iasplus.com/links.htm#proforg .

3. Chapter 1 identi! ed and described six major reasons for accounting diversity: legal system, taxation, providers of ! nancing, in# ation, political and economic ties, and culture.

Required: a. Which factor or factors appear to have exerted the greatest in# uence on

the development of accounting in each of the ! ve countries covered in this chapter?

b. Identify the distinguishing features of the accounting system in each of these countries.

4. Refer to the IASB Web site ( www.iasb.org.uk ).

Required: a. Determine the manner in which IFRS are used in each of the ! ve countries

included in this chapter. b. Determine which of these countries has a resident who is a member of the

IASB.

5. Refer to Exhibits 6.3 , 6.5 , 6.7 , 6.8, and 6.12 .

Required: Identify a. An issue in respect of which the practices of several countries discussed in

this chapter are at variance with IFRS. b. The most important ! nancial accounting practice for each of the ! ve coun-

tries which is at variance with IFRS. Also explain the reason(s) for your selection.

6. Visit the New York Stock Exchange Web site ( www.nyse.com ).

Required: Determine the number of companies listed on the NYSE from each of the ! ve countries covered in this chapter.

Exercises and Problems

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Comparative Accounting 329

7. This chapter describes the mechanisms in place to regulate accounting and ! nancial reporting in ! ve countries.

Required: Compare and contrast these mechanisms in the United Kingdom and China.

8. “In 2012, there were major reforms affecting accounting and ! nancial report- ing in the United Kingdom.” Do you agree? Explain.

9. The process of professionalization of accounting in China has been unique.

Required: Discuss the unique features of professionalization of accounting in China.

10. This chapter describes the major changes that have been introduced recently in Germany and Japan in the area of accounting regulation.

Required: Describe any similarities between those changes in Germany and Japan.

11. The Act of 2010 to modernize German accounting re# ects a willingness to change as well as retain traditional German accounting practices.

Required: Do you agree with the preceding statement? Explain.

12. The ! nancial reporting issues facing Mexico are different in some respects from those of other countries covered in this chapter.

Required: Provide two main reasons to support the above statement.

13. Refer to Exhibits 6.3 , 6.7 , and 6.9 .

Required: Explain the main areas you would focus on in comparing ! nancial statements prepared by companies in China, Japan, and Mexico with those prepared by companies using IFRS.

14. The JICPA has taken a number of positive steps toward convergence between Japanese GAAP and IFRS.

Required: Explain the steps taken by the JICPA in this regard.

15. The NAFTA agreement has had a major impact on accounting and ! nancial reporting by Mexican companies.

Required: Discuss the nature of the impact referred to in the preceding statement.

Case 6-1

China Petroleum and Chemical Corporation China Petroleum and Chemical Corporation (CPCC) is one of a growing number of Chinese companies that has cross-listed its stock on foreign stock exchanges. To provide information that might be useful for a wide audience of readers outside of China, CPCC provides a reconciliation of income and stockholders’ equity from Chinese GAAP to IFRS. Further, to provide information speci! cally for its North

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330 Chapter Six

American shareholders, the company also provides a reconciliation of net income and stockholders’ equity from IFRS to U.S. GAAP. The following is the section of CPCC’s 2003 annual report providing this information.

Differences between Financial Statements Prepared under the Chinese GAAP and IFRSs

The major differences are: i. Depreciation of oil and gas properties

Under the PRC accounting rules and regulations, oil and gas properties are depreciated on a straight-line basis. Under IFRS, oil and gas properties are depreciated on the unit of production method.

ii. Disposal of oil and gas properties Under the PRC accounting rules and regulations, gains and losses arising from the retirement or disposal of an individual item of oil and gas properties are recognized as income or expense in the income statement and are measured as the difference between the estimated net disposal proceeds and the carrying amount of the asset.

Under IFRS, gains and losses on the retirement or disposal of an individual item of proved oil and gas properties are not recognized unless the retirement or disposal encompasses an entire property. The costs of the asset abandoned or retired are charged to accumulated depreciation with the proceeds received on disposals credited to the carrying amounts of oil and gas properties.

iii. Capitalisation of general borrowing costs Under the PRC accounting rules and regulations, only borrowing costs on funds that are specially borrowed for construction are capitalized as part of the cost of fi xed assets. Under IFRS, to the extent that funds are borrowed generally and used for the purpose of obtaining a qualifying asset, the borrowing costs should be capitalized as part of the cost of that asset.

iv. Acquisition of Sinopec National Star, Sinopec Maoming, Xi’an Petrochemical and Tahe Petrochemical Under the PRC accounting rules and regulations, the acquisition of Sinopec National Star, Sinopec Maoming, Xi’an Petrochemical and Tahe Petrochemical (the “Acquisitions”) are accounted for by the acquisition method. Under the acquisition method, the income of an acquiring enterprise includes the operations of the acquired enterprise subsequent to the acquisition. The difference between the cost of acquiring Sinopec National Star and the fair value of the net assets acquired is capitalized as an exploration and production right, which is amortised over 27 years.

Under IFRS, as the Group, Sinopec National Star, Sinopec Maoming, Xi’an Petrochemical and Tahe Petrochemical are under the common control of Sinopec Group Company, the Acquisitions are considered “combination of entities under common control” which are accounted in a manner similar to a pooling-of-interests (“as in pooling of interests accounting”). Accordingly, the assets and liabilities of Sinopec National Star, Sinopec Maoming, Xi’an Petrochemicals and Tahe Petrochemicals acquired have been accounted for at historical cost and the fi nancial statements of the Group for periods prior to the Acquisitions have been restated to include the fi nancial statements and results of operations of Sinopec National Star, Sinopec Maoming, Xi’an Petrochemicals and Tahe Petrochemical on a combined basis. The consideration paid by the Group are treated as an equity transaction.

v. Gains from issuance of shares by a subsidiary Under the PRC accounting rules and regulations, the increase in the company’s share of net assets of a subsidiary after the sale of additional shares by the subsidiary is credited to capital reserve. Under IFRS, such increase is recognised as income.

vi. Gain from debt restructuring Under the PRC accounting rules and regulations, gain from debt restructuring resulting from the difference between the carrying amount of liabilities extinguished or assumed by other parties and the amount paid is credited to capital reserve. Under IFRS, the gain resulting from such difference is recognised as income.

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Comparative Accounting 331

vii. Revaluation of land use rights Under the PRC accounting rules and regulations, land use rights are carried at revalued amounts. Under IFRS, land use rights are carried at historical cost less amortisation. Accordingly, the surplus on the revaluation of land use rights, credited to revaluation reserve, was eliminated.

viii. Unrecognised losses of subsidiaries Under the PRC accounting rules and regulations, the results of subsidiaries are included in the Group’s consolidated income statement to the extent that the subsidiaries’ accumulated losses do not result in their carrying amount being reduced to zero, without the effect of minority interests. Further, losses are debited to a separate reserve in the shareholders’ funds.

Under IFRS, the results of subsidiaries are included in the Group’s consolidated income statement from the date that control effectively commences until the date that control effectively ceases.

ix. Pre-operating expenditures Under the PRC accounting rules and regulations, expenditures incurred during the start-up period are aggregated in long-term deferred expenses and charged to the income statement when operations commence. Under IFRS, expenditures on start-up activities are recognized as an expense when they are incurred.

x. Impairment losses on long-lived assets Under the PRC accounting rules and regulations and IFRS, impairment charges are recognized when the carrying value of long-lived assets exceeds the higher of their net selling price and the value in use which incorporates discounting the asset’s estimated future cash fl ows. Due to the difference in the depreciation method of oil and gas properties discussed in (i) above, the provision for impairment losses and reversal of impairment loss under the PRC Accounting Rules and Regulations are different from the amounts recorded under IFRS.

xi. Government grants Under the PRC accounting rules and regulations, government grants should be credited to capital reserve. Under IFRS, government grants relating to the purchase of equipment used for technology improvements are initially recorded as long term liabilities and are offset against the cost of assets to which the grants related when construction commences. Upon transfer to property, plant and equipment, the grants are recognized as an income over the useful life of the property, plant and equipment by way of reduced depreciation charge.

Effects of major differences between the PRC Accounting Rules and Regulations and IFRS on net profi t are analysed as follows:

Note 2003 RMB millions

Net profi t under PRC GAAP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,011

Adjustments: Depreciation of oil and gas properties . . . . . . . . . . . . . . . . . . . . . . . . (i) 1,784 Disposal of oil and gas properties. . . . . . . . . . . . . . . . . . . . . . . . . . . . (ii) 1,260 Capitalisation of general borrowing costs. . . . . . . . . . . . . . . . . . . . . . (iii) 389 Acquisition of Sinopec Maoming, Xi’an Petrochemical and Tahe Petrochemical . . . . . . . . . . . . . . . . . . . . . . (iv) 326 Acquisition of Sinopec National Star. . . . . . . . . . . . . . . . . . . . . . . . . . (iv) 117 Gain from issuance of shares by subsidiary. . . . . . . . . . . . . . . . . . . . . (v) 136 Gain from debt restructuring . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (vi) 82 Revaluation of land use rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (vii) 18 Unrecognised losses of subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . (viii) (182) Pre-operating expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (ix) (169) Effects of the above adjustments on taxation . . . . . . . . . . . . . . . . . . . (1,179) Net profi t under IFRS* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,593

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332 Chapter Six

Supplemental Information for North American Shareholders The Group’s accounting policies conform with IFRS which differ in certain signifi cant respects from accounting principles generally accepted in the United States of America (“US GAAP”). Information relating to the nature and effect of such differences are set out below. The US GAAP reconciliation presented below is included as supplemental information, is not required as part of the basic fi nancial statements and does not include differences related to classifi cation, display or disclosures.

a. Foreign exchange gains and losses In accordance with IFRS, foreign exchange differences on funds borrowed for construction are capitalized as property, plant and equipment to the extent that they are regarded as an adjustment to interest costs during the construction period. Under US GAAP, all foreign exchange gains and losses on foreign currency debts are included in current earnings.

b. Capitalisation of property, plant and equipment In the years prior to those presented herein, certain adjustments arose between IFRS and US GAAP with regard to the capitalization of interest and pre-production results under IFRS that were reversed and expensed under US GAAP. For the years presented herein, there were no adjustments related to the capitalization of interest and pre-production results. Accordingly, the US GAAP adjustments represent the amortisation effect of such originating adjustments described above.

c. Revaluation of property, plant and equipment As required by the relevant PRC regulations with respect to the Reorganisation, the property, plant and equipment of the Group were revalued at 30 September 1999. In addition, the property, plant and equipment of Sinopec National Star, Sinopec Maoming and Refi ning Assets were revalued at 31 December 2000, 30 June 2003 and 31 October 2003 respectively in connection with the Acquisitions. Under IFRS, such revaluations result in an increase in shareholders’ funds with respect to the increase in carrying amount of certain property, plant and equipment below their cost bases.

Under US GAAP, property, plant and equipment, including land use rights, are stated at their historical cost less accumulated depreciation. However, as a result of the tax deductibility of the net revaluation surplus, a deferred tax asset related to the reversal of the revaluation surplus is created under US GAAP with a corresponding increase in shareholders’ funds.

Under IFRS, effective 1 January 2002, land use rights, which were previously carried at revalued amount, are carried at cost under IFRS. The effect of this change resulted in a decrease to revaluation

Effects of major differences between the PRC Accounting Rules and Regulations and IFRS on shareholders’ funds are analysed as follows:

Note 2003 RMB millions

Shareholders’ funds under the PRC GAAP . . . . . . . . . . . . . . . . . . . . . 162,946

Adjustments:

Depreciation of oil and gas properties . . . . . . . . . . . . . . . . . . . . . . . . (i) 10,885 Disposal of oil and gas properties. . . . . . . . . . . . . . . . . . . . . . . . . . . . (ii) 1,260 Capitalisation of general borrowing costs. . . . . . . . . . . . . . . . . . . . . . (iii) 1,125 Acquisition of Sinopec Maoming, Xi’an Petrochemical and Tahe Petrochemical . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (iv) — Acquisition of Sinopec National Star. . . . . . . . . . . . . . . . . . . . . . . . . . (iv) (2,812) Revaluation of land use rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (vii) (870) Effect on minority interests on unrecognised losses of subsidiaries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (viii) 61 Pre-operating expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (ix) (169) Impairment losses on long-lived assets . . . . . . . . . . . . . . . . . . . . . . . . (x) (113) Government grants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (xi) (326) Effect of the above adjustment on taxation . . . . . . . . . . . . . . . . . . . . (4,088) Shareholders’ funds under IFRS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167,899

*The above ! gure is extracted from the ! nancial statements prepared in accordance with IFRS which have been audited by KPMG.

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Comparative Accounting 333

reserve net of minority interests of RMB 840 million as of 1 January 2002. This revaluation reserve was previously included as part of the revaluation reserve of property, plant and equipment. This change under IFRS eliminated the US GAAP difference relating to the revaluation of land use rights. However, as a result of the tax deductibility of the revalued land use rights, the reversal of the revaluation reserve resulted in a deferred tax asset.

In addition, under IFRS, on disposal of a revalued asset, the related revaluation surplus is transferred from the revaluation reserve to retained earnings. Under US GAAP, the gain and loss on disposal of an asset is determined with reference to the asset’s historical carrying amount and included in current earnings.

d. Exchange of assets During 2002, the Company and Sinopec Group Company entered into an asset swap transaction. Under IFRS, the cost of property, plant and equipment acquired in an exchange for a similar item of property, plant and equipment is measured at fair value. Under US GAAP, as the exchange of assets was between entities under common control, the assets received from Sinopec Group Company are measured at historical cost. The difference between the historical cost of the net assets transferred and the net assets received is accounted for as an equity transaction.

e. Impairment of long-lived assets Under IFRS, impairment charges are recognized when a long-lived asset’s carrying amount exceeds the higher of an asset’s net selling price and value in use, which incorporates discounting the asset’s estimated future cash fl ows.

Under US GAAP, determination of the recoverability of a long-lived asset is based on an estimate of undiscounted future cash fl ows resulting from the use of the asset and its eventual disposition. If the sum of the expected future cash fl ows is less than the carrying amount of the asset, an impairment loss is recognized. Measurement of an impairment loss for a long-lived asset is based on the fair value of the asset.

In addition, under IFRS, a subsequent increase in the recoverable amount of an asset is reversed to the consolidated income statement to the extent that an impairment loss on the same asset was previously recognized as an expense when the circumstances and events that led to the write-down or write-off cease to exist. The reversal is reduced by the amount that would have been recognized as depreciation had the write-off not occurred.

Under US GAAP, an impairment loss establishes a new cost basis for the impaired asset and the new cost basis should not be adjusted subsequently other than for further impairment losses.

The US GAAP adjustment represents the effect of reversing the recovery of previous impairment charge recorded under IFRS.

f. Capitalised interest on investment in associates Under IFRS, investment accounted for by the equity method is not considered a qualifying asset for which interest is capitalized. Under US GAAP, an investment accounted for by the equity method while the investee has activities in progress necessary to commence its planned principal operations, provided that the investee’s activities include the use of funds to acquire qualifying assets for its operations, is a qualifying asset for which interest is capitalized.

g. Goodwill amortisation Under IFRS, goodwill and negative goodwill are amortised on a systematic basis over their useful lives.

Under US GAAP, with reference to Statement of Financial Accounting Standard No.142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”), goodwill is no longer amortised beginning 1 January 2002, the date that SFAS No. 142 was adopted. Instead, goodwill is reviewed for impairment upon adoption of SFAS No. 142 and annually thereafter. In connection with SFAS No. 142’s transitional goodwill impairment evaluation, the Group determined that no goodwill impairment existed as of the date of adoption. In addition, under US GAAP, negative goodwill of RMB 11 million, net of minority interests that existed at the date of adoption of SFAS No. 142 was written off as a cumulative effect of a change in accounting principle.

h. Companies included in consolidation Under IFRS, the Group consolidates less than majority owned entities in which the Group has the power, directly or indirectly, to govern the fi nancial and operating policies of an entity so as to obtain benefi ts from its activities, and proportionately consolidates jointly controlled entities in which the Group has joint control with other venturers. However, US GAAP requires that any entity of which the Group owns 20% to 50% of total outstanding voting stock not be consolidated nor

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334 Chapter Six

proportionately consolidated, but rather be accounted for under the equity method. Accordingly, certain of the Group’s subsidiaries of which the Group owns between 40.72% to 50% of the outstanding voting stock, and the Group’s jointly controlled entities are not consolidated nor proportionately consolidated under US GAAP and instead accounted for under the equity method. This exclusion does not affect the profi t attributable to shareholders or shareholders’ funds reconciliation between IFRS and US GAAP.

Presented below is summarized financial information of such subsidiaries and jointly controlled entities.

i. Related party transactions Under IFRS, transactions of state-controlled enterprises with other state-controlled enterprises are not required to be disclosed as related party transactions. Furthermore, government departments and agencies are deemed not to be related parties to the extent that such dealings are in the normal course of business. Therefore, related party transactions as disclosed in Note 33 in the fi nancial statements prepared under IFRS only refers to transactions with enterprises over which Sinopec Group Company is able to exercise signifi cant infl uence.

Under US GAAP, there are no similar exemptions. Although the majority of the Group’s activities are with PRC government authorities and affi liates and other PRC state-owned enterprises, the Group believes that it has provided meaningful disclosures of related party transactions in Note 33 to the fi nancial statements prepared under IFRS.

Year ended 31 December 2003 RMB millions

Revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,735 Profi t before taxation . . . . . . . . . . . . . . . . . . . . . . . . . 1,329 Net Profi t . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,090

At 31 December 2003 RMB millions

Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,986 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,607 Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,902 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,238 Total equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,369

The effect on profi t attributable to shareholders of signifi cant differences between IFRS and US GAAP is as follows:

Reference in Note above US$ millions RMB millions

Profi t attributable to shareholders under IFRS. . . . . . . 2,609 21,593

US GAAP adjustments Foreign exchange gains and losses . . . . . . . . . . . . . . . (a) 9 76 Capitalisation of property, plant and equipment . . . . (b) 1 12 Reversal of defi cit on revaluation of property, plant and equipment . . . . . . . . . . . . . . . . . . . . . . . (c) 10 86 Depreciation on revalued property, plant . . . . . . . . . . (c) 483 3,998 Disposal of property, plant and equipment. . . . . . . . . (c) 159 1,316 Exchange of assets. . . . . . . . . . . . . . . . . . . . . . . . . . . (d) 3 23

Year ended 12-31-2003

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Comparative Accounting 335

Reversal of impairment of long-lived assets, Net of depreciation effect. . . . . . . . . . . . . . . . . . . . (e) 6 47 Capitalised interest on investments in associates . . . . (f) 17 141 Goodwill amortisation for the year. . . . . . . . . . . . . . . (g) — — Cumulative effect of adopting SFAS No.142 . . . . . . . (g) — — Deferred tax effect of US GAAP adjustments . . . . . . . (207) (1,715) Profi t attributable to shareholders under US GAAP . . . . . . . . . . . . . . . . . . . . . . . . . . 3,090 25,577 Basic and diluted earnings per share under US GAAP . . . . . . . . . . . . . . . . . . . . . . . . . . US$0.04 RMB0.30 Basic and diluted earning per ADS under US GAAP*. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . US$3.56 RMB29.50

*Basic and diluted earnings per ADS is calculated on the basis that one ADS is equivalent to 100 shares.

Reference in Note above US$ millions RMB millions

Year ended 12-31-2003

At December 2003

The effect on shareholders’ funds of signifi cant differences between IFRS and US GAAP is as follows:

Reference in note above US$ millions RMB millions

Shareholders’ funds under IFRS . . . . . . . . . . . . . . . . . 20,286 167,899

US GAAP adjustments: Foreign exchange gains and losses . . . . . . . . . . . . . . . (a) (43) (352) Capitalisation of property, plant and equipment . . . . (b) (1) (12) Revaluation of property, plant and equipment . . . . . . (c) (1,564) (12,943) Deferred tax adjustments on revaluation . . . . . . . . . . (c) 484 4,004 Exchange of assets. . . . . . . . . . . . . . . . . . . . . . . . . . . (d) (67) (555) Reversal of impairment of long-lived assets . . . . . . . . (e) (68) (561) Capitalised interest on investments in associates . . . . (f) 39 321 Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (g) 2 17 Deferred tax effect of US GAAP adjustments . . . . . . . 48 398

Shareholders’ funds under US GAAP . . . . . . . . . . 19,116 158,216 Note: United States dollar equivalents

For the convenience of readers, amounts in Renminbi have been translated into United States dollars at the rate of US$1.00 = RMB 8.2767 being the noon buying rate in New York City on 31 December 2003 for cable transfers in Renminbi as certifi ed for customs purposes by the Federal Reserve Bank of New York. No representation is made that the Renminbi amounts could have been, or could be, converted into United States dollars at that rate.

Source: China Petroleum and Chemical Corporation 2003 annual report, pp. 158–63.

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336 Chapter Six

Required 1. Critically comment on the results reported by CPCC under PRC GAAP, IFRS,

and U.S. GAAP. 2. Identify the main areas of difference for CPCC between:

a. PRC GAAP and IFRS. b. IFRS and U.S. GAAP.

3. Should UK readers of these ! nancial statements ! nd the information useful? 4. Should U.S. readers of these ! nancial statements ! nd the information useful? 5. Would you recommend that other companies adopt the multiple standards

approach taken by CPCC? Explain.

Alexander, David, and Simon Archer, eds. European Accounting Guide, 5th ed. New York: Aspen, 2004, p. 1.15.

Alexander, David, and Simon Archer, eds., European Accounting Guide, 4th ed. (New York: Aspen, 2003, p. 14.04.

Aono, J. “The Auditing Environment in Japan.” In International Auditing Environ- ment, ed. I. Shiobara. Tokyo: Zeimukeiri-Kyokai, 2001, pp. 199–211.

Chen, S., Z. Sun, and Y. Wang. “Evidence from China on Whether Harmonized Accounting Standards Harmonize Accounting Practices.” Accounting Horizons 16, no. 3 (2002), pp. 183–97.

Chen, Y., P. Jubb, and A. Tran. “Problems of Accounting Reform in the People’s Republic of China.” International Journal of Accounting 32, no. 2 (1997), pp. 139–53.

China Securities Regulatory Commission. China Securities and Futures Statistical Yearbook. Beijing: CSRC, 2002.

Consultative Committee on Accountancy Bodies. The Making of Accounting Stan- dards: Report of the Review Committee (Dearing Committee). London: ICAEW, 1988.

Doupnik, Timothy S. “Recent Innovations in German Accounting Practice Through the Integration of EC Directives.” Advances in International Accounting (1992), p. 80.

Douthett, E. B. Jr., and K. Jung. “Japanese Corporate Groupings ( Keiretsu ) and the Informativeness of Earnings.” Journal of International Financial Management and Accounting 12, no. 2 (2001), pp. 133–59.

Eberhartinger, E. L. E. “The Impact of Tax Rules on Financial Reporting in Germany, France, and the UK.” International Journal of Accounting 34, no. 1 (1999), pp. 93–119.

FASF. “Concerning Treatment (Compliance) of Accounting Standards and Other Pronouncements Issued by the Accounting Standards Board of Japan,” May 2002. For details, go to www.jicpa.or.jp/n_eng/e200201.html .

Glaum, M., and U. Mandler. “Global Accounting Harmonization from a German Perspective: Bridging the GAAP.” Journal of International Financial Management and Accounting 7, no. 3 (1996), pp. 215–42.

References

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Comparative Accounting 337

Goldburgh, L. “The Development of Accounting.” In Accounting Concepts Readings, ed. C. T. Gibson, G. G. Meredith, and R. Peterson. Melbourne: Cassell, 1971.

Graham, L. E. “Setting a Research Agenda for Auditing Issues in the People’s Re- public of China.” International Journal of Accounting 31, no. 1 (1996), pp. 19–37.

Graham, L. E., and C. Li. “Cultural and Economic In# uences on Current Accounting Standards in the People’s Republic of China.” International Journal of Accounting 32, no. 3 (1997), pp. 247–78.

Haw, I., D. Qi, and W. Wu. “The Nature of Information in Accruals and Cash Flows in an Emerging Capital Market: The Case of China.” International Journal of Accounting 36 (2001), pp. 391–406.

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IASC. Insight. London: IASC, March 1999. Jiang, L., and J. Kim. “Cross-Corporate Ownership, Information Asymmetry and

the Usefulness of Accounting Performance Measures in Japan.” International Journal of Accounting 35, no. 1 (2000), pp. 85–98.

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Lin, J., and F. Chen. “Applicability of the Conservatism Accounting Convention in China: Empirical Evidence.” International Journal of Accounting 34, no. 4 (1999), pp. 517–37.

Lin, K. Z., and K. H. Chan. “Auditing Standards in China: A Comparative Analy- sis with Relevant International Standards and Guidelines.” International Journal of Accounting 35, no. 4 (2000), pp. 559–77.

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Ozu, C., and S. Gray. “The Development of Segment Reporting in Japan: Achiev- ing International Harmonization Through a Process of National Consensus.” Advances in International Accounting 14 (2001), pp. 1–13.

Ravlic, T. “Japan Looks to Higher Standards.” Australian CPA 69, no. 10 (1999), pp. 48–49.

Singleton, W. R., and S. Globerman. “The Nature of Financial Disclosure in Japan.” International Journal of Accounting 37 (2002), pp. 95–111.

Tang, Y. “Bumpy Road Leading to Internationalization: A Review of Accounting Development in China.” Accounting Horizons 14, no. 1 (2000), pp. 93–102.

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338 Chapter Six

Wyman, P. “The Enron Aftermath—Where Next?” speech delivered October 10, 2002, at a conference held in Brussels (available at www.icaew.co.uk/index/ cfm?AUB = TB2I_37723 ).

Xiao, J. Z., Y. Zhang, and Z. Xie. “The Making of Independent Auditing Standards in China.” Accounting Horizons 14, no. 1 (2000), pp. 69–89.

Xiao, Z., and A. Pan. “Developing Accounting Standards on the Basis of a Concep- tual Framework by the Chinese Government.” International Journal of Account- ing 32, no. 3 (1997), pp. 279–99.

Yamori, N., and T. Baba. “Japanese Management Views on Overseas Exchange Listings: Survey Results.” Journal of International Financial Management and Ac- counting 12, no. 3 (2001), pp. 286–316.

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339

Chapter Seven

Foreign Currency Transactions and Hedging Foreign Exchange Risk Learning Objectives

After reading this chapter, you should be able to

• Provide an overview of the foreign exchange market. • Explain how fl uctuations in exchange rates give rise to foreign exchange risk. • Demonstrate the accounting for foreign currency transactions. • Describe how foreign currency forward contracts and foreign currency options can

be used to hedge foreign exchange risk. • Describe the concepts of cash fl ow hedges, fair value hedges, and hedge

accounting. • Demonstrate the accounting for forward contracts and options used as cash fl ow

hedges and fair value hedges to hedge foreign currency assets and liabilities, for- eign currency fi rm commitments, and forecasted foreign currency transactions.

INTRODUCTION

International trade (imports and exports) constitutes a signi! cant portion of the world economy. According to the World Trade Organization, more than $18  trillion worth of merchandise was exported (and imported) in 2011. 1 Recent growth in trade has been phenomenal. From 1990 to 2001, global exports increased by 75 percent while global gross domestic product increased by only 27 percent.

The number of companies involved in trade also has grown substantially. From 1987 to 1999, the number of U.S. companies making export sales rose by 233 per- cent to a total of 231,420 companies. 2 Raytheon Company is a U.S.-based electron- ics and defense systems company with more than $6.2 billion of annual export

1 World Trade Organization, International Trade Statistics 2012, Table I.7: Leading Exporters and Importers in World Merchandise Trade, 2012 ( www.wto.org ). 2 U.S. Department of Commerce, International Trade Administration, “Small and Medium-Sized Enterprises Play an Important Role,” Export America, September 2001, pp. 26–29.

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340 Chapter Seven

sales. In 2012, 25 percent of Raytheon’s sales were outside of the United States. 3 Even small businesses are signi! cantly involved in exporting. Companies with fewer than 500 workers comprise 97 percent of U.S. exporters.

Collections from export sales or payments for imports are not always made in a company’s domestic currency; they may be made in a foreign currency depend- ing on the negotiated terms of the transaction. As the exchange rate for the foreign currency # uctuates, so does the domestic currency value of these export sales and import purchases. Companies often ! nd it necessary to engage in some form of hedging activity to reduce losses arising from # uctuating exchange rates. For ex- ample, at the end of 2012, Raytheon reported having “foreign currency forward contracts with commercial banks to ! x the foreign currency exchange rates on spe- ci! c commitments, payments, and receipts.” 4 At December 31, 2012, the company had outstanding foreign currency contracts to buy or sell foreign currency in the amount of $1,305 million. At year-end 2012, Italian automaker Fiat SpA reported having contracts to hedge foreign exchange risks amounting to 10.5 billion euros (approximately $13.8 billion at the time).

This chapter covers accounting issues related to foreign currency transactions and foreign currency hedging activities. To provide background for subsequent discussion of the accounting issues, we begin with a description of foreign ex- change markets. We then discuss the accounting for import and export transac- tions, followed by coverage of various types of hedging techniques. The discussion concentrates on forward contracts and options because these are the most popular types of hedging instruments. Understanding how to account for these items is important for any company engaged in international transactions.

FOREIGN EXCHANGE MARKETS

Each country uses its own currency as the unit of value for the purchase and sale of goods and services. The currency used in the United States is the U.S. dollar, the currency used in Japan is the Japanese yen, and so on. If a U.S. citizen travels to Japan and wishes to purchase local goods, Japanese merchants require payment to be made in Japanese yen. To make the purchase, a U.S. citizen has to purchase yen using U.S. dollars. The price at which the foreign currency can be acquired is known as the foreign exchange rate. A variety of factors determine the exchange rate between two currencies; unfortunately for those engaged in international busi- ness, the exchange rate # uctuates. 5 In some cases, a change in the exchange rate is quite large and unexpected.

Exchange Rate Mechanisms Exchange rates have not always # uctuated. During the period 1945–1973, coun- tries ! xed the par value of their currency in terms of the U.S. dollar, and the value of the U.S. dollar was ! xed in terms of gold. Countries agreed to maintain the value of their currency within 1 percent of the par value. If the exchange rate for a particular currency began to move outside of this 1 percent range, the country’s

3 Raytheon Company, 2012 Annual Report, p. 122. 4 Ibid., p. 90. 5 Several theories attempt to explain exchange rate fl uctuations, but with little success, at least in the short run. A discussion of exchange rate determination can be found in any international fi nance textbook. An understanding of the causes of exchange rate changes is not necessary for an understanding of the concepts underlying the accounting for changes in exchange rates.

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 341

central bank was required to intervene by buying or selling its currency in the foreign exchange market. Due to the law of supply and demand, the purchase of currency by a central bank would cause the price of the currency to stop falling, and the sale of currency would cause the price to stop rising.

The integrity of the system hinged on the ability of the U.S. dollar to maintain its value in terms of gold and the ability of foreign countries to convert their U.S.- dollar holdings into gold at the ! xed rate of $35 per ounce. As the United States began to incur balance-of-payment de! cits in the 1960s, a glut of U.S. dollars arose worldwide, and foreign countries began converting their U.S. dollars into gold. This resulted in a decline in the U.S. government’s gold reserve from a high of $24.6 billion in 1949 to a low of $10.2 billion in 1971. In the latter year, the United States suspended the convertibility of the U.S. dollar into gold, signaling the be- ginning of the end for the ! xed exchange rate system. In March 1973, most curren- cies were allowed to # oat in value.

Today, several different currency arrangements exist. The following are some of the more important ones and the countries they affect:

1. Independent ! oat. The value of the currency is allowed to # uctuate freely according to market forces, with little or no intervention from the central bank (Australia, Brazil, Canada, Japan, Mexico, Sweden, Switzerland, United States).

2. Pegged to another currency. The value of the currency is ! xed (pegged) in terms of a particular foreign currency, and the central bank intervenes as necessary to maintain the ! xed value. For example, several countries peg their currency to the U.S. dollar (including the Bahamas and Ecuador).

3. European Monetary System (euro). In 1998, the countries comprising the European Monetary System adopted a common currency called the euro and established the European Central Bank. 6 Until 2002, local currencies such as the German mark and French franc continued to exist but were ! xed in value in terms of the euro. On January 1, 2002, local currencies disappeared and the euro became the currency in 12 European countries. In 2013, 17 countries were members of the “euro zone.” The value of the euro # oats against other currencies such as the U.S. dollar.

Foreign Exchange Rates Exchange rates between the U.S. dollar and most foreign currencies are published daily in major U.S. newspapers. Current and past exchange rates are readily ob- tainable from a variety of Web sites, such as OANDA.com and X-rates.com . U.S. dollar exchange rates at various dates for selected foreign currencies are presented in Exhibit 7.1 . These are interbank rates, or wholesale prices, that banks charge one another when exchanging currencies. Prices charged when selling foreign cur- rency to retail customers such as companies engaged in international business are higher, and prices offered to buy foreign currency from retail customers are lower. The difference between the buying and selling rates is the spread through which banks and other foreign exchange brokers earn a pro! t on foreign exchange trades.

The exchange rates in Exhibit  7.1 re# ect the U.S. dollar price for one unit of foreign currency. These are known as direct quotes. The direct quote for the UK pound on May 24, 2013, was $1.511701; in other words, one British pound could be purchased for $1.511701. Indirect quotes indicate the number of foreign currency

6 Most long-term members of the European Union (EU) are euro-zone countries. The major exception is the United Kingdom, which decided not to participate. Switzerland is another important European country that is not part of the euro zone because it is not a member of the EU.

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units that can be purchased with one U.S. dollar. Indirect quotes are simply the in- verse of direct quotes. If one British pound costs $1.511701, then $1.00 can purchase only 0.661506 (1/1.511701) British pounds; the indirect quote would be 0.661506. To avoid confusion, direct quotes are used exclusively in this chapter.

Exhibit 7.1 shows the U.S. dollar price for one unit of foreign currency at four dates: April 23, 2012, one year later on April 23, 2013, one month later on May 23, 2013, and one day later on May 24, 2013. The percentage changes from one date to the next also are presented. Four of the currencies presented in Exhibit 7.1 in- creased in price or appreciated against the U.S. dollar from May 23 to May 24, 2013 (Bahraini dinar, Brazilian real, Chinese yuan, and Swiss franc), and ! ve of the cur- rencies depreciated against the U.S. dollar on that same day (euro, Mexican peso, Taiwanese new dollar, Thai baht, and British pound). However, the percentage change by which foreign currencies appreciated or depreciated against the U.S. dollar varied considerably, from 0.02 percent for the Chinese yuan to 5.8 percent for the Swiss franc. Other than the Chinese yuan, all of the currencies in Exhibit 7.1 weakened against the U.S. dollar in the month from April 23 to May 23, 2013, with the Thai baht experiencing the greatest percentage decrease (23.70%). Over the year April 23, 2012, to April 23, 2013, ! ve currencies fell against the U.S. dollar, with the Brazilian real experiencing the greatest percentage decrease (26.43%), and four currencies strengthened against the U.S. dollar, with both the Mexican peso and Thai baht experiencing a greater than 7 percent increase in value over the year. The percentage changes reported in Exhibit  7.1 demonstrate the great variability that exists in exchange rate changes in terms of both magnitude and direction; exchange rates # uctuate constantly.

EXHIBIT 7.1 Foreign Exchange Rates U.S. Dollar per Foreign Currency (Direct Quotes)

Country (currency) Apr. 23, 2012

$ per FC Apr. 23, 2013

$ per FC May 23, 2013

$ per FC May 24, 2013

$ per FC

Bahrain (dinar) 2.652350 2.652876 2.651821 2.653227 Brazil (real) 0.530104 0.496020 0.486914 0.487346 China (yuan) 0.158550 0.161760 0.163014 0.163049 Euro 1.312792 1.301400 1.295479 1.291670 Mexico (peso) 0.075705 0.081665 0.080217 0.079843 Switzerland (franc) 1.092499 1.060788 1.033976 1.093979 Taiwan (new dollar) 0.033887 0.033568 0.033424 0.033399 Thailand (baht) 0.032230 0.034686 0.033401 0.033361 United Kingdom (pound) 1.610086 1.526615 1.512983 1.511701

Country (currency) % Change for

the Yeara % Change for the Monthb

% Change for the Dayc

Bahrain (dinar) 0.02 –0.04 0.05 Brazil (real) –6.43 –1.84 0.09 China (yuan) 2.02 0.78 0.02 Euro –0.87 –0.45 –0.29 Mexico (peso) 7.87 –1.77 –0.47 Switzerland (franc) –2.90 –2.53 5.80 Taiwan (new dollar) –0.94 –0.43 –0.07 Thailand (baht) 7.62 –3.70 –0.12 United Kingdom (pound) –5.18 –0.89 –0.08

a From April 23, 2012, to April 23, 2013. b From April 23, 2013, to May 23, 2013. c From May 23, 2013, to May 24, 2013.

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 343

Fluctuating exchange rates introduce considerable uncertainty with respect to the cash # ows associated with foreign currency transactions. Assume that a U.S. exporter sold parts to a Brazilian customer on April 23, 2013, with payment of 100,000 Brazilian reals (BRL) to be received on May 23, 2013. On April 23, 2013, the U.S. dollar equivalent value of the sale was $49,602 (BRL 100,000 3 $0.49602). On May 23, 2013, the U.S. exporter receives BRL 100,000 from the customer and sells them at the spot exchange rate of $0.486914, receiving $48,692, which is $910 less than would have been received on April 23, 2013, when the parts were sold. The important point to understand is that, because of # uctuating exchange rates, on April 23, when the sale is made, the U.S. exporter does not know how many U.S. dollars it will receive on May 23 as a result of the sale.

Spot and Forward Rates Foreign currency trades can be executed on a spot or forward basis. The spot rate is the price at which a foreign currency can be purchased or sold today. In contrast, the forward rate is the price today at which foreign currency can be purchased or sold sometime in the future. Because many international business transactions take some time to be completed, the ability to lock in a price today at which foreign currency can be purchased or sold at some future date has de! nite advantages.

The Wall Street Journal publishes forward rates quoted by New York banks for sev- eral major currencies (Canadian dollar, Japanese yen, Swiss franc, and British pound) on a daily basis. This is only a partial listing of possible forward contracts. A ! rm and its bank can tailor forward contracts in other currencies and for other time periods to meet the needs of the ! rm. There is no up-front cost to enter into a forward contract.

The forward rate can exceed the spot rate on a given date, in which case the foreign currency is said to be selling at a premium in the forward market, or the forward rate can be less than the spot rate, in which case it is selling at a discount. Currencies sell at a premium or a discount because of differences in interest rates between two countries. When the interest rate in the foreign country exceeds the interest rate domestically, the foreign currency sells at a discount in the forward market. Conversely, if the foreign interest rate is less than the domestic rate, the foreign currency sells at a premium. 7 Forward rates are said to be unbiased predic- tors of the future spot rate.

The spot rate for Swiss francs on April 15, 2013, was $1.0738, indicating that 1 franc could have been purchased on that date for $1.0738. On the same day, the one-month forward rate was $1.0741. The Swiss franc was selling at a premium in the one-month forward market. By entering into a forward contract on April 15, it was possible to guarantee that Swiss francs could be purchased one month later at a price of $1.0741 per franc, regardless of what the spot rate turned out to be on that date. Entering into the forward contract to purchase francs would have been bene! cial if the spot rate in one month turned out to be greater than $1.0741. However, such a forward contract would have been detrimental if the future spot rate turned out to be less than $1.0741. In either case, the forward contract must be honored and Swiss francs must be purchased at $1.0741.

On the same day that the Swiss franc was selling at a premium in the forward market, the British pound was selling at a discount. On April 15, 2013, when the British pound spot rate was $1.5284, a U.S. importer of British goods could have locked in a rate of only $1.5282 to purchase British pounds in one month. This

7 This relationship is based on the theory of interest rate parity, which indicates that the difference in national interest rates should be equal to but opposite in sign to the forward rate discount or premium. This topic is covered in detail in international fi nance textbooks.

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action would eliminate the risk to the importer that the British pound might actu- ally appreciate against the U.S. dollar over the next month, which would increase the U.S.-dollar cost of the British imports. 8

Option Contracts To provide companies more # exibility than exists with a forward contract, a mar- ket for foreign currency options has developed. A foreign currency option gives the holder of the option the right but not the obligation to trade foreign currency in the future. A put option is for the sale of foreign currency by the holder of the option; a call option is for the purchase of foreign currency by the holder of the option. The strike price is the exchange rate at which the option will be executed if the holder of the option decides to exercise the option. The strike price is similar to a forward rate. There are generally several strike prices to choose from at any particular time. Most foreign currency options are purchased directly from a bank in the so-called over-the-counter market, but they also may be purchased on the Philadelphia Stock Exchange and the Chicago Mercantile Exchange.

Unlike forward contracts, where banks earn their pro! t through the spread be- tween buying and selling rates, options must actually be purchased by paying an option premium. The option premium is a function of two components: intrinsic value and time value. The intrinsic value of an option is equal to the gain that could be realized by exercising the option immediately. For example, if the spot rate for a foreign currency is $1.00, a call option (to purchase foreign currency) with a strike price of $0.97 has an intrinsic value of $0.03, whereas a put option (to sell foreign currency) with a strike price of $1.00 or less has an intrinsic value of zero. An op- tion with a positive intrinsic value is said to be “in the money.”

The time value of an option relates to the fact that the spot rate can change over time and cause the option to become in the money. Even though a 90-day call op- tion with a strike price of $1.00 has zero intrinsic value when the spot rate is $1.00, it will still have a positive time value because there is a chance that the spot rate could increase over the next 90 days and bring the option into the money.

The value of a foreign currency option can be determined by applying an ad- aptation of the Black-Scholes option pricing formula. This formula is discussed in detail in international ! nance books. In very general terms, the value of an option is a function of the difference between the current spot rate and strike price, the difference between domestic and foreign interest rates, the length of time to expi- ration, and the potential volatility of changes in the spot rate. In this book, we will give the premium originally paid for a foreign currency option and its subsequent fair value up to the date of expiration derived from applying the pricing formula.

FOREIGN CURRENCY TRANSACTIONS

Export sales and import purchases are international transactions. When two par- ties from different countries enter into a transaction, they must decide which of the two countries’ currencies to use to settle the transaction. For example, if a U.S. computer manufacturer sells to a customer in Japan, the parties must decide whether the transaction will be denominated (i.e., whether payment will be made) in U.S. dollars or Japanese yen. In some cases, a third country’s currency might be used to denominate the transaction.

8 As it turned out, the spot rate for British pounds on May 15, 2013, was $1.5210, so entering into a forward contract on April 15 to purchase pounds at $1.5282 on May 15 would not have been benefi cial.

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 345

Assume that a U.S. exporter (Eximco) sells goods to a Spanish customer with pay- ment to be made in euros. In this situation, Eximco has entered into a foreign cur- rency transaction. It must restate the euro amount that actually will be received into U.S. dollars to account for this transaction. This is because Eximco keeps its books and prepares ! nancial statements in U.S. dollars. Although the Spanish importer has entered into an international transaction, it does not have a foreign currency transac- tion (payment will be made in its home currency) and no restatement is necessary.

Assume that, as is customary in its industry, Eximco does not require imme- diate payment and allows its Spanish customer three months to pay for its pur- chases. By doing this, Eximco runs the risk that from the date the sale is made until the date of payment, the euro might decrease in value (depreciate) against the U.S. dollar and the actual number of U.S. dollars generated from the sale will be less than expected. In this situation, Eximco is said to have an exposure to foreign exchange risk. Speci! cally, Eximco has a transaction exposure.

Transaction exposure can be summarized as follows:

• Export sale. A transaction exposure exists when the exporter allows the buyer to pay in a foreign currency and also allows the buyer to pay sometime after the sale has been made. The exporter is exposed to the risk that the foreign cur- rency might decrease in value between the date of sale and the date of payment, thereby decreasing the amount of domestic currency (U.S. dollars for Eximco) into which the foreign currency can be converted.

• Import purchase. A transaction exposure exists when the importer is required to pay in foreign currency and is allowed to pay sometime after the purchase has been made. The importer is exposed to the risk that the foreign currency might increase in price (appreciate) between the date of purchase and the date of pay- ment, thereby increasing the amount of domestic currency that has to be paid for the imported goods.

Accounting Issue The major issue in accounting for foreign currency transactions is how to deal with the change in the domestic-currency value of the sales revenue and account receiv- able resulting from the export when the foreign currency changes in value. The corollary issue is how to deal with the change in the domestic-currency value of the foreign currency account payable and goods being acquired in an import purchase.

Assume that Eximco sells goods to a Spanish customer at a price of 1 million euros (€) when the spot exchange rate is $1.50 per euro. If payment were received at the date of sale, Eximco could have converted €1,000,000 into $1,500,000, and this amount clearly would be the amount at which the sales revenue would be recognized. Instead, Eximco allows the Spanish customer three months to pay for its purchase. At the end of three months, the euro has depreciated to $1.48, and Eximco is able to convert the €1,000,000 received on that date into only $1,480,000. How should Eximco account for this $20,000 decrease in value?

Accounting Alternatives Conceptually, the two methods of accounting for changes in the value of a foreign currency transaction are the one-transaction perspective and the two-transaction perspective. The one-transaction perspective assumes that an export sale is not com- plete until the foreign currency receivable has been collected and converted into U.S. dollars. Any change in the U.S.-dollar value of the foreign currency will be accounted for as an adjustment to Accounts Receivable and to Sales. Under this

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perspective, Eximco would ultimately report Sales at $1,480,000 and an increase in the Cash account of the same amount. This approach can be criticized because it hides the fact that the company could have received $1,500,000 if the Spanish cus- tomer had been required to pay at the date of sale. The company incurs a $20,000 loss because of the depreciation in the euro, but that loss is buried in an adjust- ment to Sales. This approach is not acceptable under either International Financial Reporting Standards (IFRS) or U.S. GAAP.

Instead, both International Accounting Standard (IAS) 21, The Effects of Changes in Foreign Exchange Rates, and FASB ASC 830, Foreign Currency Matters, require com- panies to use a two-transaction perspective in accounting for foreign currency transac- tions. This perspective treats the export sale and the subsequent collection of cash as two separate transactions. Because management has made two decisions—(1) to make the export sale, and (2) to extend credit in foreign currency to the customer— the income effect from each of these decisions should be reported separately.

Under the two-transaction perspective, Eximco records the U.S. dollar value of the sale at the date the sale occurs. At that point, the sale has been completed; there are no subsequent adjustments to the Sales account. Any difference between the number of U.S. dollars that could have been received at the date of sale and the number of U.S. dollars actually received at the date of payment due to # uc- tuations in the exchange rate is a result of the decision to extend foreign currency credit to the customer. This difference is treated as a Foreign Exchange Gain or Loss that is reported separately from Sales in the income statement. Using the two- transaction perspective to account for its export sale to Spain, Eximco would make the following journal entries:

Date of Sale: Accounts Receivable (€). . . . . . . . . . . . . . . . . . . . . . 1,500,000 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500,000 To record the sale and euro receivable at the spot

rate of $1.50. Date of Payment: Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . 20,000

Accounts Receivable (€) . . . . . . . . . . . . . . . . 20,000 To adjust the U.S.-dollar value of the euro receiv-

able to the new spot rate of $1.48 and record a foreign exchange loss resulting from the deprecia- tion in the euro.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,480,000 Accounts Receivable (€) . . . . . . . . . . . . . . . . 1,480,000 To record the receipt of €1,000,000 and conver-

sion into U.S. dollars at the spot rate of $1.48.

Sales are reported in income at the amount that would have been received if the customer had not been given three months to pay the €1,000,000, that is, $1,500,000. A separate Foreign Exchange Loss of $20,000 is reported in income to indicate that because of the decision to extend foreign currency credit to the Spanish customer and because the euro decreased in value, fewer U.S. dollars are actually received. 9

9 Note that the foreign exchange loss results because the customer is allowed to pay in euros and is given 30 days to pay. If the transaction were denominated in U.S. dollars, no loss would result. There would also be no loss if the euros had been received at the date the sale was made.

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 347

Note that Eximco keeps its Account Receivable (€) account separate from its U.S.-dollar receivables. Companies engaged in international trade need to keep separate payable and receivable accounts in each of the currencies in which they have transactions. Each foreign currency receivable and payable should have a separate account number in the company’s chart of accounts.

We can summarize the relationship between # uctuations in exchange rates and foreign exchange gains and losses as follows:

Foreign Currency (FC)

Transaction Type of Exposure Appreciates Depreciates

Export sale Asset Gain Loss Import purchase Liability Loss Gain

A foreign currency receivable arising from an export sale creates an asset expo- sure to foreign exchange risk. If the foreign currency appreciates, the foreign cur- rency asset increases in terms of domestic-currency value and a foreign exchange gain arises; depreciation of the foreign currency causes a foreign exchange loss. A foreign currency payable arising from an import purchase creates a liability expo- sure to foreign exchange risk. If the foreign currency appreciates, the foreign cur- rency liability increases in domestic-currency value and a foreign exchange loss results; depreciation of the currency results in a foreign exchange gain.

Balance Sheet Date before Date of Payment The question arises as to what accounting should be done if a balance sheet date falls between the date of sale and the date of payment. For example, assume that Eximco shipped goods to its Spanish customer on December 10, Year 1, with pay- ment to be received on March 1, Year 2. Assume that at December 10 the spot rate for euros is $1.50, but by December 31 the euro has appreciated to $1.51. Is any ad- justment needed at December 31, Year 1, when the books are closed to account for the fact that the foreign currency receivable has changed in U.S. dollar value since December 10?

The general consensus worldwide is that a foreign currency receivable or for- eign currency payable should be revalued at the balance sheet date to account for the change in exchange rates. Under the two-transaction perspective, this means that a foreign exchange gain or loss arises at the balance sheet date. The next ques- tion, then, is what should be done with these foreign exchange gains and losses that have not yet been realized in cash. Should they be included in net income?

The two approaches to accounting for unrealized foreign exchange gains and losses are the deferral approach and the accrual approach. Under the deferral approach, unrealized foreign exchange gains and losses are deferred on the balance sheet until cash is actually paid or received. When cash is paid or received, a real- ized foreign exchange gain or loss would be included in income. This approach is not acceptable under either IFRS or U.S. GAAP.

IAS 21 (as well as FASB ASC 830) requires companies to use the accrual approach to account for unrealized foreign exchange gains and losses. Under this approach, a ! rm reports unrealized foreign exchange gains and losses in net income in the period in which the exchange rate changes. The FASB justi! ed this approach by saying: “This is consistent with accrual accounting; it results in reporting the effect of a rate change that will have cash # ow effects when the event causing the effect

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takes place.” 10 Thus, any change in the exchange rate from the date of sale to the balance sheet date would result in a foreign exchange gain or loss to be reported in income in that period. Any change in the exchange rate from the balance sheet date to the date of payment would result in a second foreign exchange gain or loss that would be reported in the second accounting period. The journal entries Eximco would make under the accrual approach would be as follows:

12/1/Y1 Accounts Receivable (€). . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500,000 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500,000 To record the sale and euro receivable at the spot rate of

$1.50. 12/31/Y1 Accounts Receivable (€). . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Foreign Exchange Gain . . . . . . . . . . . . . . . . . . . . . . . 10,000 To adjust the value of the euro receivable to the new spot

rate of $1.51 and record a foreign exchange gain resulting from the appreciation in the euro since December 10.

3/1/Y2 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . 30,000 To adjust the value of the euro receivable to the new spot

rate of $1.48 and record a foreign exchange loss resulting from the depreciation in the euro since December 31.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,480,000 Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . 1,480,000 To record the receipt of €1,000,000 and conversion at the

spot rate of $1.48.

The net impact on income in Year 1 includes Sales of $1,500,000 and a Foreign Exchange Gain of $10,000; in Year 2, a Foreign Exchange Loss of $30,000 is recorded. This results in a net increase in Retained Earnings of $1,480,000 that is balanced by an equal increase in Cash. 11

One criticism of the accrual approach is that it leads to a violation of conservatism when an unrealized foreign exchange gain arises at the balance sheet date. In fact, this is one of only two situations in U.S. GAAP (the other relates to trading market- able securities reported at market value) where it is acceptable to recognize an un- realized gain in income. Historically, several European Union (EU) countries (such as Germany and Austria) more strictly adhered to the concept of conservatism. In those countries, if at the balance sheet date the exchange rate had changed such that an unrealized gain had arisen, the change in exchange rate was ignored and the foreign currency account receivable or payable continued to be carried on the balance sheet at the exchange rate that existed at the date of the transaction. In con- trast, if the exchange rate had changed to cause a foreign exchange loss, the account receivable would have been revalued and an unrealized loss would have been re- corded and reported in income. This is a classic application of conservatism. With

3/1/Y2 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,480,000 Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . 1,510,000

10 FASB Statement No. 52, Foreign Currency Translation (Stamford, CT, 1981), para. 124. 11 Note that the journal entries recorded at March 1, Year 2, could have been combined into the following single entry:

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 349

the introduction of the requirement to use IFRS, this practice is no longer used by EU-based companies in preparing consolidated ! nancial statements.

All foreign currency assets and liabilities carried on a company’s books must be restated at the balance sheet date. In addition to foreign currency payables and re- ceivables arising from import and export transactions, companies also might have dividends receivable from foreign subsidiaries, loans payable to foreign lenders, lease payments receivable from foreign customers, and so on that are denomi- nated in a foreign currency and therefore must be restated at the balance sheet date. Each of these foreign-currency-denominated assets and liabilities is exposed to foreign exchange risk; therefore, # uctuations in the exchange rate will result in foreign exchange gains and losses.

Many U.S. companies report foreign exchange gains and losses on the income statement in a line item often titled “Other Income (Expense).” Other incidental gains and losses such as gains and losses on sales of assets would be included in this line item as well. Companies must disclose the magnitude of foreign exchange gains and losses if material. For example, in the Notes to Financial Statements in its 2012 annual report, Merck & Company Inc. indicated that the income statement item “Other (Income) Expense, Net” included exchange losses of $185 million in 2012, $143 million in 2011, and $214 million in 2010. 12

HEDGING FOREIGN EXCHANGE RISK

In the preceding example, Eximco has an asset exposure in euros when it sells goods to the Spanish customer and it allows the customer three months to pay for its purchase. If the euro depreciates over the next three months, Eximco incurs a foreign exchange loss. For many companies, the uncertainty of not knowing ex- actly how much domestic currency will be received on this export sale is of great concern. To avoid this uncertainty, companies often use foreign currency deriva- tives to hedge against the effect of unfavorable changes in the value of foreign cur- rencies. 13 The two most common derivatives used to hedge foreign exchange risk are foreign currency forward contracts and foreign currency options. Through a forward contract, Eximco can lock in the price at which it will sell the euros it re- ceives in three months. An option establishes a price at which Eximco will be able, but is not required, to sell the euros it receives in three months. If Eximco enters into a forward contract or purchases an option on the date the sale is made, the derivative is being used as a hedge of a recognized foreign-currency-denominated asset (the euro account receivable).

Companies engaged in foreign currency activities often enter into hedging ar- rangements as soon as a noncancelable sales order is received or a noncancelable pur- chase order is placed. A noncancelable order that speci! es the foreign currency price and date of delivery is a known as a foreign currency " rm commitment. Assume that, on April 1, Eximco accepts an order to sell parts to a customer in Thailand at a price of 20 million Thai baht. The parts will be delivered and payment will be received on May 15. On April 1, before the sale has been made, Eximco enters into a forward contract to sell 20 million Thai baht on May 15. In this case, Eximco is using a foreign currency derivative as a hedge of an unrecognized foreign currency " rm commitment.

12 Merck & Company, Inc., Form 10-K, 2012, Note 15, Other (Income) Expense, Net, p. 126. 13 A derivative is a fi nancial instrument whose value changes in response to the change in a specifi ed interest rate, security price, commodity price, index of prices or rates, or other variable. The value of a foreign currency derivative changes in response to changes in foreign exchange rates.

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350 Chapter Seven

Some companies have foreign currency transactions that occur on a regular basis and can be reliably forecast. For example, Eximco regularly purchases com- ponents from a supplier in Singapore, making payment in Singapore dollars. Even if Eximco has no contract to make future purchases, it has an exposure to foreign currency risk if it plans to continue making purchases from the Singapore supplier. Assume that, on October 1, Eximco forecasts that it will make a purchase from the Singapore supplier in one month. To hedge against a possible increase in the price of the Singapore dollar, Eximco acquires a call option on October 1 to purchase Singapore dollars in one month. The foreign currency option represents a hedge of a forecasted foreign-currency-denominated transaction.

ACCOUNTING FOR DERIVATIVES

In the development of a core set of standards for global use, the International Orga- nization of Securities Commissions (IOSCO) required the International Accounting Standards Board (IASB) to include a standard on the recognition and measurement of ! nancial instruments, off-balance-sheet items, and hedging activities. In 1988, the IASB embarked on a joint project with the Canadian Institute of Chartered Ac- countants to develop a comprehensive standard in this area. Due to the critical response to an early Exposure Draft, the project was subsequently divided into two parts, and IAS 32, Financial Instruments: Disclosure and Presentation, was issued in 1995. Work continued on the recognition and measurement dimensions of the project, with a discussion paper published in 1997. Comments on the discussion paper raised numerous issues that caused the IASB to conclude that developing a ! nal standard in the near term was not possible. Therefore, to provide users of IFRS with some guidance in this area, an interim statement, IAS 39, Financial Statements: Recognition and Measurement, was issued in 1999. The IASB continues to work on an integrated standard on ! nancial instruments. 14 IAS 39 provides the following general principles with respect to the accounting for derivatives:

1. All derivatives should be reported on the balance sheet at fair value (off- balance- sheet treatment is not acceptable).

2. “Hedge accounting” is acceptable for those derivatives used for hedging pur- poses provided the hedging relationship is clearly de! ned, measurable, and actually effective.

Hedge accounting is described in more detail later in this chapter. IAS 39 (as well as FASB ASC 830) provides guidance for hedges of the following

sources of foreign exchange risk:

1. Recognized foreign-currency-denominated assets and liabilities. 2. Unrecognized foreign currency ! rm commitments. 3. Forecast foreign-currency-denominated transactions. 4. Net investments in foreign operations.

Different accounting applies to each of these different types of foreign currency hedge. This chapter demonstrates the accounting for the ! rst three types of hedge. Hedges of net investments in foreign operations are covered in Chapter 8.

14 The IASB completed the fi rst phase of its project to replace IAS 39 in November 2009 by issuing IFRS 9, Financial Instruments. IFRS 9 does not cover fi nancial instruments used in hedging activities.

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 351

Fundamental Requirement of Derivatives Accounting In accounting for derivative ! nancial instruments, the fundamental requirement is that all derivatives must be carried on the balance sheet at their fair value. De- rivatives are reported on the balance sheet as assets when they have a positive fair value and as liabilities when they have a negative fair value. The ! rst issue in ac- counting for derivatives is the determination of fair value.

The fair value of derivatives can change over time, causing adjustments to be made to the carrying values of the assets and liabilities. The second issue in ac- counting for derivatives is the treatment of the unrealized gains and losses that arise from these adjustments.

Determining the Fair Value of Derivatives The fair value of a foreign currency forward contract is determined by reference to changes in the forward rate over the life of the contract, discounted to the pres- ent value. Three pieces of information are needed to determine the fair value of a forward contract at any time:

1. The forward rate when the forward contract was entered into. 2. The current forward rate for a contract that matures on the same date as the

forward contract entered into. 3. A discount rate—typically, the company’s incremental borrowing rate.

Assume that Interco enters into a forward contract on November 1 to sell 1 mil- lion South African rand on May 1 at a forward rate of $0.15 per rand, or a total of $150,000. There is no cost to Interco to enter into the forward contract, and the for- ward contract has no value on November 1. On December 31, when Interco closes its books to prepare ! nancial statements, the forward rate to sell South African rand on May 1 has changed to $0.147. On that date, a forward contract for the delivery of 1 million South African rand could be negotiated that would result in a cash in# ow on May 1 of only $147,000. This represents a favorable change in the value of Inter- co’s forward contract of $3,000 ($150,000  −  $147,000). The fair value of the forward contract on December 31 is $3,000, discounted to its present value. Assuming that the company’s incremental borrowing rate is 12 percent per annum, the fair value of the forward contract must be discounted at the rate of 1 percent per month for four months (from the current date of December 31 to the settlement date of May 1). The fair value of the forward contract at December 31 is $2,883 ($3,000  ×  0.96098). 15

The manner in which the fair value of a foreign currency option is determined de- pends on whether the option is traded on an exchange or has been acquired in the over-the-counter market. The fair value of an exchange-traded foreign currency option is its current market price quoted on the exchange. For over-the-counter options, fair value can be determined by obtaining a price quote from an option dealer (such as a bank). If dealer price quotes are unavailable, the company can estimate the value of an option using the modi! ed Black-Scholes option pricing model (brie# y mentioned earlier in this chapter). Regardless of who does the cal- culation, principles similar to those in the Black-Scholes pricing model will be used in determining the fair value of the option.

Accounting for Changes in the Fair Value of Derivatives Changes in the fair value of derivatives must be included in comprehensive in- come. Comprehensive income is de! ned as all changes in equity from nonowner

15 The present value factor for four months at 1 percent per month is calculated as 1/1.01 4 , or 0.96098.

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352 Chapter Seven

sources and consists of two components: net income and other comprehensive in- come. Other comprehensive income consists of unrealized income items that account- ing standards require to be deferred in stockholders’ equity, such as gains and losses on available-for-sale marketable securities. Other comprehensive income is accumulated and reported as a separate line in the stockholders’ equity section of the balance sheet. The account title Accumulated Other Comprehensive Income is used in this chapter to describe this stockholders’ equity line item.

Gains and losses arising from changes in the fair value of derivatives are rec- ognized initially either (1) on the income statement as a part of net income or (2) on the balance sheet as a component of other comprehensive income. Recognition treatment partly depends on whether the derivative is used for hedging purposes or for speculation. 16 For speculative derivatives, the change in the fair value of the derivative (the unrealized gain or loss) is recognized immediately in net income.17 The accounting for changes in the fair value of derivatives used for hedging de- pends on the nature of the foreign exchange risk being hedged, and whether the derivative quali! es for hedge accounting.

HEDGE ACCOUNTING

Companies enter into hedging relationships to minimize the adverse effect that changes in exchange rates have on cash # ows and net income. As such, companies would like to account for hedges in such a way that the gain or loss from the hedge is recognized in net income in the same period as the loss or gain on the risk being hedged. This approach is known as hedge accounting. Hedge accounting for foreign currency derivatives may be used only if three conditions are satis! ed:

1. The derivative is used to hedge either a fair value exposure or cash # ow expo- sure to foreign exchange risk.

2. The derivative is highly effective in offsetting changes in the fair value or cash # ows related to the hedged item.

3. The derivative is properly documented as a hedge.

Each of these conditions is discussed in turn.

Nature of the Hedged Risk A fair value exposure exists if changes in exchange rates can affect the fair value of an asset or liability reported on the balance sheet. To qualify for hedge accounting, the fair value risk must have the potential to affect net income if it is not hedged. For example, there is a fair value risk associated with a foreign currency account receivable. If the foreign currency depreciates, the receivable must be written down, with an offsetting loss recognized in net income. A fair value exposure also exists for foreign currency ! rm commitments.

16 Companies can acquire derivative fi nancial instruments as investments for speculative purposes. For example, assume the three-month forward rate for Swiss francs is $1.03, and a speculator believes the Swiss franc spot rate in three months will be $1.00. In that case, the speculator would enter into a three- month forward contract to sell Swiss francs. At the future date, the speculator purchases francs at the spot rate of $1.00 and sells them at the contracted forward rate of $1.03, reaping a gain of $0.03 per franc. Of course, such an investment might just as easily generate a loss if the spot rate does not move in the expected direction. 17 In the next section, we will see that the change in fair value of a derivative designated as the fair value hedge of a foreign-currency-denominated asset or liability also is recognized immediately in net income.

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 353

A cash ! ow exposure exists if changes in exchange rates can affect the amount of cash # ow to be realized from a transaction, with changes in cash # ow re# ected in net income. A cash # ow exposure exists for (1) recognized foreign currency assets and liabilities, (2) foreign currency ! rm commitments, and (3) forecasted foreign currency transactions.

Derivatives for which companies wish to use hedge accounting must be des- ignated as either a fair value hedge or a cash ! ow hedge. For hedges of recognized foreign currency assets and liabilities and hedges of foreign currency ! rm commit- ments, companies must choose between the two types of designation. Hedges of forecasted foreign currency transactions can qualify only as cash # ow hedges. Ac- counting procedures differ for the two types of hedge. In general, gains and losses on fair value hedges are recognized immediately in net income, whereas gains and losses on cash # ow hedges are included in other comprehensive income. 18

Hedge Effectiveness For hedge accounting to be used initially, the hedge must be expected to be highly effective in generating gains and losses that offset losses and gains on the item being hedged. The hedge actually must be effective in generating offsetting gains and losses for hedge accounting to continue to be applied.

At inception, a foreign currency derivative can be considered an effective hedge if the critical terms of the hedging instrument match those of the hedged item. Critical terms include the currency type, currency amount, and settlement date. For example, a forward contract to purchase 1 million Japanese yen in 30 days would be an effective hedge of a liability of 1 million Japanese yen that is payable in 30 days. Assessing hedge effectiveness on an ongoing basis can be accomplished using a cumulative dollar offset method.

Hedge Documentation For hedge accounting to be applied, the hedging relationship must be formally documented at the inception of the hedge, that is, on the date a foreign currency forward contract is entered into or a foreign currency option is acquired. The hedg- ing company must prepare a document that identi! es the hedged item, the hedg- ing instrument, the nature of the risk being hedged, how the hedging instrument’s effectiveness will be assessed, and the risk management objective and strategy for undertaking the hedge.

HEDGING COMBINATIONS

The speci! c entries required to account for a foreign currency hedging relation- ship are determined by a combination of the following factors:

1. The type of item being hedged: a. Foreign-currency-denominated asset/liability, b. Foreign currency ! rm commitment, or c. Forecasted foreign currency transaction.

18 Many companies choose not to designate derivatives used to hedge recognized foreign currency assets and liabilities as hedges per se. In that case, the derivative is accounted for in exactly the same manner as if it had been designated as a fair value hedge; gains and losses are recognized immediately. As a result, designating a hedge of a recognized foreign currency asset/liability as a fair value hedge is of no importance.

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354 Chapter Seven

2. The nature of the item being hedged: a. Existing (or future) asset, or b. Existing (or future) liability.

3. The type of hedging instrument being used: a. Forward contract, or b. Option.

4. The nature of the hedged risk: a. Fair value exposure, or b. Cash # ow exposure.

To measure the fair value of a ! rm commitment, a choice must be made between using

1. Changes in the spot rate, or 2. Changes in the forward rate.

We do not have enough space in this chapter to demonstrate the accounting for over 20 different combinations of hedging relationships. However, it is important to see the differences in accounting for (1) foreign-currency-denominated assets/ liabilities, (2) ! rm commitments, and (3) forecasted transactions. We show this by focusing on the accounting that would be done by an exporter who has an exist- ing or future foreign currency asset. We also demonstrate the use of both forward contracts and options for different types of items being hedged, and we selectively demonstrate the accounting for fair value and cash # ow hedges. The appendix to this chapter demonstrates the accounting for hedges entered into by an importer who has existing and future foreign currency liabilities.

HEDGES OF FOREIGN-CURRENCY-DENOMINATED ASSETS AND LIABILITIES

Hedges of foreign-currency-denominated assets and liabilities, such as accounts receivable and accounts payable, can qualify as either cash ! ow hedges or fair value hedges. To qualify as a cash # ow hedge, the hedging instrument must completely offset the variability in the cash # ows associated with the foreign currency receiv- able or payable. If the hedging instrument does not qualify as a cash # ow hedge, or if the company elects not to designate the hedging instrument as a cash # ow hedge, the hedge is designated as a fair value hedge. The following lists summa- rize the basic accounting for the two types of hedges.

Cash Flow Hedge At each balance sheet date:

1. The hedged asset or liability is adjusted to fair value according to changes in the spot exchange rate, and a foreign exchange gain or loss is recognized in net income.

2. The derivative hedging instrument is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a change in accumulated other comprehensive income (AOCI).

3. An amount equal to the foreign exchange gain or loss on the hedged asset or liability is then transferred from AOCI to net income; the net effect is to offset any gain or loss on the hedged asset or liability.

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 355

4. An additional amount is removed from AOCI and recognized in net income to re# ect ( a ) the current period’s amortization of the original discount or premium on the forward contract (if a forward contract is the hedging instrument) or ( b ) the change in the time value of the option (if an option is the hedging instrument).

Fair Value Hedge At each balance sheet date:

1. The hedged asset or liability is adjusted to fair value according to changes in the spot exchange rate, and a foreign exchange gain or loss is recognized in net income.

2. The derivative hedging instrument is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a gain or loss in net income.

FORWARD CONTRACT USED TO HEDGE A RECOGNIZED FOREIGN-CURRENCY-DENOMINATED ASSET

We now return to the Eximco example in which the company has a foreign cur- rency account receivable to demonstrate the accounting for a hedge of a recognized foreign-currency-denominated asset. In the preceding example, Eximco has an asset exposure in euros when it sells goods to the Spanish customer and allows the customer three months to pay for its purchase. To hedge its exposure to a decline in the U.S. dollar value of the euro, Eximco decides to enter into a forward contract.

Assume that on December 1, Year 1, the three-month forward rate for euros is $1.485 and Eximco signs a contract with First National Bank to deliver €1,000,000 in three months in exchange for $1,485,000. No cash changes hands on December 1. Given that the spot rate on December 1 is $1.50, the euro is selling at a discount in the three-month forward market (the forward rate is less than the spot rate). Because the euro is selling at a discount of $0.015 per euro, Eximco receives $15,000 less than if payment had been received at the date the goods are delivered ($1,485,000 vs. $1,500,000). This $15,000 reduction in cash # ow can be seen as an expense; it is the cost of extending foreign currency credit to the foreign customer. 19 Conceptually, this expense is similar to the transaction loss that arises on the export sale. It exists only because the transaction is denominated in a for- eign currency. The major difference is that Eximco knows the exact amount of the discount expense at the date of sale, whereas, if the receivable is left unhedged, Eximco does not know the size of the transaction loss until three months pass. In fact, it is possible that the unhedged receivable could result in a transaction gain rather than a transaction loss.

Given that the future spot rate turns out to be only $1.48, selling euros at a for- ward rate of $1.485 is obviously better than leaving the euro receivable unhedged— Eximco will receive $5,000 more as a result of the hedge. This can be viewed as a gain resulting from the use of the forward contract. Unlike the discount expense, the exact size of this gain is not known until three months pass. (In fact, it is pos- sible that use of the forward contract could result in an additional loss. This would occur if the spot rate on March 1, Year 2, is higher than the forward rate of $1.485.)

19 This should not be confused with the cost associated with normal credit risk; that is, the risk that the customer will not pay for its purchase. That is a separate issue unrelated to the currency in which the transaction is denominated.

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356 Chapter Seven

Eximco must account for its foreign currency transaction and the related for- ward contract simultaneously but separately. The process can be better under- stood by referring to the steps involving the three parties—Eximco, the Spanish customer, and First National Bank—shown in Exhibit 7.2 .

Because the settlement date, currency type, and currency amount of the forward contract match the corresponding terms of the account receivable, the hedge is ex- pected to be highly effective. If Eximco properly designates the forward contract as a hedge of its euro account receivable position, hedge accounting may be applied. Because it completely offsets the variability in the cash # ows related to the account- ing receivable, the forward contract may be designated as a cash # ow hedge. Alter- natively, Eximco may elect to account for this forward contract as a fair value hedge.

In either case, Eximco determines the fair value of the forward contract by refer- ring to the change in the forward rate for a contract maturing on March 1, Year 2. The relevant exchange rates, U.S.-dollar value of the euro receivable, and fair value of the forward contract are determined as follows:

Steps on December 1, Year 1

1. Eximco ships the goods to the Spanish customer, thereby creating a €1,000,000 account receivable.

2. Eximco sells €1,000,000 three months forward to First National Bank, creating an executory contract to pay €1,000,000 and receive $1,485,000.

Steps on March 1, Year 2

3. The Spanish customer sends €1,000,000 to Eximco to settle the account receivable; Eximco now has €1,000,000 in foreign currency.

4. Eximco delivers €1,000,000 to First National Bank.

5. First National Bank pays Eximco $1,485,000.

1. 12/1/Y1—goods shipped €1,000,000 account receivable

3. 3/1/Y2—€1,000,000 received 4. 3/1/Y2—€1,000,000 delivered

5. 3/1/Y2—$1,485,000 received

Spanish customer First National BankEximco

2. 12/1/Y1—€1,000,000 sold forward executory contract

EXHIBIT 7.2 Hedge of a Foreign Currency Account Receivable with a Forward Contract

Account Receivable (€) Forward Contract

Date Spot Rate U.S.-Dollar

Value

Change in U.S.-Dollar

Value Forward Rate

to 3/1/Y2 Fair Value Change in Fair Value

12/1/Y1 $1.50 $1,500,000 — $1.485 $0 — 12/31/Y1 $1.51 $1,510,000 +$10,000 $1.496 $(10,783)* −$10,783 3/1/Y2 $1.48 $1,480,000 −$30,000 $1.480 $5,000† +$15,783

* $1,485,000 − $1,496,000 = $(11,000) × 0.9803 = $(10,783), where 0.9803 is the present value factor for two months at an annual interest rate of 12% (1% per month) calculated as 1/1.01 2 . † $1,485,000 − $1,480,000 = $5,000.

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 357

Eximco pays nothing to enter into the forward contract at December 1, Year 1, and the forward contract has a fair value of zero on that date. At December 31, Year 1, the forward rate for a contract to deliver euros on March 1, Year 2, is $1.496. A forward contract could be entered into on December 31, Year 1, to sell €1,000,000 for $1,496,000 on March 1, Year 2. Because Eximco is committed to sell €1,000,000 for $1,485,000, the nominal value of the forward contract is negative $11,000. The fair value of the forward contract is the present value of this amount. Assuming that Eximco has an incremental borrowing rate of 12 percent per year (1 percent per month), and discounting for two months (from 12/31/Y1 to 3/1/Y2), the fair value of the forward contract at December 31, Year 1, is negative $10,783 (a liability). On March 1, Year 2, the forward rate to sell euros on that date is the spot rate—$1.48. At that rate, €1,000,000 could be sold for $1,480,000. Because Ex- imco has a contract to sell euros for $1,485,000, the fair value of the forward con- tract on March 1, Year 2, is $5,000. This represents an increase in fair value from December 31, Year 1, of $15,783. The original discount on the forward contract is determined by the difference in the euro spot rate and three-month forward rate on December 1, Year 1: ($1.485  −  $1.50)  ×  €1,000,000  =  $15,000.

Forward Contract Designated as Cash Flow Hedge Assume that Eximco designates the forward contract as a cash ! ow hedge of a foreign-currency-denominated asset. In this case, the original forward discount or premium is allocated to net income over the life of the forward contract using an ef- fective interest method. The company would prepare the following journal entries to account for the foreign currency transaction and the related forward contract:

Year 1 Journal Entries—Forward Contract Designated as a Cash Flow Hedge

12/1/Y1 Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . . . $1,500,000 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500,000 To record the sale and €1,000,000 account receivable

at the spot rate of $1.50 (Step 1 in Exhibit 7.2).

There is no formal entry for the forward contract, as it is an executory contract (no cash changes hands) and has a fair value of zero (Step 2 in Exhibit 7.2 ).

A memorandum would be prepared designating the forward contract as a hedge of the risk of changes in the cash # ow to be received on the foreign currency account receivable resulting from changes in the U.S. dollar–euro exchange rate.

12/31/Y1 Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000 Foreign Exchange Gain . . . . . . . . . . . . . . . . . . . . . . . $10,000 To adjust the value of the euro receivable to the new spot

rate of $1.51 and record a foreign exchange gain resulting from the appreciation of the euro since December 1.

Accumulated Other Comprehensive Income (AOCI) . . . . . . . $10,783 Forward Contract20 . . . . . . . . . . . . . . . . . . . . . . . . . . $10,783 To record the forward contract as a liability at its fair value

of $10,783 with a corresponding debit to AOCI.

20 “Forward Contract” is a generic account title. In practice, the balance sheet line item in which forward contract assets and liabilities are recognized will differ across companies. Chevron Corporation, for example, indicates that the fair values of forward contracts “are reported on the Consolidated Balance Sheet as “Accounts and notes receivable, net” or “Accrued liabilities,” with gains and losses reported in “Other income” (2009 Form 10-K, Note 10: Financial and Derivative Instruments).

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358 Chapter Seven

The ! rst entry on 12/31/Y1 ensures that the foreign-currency-denominated asset is reported on the balance sheet at its current US$ value of $1,510,000 and that its change in US$ value is re# ected as a $10,000 gain in income. The forward contract should be reported on the balance sheet as a liability. Thus, the second entry makes a credit of $10,783 to Forward Contract. Under cash # ow hedge ac- counting, the change in the fair value of the forward contract, which has gone from $0 to $(10,783), is not recognized immediately in income, but is instead deferred in stockholders’ equity. Thus, the debit of $10,783 in the second entry is made to AOCI. The third entry achieves the objective of hedge accounting by transferring $10,000 from AOCI to a loss on forward contract. As a result of this entry, the loss on forward contract of $10,000 and the foreign exchange gain on the account receivable of $10,000 exactly offset one another, and the net impact on income is zero—this is the essence of hedge accounting. As a result of the sec- ond and third entries, the forward contract is reported on the balance sheet as a liability at its fair value of $(10,783); a loss on forward contract is recognized in the amount of $10,000 to offset the foreign exchange gain; and AOCI has a nega- tive (debit) balance of $783. The second and third entries could be combined into one entry as follows:

Loss on Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Accumulated Other Comprehensive Income (AOCI) . . . . . . . . . . . . . . . . 783 Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,783

The negative balance in AOCI of $783 can be understood as that portion of the loss on the forward contract (decrease in fair value of the forward contract) that is not recognized in net income, but instead is deferred in stockholders’ equity. Under cash # ow hedge accounting, a loss on the hedging instrument (forward contract) is recognized only to the extent that it offsets a gain on the item being hedged (account receivable).

The last entry uses the effective interest method to allocate a portion of the $15,000 forward contract discount as an expense to net income. The company cal- culates the implicit interest rate associated with the forward contract by consider- ing the fact that the forward contract will generate cash # ow of $1,485,000 from a foreign currency asset with an initial value of $1,500,000. Because the discount of $15,000 accrues over a three-month period, the effective interest rate is calculated as 1 2 3 √

____________________ $1,485,000y$1,500,000 5 0.003345. The amount of discount to be allocated to

net income for the month of December Year 1 is $1,500,000  ×  0.3345%  =  $5,017. A debit of $5,017 is made to Discount Expense in the last journal entry on 12/31/Y1. By making the credit in this journal entry to AOCI, the theoretically correct amounts are reported in net income and on the balance sheet, and the balance sheet remains in balance, as is shown next.

Loss on Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000 Accumulated Other Comprehensive Income (AOCI) . . . $10,000 To record a loss on forward contract to offset the foreign

exchange gain on account receivable with a corresponding credit to AOCI.

Discount Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,017 Accumulated Other Comprehensive Income

(AOCI). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,017 To allocate the forward contract discount to net income

over the life of the contract using the effective interest method with a corresponding credit to AOCI.

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 359

The effect on the December 31, Year 1, balance sheet is as follows:

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500,000 Foreign Exchange Gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000 Loss on Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (10,000) Net gain (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Discount Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (5,017) Impact on net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,494,983

Assets Liabilities and Stockholders’ Equity

Accounts receivable (€) . . . . $1,510,000 Forward contract . . . . . . . $ 10,783 Retained earnings . . . . . . 1,494,983 AOCI . . . . . . . . . . . . . . . . 4,234

$1,510,000

Year 2 Journal Entries—Forward Contract Designated as Cash Flow Hedge

3/1/Y2 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $30,000 Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . . $30,000 To adjust the value of the euro receivable to the new spot

rate of $1.48 and record a foreign exchange loss resulting from the depreciation of the euro since December 31.

Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,783 Accumulated Other Comprehensive Income (AOCI). . . . $15,783 To adjust the carrying value of the forward contract to its

current fair value of $5,000 with a corresponding credit to AOCI.

Accumulated Other Comprehensive Income (AOCI) . . . . . . . . $30,000 Gain on Forward Contract . . . . . . . . . . . . . . . . . . . . . . $30,000 To record a gain on forward contract to offset the foreign

exchange loss on account receivable with a corresponding debit to AOCI.

Discount Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,983 Accumulated Other Comprehensive Income (AOCI) . . . $9,983 To allocate the remaining forward contract discount to net

income ($15,000 − $5,017 = $9,983) with a corresponding credit to AOCI.

As a result of these entries, the balance in AOCI is zero: $4,234  −   $30,000  +   $15,783  +  $9,983  =  $0.

Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,480,000

Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,480,000

To record receipt of €1,000,000 from the Spanish customer as an asset (Foreign Currency) at the spot rate of $1.48 (Step 3 in Exhibit 7.2).

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,485,000

Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,480,000

Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

The impact on Year 1 net income is as follows:

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360 Chapter Seven

To record settlement of the forward contract, that is, record receipt of $1,485,000 in exchange for delivery of €1,000,000, and remove the forward contract from the accounts (Steps 4 and 5 in Exhibit 7.2).

The net effect on the balance sheet over the two years is an increase in cash of $1,485,000 with a corresponding increase in retained earnings of $1,485,000 ($1,494,983 − $9,983). The cumulative Discount Expense of $15,000 re# ects the cost of extending credit to the Spanish customer.

The net bene! t from having entered into the forward contract is $5,000. Ex- imco has a cash in# ow of $1,485,000 rather than only the $1,480,000 that would have been received without a forward contract. This “gain” is re# ected in net income as the difference between the net Gain on Forward Contract and the cumulative Discount Expense ($20,000  −  $15,000  =  $5,000) recognized over the two periods.

Effective Interest versus Straight-Line Methods Use of the effective interest method results in allocation of the forward contract discount of $5,017 at the end of the ! rst month and $9,983 at the end of the next two months. Straight-line allocation on a monthly basis of the $15,000 discount would result in a reasonable approximation of these amounts:

The impact on Year 2 net income is:

Foreign Exchange Loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(30,000) Gain on Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 Net gain (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Discount Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (9,983) Impact on net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(9,983)

Determining the effective interest rate is complex, and no conceptual insights are gained by its use. For the remainder of this chapter, we use straight-line alloca- tion of forward contract discounts and premiums, as is allowed by the FASB. The important thing to keep in mind in this example is that, with a cash # ow hedge, an expense equal to the original forward contract discount is recognized in net income over the life of the contract.

What if the forward rate on December 1, Year 1, had been $1.506 (i.e., the euro was selling at a premium in the forward market)? In that case, Eximco would re- ceive $6,000 more through the forward sale of euros ($1,506,000) than if the euros had been received and converted into dollars at the date of sale ($1,500,000). The forward contract premium would be allocated as an increase in net income at the rate of $2,000 per month; $2,000 at 12/31/Y1 and $4,000 at 3/1/Y2.

12/31/Y1 . . . . . . . . . . . . . . $15,000 3 1 __ 3 5 $5,000

3/1/Y2 . . . . . . . . . . . . . . . . $15,000 3 2 __ 3 5 $10,000

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 361

Forward Contract Designated as Fair Value Hedge Assume that Eximco decides not to designate the forward contract as a cash # ow hedge, but instead elects to treat it as a fair value hedge. In that case, the gain or loss on the forward contract is taken directly to net income and there is no separate amortization of the original discount on the forward contract.

Year 1 Journal Entries—Forward Contract Designated as a Fair Value Hedge

12/1/Y1 Accounts Receivable (€). . . . . . . . . . . . . . . . . . . . . . . . . $1,500,000 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500,000 To record the sale and €1,000,000 account receivable

at the spot rate of $1.50 (Step 1 in Exhibit 7.2).

There is no formal entry for the forward contract (Step 2 in Exhibit 7.2 ). A memo- randum would be prepared designating the forward contract as a hedge of the risk of changes in the fair value of the foreign currency account receivable resulting from changes in the U.S. dollar–euro exchange rate.

12/31/Y1 Accounts Receivable (€). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000 Foreign Exchange Gain . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000 To adjust the value of the euro receivable to the new spot

rate of $1.51 and record a foreign exchange gain resulting from the appreciation of the euro since December 1.

Loss on Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,783 Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,783 To record the forward contract as a liability at its fair value

of $10,783 and record a forward contract loss for the change in the fair value of the forward contract since December 1.

Assets Liabilities and Stockholders’ Equity

Accounts receivable (€) . . . . $1,510,000 Forward contract . . . . . . $ 10,783 Retained earnings . . . . . 1,499,217

$1,510,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500,000 Foreign Exchange Gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000 Loss on Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . (10,783) Net gain (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (783) Impact on net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,499,217

The impact on Year 1 net income is:

The effect on the December 31, Year 1, balance sheet is:

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362 Chapter Seven

Year 2 Journal Entries—Forward Contract Designated as a Fair Value Hedge

The impact on Year 2 net income is as follows:

3/1/Y2 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000 Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . $ 30,000 To adjust the value of the euro receivable to the new

spot rate of $1.48 and record a foreign exchange loss resulting from the depreciation of the euro since December 31.

Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 15,783 Gain on Forward Contract . . . . . . . . . . . . . . . . . . . . $ 15,783 To adjust the carrying value of the forward contract to its

current fair value of $5,000 and record a forward contract gain for the change in the fair value since December 31.

Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,480,000 Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . $1,480,000 To record receipt of €1,000,000 from the Spanish cus-

tomer as an asset at the spot rate of $1.48 (Step 3 in Exhibit 7.2).

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,485,000 Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . $1,480,000 Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . 5,000 To record settlement of the forward contract, that is, record receipt of $1,485,000 in exchange for delivery of €1,000,000 and remove the forward contract from the accounts (Steps 4 and 5 in Exhibit 7.2).

Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . $(30,000) Gain on Forward Contract . . . . . . . . . . . . . . . . . . . 15,783 Impact on Net Income . . . . . . . . . . . . . . . . . . . . . $(14,217)

The net effect on the balance sheet for the two years is an increase in cash of $1,485,000 with a corresponding increase in retained earnings of $1,485,000  ($1,499,217  −  $14,217).

Under fair value hedge accounting, the original forward contract discount is not amortized systematically over the life of the contract. Instead, it is recognized in income as the difference between the Foreign Exchange Gain (Loss) on the ac- count receivable and the Gain (Loss) on the Forward Contract, that is, $(783) in Year 1 and $(14,217) in Year 2. The net impact on net income over the two years is $(15,000), which re# ects the cost of extending credit to the Spanish customer. The net Gain on Forward Contract of $5,000 ($10,783 loss in Year 1 and $15,783 gain in Year 2) re# ects the net bene! t—that is increase in cash in# ow—from Eximco’s decision to hedge the euro receivable.

The accounting for a fair value hedge of a foreign-currency-denominated asset or liability is the same as if the forward contract were not designated as a hedg- ing instrument; changes in the fair value of the forward contract are immediately recognized in net income. Exhibit  7.3 provides an excerpt from the Coca-Cola Company annual report describing the accounting for forward contracts used as

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 363

hedges of foreign-currency-denominated assets and liabilities that demonstrates this point. Coca-Cola uses the term remeasurement to refer to the process of adjust- ing the value of foreign currency “monetary assets and liabilities,” that is, receiv- ables and payables.

FOREIGN CURRENCY OPTION USED TO HEDGE A RECOGNIZED FOREIGN-CURRENCY-DENOMINATED ASSET

As an alternative to a forward contract, Eximco could hedge its exposure to for- eign exchange risk arising from the euro account receivable by purchasing a for- eign currency put option. A put option would give Eximco the right but not the obligation to sell €1,000,000 on March 1, Year 2, at a predetermined strike price. Assume that on December 1, Year 1, Eximco purchases an over-the-counter op- tion from its bank with a strike price of $1.50 when the spot rate is $1.50 and

COCA-COLA COMPANY Annual Report

2009

Notes to the Consolidated Financial Statements

Excerpt from Note 4: Hedging Transactions and Derivative Financial Instruments

Cash Flow Hedging Strategy

The Company uses cash fl ow hedges to minimize the variability in cash fl ows of assets or liabilities or forecasted transactions caused by fl uctuations in foreign currency exchange rates, commodity prices or interest rates. The changes in the fair values of derivatives designated as cash fl ow hedges are recorded in AOCI and are reclassifi ed into the line item in the consolidated income statement in which the hedged items are recorded in the same period the hedged items affect earnings. The changes in fair values of hedges that are determined to be ineffective are immediately reclassifi ed from AOCI into earnings. The Company did not discontinue any cash fl ow hedging relationships during the year ended December 31, 2009. The maximum length of time over which the Company hedges its exposure to future cash fl ows is typically three years.

The Company maintains a foreign currency cash fl ow hedging program to reduce the risk that our eventual U.S. dollar net cash infl ows from sales outside the United States and U.S. dollar net cash outfl ows from procurement activities will be adversely affected by changes in foreign currency exchange rates. We enter into forward contracts and purchase foreign currency options (principally euros and Japanese yen) and collars to hedge certain portions of forecasted cash fl ows denominated in foreign currencies. When the dollar strengthens against the foreign currencies, the decline in the present value of future foreign currency cash fl ows is partially offset by gains in the fair value of the derivative instruments. Conversely, when the dollar weakens, the increase in the present value of future foreign currency cash fl ows is partially offset by losses in the fair value of the derivative instruments. The total notional value of derivatives that have been designated and qualify for the Company’s foreign currency cash fl ow hedging program as of December 31, 2009, was approximately $3,679 million.

Economic Hedging Strategy

In addition to derivative instruments that are designated and qualify for hedge accounting, the Company also uses certain derivatives as economic hedges. Although these derivatives were not designated and/ or did not qualify for hedge accounting, they are effective economic hedges. The Company primarily uses economic hedges to offset the earnings impact that fl uctuations in foreign currency exchange rates have on certain monetary assets and liabilities denominated in nonfunctional currencies. The changes in fair values of these economic hedges are immediately recognized into earnings in the line item other income (loss)—net. The total notional value of derivatives related to our economic hedges of this type as of December 31, 2009, was approximately $651 million. The Company’s other economic hedges are not signifi cant to the Company’s consolidated fi nancial statements.

EXHIBIT 7.3

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364 Chapter Seven

pays a premium of $0.009 per euro. 21 Thus, the purchase price for the option is $9,000 (€1,000,000  ×  $0.009).

Because the strike price and spot rate are the same, there is no intrinsic value associated with this option. The premium is based solely on time value; that is, it is possible that the euro will depreciate and the spot rate on March 1, Year 2, will be less than $1.50, in which case the option will be in the money. If the spot rate for euros on March 1, Year 2, is less than the strike price of $1.50, Eximco will exercise its option and sell its €1,000,000 at the strike price of $1.50. If the spot rate for euros in three months is greater than the strike price of $1.50, Eximco will not exercise its option and instead will sell euros at the higher spot rate. By purchas- ing this option, Eximco is guaranteed a minimum cash # ow from the export sale of $1,491,000 ($1,500,000 from exercising the option less the $9,000 cost of the option). There is no limit to the maximum number of U.S. dollars that could be received.

As is true for other derivative ! nancial instruments, foreign currency options must be reported on the balance sheet at fair value. The fair value of a foreign cur- rency option at the balance sheet date is determined by reference to the premium quoted by banks on that date for an option with a similar expiration date. Banks (and other sellers of options) determine the current premium by incorporating relevant variables at the balance sheet date into the modi! ed Black-Scholes option pricing model. Changes in value for the euro account receivable and the foreign currency option are summarized as follows:

21 The price of the option (the premium) was determined by the seller of the option through the use of a variation of the Black-Scholes option pricing formula.

Date Fair Value Intrinsic Value Time Value

Change in Time Value

12/1/Y1 $9,000 $0 $9,000 — 12/31/Y1 $6,000 $0 $6,000 −$3,000 3/1/Y2 $20,000 $20,000 $0 −$6,000

The fair value of the foreign currency option can be decomposed into its intrin- sic value and time value components as follows:

Account Receivable (€) Foreign Currency Option

Date Spot Rate U.S.-Dollar

Value

Change in U.S.-Dollar

Value

Option Premium

for 3/1/Y2 Fair Value Change

in Fair Value

12/1/Y1 $1.50 $1,500,000 — $0.009 $9,000 —

12/31/Y1 $1.51 $1,510,000 +$10,000 $0.006 $6,000 −$3,000 3/1/Y2 $1.48 $1,480,000 −$30,000 $0.020 $20,000 +$14,000

Because the option strike price is less than or equal to the spot rate at both December 1 and December 31, the option has no intrinsic value at those dates. The entire fair value is attributable to time value only. On March 1, the date of expiration, there is no time value remaining and the entire amount of fair value is attributable to intrinsic value.

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 365

Option Designated as Cash Flow Hedge Assume that Eximco designates the foreign currency option as a cash ! ow hedge of a foreign-currency-denominated asset. In this case, the change in the option’s time value is recognized immediately in net income. The company prepares the follow- ing journal entries to account for the foreign currency transaction and the related foreign currency option:

Year 1 Journal Entries—Option Designated as a Cash Flow Hedge

12/1/Y1 Accounts Receivable (€). . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500,000 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500,000 To record the sale and €1,000,000 account receivable at

the spot rate of $1.50. Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,000 To record the purchase of the foreign currency option as

an asset at its fair value of $9,000.

12/31/Y1 Accounts Receivable (€). . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000 Foreign Exchange Gain . . . . . . . . . . . . . . . . . . . . . . . $10,000 To adjust the value of the euro receivable to the new

spot rate of $1.51 and record a foreign exchange gain resulting from the appreciation of the euro since December 1.

Accumulated Other Comprehensive Income (AOCI) . . . . . . $ 3,000 Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . $ 3,000 To adjust the fair value of the option from $9,000 to

$6,000 with a corresponding debit to AOCI. Loss on Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . $10,000 Accumulated Other Comprehensive Income (AOCI). . $10,000 To record a loss on foreign currency option to offset the

foreign exchange gain on the euro account receivable with a corresponding credit to AOCI.

Option Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,000 Accumulated Other Comprehensive Income (AOCI). . $ 3,000 To recognize the change in the time value of the option

as a decrease in net income with a corresponding credit to AOCI.

The impact on Year 1 net income is as follows:

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500,000

Foreign Exchange Gain . . . . . . . . . . . . . . . . . . . . . . . . $10,000 Loss on Foreign Currency Option . . . . . . . . . . . . . . . . . (10,000) Net gain (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Option Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,000) Impact on net income . . . . . . . . . . . . . . . . . . . . . . . . . $1,497,000

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366 Chapter Seven

The effect on the December 31, Year 1, balance sheet is:

Assets Liabilities and Stockholders’ Equity

Cash . . . . . . . . . . . . . . . . . . . . $ (9,000) Retained earnings . . . . . . $1,497,000 Accounts receivable (€) . . . . . . 1,510,000 AOCI . . . . . . . . . . . . . . . . 10,000 Foreign currency option . . . . . . 6,000 $1,507,000

$1,507,000

3/1/Y2 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $30,000 Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . . . $30,000 To adjust the value of the euro receivable to the new spot rate

of $0.98 and record a foreign exchange loss resulting from the depreciation of the euro since December 31.

Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14,000 Accumulated Other Comprehensive Income (AOCI) . . . . $14,000 To adjust the fair value of the option from $6,000 to $20,000

with a corresponding credit to AOCI. Accumulated Other Comprehensive Income (AOCI) . . . . . . . . . $30,000 Gain on Foreign Currency Option . . . . . . . . . . . . . . . . . . $30,000 To record a gain on foreign currency option to offset the foreign

exchange gain on account receivable with a corresponding debit to AOCI.

Option Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,000 Accumulated Other Comprehensive Income (AOCI) $6,000 To recognize the change in the time value of the option as a

decrease in net income with a corresponding credit to AOCI. Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,480,000 Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . . . $1,480,000 To record receipt of €1,000,000 from the Spanish customer as an asset at the spot rate of $1.48. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500,000 Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,480,000 Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 To record exercise of the option, that is, record receipt of

$1,500,000 in exchange for delivery of €1,000,000, and remove the foreign currency option from the accounts.

At March 1, Year 2, the option has increased in fair value by $14,000—time value decreases by $6,000, and intrinsic value increases by $20,000. The accounting entries made in Year 2 are as follows:

Year 2 Journal Entries—Option Designated as a Cash Flow Hedge

The impact on Year 2 net income is as follows:

Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(30,000)

Gain on Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . 30,000 Net gain (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Option Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (6,000) Impact on net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(6,000)

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 367

Over the two accounting periods, Eximco would report Sales of $1,500,000 and a cumulative Option Expense of $9,000. The net effect on the balance sheet is an increase in cash of $1,491,000 ($1,500,000  −  $9,000) with a corresponding increase in retained earnings of $1,491,000 ($1,497,000  −  $6,000).

The net bene! t from having acquired the option is $11,000. Eximco has a net cash in# ow of $1,491,000 rather than only $1,480,000 if the option had not been purchased. This “gain” is re# ected in net income as the net Gain on Foreign Currency Option less the cumulative Option Expense ($20,000  −  $9,000  =  $11,000) recognized over the two accounting periods.

Spot Rate Exceeds Strike Price If the spot rate at March 1, Year 2, had been greater than the strike price of $1.50, Eximco would allow its option to expire unexercised. Instead it would sell its for- eign currency (€) at the spot rate. The fair value of the foreign currency option on March 1, Year 2, would be zero. The journal entries for Year 1 to re# ect this sce- nario would be the same as above. The option would be reported as an asset on the December 31, Year 1, balance sheet at $6,000, and the euro receivable would have a carrying value of $1,510,000. The entries on March 1, Year 2, assuming a spot rate on that date of $1.505 (rather than $1.48), would be as follows:

3/1/Y2 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,000 Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . $5,000 To adjust the value of the euro receivable to the new spot rate

of $1.505 and record a foreign exchange loss resulting from the depreciation of the euro since December 31.

Loss on Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . $6,000 Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . $6,000 To adjust the fair value of the option from $6,000 to $0

and record a loss on foreign currency option for the change in fair value since December 31.

Accumulated Other Comprehensive Income (AOCI) . . . . . . . $5,000 Gain on Foreign Currency Option . . . . . . . . . . . . . . . . $5,000 To record a gain on foreign currency option to offset the

foreign exchange loss on account receivable with a corre- sponding debit to AOCI.

Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,505,000 Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . $1,505,000 To record receipt of €1,000,000 from the Spanish customer

as an asset at the spot rate of $1.505. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,505,000 Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . $1,505,000 To record the sale of €1,000,000 at the spot rate of $1.505.

The preceding entries result in a credit balance in AOCI of $5,000. The following entry must be made to close AOCI and recognize a corresponding increase in net income.

AOCI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,000 Adjustment to Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,000 To close the balance in accumulated other comprehensive income as an

adjustment to net income.

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368 Chapter Seven

As a result of the last entry, net income related to this hedged transaction is a total of $1,496,000 ($1,500,000 Sales  −  $9,000  Option Expense  +  $5,000 Adjustment to Net Income), which is exactly equal to the net increase in cash ($1,505,000  −  $9,000). In practice, companies might use a variety of account titles for the adjustment to net income that results from closing AOCI.

Option Designated as Fair Value Hedge If Eximco had decided to designate the foreign currency option as a fair value hedge, the gain or loss on the option would have been taken directly to net income and there would have been no separate recognition of the change in the time value of the option. The net gain (loss) recognized in Year 1 and Year 2 would be dif- ferent from the amounts recognized under the cash # ow hedge, but over the two- year period, the same amount of net income would be recognized. The accounting method (fair value hedge or cash # ow hedge) has no impact on cash # ows or on the net amount of income recognized.

HEDGES OF UNRECOGNIZED FOREIGN CURRENCY FIRM COMMITMENTS

In the examples thus far, Eximco does not enter into a hedge of its export sale until the sale is actually made. Assume now that on December 1, Year 1, Eximco re- ceives and accepts an order from a Spanish customer to deliver goods on March 1, Year 2, at a price of €1,000,000. Assume further that under the terms of the sales agreement, Eximco will ship the goods to the Spanish customer on March 1, Year 2, and will receive immediate payment on delivery. In other words, Eximco will not allow the Spanish customer time to pay. Although Eximco will not make the sale until March 1, Year 2, it has a ! rm commitment to make the sale and receive €1,000,000 in three months. This creates a euro asset exposure to foreign exchange risk as of December 1, Year 1. On that date, Eximco wants to hedge against an ad- verse change in the value of the euro over the next three months. This is known as a hedge of a foreign currency ! rm commitment. Because the results of fair value hedge accounting are intuitively more appealing, we do not cover cash # ow hedge accounting for ! rm commitments.

Under fair value hedge accounting, (1) the gain or loss on the hedging instru- ment is recognized currently in net income and (2) the gain or loss (i.e., the change in fair value) on the ! rm commitment attributable to the hedged risk is also recog- nized currently in net income. This accounting treatment requires (1) measurement of the fair value of the ! rm commitment, (2) recognizing the change in fair value in net income, and (3) reporting the ! rm commitment on the balance sheet as an asset or liability. This raises the conceptual question of how the fair value of the ! rm commitment should be measured. Two possibilities are (1) through reference to changes in the spot exchange rate or (2) through reference to changes in the forward rate. These two approaches are demonstrated in the examples that follow.

Forward Contract Used as Fair Value Hedge of a Firm Commitment To hedge its ! rm commitment exposure to a decline in the U.S.-dollar value of the euro, Eximco decides to enter into a forward contract on December 1, Year 1. As- sume that on December 1, Year 1, the three-month forward rate for euros is $1.485 and Eximco signs a contract with New Manhattan Bank to deliver €1,000,000 in

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 369

three months in exchange for $1,485,000. No cash changes hands on December 1, Year 1. Eximco elects to measure the fair value of the ! rm commitment through changes in the forward rate. As the fair value of the forward contract is also mea- sured using changes in the forward rate, the gains and losses on the ! rm commit- ment and forward contract exactly offset. The fair value of the forward contract and ! rm commitment are determined as follows:

Forward Contract Firm Commitment

Date Forward Rate

to 3/1/Y2 Fair Value Change in Fair Value Fair Value

Change in Fair Value

12/1/Y1 $1.485 $0 — $0 —

12/31/Y1 $1.496 $(10,783)* −$10,783 $10,783* +$10,783 3/1/Y2 $1.48 (spot) $5,000† +$15,783 $(5,000)† −$15,783

* ($1,485,000 − $1,496,000) = $(11,000) × 0.9803 = $(10,783), where 0.9803 is the present value factor for two months at an annual interest rate of 12% (1% per month) calculated as 1/1.01 2 . † ($1,485,000 − $1,480,000) = $5,000.

Eximco pays nothing to enter into the forward contract at December 1, Year 1. Both the forward contract and the ! rm commitment have a fair value of zero on that date. At December 31, Year 1, the forward rate for a contract to deliver euros on March 1, Year 2, is $1.496. A forward contract could be entered into on December 31, Year 1, to sell €1,000,000 for $1,496,000 on March 1, Year 2. Because Eximco is committed to sell €1,000,000 for $1,485,000, the value of the forward contract is negative $11,000; present value is negative $10,783 (a liability). The fair value of the ! rm commitment is also measured through reference to changes in the forward rate. As a result, the fair value of the ! rm commitment is equal in amount but of opposite sign to the fair value of the forward contract. At December 31, Year 1, the ! rm commitment is an asset of $10,783.

On March 1, Year 2, the forward rate to sell euros on that date is the spot rate—$1.48. At that rate, €1,000,000 could be sold for $1,480,000. Because Eximco has a contract to sell euros for $1,485,000, the fair value of the forward contract on March 1, Year 2, is $5,000 (an asset). The ! rm commitment has a value of negative $5,000 (a liability). The journal entries to account for the forward con- tract fair value hedge of a foreign currency ! rm commitment are as follows:

Year 1 Journal Entries—Forward Contract Fair Value Hedge of Firm Commitment

12/1/Y1 There is no entry to record either the sales agreement or the for- ward contract, as both are executory contracts. A memorandum would be prepared designating the forward contract as a hedge of the risk of changes in the fair value of the fi rm commitment result- ing from changes in the U.S. dollar–euro forward exchange rate.

12/31/Y1 Loss on Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,783 Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,783 To record the forward contract as a liability at its fair value of

$(10,783) and record a forward contract loss for the change in the fair value of the forward contract since December 1.

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370 Chapter Seven

Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,783 Gain on Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . $10,783 To record the fi rm commitment as an asset at its fair value of

$10,783 and record a fi rm commitment gain for the change in the fair value of the fi rm commitment since December 1.

Consistent with the objective of hedge accounting, the gain on the ! rm commit- ment offsets the loss on the forward contract and the impact on Year 1 net income is zero. The Forward Contract is reported as a liability and the Firm Commitment is reported as an asset on the 12/31/Y1 balance sheet. This achieves the objective of making sure that derivatives are recognized on the balance sheet and at the same time ensures that there is no impact on net income.

Year 2 Journal Entries—Forward Contract Fair Value Hedge of Firm Commitment

3/1/Y2 Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,783 Gain on Forward Contract . . . . . . . . . . . . . . . . . . . . $15,783 To adjust the fair value of the forward contract from

$(10,783) to $5,000 and record a forward contract gain for the change in fair value since December 31.

Loss on Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . $15,783 Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . $15,783 To adjust the fair value of the fi rm commitment from

$10,783 to $(5,000) and record a fi rm commitment loss for the change in fair value since December 31.

Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,480,000 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,480,000 To record the sale and the receipt of €1,000,000 as an

asset at the spot rate of $1.48. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,485,000 Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . $1,480,000 Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 To record settlement of the forward contract (receipt of

$1,485,000 in exchange for delivery of €1,000,000), and remove the forward contract from the accounts.

Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,000 Adjustment to Net Income . . . . . . . . . . . . . . . . . . . . $5,000 To close the fi rm commitment as an adjustment to net

income.

Once again, the gain on forward contract and the loss on ! rm commitment off- set. As a result of the last entry, the export sale increases Year 2 net income by $1,485,000 ($1,480,000 in Sales plus a $5,000 Adjustment to Net Income). This is exactly equal to the amount of cash received. In practice, companies might use a variety of account titles for the adjustment to net income that results from closing the ! rm commitment account.

The net Gain on Forward Contract of $5,000 ($10,783 loss in Year 1 plus $15,783 gain in Year 2) measures the net bene! t to the company from hedging

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 371

its ! rm commitment. Without the forward contract, Eximco would have sold the €1,000,000 received on March 1, Year 2, at the spot rate of $1.48, generating cash # ow of $1,480,000. Through the forward contract, Eximco is able to sell the euros for $1,485,000, a net gain of $5,000.

Option Used as Fair Value Hedge of Firm Commitment Now assume that to hedge its exposure to a decline in the U.S.-dollar value of the foreign currency ! rm commitment, Eximco purchases a put option to sell €1,000,000 on March 1, Year 2, at a strike price of $1.50. The premium for such an option on December 1, Year 1, is $0.009 per euro. With this option, Eximco is guar- anteed a minimum cash # ow from the export sale of $1,491,000 ($1,500,000 from option exercise less $9,000 cost of the option).

Eximco elects to measure the fair value of the ! rm commitment through refer- ence to changes in the U.S. dollar–euro spot rate. In this case, the fair value of the ! rm commitment must be discounted to its present value. The fair value and changes in fair value for the ! rm commitment and foreign currency option are summarized as follows:

Date

Option Premium

for 3/1/Y2

Foreign Currency Option Firm Commitment

Fair Value Change in Fair

Value Spot Rate Fair Value

Change in Fair Value

12/1/Y1 $0.009 $9,000 — $1.50 — — 12/31/Y1 $0.006 $6,000 −$3,000 $1.51 $9,803* +$9,803 3/1/Y2 $0.020 $20,000 +$14,000 $1.48 $(20,000)† −$29,803

* $1,510,000 − $1,500,000 = $10,000 × 0.9803 = $9,803, where 0.9803 is the present value factor for two months at an annual interest rate of 12% (1% per month) calculated as 1/1.01 2 . † $1,480,000 − $1,500,000 = $(20,000).

At December 1, Year 1, given the spot rate of $1.50, the ! rm commitment to receive €1,000,000 in three months would generate a cash # ow of $1,500,000. At December 31, Year 1, the cash # ow that could be generated from the ! rm commit- ment increases by $10,000 to $1,510,000. The fair value of the ! rm commitment at December 31, Year 1, is the present value of $10,000 discounted at 1 percent per month for two months. The fair value of the ! rm commitment on March 1, Year 2, is determined through reference to the change in the spot rate from December 1, Year 1, to March 1, Year 2. Because the spot rate declines by $0.02 over that period, the ! rm commitment to receive €1,000,000 has a fair value of negative $20,000 on March 1, Year 2. The journal entries to account for the foreign currency option and related foreign currency ! rm commitment are as follows:

Year 1 Journal Entries—Option Fair Value Hedge of Firm Commitment

12/1/Y1 Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,000 Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,000 To record the purchase of the foreign currency option as an asset.

There is no entry to record the sales agreement, as it is an executory contract. A memorandum would be prepared designating the option as a hedge of the risk

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372 Chapter Seven

12/31/Y1 Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,803 Gain on Firm Commitment . . . . . . . . . . . . . . . . . . . . . . $9,803 To record the fi rm commitment as an asset at its fair value of

$9,803 and record a fi rm commitment gain for the change in the fair value of the fi rm commitment since December 1.

Loss on Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . $3,000 Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . $3,000 To adjust the fair value of the option from $9,000 to $6,000

and record the change in the value of the option as a loss.

of changes in the fair value of the ! rm commitment resulting from changes in the spot exchange rate.

The impact on Year 1 net income is as follows:

Gain on Firm Commitment . . . . . . . . . . . . . . . . . . . $9,803 Loss on Foreign Currency option . . . . . . . . . . . . . . . (3,000) Impact on net income . . . . . . . . . . . . . . . . . . . . . . . $6,803

The effect on the December 31, Year 1, balance sheet is as follows:

Assets Liabilities and Stockholders’ Equity

Cash . . . . . . . . . . . . . . . . . . $(9,000) Retained earnings. . . . . $6,803 Foreign currency option . . . . 6,000 Firm commitment . . . . . . . . 9,803

$ 6,803

Year 2 Journal Entries—Option Fair Value Hedge of Firm Commitment

3/1/Y2 Loss on Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . $ 29,803 Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . $ 29,803 To adjust the fair value of the fi rm commitment from

$9,803 to $(20,000) and record a fi rm commitment loss for the change in fair value since December 31.

Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . $ 14,000 Gain on Foreign Currency Option $ 14,000 To adjust the fair value of the foreign currency option

from $6,000 to $20,000 and record a gain on foreign currency option for the change in fair value since December 31.

Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,480,000 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,480,000 To record the sale and the receipt of €1,000,000 as an

asset at the spot rate of $1.48.

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 373

The net increase in net income over the two accounting periods is $1,491,000 ($6,803 in Year 1 plus $1,484,197 in Year 2), which is exactly equal to the net cash # ow realized on the export sale ($1,500,000 from exercising the option less $9,000 to purchase the option). The net gain on option of $11,000 (loss of $3,000 in Year 1 plus gain of $14,000 in Year 2) re# ects the net bene! t from having entered into the hedge. Without the option, Eximco would have sold the €1,000,000 received on March 1, Year 2, at the spot rate of $1.48 for $1,480,000.

HEDGE OF FORECASTED FOREIGN-CURRENCY-DENOMINATED TRANSACTION

Cash # ow hedge accounting is used for foreign currency derivatives that hedge the cash # ow risk associated with a forecasted foreign currency transaction. For hedge accounting to apply, the forecasted transaction must be probable (likely to occur), the hedge must be highly effective in offsetting # uctuations in the cash # ow associated with the foreign currency risk, and the hedging relationship must be properly documented.

The accounting for a hedge of a forecasted transaction differs from the account- ing for a hedge of a foreign currency ! rm commitment in two ways:

1. Unlike the accounting for a ! rm commitment, there is no recognition of the forecasted transaction or gains and losses on the forecasted transaction.

2. The hedging instrument (forward contract or option) is reported at fair value, but because there is no gain or loss on the forecasted transaction to offset against, changes in the fair value of the hedging instrument are not reported as gains and losses in net income. Instead they are reported in other comprehen- sive income. On the projected date of the forecasted transaction, the cumulative change in the fair value of the hedging instrument is transferred from other comprehensive income (balance sheet) to net income (income statement).

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500,000 Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . $1,480,000 Foreign Currency Option . . . . . . . . . . . . . . . . . . . 20,000 To record exercise of the foreign currency option (receipt

of $1,500,000 in exchange for delivery of €1,000,000), and remove the foreign currency option from the accounts.

Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000 Adjustment to Net Income . . . . . . . . . . . . . . . . . . $ 20,000 To close the fi rm commitment as an adjustment to net

income.

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,480,000 Loss on Firm Commitment . . . . . . . . . . . . . . . . . . (29,803) Gain on Foreign Currency Option . . . . . . . . . . . . . 14,000 Adjustment to Net Income . . . . . . . . . . . . . . . . . . 20,000 Impact on net income . . . . . . . . . . . . . . . . . . . . $1,484,197

The impact on Year 2 net income is as follows:

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374 Chapter Seven

Option Designated as a Cash Flow Hedge of a Forecasted Transaction To demonstrate the accounting for a hedge of a forecasted foreign currency trans- action, assume that Eximco has a long-term relationship with its Spanish customer and can reliably forecast that the customer will require delivery of goods costing €1,000,000 in March of Year 2. Con! dent that it will receive €1,000,000 on March 1, Year 2, Eximco hedges its forecasted foreign currency transaction by purchasing a €1,000,000 put option on December 1, Year 1. The facts are essentially the same as for the option hedge of a ! rm commitment, except that Eximco does not receive a sales order from the Spanish customer until late February, Year 2.

The option, which expires on March 1, Year 2, has a strike price of $1.50 and a premium of $0.009 per euro. The fair value of the option at relevant dates is as follows:

Date

Option Premium

for 3/1/Y2

Foreign Currency Option

Fair Value Change in Fair Value

Intrinsic Value

Time Value

Change in Time Value

12/1/Y1 $0.009 $9,000 — $0 $9,000 —

12/31/Y1 $0.006 $6,000 −$3,000 $0 $6,000 −$3,000 3/1/Y2 $0.020 $20,000 −$14,000 $20,000 $0 −$6,000

Year 1 Journal Entries—Option Hedge of a Forecasted Transaction

12/1/Y1 Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,000 To record the purchase of the foreign currency option as an asset.

12/31/Y1 Option Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000 Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . $3,000 To adjust the carrying value of the option to its fair value and

recognize the change in the time value of the option as an expense.

There is no entry to record the forecasted sale. A memorandum would be pre- pared designating the foreign currency option as a hedge of the risk of changes in the cash # ows related to the forecasted sale.

Option Expense . . . . . . . . . . . . . . . . . . . . . . . . . $(3,000) Impact on net income . . . . . . . . . . . . . . . . . . $(3,000)

The impact on Year 1 net income is as follows:

A Foreign Currency Option of $6,000 is reported as an asset on the December 31, Year 1, balance sheet. Cash decreases by $9,000, and retained earnings decreases by $3,000.

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 375

3/1/Y2 Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14,000 Option Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 Accumulated Other Comprehensive Income (AOCI). . . $20,000 To adjust the carrying value of the option to its fair value

and recognize the change in the time value of the option as an expense, with a corresponding credit to AOCI.

Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,480,000 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,480,000 To record the sale and the receipt of €1,000,000 as an asset

at the spot rate of $0.98. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500,000 Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . $1,480,000 Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . 20,000 To record exercise of the foreign currency option (receipt of

$1,000,000 in exchange for delivery of €1,000,000), and remove the foreign currency option from the accounts.

Accumulated Other Comprehensive Income (AOCI) . . . . . . . $20,000 Adjustment to Net Income . . . . . . . . . . . . . . . . . . . . . $20,000 To close AOCI as an adjustment to net income.

Year 2 Journal Entries—Option Hedge of a Forecasted Transaction

The impact on Year 2 net income is as follows:

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,480,000 Option Expense . . . . . . . . . . . . . . . . . . . . (6,000) Adjustment to Net Income . . . . . . . . . . . 20,000 Impact on net income . . . . . . . . . . . . . $1,494,000

Over the two-year period, net income increases by $1,491,000 ($1,494,000 in Year 2 minus $3,000 in Year 1), equal to the net cash in# ow realized from the export sale.

USE OF HEDGING INSTRUMENTS

There probably are as many different corporate strategies regarding hedging for- eign exchange risk as there are companies exposed to that risk. Some companies simply require hedges of all foreign currency transactions. Others require the use of a forward contract hedge when the forward rate results in a greater cash in# ow or smaller cash out# ow than with the spot rate. Still other companies have propor- tional hedging policies that require hedging on some predetermined percentage (e.g., 50 percent, 60 percent, or 70 percent) of transaction exposure.

It is quite common for companies to use foreign currency derivatives to hedge the exposure to foreign exchange risk arising from forecasted foreign currency

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376 Chapter Seven

transactions. Exhibit 7.4 presents information provided by two U.S.-based com- panies with respect to hedging forecasted transactions. International Business Machines Corporation (IBM) uses forward contracts to hedge transactions that are anticipated to take place in no longer than four years. In contrast, Boeing Company uses both forward contracts and options to hedge future transactions principally occurring up to ! ve years in the future, with certain contracts hedging transactions up to the year 2021.

The notes to ! nancial statements of multinational companies also indicate the magnitude of foreign exchange risk and the importance of hedging contracts. Exhibit 7.5 presents information extracted from Abbott Laboratories’ 2012 Annual Report. At December 31, 2012, Abbott had $1.6 billion in foreign currency for- ward contracts related to anticipated foreign currency transactions and $18.2 bil- lion in forward contracts used to hedge foreign-currency-denominated payables and receivables. To better appreciate the signi! cance of these amounts, consider that Abbott had assets of $67.2 billion, sales of $39.9 billion, and net earnings of $6.0 billion in 2012.

INTERNATIONAL BUSINESS MACHINES CORPORATION Annual Report

2012

Excerpt from Note D. Financial Instruments

Anticipated Royalties and Cost Transactions

The company’s operations generate signifi cant nonfunctional currency, third-party vendor payments and intercompany payments for royalties and goods and services among the company’s non-U.S. subsidiaries and with the parent company. In anticipation of these foreign currency cash fl ows and in view of the volatility of the currency markets, the company selectively employs foreign exchange forward contracts to manage its currency risk. These forward contracts are accounted for as cash fl ow hedges. The maximum length of time over which the company is hedging its exposure to the variability in future cash fl ows is approximately four years. At December 31, 2012, the total notional amount of forward contracts designated as cash fl ow hedges of forecasted royalty and cost transactions was $10.7 billion, with a weighted-average remaining maturity of 0.7 years.

THE BOEING COMPANY Annual Report

2012

Excerpt from Note 18—Derivative Financial Instruments Cash Flow Hedges

Our cash fl ow hedges include foreign currency forward contracts, foreign currency option contracts, and commodity purchase contracts. We use foreign currency forward and option contracts to manage currency risk associated with certain transactions, specifi cally forecasted sales and purchases made in foreign currencies. Our foreign currency contracts hedge forecasted transactions principally occurring within fi ve years in the future, with certain contracts hedging transactions up to 2021.

Derivative Instruments Not Receiving Hedge Accounting Treatment

We also hold certain derivative instruments, primarily foreign currency forward contracts, for risk management purposes that are not receiving hedge accounting treatment.

Author’s note: Emphasis added.

EXHIBIT 7.4 Hedges of Forecasted Foreign Currency Transactions

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 377

Dell Inc. uses “foreign currency option contracts and forward contracts to hedge our exposure on forecasted transactions and ! rm commitments for cer- tain currencies. During Fiscal 2013, we hedged our exposures on more than 20 currencies.” 22 The Coca-Cola Company reports using a combination of forward contracts, options, and collars in its foreign currency hedging strategy. 23

FOREIGN CURRENCY BORROWING

In addition to the receivables and payables that arise from import and export ac- tivities, companies often must account for foreign currency borrowings, another type of foreign currency transaction. Companies borrow foreign currency from foreign lenders either to ! nance foreign operations or perhaps to take advantage of more favorable interest rates. Accounting for a foreign currency borrowing is complicated by the fact that both the principal and interest are denominated in foreign currency and both create an exposure to foreign exchange risk.

To demonstrate the accounting for foreign currency debt, assume that on July 1, Year 1, Mapleleaf International (a company based in Canada) borrowed 1 billion Japanese yen (¥) on a one-year note at a per annum interest rate of

ABBOTT LABORATORIES Annual Report

2012

Notes to Consolidated Financial Statements Note 3—Financial Instruments, Derivatives and Fair Value Measures

Certain Abbott foreign subsidiaries enter into foreign currency forward exchange contracts to manage exposures to changes in foreign exchange rates for anticipated intercompany purchases by those subsidiaries whose functional currencies are not the U.S. dollar. These contracts, totaling $1.6 billion at December 31, 2012 and 2011 and $1.3 billion at December 31, 2010, are designated as cash fl ow hedges of the variability of the cash fl ows due to changes in foreign exchange rates and are recorded at fair value. Accumulated gains and losses as of December 31, 2012 will be included in Cost of products sold at the time the products are sold, generally through the next twelve months.

Abbott enters into foreign currency forward exchange contracts to manage currency exposures for foreign currency denominated third-party trade payables and receivables, and for intercompany loans and trade accounts payable where the receivable or payable is denominated in a currency other than the functional currency of the entity. For intercompany loans, the contracts require Abbott to sell or buy foreign currencies, primarily European currencies and Japanese yen, in exchange for primarily U.S. dollars and other European currencies. For intercompany and trade payables and receivables, the currency exposures are primarily the U.S. dollar, European currencies and Japanese yen. At December 31, 2012, 2011, and 2010, Abbott held $18.2 billion, $15.7 billion, and $10.8 billion, respectively, of such foreign currency forward exchange contracts.

EXHIBIT 7.5

22 Dell Inc., 2013 Form 10-K, p. 59. 23 A foreign currency collar can be created by simultaneously purchasing a call option and selling a put option to fi x a range of prices at which foreign currency can be purchased at a predetermined future date.

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378 Chapter Seven

Date

Canadian Dollars (C$) per Japanese Yen (¥)

Spot Rate

July 1, Year 1 . . . . . . . . . . . . . . . . . C$0.00921

December 31, Year 1 . . . . . . . . . . . 0.00932

July 1, Year 2 . . . . . . . . . . . . . . . . . 0.00937

On July 1, Year 1, Mapleleaf borrows ¥1,000,000,000 and converts it into C$9,210,000 in the spot market. Over the life of the note, Mapleleaf must record ac- crued interest expense at year-end and interest payments on the anniversary date of July 1. In addition, the Japanese yen note payable must be revalued at year-end, with foreign exchange gains and losses reported in income. The journal entries to account for this foreign currency borrowing are as follows:

July 1, Year 1 Dr. Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,210,000 Cr. Note Payable (¥). . . . . . . . . . . . . . . . . . . 9,210,000 To record the yen note payable at the spot

rate of C$0.00921 and the conversion of ¥1,000,000,000 into Canadian dollars.

December 31, Year 1 Dr. Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . 233,000 Cr. Accrued Interest Payable (¥) . . . . . . . . . . 233,000 To accrue interest for the period July 1–December

31, Year 2: (¥1,000,000,000 3 5% 3 ¹– ² year 5

¥25,0000,000 × C$0.00932 = C$233,0000. Dr. Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . 110,000 Cr. Note Payable (¥). . . . . . . . . . . . . . . . . . . 110,000 To revalue the yen note payable at the spot rate

of C$0.00932 and record a foreign exchange loss of C$110,000 (¥1,000,000,000 × [C$0.00932 − C$0.00921]).

July 1, Year 2 Dr. Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . 234,250 Accrued Interest Payable (¥) . . . . . . . . . . . . . . . . 233,000 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . 1,250 Cr. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 468,500 To record the interest payment of ¥50,000,000

acquired at the spot rate of C$0.00937 for C$468,500; interest expense for the period January 1–July 1, Year 2 (¥25,000,000 × C$0.00937); and a foreign exchange loss on the yen accrued interest payable (¥ 25,000,000 × [C$0.00937 − C$0.00932]).

Dr. Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . 50,000 Cr. Note Payable (¥). . . . . . . . . . . . . . . . . . . 50,000 To revalue the yen note payable at the spot rate

of C$0.00937 and record a foreign exchange loss of C$50,000 (¥1,000,000,000 × [C$0.00937 − C$0.00932]).

5 percent. Interest is payable and the note comes due on July 1, Year 2. The follow- ing exchange rates apply:

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 379

Foreign Currency Loan At times companies might lend foreign currency to related parties, creating the opposite situation to that with a foreign currency borrowing. The accounting will involve keeping track of a note receivable and interest receivable, both of which are denominated in foreign currency. Fluctuations in the U.S.-dollar value of the principal and interest will generally give rise to foreign exchange gains and losses, which would be included in income. Under U.S. GAAP, an exception arises when the foreign currency loan is being made on a long-term basis to a foreign branch, subsidiary, or equity method af! liate. Foreign exchange gains and losses on “in- tercompany foreign currency transactions that are of a long-term investment na- ture (that is, settlement is not planned or anticipated in the foreseeable future)” are reported in other comprehensive income until the loan is repaid. Only the foreign exchange gains and losses related to the interest receivable would be recorded currently in net income.

Summary 1. There are a variety of exchange rate mechanisms in use around the world. A majority of national currencies are allowed to # uctuate in value against other currencies over time.

2. Exposure to foreign exchange risk exists when a payment to be made or re- ceived is denominated in terms of a foreign currency. Appreciation in a foreign currency will result in a foreign exchange gain on a foreign currency receivable and a foreign exchange loss on a foreign currency payable. Conversely, a de- crease in the value of a foreign currency will result in a foreign exchange loss on a foreign currency receivable and a foreign exchange gain on a foreign currency payable.

3. Foreign exchange gains and losses on foreign currency balances are recorded in income in the period in which an exchange rate change occurs; this is a two- transaction perspective, accrual approach. Foreign currency balances must be revalued to their current domestic-currency equivalent using current exchange rates whenever ! nancial statements are prepared. This approach violates the conservatism principle when unrealized foreign exchange gains are recognized as income.

4. Exposure to foreign exchange risk can be eliminated through hedging. Hedging involves establishing a price today at which a foreign currency to be received in the future can be sold in the future or at which a foreign currency to be paid in the future can be purchased in the future.

5. The two most popular instruments for hedging foreign exchange risk are for- eign currency forward contracts and foreign currency options. A forward con- tract is a binding agreement to exchange currencies at a predetermined rate. An

Dr. Note Payable (¥) . . . . . . . . . . . . . . . . . . . . . . . . 9,370,000 Cr. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,370,000 To record repayment of the ¥1,000,000,000

note through purchase of yen at the spot rate of C$0.00937.

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380 Chapter Seven

option gives the buyer the right, but not the obligation, to exchange currencies at a predetermined rate.

6. Derivative ! nancial instruments must be reported on the balance sheet at their fair value. Hedge accounting is appropriate if the derivative is ( a ) used to hedge an exposure to foreign exchange risk, ( b ) highly effective in offsetting changes in the fair value or cash # ows related to the hedged item, and ( c ) properly docu- mented as a hedge. Under hedge accounting, gains and losses on the hedging instrument are reported in net income in the same period as gains and losses on the item being hedged.

7. Accounting standards provide guidance for hedges of ( a ) recognized foreign- currency-denominated assets and liabilities, ( b ) unrecognized foreign currency ! rm commitments, and ( c ) forecasted foreign-currency-denominated transac- tions. Cash # ow hedge accounting can be used for all three types of hedges; fair value hedge accounting can be used only for ( a ) and ( b ).

Appendix to Chapter 7

Illustration of the Accounting for Foreign Currency Transactions and Hedging Activities by an Importer This appendix provides illustrations of the accounting for the following types of hedges used by an importing company:

1. Forward contract cash # ow hedge of a recognized foreign currency liability. 2. Forward contract fair value hedge of a recognized foreign currency liability. 3. Option cash # ow hedge of a recognized foreign currency liability. 4. Forward contract fair value hedge of a foreign currency ! rm commitment. 5. Option fair value hedge of a foreign currency ! rm commitment. 6. Option cash # ow hedge of a forecasted foreign currency transaction.

BASIC FACTS Telectro Company is a U.S. company that produces electronic switches for the telecommunications industry. Telectro regularly imports component parts from a supplier located in Guadalajara, Mexico, with payments made in Mexican pesos (Mex$). The following spot exchange rates, forward exchange rates, and call op- tion premiums for Mexican pesos exist during the period August to October.

US$ per Mexican Peso

Date Spot Rate Forward Rate to October 31

Call Option Premium for October 31 (strike price $0.080)

August 1 . . . . . . . . . . . . . . . . . $0.080 $0.085 $0.0052 September 30 . . . . . . . . . . . . . 0.086 0.088 0.0095 October 31 . . . . . . . . . . . . . . . 0.091 0.091 0.0110

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 381

1. Forward Contract Cash Flow Hedge of a Recognized Foreign Currency Liability On August 1, Telectro imports parts from its Mexican supplier at a price of Mex$1,000,000. The parts are received on August 1, but are not paid for until October 31. In addition, on August 1, Telectro enters into a forward contract to purchase Mex$1,000,000 on October 31. The forward contract is appropriately designated as a cash ! ow hedge of the Mexican peso liability exposure. Telectro’s incremental borrowing rate is 12 percent per annum (1 percent per month), and the company uses a straight-line method on a monthly basis for allocating forward discounts and premiums.

Journal Entries and Impact on the September 30 and October 31 Trial Balances

8/1 Parts Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $80,000 Accounts Payable (Mex$) . . . . . . . . . . . . . . . . . . . . . . . . . $80,000 To record the purchase of parts and a Mexican peso account

payable at the spot rate of $0.080.

There is no formal entry for the forward contract. A memorandum would be pre- pared designating the forward contract as a hedge of the risk of changes in the cash # ow to be paid on the foreign currency payable resulting from changes in the U.S. dollar–Mexican peso exchange rate.

9/30 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,000 Accounts Payable (Mex$) . . . . . . . . . . . . . . . . . . . . . . . . . . $6,000 To adjust the value of the peso payable to the new spot rate of

$0.086 and record a foreign exchange loss resulting from the appreciation of the peso since August 1.

Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,970 Accumulated Other Comprehensive Income (AOCI) . . . . . . $2,970 To record the forward contract as an asset at its fair value of

$2,970 with a corresponding credit to AOCI. Accumulated Other Comprehensive Income (AOCI) . . . . . . . . . . . $6,000 Gain on Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . $6,000 To record a gain on forward contract to offset the foreign

exchange loss on account payable with a corresponding debit to AOCI.

The fair value of the forward contract is determined by reference to the change in the forward rate for a contract that settles on October 31: ($0.088  −  $0.085)  ×   Mex$1,000,000  =  $3,000. The present value of $3,000 discounted for one month (from October 31 to September 30) at an interest rate of 12 percent per year (1 percent per month) is calculated as follows: $3,000  ×  0.9901  =  $2,970.

Premium Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,333

Accumulated Other Comprehensive Income (AOCI) . . . . . . . . . . . . . . . . $3,333

To allocate the forward contract premium to income over the life of the contract using a straight-line method on a monthly basis ($5,000 3 2 _ 3 5 $3,333).

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382 Chapter Seven

The original premium on the forward contract is determined by the difference in the Mexican peso spot rate and three-month forward rate on August 1: ($0.085  −   $0.080)  ×  Mex$1,000,000  =  $5,000.

Trial Balance—September 30 Debit Credit

Parts Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $80,000 Accounts Payable (Mex$) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $86,000 Forward Contract (asset) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,970 AOCI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 Gain on Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 Premium Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,333

$92,303 $92,303

The current fair value of the forward contract is determined by reference to the difference in the spot rate on October 31 and the original forward rate: ($0.091  −   $0.085)  ×  Mex$1,000,000  =  $6,000. The forward contract adjustment on October 31 is calculated as the difference in the current fair value and the carrying value at September 30: $6,000  −  $2,970  =  $3,030.

10/31 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,000 Accounts Payable (Mex$) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,000 To adjust the value of the peso payable to the new spot rate of

$0.091 and record a foreign exchange loss resulting from the appreciation of the peso since September 30.

Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,030 Accumulated Other Comprehensive Income (AOCI) . . . . . . . . $3,030 To adjust the carrying value of the forward contract to its current

fair value of $6,000 with a corresponding credit to AOCI. Accumulated Other Comprehensive Income (AOCI) . . . . . . . . . . . . . $5,000 Gain on Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,000 To record a gain on forward contract to offset the foreign exchange

loss on account payable with a corresponding debit to AOCI.

Premium Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,667 Accumulated Other Comprehensive Income (AOCI) . . . . . . . . . . . . . $1,667

To allocate the forward contract premium to income over the life of the contract using a straight-line method on a monthly basis ($5,000 3 1 _ 3 5 $1,667).

Foreign Currency (Mex$) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $91,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $85,000 Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 383

To record settlement of the forward contract: record payment of $85,000 in exchange for Mex$1,000,000, record the receipt of Mex$1,000,000 as an asset at the spot rate of $0.091, and remove the forward contract from the accounts.

Accounts Payable (Mex$) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $91,000 Foreign Currency (Mex$) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $91,000 To record remittance of Mex$1,000,000 to the Mexican supplier.

Trial Balance—October 31 Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $85,000 Parts Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $80,000 Retained Earnings, 9/30 . . . . . . . . . . . . . . . . . . . . . . . 3,333 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . 5,000 Gain on Forward Contract . . . . . . . . . . . . . . . . . . . . . 5,000 Premium Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,667

$90,000 $90,000

2. Forward Contract Fair Value Hedge of a Recognized Foreign Currency Liability The facts are the same as in (1), with the exception that Telectro designates the forward contract as a fair value hedge of the Mexican peso liability exposure.

Journal Entries and Impact on the September 30 and October 31 Trial Balances

8/1 Parts Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $80,000

Accounts Payable (Mex$) . . . . . . . . . . . . . . . . . . . . . . . . $80,000

To record the purchase of parts and a Mexican peso account payable at the spot rate of $0.080.

9/30 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,000

Accounts Payable (Mex$) . . . . . . . . . . . . . . . . . . . . . . . . . $6,000

To adjust the value of the peso payable to the new spot rate of $0.086 and record a foreign exchange loss resulting from the appreciation of the peso since August 1.

Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,970

Gain on Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . $2,970 To record the forward contract as an asset at its fair value of

$2,970 and record a forward contract gain for the change in the fair value of the forward contract since August 1.

There is no formal entry for the forward contract. A memorandum would be pre- pared designating the forward contract as a hedge of the risk of changes in the cash # ow to be paid on the foreign currency payable resulting from changes in the U.S. dollar–Mexican peso exchange rate.

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384 Chapter Seven

Trial Balance—September 30 Debit Credit

Parts Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $80,000 Accounts Payable (Mex$) . . . . . . . . . . . . . . . . . . . . . . . . . . . $86,000 Forward Contract (asset) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,970 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 Gain on Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . 2,970

$88,970 $88,970

10/31 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,000

Accounts Payable (Mex$) . . . . . . . . . . . . . . . . . . . . . . . $5,000

To adjust the value of the peso payable to the new spot rate of $0.091 and record a foreign exchange loss resulting from the appreciation of the peso since September 30.

Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,030

Gain on Forward Contract . . . . . . . . . . . . . . . . . . . . . . $3,030

To adjust the carrying value of the forward contract to its cur- rent fair value of $6,000 and record a forward contract gain for the change in fair value since September 30.

Foreign Currency (Mex$) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $91,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $85,000

Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

To record settlement of the forward contract: record payment of $85,000 in exchange for Mex$1,000,000, record the receipt of Mex$1,000,000 as an asset at the spot rate of $0.091, and remove the forward contract from the accounts.

Accounts Payable (Mex$) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $91,000

Foreign Currency (Mex$) . . . . . . . . . . . . . . . . . . . . . . . $91,000

To record remittance of Mex$1,000,000 to the Mexican supplier.

Trial Balance—October 31 Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $85,000 Parts Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $80,000 Retained Earnings, 9/30 . . . . . . . . . . . . . . . . . . . . . . 3,030 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . 5,000 Gain on Forward Contract . . . . . . . . . . . . . . . . . . . . 3,030

$88,030 $88,030

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 385

3. Option Cash Flow Hedge of a Recognized Foreign Currency Liability On August 1, Telectro imports parts from its Mexican supplier at a price of Mex$1,000,000. The parts are received on August 1 but are not paid for until October 31. In addition, on August 1, Telectro purchases a three-month call option on Mex$1,000,000 with a strike price of $0.080. The option is appropriately desig- nated as a cash ! ow hedge of the Mexican peso liability exposure.

The following schedule summarizes the changes in the components of the fair value of the Mexican peso call option with a strike price of $0.080:

Date Spot Rate

Option Premium

Fair Value

Change in Fair Value

Intrinsic Value

Time Value

Change in Time Value

8/1 $0.080 $0.0052 $5,200 — $0 $5,200a — 9/30 $0.086 $0.0095 $9,500 +$4,300 $ 6,000b $3,500b −$1,700 10/31 $0.091 $0.0110 $11,000 +$1,500 $11,000 $0c −$3,500

a Because the strike price and spot rate are the same, the option has no intrinsic value. Fair value is attributable solely to the time value of the option. b With a spot rate of $0.086 and a strike price of $0.080, the option has an intrinsic value of $6,000. The remaining $3,500 of fair value is attributable to the time value. c The time value of the option at maturity is zero.

8/1 Parts Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $80,000

Accounts Payable (Mex$) . . . . . . . . . . . . . . . . . . . . . . . . . . $80,000

To record the purchase of parts and a Mexican peso account payable at the spot rate of $0.080.

Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,200 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,200 To record the purchase of a foreign currency option as an asset.

9/30 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,000 Accounts Payable (Mex$) . . . . . . . . . . . . . . . . . . . . . . . . . . $6,000 To adjust the value of the peso payable to the new spot rate of

$0.086 and record a foreign exchange loss resulting from the appreciation of the peso since August 1.

Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,300 Accumulated Other Comprehensive Income (AOCI) . . . . . . $4,300 To adjust the fair value of the option from $5,200 to $9,500

with a corresponding credit to AOCI. Accumulated Other Comprehensive Income (AOCI) . . . . . . . . . . . $6,000 Gain on Foreign Currency Option . . . . . . . . . . . . . . . . . . . . $6,000 To record a gain on foreign currency option to offset the foreign

exchange loss on account payable with a corresponding debit to AOCI.

Journal Entries and Impact on the September 30 and October 31 Trial Balances

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386 Chapter Seven

Trial Balance—September 30 Debit Credit

Parts Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $80,000 Accounts Payable (Mex$) . . . . . . . . . . . . . . . . . . . . . . . . . . . $86,000 Foreign Currency Option (asset) . . . . . . . . . . . . . . . . . . . . . . 9,500 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,200 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 Gain on Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . 6,000 Option Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700

$97,200 $97,200

10/31 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,000

Accounts Payable (Mex$) . . . . . . . . . . . . . . . . . . . . . . . . . . $5,000

To adjust the value of the peso payable to the new spot rate of $0.091 and record a foreign exchange loss resulting from the appreciation of the peso since September 30.

Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500

Accumulated Other Comprehensive Income (AOCI) . . . . . . $1,500

To adjust the carrying value of the foreign currency option to its current fair value of $11,000 with a corresponding credit to AOCI.

Accumulated Other Comprehensive Income (AOCI) . . . . . . . . . . . $5,000

Gain on Foreign Currency Option . . . . . . . . . . . . . . . . . . . . $5,000

To record a gain on foreign currency option to offset the foreign exchange loss on account payable with a corresponding debit to AOCI.

Option Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,500

Accumulated Other Comprehensive Income (AOCI) . . . . . . $3,500

To recognize the change in the time value of the foreign currency option as an expense with a corresponding credit to AOCI.

Foreign Currency (Mex$) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $91,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $80,000

Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000

To record exercise of the foreign currency option: record payment of $80,000 in exchange for Mex$1,000,000, record the receipt of Mex$1,000,000 as an asset at the spot rate of $0.091, and remove the option from the accounts.

Accounts Payable (Mex$) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $91,000

Foreign Currency (Mex$) . . . . . . . . . . . . . . . . . . . . . . . . . . $91,000

To record remittance of Mex$1,000,000 to the Mexican supplier.

Option Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,700 Accumulated Other Comprehensive Income (AOCI) . . . . . . $1,700 To recognize the change in the time value of the foreign currency

option as an expense with a corresponding credit to AOCI.

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 387

Trial Balance—October 31 Debit Credit

Cash ($5,200 credit + $80,000 credit) . . . . . . . . . . . . . . . . . . . . $85,200 Parts Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $80,000 Retained Earnings, 9/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 Gain on Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . 5,000 Option Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500

$90,200 $90,200

4. Forward Contract Fair Value Hedge of a Foreign Currency Firm Commitment On August 1, Telectro orders parts from its Mexican supplier at a price of Mex$1,000,000. The parts are received and paid for on October 31. On August 1, Telectro enters into a forward contract to purchase Mex$1,000,000 on October 31. The forward contract is designated as a fair value hedge of the Mexican peso ! rm commitment. The fair value of the ! rm commitment is determined through refer- ence to changes in the forward exchange rate.

Journal Entries and Impact on the September 30 and October 31 Trial Balances

8/1 There is no formal entry for the forward contract or the purchase order. A memorandum would be prepared designating the forward contract as a fair value hedge of the foreign currency fi rm commitment.

9/30 Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,970

Gain on Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,970

To record the forward contract as an asset at its fair value of $2,970 and record a forward contract gain for the change in the fair value of the forward contract since August 1.

Loss on Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,970

Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,970

To record the fi rm commitment as a liability at its fair value of $2,970 based on changes in the forward rate and record a fi rm commitment loss for the change in fair value since August 1.

Trial Balance—September 30 Debit Credit

Forward Contract (asset) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,970 Firm Commitment (liability) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,970 Gain on Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,970 Loss on Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,970

$5,940 $5,940

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388 Chapter Seven

Note that the ! nal entry to close the Firm Commitment as an Adjustment to Net Income will be made only in the period in which the Parts Inventory affects net income through Cost of Goods Sold. The Firm Commitment remains on the books as a liability until that time.

10/31 Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,030

Gain on Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . $3,030

To adjust the carrying value of the forward contract to its current fair value of $6,000 and record a forward contract gain for the change in fair value since September 30.

Loss on Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,030

Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,030

To adjust the value of the fi rm commitment to $6,000 based on changes in the forward rate and record a fi rm commitment loss for the change in fair value since September 30.

Foreign Currency (pesos) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $91,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $85,000

Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

To record settlement of the forward contract: record payment of $85,000 in exchange for Mex$1,000,000, record the receipt of 1 million pesos as an asset at the spot rate of $0.091, and remove the forward contract from the accounts.

Parts Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $91,000

Foreign Currency (Mex$) . . . . . . . . . . . . . . . . . . . . . . . . . . . $91,000

To record the purchase of parts through the payment of Mex$1,000,000 to the Mexican supplier.

Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,000

Adjustment to Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . $6,000

To close the fi rm commitment account as an adjustment to net income.

Trial Balance—October 31 Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $85,000 Parts Inventory (Cost of Goods Sold) . . . . . . . . . . . . . . . . . $91,000 Gain on Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . 3,030 Loss on Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . 3,030 Adjustment to Net Income . . . . . . . . . . . . . . . . . . . . . . . . 6,000

$94,030 $94,030

5. Option Fair Value Hedge of a Foreign Currency Firm Commitment On August 1, Telectro orders parts from its Mexican supplier at a price of Mex$1,000,000. The parts are received and paid for on October 31. On August 1, Telectro purchases a three-month call option on Mex$1,000,000 with a strike price of $0.080. The option is appropriately designated as a fair value hedge of the

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 389

Mexican peso ! rm commitment. The fair value of the ! rm commitment is deter- mined through reference to changes in the spot exchange rate.

Journal Entries and Impact on the September 30 and October 31 Trial Balances

8/1 Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,200

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,200

To record the purchase of a foreign currency option as an asset.

9/30 Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,300

Gain on Foreign Currency Option . . . . . . . . . . . . . . . . . . . . $4,300

To adjust the fair value of the option from $5,200 to $9,500 and record an option gain for the change in fair value since August 1.

Loss on Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,940

Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,940

To record the fi rm commitment as a liability at its fair value of $5,940 based on changes in the spot rate and record a fi rm commitment loss for the change in fair value since August 1.

The fair value of the ! rm commitment is determined through reference to changes in the spot rate from August 1 to September 30: ($0.080  −  $0.086)  ×  Mex$1,000,000  =   $(6,000). This amount must be discounted for one month at 12 percent per annum (1 percent per month): $(6,000)  ×  0.9901  =  $(5,940).

Trial Balance—September 30 Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,200

Foreign Currency Option (asset) . . . . . . . . . . . . . . . . . . . . . . . . $ 9,500 Firm Commitment (liability) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,940 Gain on Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . 4,300 Loss on Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,940

$15,440 $15,440

10/31 Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500

Gain on Foreign Currency Option $1,500

To adjust the fair value of the option from $9,500 to $11,000 and record an option gain for the change in fair value since September 30.

Loss on Firm Commitment $5,060

Firm Commitment $5,060

To adjust the fair value of the fi rm commitment from $5,940 to $11,000 and record a fi rm commitment loss for the change in fair value since September 30.

The fair value of the ! rm commitment is determined through reference to changes in the spot rate from August 1 to October 31: ($0.080  −  $0.091)  ×  Mex$1,000,000  =   $(11,000).

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390 Chapter Seven

Note that the ! nal entry to close the Firm Commitment as an Adjustment to Net Income will be made only in the period in which the Parts Inventory affects net income through Cost of Goods Sold. The Firm Commitment remains on the books as a liability until that point in time.

Foreign Currency (Mex$) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $91,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $80,000

Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000

To record exercise of the foreign currency option; record payment of $80,000 in exchange for Mex$1,000,000, record the receipt of Mex$1,000,000 as an asset at the spot rate of $0.091, and remove the option from the accounts.

Parts Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $91,000

Foreign Currency (Mex$) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $91,000

To record the purchase of parts through the payment of Mex$1,000,000 to the Mexican supplier.

Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,000

Adjustment to Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,000

To close the fi rm commitment account as an adjustment to net income.

Trial Balance—October 31 Debit Credit

Cash ($5,200 credit + $80,000 credit) . . . . . . . . . . . . . . . . . . . . $85,200 Parts Inventory (Cost of Goods Sold) . . . . . . . . . . . . . . . . . . . . . . $91,000 Retained Earnings, 9/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,640 Gain on Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . 1,500 Loss on Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,060 Adjustment to Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000

$97,700 $97,700

6. Option Cash Flow Hedge of a Forecasted Foreign Currency Transaction Telectro anticipates that it will import component parts from its Mexican supplier in the near future. On August 1, Telectro purchases a three-month call option on Mex$1,000,000 with a strike price of $0.080. The option is appropriately desig- nated as a cash ! ow hedge of a forecasted Mexican peso transaction. Parts costing Mex$1,000,000 are received and paid for on October 31.

Journal Entries and Impact on the September 30 and October 31 Trial Balances

8/1 Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,200

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,200

To record the purchase of a foreign currency option as an asset.

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 391

9/30 Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,300

Accumulated Other Comprehensive Income (AOCI) . . . . . . $4,300

To adjust the fair value of the option from $5,200 to $9,500 with a corresponding adjustment to AOCI.

Option Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,700

Accumulated Other Comprehensive Income (AOCI) . . . . . . $1,700

To recognize the change in the time value of the foreign currency option as an expense with a corresponding credit to AOCI.

Trial Balance—September 30 Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,200 Foreign Currency Option (asset) . . . . . . . . . . . . . . . . . . . . . . . $ 9,500 Accumulated Other Comprehensive Income. . . . . . . . . . . . . . . 6,000 Option Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700

$11,200 $11,200

10/31 Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500

Accumulated Other Comprehensive Income (AOCI) . . . . . . . . $1,500

To adjust the fair value of the option from $9,500 to $11,000 with a corresponding adjustment to AOCI.

Option Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,500

Accumulated Other Comprehensive Income (AOCI) . . . . . . . . $3,500

To recognize the change in the time value of the foreign currency option as an expense with a corresponding credit to AOCI.

Foreign Currency (Mex$) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $91,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $80,000

Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000

To record exercise of the foreign currency option: record payment of $80,000 in exchange for Mex$1,000,000, record the receipt of Mex$1,000,000 as an asset at the spot rate of $0.091, and remove the option from the accounts.

Parts Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $91,000

Foreign Currency (Mex$) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $91,000

To record the purchase of parts through the payment of Mex$1,000,000 to the Mexican supplier.

Accumulated Other Comprehensive Income (AOCI) . . . . . . . . . . . . . $11,000

Adjustment to Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,000

To close AOCI as an adjustment to net income.

Note that the ! nal entry to close AOCI as an Adjustment to Net Income is made at the date that the forecasted transaction was expected to occur, regardless of when the Parts Inventory affects net income.

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392 Chapter Seven

1. What is the concept underlying the two-transaction perspective to accounting for foreign currency transactions?

2. A company makes an export sale denominated in a foreign currency and al- lows the customer one month to pay. Under the two-transaction perspective, accrual approach, how does the company account for # uctuations in the ex- change rate for the foreign currency?

3. What factors create a foreign exchange gain on a foreign currency transaction? What factors create a foreign exchange loss?

4. What does the word hedging mean? Why do companies hedge foreign ex- change risk?

5. How does a foreign currency option differ from a foreign currency forward contract?

6. How does the timing of hedges of the following differ? a. Foreign-currency-denominated assets and liabilities. b. Foreign currency ! rm commitments. c. Forecasted foreign currency transactions.

7. Why might a company prefer a foreign currency option rather than a forward contract in hedging a foreign currency ! rm commitment? Why might a com- pany prefer a forward contract over an option in hedging a foreign currency asset or liability?

8. How are foreign currency derivatives such as forward contracts and options reported on the balance sheet?

9. How is the fair value of a foreign currency forward contract determined? How is the fair value of an option determined?

10. What is hedge accounting? 11. Under what conditions can hedge accounting be used to account for a foreign

currency option used to hedge a forecasted foreign currency transaction? 12. What are the differences in accounting for a forward contract used as ( a ) a cash

# ow hedge and ( b ) a fair value hedge of a foreign-currency-denominated asset or liability?

13. What are the differences in accounting for a forward contract used as a fair value hedge of ( a ) a foreign-currency-denominated asset or liability and ( b ) a foreign currency ! rm commitment?

14. What are the differences in accounting for a forward contract used as a cash # ow hedge of ( a ) a foreign-currency-denominated asset or liability and ( b ) a forecasted foreign currency transaction?

Questions

Trial Balance—October 31 Debit Credit

Cash ($5,200 credit + $80,000 credit) . . . . . . . . . . . . . . . . . . $85,200 Parts Inventory (Cost of Goods Sold) . . . . . . . . . . . . . . . . . . . . $91,000 Retained Earnings, 9/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700 Loss on Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . 3,500 Adjustment to Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000

$96,200 $96,200

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 393

15. How are changes in the fair value of an option accounted for in a cash # ow hedge? In a fair value hedge?

16. In what way is the accounting for a foreign currency borrowing more compli- cated than the accounting for a foreign currency account payable?

1. Which of the following combinations correctly describes the relationship between foreign currency transactions, exchange rate changes, and foreign exchange gains and losses?

Type of Transaction

Foreign Currency

Foreign Exchange Gain or Loss

a. Export sale Appreciates Loss b. Import purchase Appreciates Gain c. Import purchase Depreciates Gain d. Export sale Depreciates Gain

2. Gracie Corporation had a Japanese yen receivable resulting from exports to Japan and a Brazilian real payable resulting from imports from Brazil. Gracie recorded foreign exchange gains related to both its yen receivable and real payable. Did the foreign currencies increase or decrease in dollar value from the date of the transaction to the settlement date?

Yen Real

a. Increase Increase b. Decrease Decrease c. Decrease Increase d. Increase Decrease

3. On December 1, Year 1, Tackett Company (a U.S.-based company) entered into a three-month forward contract to purchase 1 million Mexican pesos on March 1, Year 2. The following U.S. dollar per peso exchange rates apply:

Date Spot Rate Forward Rate

(to March 1, Year 2)

December 1, Year 1 . . . . . . . . . . $0.088 $0.084 December 31, Year 1 . . . . . . . . . 0.080 0.074 March 1, Year 2 . . . . . . . . . . . . . 0.076

Tackett’s incremental borrowing rate is 12 percent. The present value factor for two months at an annual interest rate of 12 percent (1 percent per month) is 0.9803.

Which of the following correctly describes the manner in which Tackett Com- pany will report the forward contract on its December 31, Year 1, balance sheet? a. As an asset in the amount of $3,921.20. b. As an asset in the amount of $7,842.40. c. As a liability in the amount of $13,724.20. d. As a liability in the amount of $9,803.00.

Exercises and Problems

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394 Chapter Seven

Use the following information for Exercises 4 and 5 : Reiter Corp. (a U.S.- based company) sold parts to an Israeli customer on December 1, Year 1, with payment of 100,000 Israeli shekels to be received on March 31, Year 2. The fol- lowing exchange rates apply:

Date Spot Rate Forward Rate

(to March 31, Year 2)

December 1, Year 1 . . . . . . . . $0.24 $0.23 December 31, Year 1 . . . . . . . 0.22 0.20 March 31, Year 2 . . . . . . . . . . 0.25

Reiter’s incremental borrowing rate is 12 percent. The present value factor for three months at an annual interest rate of 12 percent (1 percent per month) is 0.9706.

4. Assuming no forward contract was entered into, how much foreign exchange gain or loss should Reiter report on its Year 1 income statement with regard to this transaction? a. A $5,000 gain. b. A $3,000 gain. c. A $2,000 loss. d. A $1,000 loss.

5. Assuming a forward contract to sell 100,000 Israeli shekels was entered into on December 1, Year 1, as a fair value hedge of a foreign currency receivable, what would be the net impact on net income in Year 1 resulting from a # uctuation in the value of the shekel? a. No impact on net income. b. A $58.80 decrease in net income. c. A $2,000 decrease in income. d. A $911.80 increase in income.

Use the following information for Exercises 6 through 8: On September 1, Year 1, Keefer Company received an order to sell a machine to a customer in Canada at a price of 100,000 Canadian dollars. The machine was shipped and payment was received on March 1, Year 2. On September 1, Year 1, Keefer Company purchased a put option giving it the right to sell 100,000 Canadian dollars on March 1, Year 2, at a price of $75,000. Keefer Company properly des- ignates the option as a fair value hedge of the Canadian-dollar ! rm commit- ment. The option cost $1,700 and had a fair value of $2,800 on December 31, Year 1. The fair value of the ! rm commitment is measured through reference to changes in the spot rate. The following spot exchange rates apply:

Date U.S. Dollar per Canadian Dollar

September 1, Year 1 . . . . . . . $0.75 December 31, Year 1 . . . . . . 0.73 March 1, Year 2 . . . . . . . . . . 0.71

Keefer Company’s incremental borrowing rate is 12 percent. The present value factor for two months at an annual interest rate of 12 percent (1 percent per month) is 0.9803.

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 395

6. What was the net impact on Keefer Company’s Year 1 income as a result of this fair value hedge of a ! rm commitment? a. $0. b. An $860.60 decrease in income. c. An $1,100.00 increase in income. d. A $1,960.60 increase in income.

7. What was the net impact on Keefer Company’s Year 2 income as a result of this fair value hedge of a ! rm commitment? a. $0. b. An $839.40 decrease in income. c. A $74,160.60 increase in income. d. A $76,200.00 increase in income.

8. What was the net increase or decrease in cash # ow from having purchased the foreign currency option to hedge this exposure to foreign exchange risk? a. $0. b. A $1,000 increase in cash # ow. c. A $1,700 decrease in cash # ow. d. A $2,300 increase in cash # ow.

Use the following information for Problems 9 and 10: On November 1, Year 1, Black Lion Company forecasts the purchase of raw materials from an Argentinian supplier on February 1, Year 2, at a price of 200,000 Argentinian pesos. On November 1, Year 1, Black Lion pays $1,200 for a three-month call option on 200,000 Argentinian pesos with a strike price of $0.35 per peso. The option is properly designated as a cash # ow hedge of a forecasted foreign cur- rency transaction. On December 31, Year 1, the option has a fair value of $900. The following spot exchange rates apply:

Date U.S. Dollar per Argentinian Peso

November 1, Year 1 . . . . . . . . . $0.35 December 31, Year 1 . . . . . . . . 0.30 February 1, Year 2 . . . . . . . . . . . 0.36

9. What is the net impact on Black Lion Company’s Year 1 net income as a result of this hedge of a forecasted foreign currency purchase? a. $0. b. A $200 increase in net income. c. A $300 decrease in net income. d. An $800 decrease in net income.

10. What is the net impact on Black Lion Company’s Year 2 net income as a result of this hedge of a forecasted foreign currency purchase? Assume that the raw materials are consumed and become a part of cost of goods sold in Year 2. a. A $70,000 decrease in net income. b. A $70,900 decrease in net income. c. A $71,100 decrease in net income. d. A $72,900 decrease in net income.

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396 Chapter Seven

11. Garden Grove Corporation made a sale to a foreign customer on September 15, Year 1, for 100,000 foreign currency units (FCU). Payment was received on October 15, Year 1. The following exchange rates apply:

Date U.S. Dollar per FCU

September 15, Year 1 . . . . . . . . $0.40 September 30, Year 1 . . . . . . . . 0.42 October 15, Year 1 . . . . . . . . . . 0.37

Required: Prepare all journal entries for Garden Grove Corporation in connection with this sale, assuming that the company closes its books on September 30 to pre- pare interim ! nancial statements.

12. On December 1, Year 1, El Primero Company purchases inventory from a for- eign supplier for 40,000 coronas. Payment will be made in 90 days after El Primero has sold this merchandise. Sales are made rather quickly, and El Prim- ero pays this entire obligation on February 15, Year 2. The following exchange rates for 1 corona apply:

Date U.S. Dollar per Corona

December 1, Year 1 . . . . . . . . . $0.87 December 31, Year 1 . . . . . . . . 0.82 February 15, Year 2 . . . . . . . . . . 0.91

Required: Prepare all journal entries for El Primero in connection with the purchase and payment.

13. On September 30, Year 1, the Lester Company negotiated a two-year loan of 1,000,000 markkas from a foreign bank at an interest rate of 2 percent per annum. Interest payments are made annually on September 30, and the principal will be repaid on September 30, Year 3. Lester Company prepares U.S.- dollar ! nancial statements and has a December 31 year-end. Prepare all journal entries related to this foreign currency borrowing, assuming the fol- lowing exchange rates for 1 markka:

Date U.S. Dollars per Markka

September 30, Year 1 . . . . . . $0.20 December 31, Year 1 . . . . . . 0.21 September 30, Year 2 . . . . . . 0.23 December 31, Year 2 . . . . . . 0.24 September 30, Year 3 . . . . . . 0.27

Required: Prepare all journal entries for the Lester Company in connection with the foreign currency borrowing. What is the effective annual cost of borrowing in dollars in each of the three years Year 1, Year 2, and Year 3?

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 397

14. The Budvar Company sells parts to a foreign customer on December 1, Year 1, with payment of 20,000 crowns to be received on March 1, Year 2. Budvar enters into a forward contract on December 1, Year 1, to sell 20,000 crowns on March 1, Year 2. Relevant exchange rates for the crown on various dates are as follows:

Date Spot Rate Forward Rate

(to March 1, Year 2)

December 1, Year 1 . . . . . . . . . $1.00 $1.04 December 31, Year 1 . . . . . . . . 1.05 1.10 March 1, Year 2 . . . . . . . . . . . . 1.12

Budvar’s incremental borrowing rate is 12 percent. The present value factor for two months at an annual interest rate of 12 percent (1 percent per month) is 0.9803. Budvar must close its books and prepare ! nancial statements at De- cember 31.

Required: a. Assuming that Budvar designates the forward contract as a cash # ow hedge

of a foreign currency receivable, prepare journal entries for these transac- tions in U.S. dollars. What is the impact on Year 1 net income? What is the impact on Year 2 net income? What is the impact on net income over the two accounting periods?

b. Assuming that Budvar designates the forward contract as a fair value hedge of a foreign currency receivable, prepare journal entries for these transac- tions in U.S. dollars. What is the impact on Year 1 net income? What is the impact on Year 2 net income? What is the impact on net income over the two accounting periods?

15. The same facts apply as in Exercise 14 except that Budvar Company purchases parts from a foreign supplier on December 1, Year 1, with payment of 20,000 crowns to be made on March 1, Year 2. On December 1, Year 1, Budvar enters into a forward contract to purchase 20,000 crowns on March 1, Year 2. The parts purchased on December 1, Year 1, become a part of the cost of goods sold on March 15, Year 2.

Required: a. Assuming that Budvar designates the forward contract as a cash # ow hedge

of a foreign currency payable, prepare journal entries for these transactions in U.S. dollars. What is the impact on Year 1 net income? What is the im- pact on Year 2 net income? What is the impact on net income over the two accounting periods?

b. Assuming that Budvar designates the forward contract as a fair value hedge of a foreign currency payable, prepare journal entries for these transactions in U.S. dollars. What is the impact on Year 1 net income? What is the im- pact on Year 2 net income? What is the impact on net income over the two accounting periods?

16. On November 1, Year 1, Alexandria Company sold merchandise to a foreign customer for 100,000 francs with payment to be received on April 30, Year 2. At the date of sale, Alexandria Company entered into a six-month forward contract to sell 100,000 francs. The forward contract is properly designated as

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398 Chapter Seven

a cash # ow hedge of a foreign currency receivable. Relevant exchange rates for the franc are:

Date Spot Rate Forward Rate

(to April 30, Year 2)

November 1, Year 1 . . . . . . . . . $0.23 $0.22 December 31, Year 1 . . . . . . . . 0.20 0.18 April 30, Year 2 . . . . . . . . . . . . . 0.19

Alexandria Company’s incremental borrowing rate is 12 percent. The present value factor for four months at an annual interest rate of 12 percent (1 percent per month) is 0.9610.

Required: Prepare all journal entries, including December 31 adjusting entries, to record the sale and forward contract. What is the impact on net income in Year 1? What is the impact on net income in Year 2?

17. Artco Inc. engages in various transactions with companies in the country of Santrica. On November 30, Year 1, Artco sold artwork at a price of 400,000 ricas to a Santrican customer, with payment to be received on January 31, Year 2. In addition, on November 30, Year 1, Artco purchased art supplies from a Sant- rican supplier at a price of 300,000 ricas; payment will be made on January 31, Year 2. The art supplies are consumed by the end of November, Year  1. To hedge its net exposure in ricas, Artco entered into a two-month forward con- tract on November 30, Year 1, wherein Artco will deliver 100,000 ricas to the foreign currency broker in exchange for U.S dollars at the agreed-on forward rate. Artco properly designates its forward contract as a fair value hedge of a foreign currency receivable. The following rates for the rica apply:

Date Spot Rate Forward Rate

(to January 31, Year 2)

November 30, Year 1 . . . . . . . . $0.13 $0.12 December 31, Year 1 . . . . . . . . 0.10 0.08 January 31, Year 2 . . . . . . . . . . 0.09

Artco Inc.’s incremental borrowing rate is 12 percent. The present value factor for one month at an annual interest rate of 12 percent (1 percent per month) is 0.9901.

Required: Prepare all journal entries, including December 31 adjusting entries, to record these transactions and forward contract. What is the impact on net income in Year 1? What is the impact on net income in Year 2?

18. On October 1, Year 1, Butterworth Company entered into a forward contract to sell 100,000 rupees in four months (on January 31, Year 2). Relevant exchange rates for the rupee are as follows:

Date Spot Rate Forward Rate

(to January 31, Year 2)

October 1, Year 1 . . . . . . . . . . . $0.069 $0.065 December 31, Year 1 . . . . . . . . 0.071 0.074 January 31, Year 2 . . . . . . . . . . 0.072

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 399

Butterworth Company’s incremental borrowing rate is 12 percent. The present value factor for one month at an annual interest rate of 12 percent (1 percent per month) is 0.9901. Butterworth must close its books and prepare ! nancial statements on December 31.

Required: a. Prepare journal entries assuming the forward contract was entered into as

a fair value hedge of a 100,000-rupee receivable arising from a sale made on October 1, Year 1. Include entries for both the sale and the forward contract.

b. Prepare journal entries assuming the forward contract was entered into as a fair value hedge of a ! rm commitment related to a 100,000-rupee sale that will be made on January 31, Year 2. Include entries for both the ! rm com- mitment and the forward contract. The fair value of the ! rm commitment is measured through reference to changes in the forward rate.

19. On August 1, Year 1, Huntington Corporation placed an order to purchase merchandise from a foreign supplier at a price of 100,000 dinars. The merchan- dise is received and paid for on October 31, Year 1, and is fully consumed by December 31, Year 1. On August 1, Huntington entered into a forward contract to purchase 100,000 dinars in three months at the agreed-on forward rate. The forward contract is properly designated as a fair value hedge of a foreign cur- rency ! rm commitment. The fair value of the ! rm commitment is measured through reference to changes in the forward rate. Relevant exchange rates for the dinar are as follows:

Date Spot Rate Forward Rate

(to October 31, Year 1)

August 1 . . . . . . . . . . . . . . . . . . $1.300 $1.310 September 30 . . . . . . . . . . . . . . 1.305 1.325 October 31 . . . . . . . . . . . . . . . . 1.320

Huntington’s incremental borrowing rate is 12 percent. The present value factor for one month at an annual interest rate of 12 percent (1 percent per month) is 0.9901. Huntington Corporation must close its books and pre- pare its third-quarter ! nancial statements on September 30, Year 1.

Required: Prepare journal entries for the forward contract and ! rm commitment. What is the impact on net income in Year 1? What is the net cash out# ow on the pur- chase of merchandise from the foreign customer?

20. On June 1, Year 1, Tsanumis Corporation (a U.S.-based manufacturing ! rm) re- ceived an order to sell goods to a foreign customer at a price of 1 million euros. The goods will be shipped and payment will be received in three months on September 1, Year 1. On June 1, Tsanumis Corporation purchased an option to sell 1 million euros in three months at a strike price of $1.00. The option is properly designated as a fair value hedge of a foreign currency ! rm commit- ment. The fair value of the ! rm commitment is measured through reference to changes in the spot rate. Relevant exchange rates and option premiums for the euro during Year 1 are as follows:

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400 Chapter Seven

Date Spot Rate

Call Option Premium for September 1, Year 1

(strike price $1.00)

June 1 . . . . . . . . . . . . . . . . . . . . $1.00 $0.010 June 30 . . . . . . . . . . . . . . . . . . . 0.99 0.015 September 1 . . . . . . . . . . . . . . . 0.97

Tsanumis Corporation’s incremental borrowing rate is 12 percent. The pres- ent value factor for two months at an annual interest rate of 12 percent (1 percent per month) is 0.9803. Tsanumis Corporation must close its books and prepare its second-quarter ! nancial statements on June 30.

Required: Prepare journal entries for the foreign currency option and ! rm commitment. What is the impact on Year 1 net income? What is the net cash in# ow resulting from the sale of goods to the foreign customer?

21. The Zermatt Company ordered parts from a foreign supplier on November 20 at a price of 100,000 francs when the spot rate was $0.80 per peso. Delivery and payment were scheduled for December 20. On November 20, Zermatt acquired a call option on 100,000 francs at a strike price of $0.80, paying a premium of $0.008 per franc. The option is designated as a fair value hedge of a foreign currency ! rm commitment. The fair value of the ! rm commitment is measured through reference to changes in the spot rate. The parts are deliv- ered and paid for according to schedule. Zermatt does not close its books until December 31.

Required: a. Assuming a spot rate of $0.83 per franc on December 20, prepare all journal

entries to account for the option and ! rm commitment. b. Assuming a spot rate of $0.78 per franc on December 20, prepare all journal

entries to account for the option and ! rm commitment.

22. Given its experience, Garnier Corporation expects that it will sell goods to a foreign customer at a price of 1 million lire on March 15, Year 2. To hedge this forecasted transaction, a three-month put option to sell 1 million lire is acquired on December 15, Year 1. Garnier selects a strike price of $0.15 per lire, paying a premium of $0.005 per unit, when the spot rate is $0.15. The spot rate decreases to $0.14 at December 31, Year 1, causing the fair value of the option to increase to $12,000. By March 15, Year 2, when the goods are delivered and payment is received from the customer, the spot rate has fallen to $0.13, result- ing in a fair value for the option of $20,000.

Required: Prepare all journal entries for the option hedge of a forecasted transaction and for the export sale, assuming that December 31 is Garnier Corporation’s year- end. What is the overall impact on net income over the two accounting peri- ods? What is the net cash in# ow from this export sale?

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 401

Case 7-1

Zorba Company Zorba Company, a U.S.-based importer of specialty olive oil, placed an order with a foreign supplier for 500 cases of olive oil at a price of 100 crowns per case. The total purchase price is 50,000 crowns. Relevant exchange rates are as follows:

Date Spot Rate

Forward Rate (to January 31, Year 2)

Call Option Premium for January 31, Year 2

(strike price $1.00)

December 1, Year 1 . . . . . $1.00 $1.08 $0.04 December 31, Year 1 . . . . 1.10 1.17 0.12 January 31, Year 2 . . . . . . 1.15 1.15 0.15

Zorba Company has an incremental borrowing rate of 12 percent (1 percent per month) and closes the books and prepares ! nancial statements on December 31.

Required

1. Assume the olive oil was received on December 1, Year 1, and payment was made on January 31, Year 2. There was no attempt to hedge the exposure to for- eign exchange risk. Prepare journal entries to account for this import purchase.

2. Assume the olive oil was received on December 1, Year 1, and payment was made on January 31, Year 2. On December 1, Zorba Company entered into a two-month forward contract to purchase 50,000 crowns. The forward contract is properly designated as a fair value hedge of a foreign currency payable. Prepare journal entries to account for the import purchase and foreign currency forward contract.

3. The olive oil was ordered on December 1, Year 1. It was received and paid for on January 31, Year 2. On December 1, Zorba Company entered into a two-month forward contract to purchase 50,000 crowns. The forward contract is properly designated as a fair value hedge of a foreign currency ! rm commitment. The fair value of the ! rm commitment is measured through reference to changes in the forward rate. Prepare journal entries to account for the foreign currency forward contract, ! rm commitment, and import purchase.

4. The olive oil was received on December 1, Year 1, and payment was made on January 31, Year 2. On December 1, Zorba Company purchased a two-month call option for 50,000 crowns. The option was properly designated as a cash # ow hedge of a foreign currency payable. Prepare journal entries to account for the import purchase and foreign currency option.

5. The olive oil was ordered on December 1, Year 1. It was received and paid for on January 31, Year 2. On December 1, Zorba Company purchased a two-month call option for 50,000 crowns. The option was properly designated as a fair value hedge of a foreign currency ! rm commitment. The fair value of the ! rm commitment is measured through reference to changes in the spot rate. Prepare journal entries to account for the foreign currency option, ! rm commitment, and import purchase.

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402 Chapter Seven

U.S. Department of Commerce, International Trade Administration. “Small and Medium-Sized Enterprises Play an Important Role.” Export America, September 2001.

World Trade Organization. International Trade Statistics 2012 ( www.wto.org ).

References

Case 7-2

Porto! no Company Porto! no Company made purchases on account from three foreign suppliers on December 15, 2012, with payment made on January 15, 2013. Information related to these purchases is as follows:

Supplier Location Invoice Price

Beija Flor Ltda. São Paulo, Brazil 65,000 Brazilian reals Quetzala SA Guatemala City, Guatemala 250,000 Guatemalan quetzals Mariposa SA de CV Guadalajara, Mexico 400,000 Mexican pesos

Porto! no Company’s ! scal year ends December 31.

Required

1. Use historical exchange rate information available on the Internet at www.oanda.com to ! nd interbank exchange rates between the U.S. dollar and each foreign currency for the period December 15, 2012, to January 15, 2013.

2. Determine the foreign exchange gains and losses that Porto! no would have recognized in net income in 2012 and 2013, and the overall foreign exchange gain or loss for each transaction. Determine for which transaction it would have been most important for Porto! no to hedge its foreign exchange risk.

3. Porto! no could have acquired a one-month call option on December 15, 2012, to hedge the foreign exchange risk associated with each of the three import pur- chases. In each case, the option would have had an exercise price equal to the spot rate at December 15, 2012, and would have cost $200. Determine for which hedges, if any, Porto! no would have recognized a net gain on the foreign currency option.

Case 7-3

Better Food Corporation Better Food Corporation (BFC) regularly purchases nutritional supplements from a supplier in Japan with the invoice price denominated in Japanese yen. BFC has experienced several foreign exchange losses in the past year due to increases in the U.S.-dollar price of the Japanese currency. As a result, BFC’s CEO, Harvey Carlisle, has asked you to investigate the possibility of using derivative ! nancial instruments, speci! cally foreign currency forward contracts and foreign currency options, to hedge the company’s exposure to foreign exchange risk.

Required Draft a memo to CEO Carlisle comparing the advantages and disadvantages of using forward contracts and options to hedge foreign exchange risk. Make a recommendation for which type of hedging instrument you believe the company should employ, and provide your justi! cation for this recommendation.

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403

Chapter Eight

Translation of Foreign Currency Financial Statements Learning Objectives

After reading this chapter, you should be able to • Describe the conceptual issues involved in translating foreign currency fi nancial

statements. • Explain balance sheet exposure and how it differs from transaction exposure. • Describe the concepts underlying the current rate and temporal methods of

translation. • Apply the current rate and temporal methods of translation and compare the

results of the two methods. • Describe the requirements of applicable International Financial Reporting

Standards (IFRS) and U.S. generally accepted accounting principles (GAAP). • Discuss hedging of balance sheet exposure.

INTRODUCTION

In today’s global business environment, many companies have operations in foreign countries. In its 2012 10-K report, Ford Motor Company provided a list of subsidiaries located in some 20 different countries around the world. The German automaker Volkswagen AG reports having wholly owned subsidiar- ies in more than 50 countries other than Germany. Many operations located in foreign countries keep their accounting records and prepare ! nancial statements in the local currency using local accounting principles. To prepare consolidated ! nancial statements, parent companies must restate their foreign subsidiaries’ ! nancial statements in terms of the parent company’s reporting generally accepted accounting principles (GAAP) and then translate the statements into the parent company’s reporting currency. The diversity in national accounting standards and the problems associated with that diversity (such as the GAAP reconciliation for consolidation purposes) are discussed in Chapter 2.

This chapter focuses on the translation of foreign currency ! nancial statements for the purpose of preparing consolidated ! nancial statements. We begin by ex- amining the conceptual issues related to translation and then describe the man- ner in which these issues have been addressed by the International Accounting

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404 Chapter Eight

Standards Board (IASB) and by the Financial Accounting Standards Board (FASB) in the United States. We then illustrate application of the two methods prescribed by those standard-setters and compare the results from applying the two differ- ent methods. We also discuss hedging the net investment in foreign operations to avoid the adverse impact the translation of foreign currency ! nancial statements can have on the consolidated accounts.

TWO CONCEPTUAL ISSUES

In translating foreign currency ! nancial statements into the parent company’s reporting currency, two questions must be addressed:

1. What is the appropriate exchange rate to be used in translating each ! nancial statement item?

2. How should the translation adjustment that inherently arises from the transla- tion process be re" ected in the consolidated ! nancial statements?

We introduce these issues and the basic concepts underlying the translation of ! nancial statements through the following example.

Example Parentco, a U.S.-based company, establishes a wholly owned subsidiary, For- eignco, in Foreign Country on January 1 by investing US$600 when the exchange rate between the U.S. dollar and the foreign currency (FC) is FC1 5  US$1.00. The equity investment of US$600 is physically converted into FC600. In addition, For- eignco borrows FC400 from local banks on January 2. Foreignco purchases inven- tory that costs FC900 and maintains FC100 in cash. Foreignco’s opening balance sheet appears as follows:

FOREIGNCO Opening Balance Sheet

Cash . . . . . . . . . . . . . . . . FC 100 Liabilities . . . . . . . . . . . . . FC 400 Inventory . . . . . . . . . . . . . 900 Common stock . . . . . . . . 600 Total . . . . . . . . . . . . . . . . FC1,000 Total . . . . . . . . . . . . . . . . FC1,000

To prepare a consolidated balance sheet at the date of acquisition, all FC balances on Foreignco’s balance sheet are translated at the exchange rate of US$1.00 per FC. There is no other exchange rate that possibly could be used on that date. A partial consolidation worksheet at the date of acquisition would appear as follows:

Foreignco Eliminations

Consolidation Worksheet at Date of Acquisition for Parentco and Its Subsidiary Foreignco

Parentco US$ FC Exchange Rate US$ Dr. Cr.

Consolidated Balance Sheet

US$

Investment . . . . . . . . . . . 600 — (1) 600* 0 Cash . . . . . . . . . . . . . . . . (600) 100 $1.00 100 (500) Inventory . . . . . . . . . . . . xx 900 $1.00 900 900 Total . . . . . . . . . . . . . . . . xxx 1,000 1,000 400

Liabilities . . . . . . . . . . . . . xx 400 $1.00 400 400 Common stock . . . . . . . . xx 600 $1.00 600 (1) 600 0 Total . . . . . . . . . . . . . . . . xxx 1,000 1,000 400

* The elimination entry eliminates Parentco’s Investment in Subsidiary account against Foreignco’s Common Stock account.

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Translation of Foreign Currency Financial Statements 405

By translating each FC balance on Foreignco’s balance sheet at the same exchange rate (US$1.00), Foreignco’s US$ translated balance sheet re" ects an equal amount of total assets and total liabilities and equity.

Three Months Later During the period January 1 to March 31, Foreignco engages in no transactions. However, during that period the FC appreciates in value against the US$ such that the exchange rate at March 31 is US$1.20 per FC.

In preparing the March 31 interim consolidated ! nancial statements, Parentco now must choose between the current exchange rate of US$1.20 and the past (historical) exchange rate of US$1.00 to translate Foreignco’s balance sheet into U.S. dollars. Foreignco’s stockholders’ equity must be translated at the historical rate of US$1.00 so that Parentco’s Investment account can be eliminated against the subsidiary’s common stock in the consolidation worksheet. Two approaches exist for translating the subsidiary’s assets and liabilities:

1. All assets and liabilities are translated at the current exchange rate (the spot exchange rate on the balance sheet date).

2. Some assets and liabilities are translated at the current exchange rate, and other assets and liabilities are translated at historical exchange rates (the exchange rates that existed when the assets and liabilities were acquired).

All Assets and Liabilities Are Translated at the Current Exchange Rate If the ! rst approach is adopted, in which all assets and liabilities are translated at the current exchange rate, the consolidation worksheet on March 31 would appear as follows:

Consolidation Worksheet Three Months after Date of Acquisition for Parentco and Its Subsidiary Foreignco

Parentco US$ FC

Exchange Rate US$

Change in US$ Value Since January 1 Dr. Cr.

Consolidated Balance Sheet

US$

Investment . . . . . . . 600 — 600 0 Cash . . . . . . . . . . . . (600) 100 $1.20 120 +20 (480) Inventory . . . . . . . . xx 900 $1.20 1,080 +180 1,080 Total . . . . . . . . . . . . xxx 1,000 1,200 +200 600

Liabilities . . . . . . . . . xx 400 $1.20 480 +80 480 Common stock . . . . xx 600 $1.00 600 0 600 0 Subtotal . . . . . . . . . xxx 1,000 1,080 +80 480 Translation adjustment . . . . . 120 +120 120 Total . . . . . . . . . . . . 1,200 +200 600

Foreignco Eliminations

By translating all assets at the higher current exchange rate, assets are written up in terms of their U.S.-dollar value by US$200. Liabilities are also written up by US$80. To keep the U.S.-dollar translated balance sheet in balance, a positive (credit) translation adjustment of US$120 must be recorded. As a result, total as- sets on the consolidated balance sheet are US$120 greater than on January 1, as are consolidated total liabilities and stockholders’ equity.

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406 Chapter Eight

Translating foreign currency balances at the current exchange rate is similar to revaluing foreign currency receivables and payables at the balance sheet date. The translation adjustment is analogous to the net foreign exchange gain or loss caused by a change in the exchange rate:

$20 gain on cash 1 $180 gain on inventory 2 $80 loss on liabilities 5 $120 net gain The net foreign exchange gain (positive translation adjustment) is unreal-

ized, that is, it does not result in a cash in" ow of US$120 for Parentco. However, the gain can be realized by selling Foreignco at the book value of its net assets (FC600) and converting the proceeds into U.S. dollars at the current exchange rate (FC600  ×  $1.20  =  US$720). In that case, Parentco would realize a gain from the sale of its investment in Foreignco that would be due solely to the appreciation in value of the foreign currency:

Proceeds from the sale . . . . . . . . . . . . . . . . . . . . . . $720 Original investment . . . . . . . . . . . . . . . . . . . . . . . . . 600 Realized gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120

The translation adjustment re" ects the change in the dollar value of the net invest- ment in Foreignco if the subsidiary were to be sold. In addition, a positive transla- tion adjustment signals that the appreciation of the foreign currency will result in an increase in the U.S. dollar value of future foreign currency dividends to be paid by Foreignco to its parent. For example, a dividend of FC10 distributed on March 31 can be converted into US$12, whereas the same amount of foreign currency dividend would have been worth only US$10 at the beginning of the year.

Monetary Assets and Liabilities Are Translated at the Current Exchange Rates Now assume that only monetary assets (cash and receivables) and monetary lia- bilities (most liabilities) are translated at the current exchange rate. The worksheet to translate Foreignco’s ! nancial statements into U.S. dollars on March 31 appears as follows:

Consolidation Worksheet Three Months after Date of Acquisition for Parentco and Its Subsidiary Foreignco

Parentco US$ FC

Exchange Rate US$

Change in US$ Value Since January 1 Dr. Cr.

Consolidated Balance

Sheet US$

Investment . . . . . . . 600 — 600 0 Cash . . . . . . . . . . . . (600) 100 $1.20 120 +20 (480) Inventory . . . . . . . . xx 900 $1.00 900 0 900 Total . . . . . . . . . . . . xxx 1,000 1,020 +20 420

Liabilities . . . . . . . . . xx 400 $1.20 480 +80 480 Common stock . . . . xx 600 $1.00 600 0 600 0 Subtotal . . . . . . . . . xxx 1,000 1,080 +80 480 Translation adjustment . . . . . (60) −60 (60) Total . . . . . . . . . . . . 1,020 +20 420

Foreignco Eliminations

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Translation of Foreign Currency Financial Statements 407

Using this approach, cash is written up by US$20 and liabilities are written up by US$80. To keep the balance sheet in balance, a negative (debit) translation ad- justment of US$60 must be recorded. As a result, both total assets and total liabili- ties and stockholders’ equity on the consolidated balance sheet are US$20 greater than on January 1.

The translation adjustment is analogous to the net foreign exchange gain or loss caused by a change in the exchange rate:

$20 gain on cash 2 $80 loss on liabilities 5 $60 net loss This net foreign exchange loss (negative translation adjustment) also is unrealized. However, the loss can be realized through the following process:

1. The subsidiary uses its cash (FC100) to pay its liabilities to the extent possible. 2. The parent sends enough U.S. dollars to the subsidiary to pay its remaining li-

abilities (FC300). At January 1, the parent would have sent US$300 to pay FC300 of liabilities (at the $1.00/FC1 exchange rate). At March 31, the parent must send US$360 to pay FC300 of liabilities (at the $1.20/FC1 exchange rate). A foreign exchange loss (negative translation adjustment) of US$60 (US$360 −  US$300) arises on the net monetary liability position because the foreign currency has appreciated from January 1 to March 31.

Note that under this translation approach, the negative translation adjustment does not re" ect the change in the U.S.-dollar value of the net investment in For- eignco. Moreover, the negative translation adjustment is not consistent with the change in the U.S.-dollar value of future foreign currency dividends. As the for- eign currency appreciates, the U.S.-dollar value of foreign currency dividends received from Foreignco increases.

Balance Sheet Exposure As exchange rates change, assets and liabilities translated at the current exchange rate change in value from balance sheet to balance sheet in terms of the parent company’s reporting currency (for example, U.S. dollar). These items are exposed to translation adjustment. Balance sheet items translated at historical exchange rates do not change in parent currency value from one balance sheet to the next. These items are not exposed to translation adjustment. Exposure to translation adjustment is referred to as balance sheet, translation, or accounting exposure. Balance sheet exposure can be contrasted with the transaction exposure discussed in Chapter 7 that arises when a company has foreign currency receivables and pay- ables in the following way:

Transaction exposure gives rise to foreign exchange gains and losses that are ultimately realized in cash; translation adjustments that arise from balance sheet exposure do not directly result in cash in" ows or out" ows.

Each item translated at the current exchange rate is exposed to translation adjustment. In effect, a separate translation adjustment exists for each of these exposed items. However, positive translation adjustments on assets when the foreign currency appreciates are offset by negative translation adjustments on liabilities. If total exposed assets are equal to total exposed liabilities throughout the year, the translation adjustments (although perhaps signi! cant on an indi- vidual basis) net to a zero balance. The net translation adjustment needed to keep the consolidated balance sheet in balance is based solely on the net asset or net liability exposure.

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408 Chapter Eight

A foreign operation will have a net asset balance sheet exposure when assets trans- lated at the current exchange rate are greater in amount than liabilities translated at the current exchange rate. A net liability balance sheet exposure exists when liabili- ties translated at the current exchange rate are greater than assets translated at the current exchange rate. The relationship between exchange rate " uctuations, bal- ance sheet exposure, and translation adjustments can be summarized as follows:

Foreign Currency (FC)

Balance Sheet Exposure Appreciates Depreciates

Net asset Positive translation adjustment Negative translation adjustment Net liability Negative translation adjustment Positive translation adjustment

Exactly how the translation adjustment should be reported in the consolidated ! nancial statements is a matter of some debate. The major question is whether the translation adjustments should be treated as a translation gain or loss reported in income or whether the translation adjustment should be treated as a direct adjust- ment to owners’ equity without affecting income. This issue is considered in this chap- ter in more detail after ! rst examining different methods of translation.

TRANSLATION METHODS

Four major methods of translating foreign currency ! nancial statements have been used worldwide: (1) the current/noncurrent method, (2) the monetary/non- monetary method, (3) the temporal method, and (4) the current rate (or closing rate) method.

Current/Noncurrent Method The rules for the current/noncurrent method are as follows: current assets and current liabilities are translated at the current exchange rate; noncurrent assets, noncurrent liabilities, and stockholders’ equity accounts are translated at histori- cal exchange rates. There is no theoretical basis underlying this method. Although once the predominant method, the current/noncurrent method has been unac- ceptable in the United States since 1975, has never been allowed under Interna- tional Financial Reporting Standards, and is seldom used in other countries.

Monetary/Nonmonetary Method To remedy the lack of theoretical justi! cation for the current/noncurrent method, Hepworth developed the monetary/nonmonetary method of translation in 1956. 1 Under this method, monetary assets and liabilities are translated at the current exchange rates; nonmonetary assets, nonmonetary liabilities, and stockholders’ equity accounts are translated at historical exchange rates. Monetary assets are those assets whose value does not " uctuate over time—primarily cash and receiv- ables. Nonmonetary assets are assets whose monetary value can " uctuate. They consist of marketable securities, inventory, prepaid expenses, investments, ! xed assets, and intangible assets; that is, all assets other than cash and receivables.

1 Samuel R. Hepworth, Reporting Foreign Operations (Ann Arbor: University of Michigan, Bureau of Business Research, 1956).

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Translation of Foreign Currency Financial Statements 409

Monetary liabilities are those liabilities whose monetary value cannot " uctuate over time, which is true for most payables.

Under the monetary/nonmonetary method, cash, receivables, and payables carried on the foreign operation’s balance sheet are exposed to foreign exchange risk. There is a net asset exposure when cash plus receivables exceed payables, and a net liability exposure when payables exceed cash plus receivables.

Cash 1 Receivables . Payables → Net asset exposure Cash 1 Receivables , Payables → Net liability exposure

The previous example in which Foreignco’s monetary assets and monetary li- abilities were translated at the current exchange rate demonstrates the monetary/ nonmonetary method. In that example, Foreignco had a net liability exposure that, when coupled with an appreciation in the foreign currency, resulted in a negative translation adjustment.

One way to understand the concept of exposure underlying the monetary/non- monetary method is to assume that the foreign operation’s cash, receivables, and payables are actually foreign currency assets and liabilities of the parent company. For example, consider the Japanese subsidiary of a New Zealand parent company. The Japanese subsidiary’s yen receivables that result from sales in Japan may be thought of as Japanese yen receivables of the New Zealand parent resulting from export sales to Japan. If the New Zealand parent had yen receivables on its balance sheet, an increase in the value of the yen would result in a foreign exchange gain. There also would be a foreign exchange gain on the Japanese yen held in cash by the parent. These foreign exchange gains would be offset by a foreign exchange loss on the parent’s Japanese yen payables resulting from foreign purchases. Whether a net gain or a net loss exists depends on the relative size of yen cash and receivables versus yen payables. Under the monetary/nonmonetary method, the translation adjustment measures the net foreign exchange gain or loss on the foreign operation’s cash, receivables, and payables as if those items were actually carried on the books of the parent.

Temporal Method The basic objective underlying the temporal method of translation is to produce a set of parent currency translated ! nancial statements as if the foreign subsidiary had actually used the parent currency in conducting its operations. For example, land carried on the books of a foreign subsidiary should be translated such that it is reported on the consolidated balance sheet at the amount of parent currency that would have been spent if the parent had sent parent currency to the subsid- iary to purchase the land. Assume that a piece of land costs ¥12,000,000 and is acquired at a time when one yen costs NZ$0.016. A New Zealand parent would send NZ$192,000 to its Japanese subsidiary to acquire the land—this is the land’s historical cost in parent currency terms.

Consistent with the temporal method’s underlying objective, assets and li- abilities reported on the foreign operation’s balance sheet at historical cost are translated at historical exchange rates to yield an equivalent historical cost in parent currency terms. Conversely, assets and liabilities reported on the for- eign operation’s balance sheet at a current (or future) value are translated at the current exchange rate to yield an equivalent current value in parent currency terms. (As is true under any translation method, equity accounts are translated at historical exchange rates.) Application of these rules maintains the underlying

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410 Chapter Eight

valuation method (historical cost or current value) used by the foreign subsidiary in accounting for its assets and liabilities.

Cash, receivables, and most liabilities are carried at current or future values under the traditional historical cost model of accounting. These balance sheet ac- counts are translated at the current exchange rate under the temporal method. By coincidence, the temporal method and the monetary/nonmonetary method produce similar results in this situation. The two methods diverge from one an- other only when nonmonetary assets are carried at current value. Many national accounting standards require inventory to be carried on the balance sheet at the lower of historical cost or current market value. Although inventory is a nonmon- etary asset, the temporal method requires its translation at the current exchange rate when it is written down to market value. In those jurisdictions in which mar- ketable securities are carried at current market value, as is required by Interna- tional Financial Reporting Standards (IFRS) and U.S. GAAP, marketable securities are also translated at the current exchange rate.

The temporal method generates either a net asset or a net liability balance sheet exposure depending on whether assets carried at current value are greater than or less than liabilities carried at current value. This can be generalized as follows:

Cash Marketable securities Receivables Invenntory when carried at current value Liabi

( ) llities Net asset exposure

Cash Marketable s →

eecurities Receivables Inventory when carr( iied at current value Liabilities Net liabi) → llity exposure

Because liabilities (current plus long-term) usually are greater than assets trans- lated at current rates, a net liability exposure generally exists when the temporal method is used.

Under the temporal method, income statement items are translated at ex- change rates that exist when the revenue is generated or the expense is incurred. For most items, an assumption can be made that the revenue or expense is in- curred evenly throughout the accounting period and an average-for-the-period exchange rate can be used for translation. Some expenses—such as cost of goods sold, depreciation of ! xed assets, and amortization of intangibles—are related to assets carried at historical cost. Because these assets are translated at histori- cal exchange rates, the expenses related to them must be translated at historical exchange rates as well.

The major difference between the translation adjustment resulting from the use of the temporal method and a foreign exchange gain or loss on a foreign currency transaction is that the translation adjustment is not necessarily realized through in" ows or out" ows of cash. The translation adjustment could be realized as a gain or loss only (1) if the foreign subsidiary collects all its receivables in yen cash and then uses its cash to pay off liabilities to the extent possible, and (2) if there is a net asset exposure, the excess of cash over liabilities is remitted to the parent, where it is converted into parent currency, or if there is a net liability exposure, the parent sends parent currency to its foreign subsidiary which is converted into foreign currency to pay the remaining liabilities.

Current Rate Method The fourth major method used in translating foreign currency ! nancial state- ments is the current rate method. The fundamental concept underlying the cur- rent rate method is that a parent’s entire investment in a foreign operation is

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Translation of Foreign Currency Financial Statements 411

exposed to foreign exchange risk, and translation of the foreign operation’s ! - nancial statements should re" ect this risk. To measure the net investment’s ex- posure to foreign exchange risk:

• All assets and liabilities of the foreign operation are translated using the current exchange rate.

• Equity accounts are translated at historical exchange rates.

The balance sheet exposure measured by the current rate method is equal to the foreign operation’s net asset position (total assets minus total liabilities).

Total assets . Total liabilities → Net asset exposure A positive translation adjustment results when the foreign currency appreci-

ates, and a negative translation adjustment results when the foreign currency depreciates (assuming that assets exceed liabilities). The translation adjustment arising when the current rate method is used also is unrealized. It can become a realized gain or loss if the foreign operation is sold (for its book value) and the foreign currency proceeds from the sale are converted into parent currency.

Under the current rate method, revenues and expenses are translated using the exchange rate in effect at the date of accounting recognition. In most cases an as- sumption can be made that the revenue or expense is incurred evenly throughout the year, and an average-for-the-period exchange rate is used. However, when an income item, such as a gain or loss on the sale of an asset, occurs at a speci! c point in time, the exchange rate at that date should be used for translation. Alternatively, all income statement items may be translated at the current exchange rate.

The example above in which all of Foreignco’s assets and liabilities were trans- lated at the current exchange rate demonstrates the current rate method. Foreignco has a net asset exposure that, because of the appreciation in the foreign currency, resulted in a positive translation adjustment. The positive translation adjustment that arises under the current rate method becomes a realized foreign exchange gain if the foreign subsidiary is sold at its foreign currency book value and the foreign currency proceeds are converted into parent currency.

The current rate method and the temporal method are the two methods re- quired to be used under IAS 21, The Effects of Changes in Foreign Exchange Rates, and FASB ASC 830, Foreign Currency Matters. A summary of the appropriate exchange rate for selected ! nancial statement items under these two methods is presented in Exhibit 8.1.

Translation of Retained Earnings Stockholders’ equity items are translated at historical exchange rates under both the temporal and current rate methods. This creates somewhat of a problem in translating retained earnings, which is a composite of many previous transactions: revenues, expenses, gains, losses, and declared dividends occurring over the life of the company. At the end of the ! rst year of operations, foreign currency (FC) retained earnings are translated as follows:

Net income in FC Translated per method[ uused to translate income statement items] Net income in PC

Dividends in FC Endding R/E in FC

Historical exchange rate wwhen declared

5 Dividends in PC Endiing R/E in PC

5

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412 Chapter Eight

EXHIBIT 8.1 Exchange Rates Used under the Current Rate Method and the Temporal Method for Selected Financial Statement Items

Balance Sheet

Exchange Rate Used under the Current Rate

Method

Exchange Rate Used under the

Temporal Method Assets Cash and receivables Current Current Marketable securities Current Current*

Inventory at market Current Current Inventory at cost Current Historical Prepaid expenses Current Historical Property, plant, and equipment Current Historical Intangible assets Current Historical Liabilities Current liabilities Current Current Deferred income Current Historical Long-term debt Current Current Stockholders’ Equity Capital stock Historical Historical Additional paid-in capital Historical Historical Retained earnings Historical Historical Dividends Historical Historical

Income Statement

Exchange Rate Used under the Current Rate

Method

Exchange Rate Used under the

Temporal Method Revenues Average Average Most expenses Average Average Cost of goods sold Average Historical Depreciation of property, plant, and equipment Average Historical Amortization of intangibles Average Historical

*Marketable debt securities classi! ed as hold-to-maturity are carried at cost and therefore are translated at the historical exchange rate under the temporal method.

The ending parent currency retained earnings in Year 1 becomes the beginning parent currency retained earnings for Year 2, and the translated retained earnings in Year 2 (and subsequent years) is then determined as follows:

Beginning R/E in FC Net income in FC

(from laast year’s translation) [Translated per methhod used to translate income statement items]]

Beginning R/E in PC

Di

Net income in FC

vvidends in FC istorical exchange rate

Endinng R / E in PC when declared Dividends in PC

Ending R / E in PC

H

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Translation of Foreign Currency Financial Statements 413

The same approach is used for translating retained earnings under both the cur- rent rate and the temporal methods. The only difference is that translation of the current period’s net income is done differently under the two methods.

Complicating Aspects of the Temporal Method Under the temporal method, it is necessary to keep a record of the exchange rates that exist when inventory, prepaid expenses, ! xed assets, and intangible assets are acquired because these assets, carried at historical cost, are translated at historical exchange rates. Keeping track of the historical rates for these assets is not nec- essary under the current rate method. Translating these assets at historical rates makes application of the temporal method more complicated than the current rate method.

Calculation of Cost of Goods Sold (COGS) Under the current rate method, cost of goods sold (COGS) in foreign currency (FC) is simply translated into the parent currency (PC) using the average-for-the-period exchange rate (ER):

COGS in FC 3 Average ER 5 COGS in PC

Under the temporal method, COGS must be decomposed into beginning inven- tory, purchases, and ending inventory, and each component of COGS must then be translated at its appropriate historical rate. For example, if beginning inven- tory (FIFO basis) in Year 2 was acquired evenly throughout the fourth quarter of Year 1, then the average exchange rate in the fourth quarter of Year 1 will be used to translate beginning inventory. Likewise, the fourth-quarter (4thQ) Year 2 exchange rate will be used to translate Year 2 ending inventory. If purchases were made evenly throughout Year 2, then the average Year 2 exchange rate will be used to translate purchases:

Beginning inventory

Purchases in FC EEnding inventory

COGS in FC

Historiccal ER

Average ER Year

(e.g 4thQ Year 1., )

, 22 Historical ER

Beginn

e g 4thQ Year 2( . ., )

iing inventory in PC

in FC

in FC

Purchases in PC

Endingg inventory in PC

COGS in PC

There is no single exchange rate that can be used to directly translate COGS in FC into COGS in PC.

Application of the Lower of Cost or Market Rule Under the current rate method, the ending inventory reported on the foreign cur- rency balance sheet is translated at the current exchange rate regardless of whether it is carried at cost or at a lower market value. Application of the temporal method requires the foreign currency cost and foreign currency market value of the inven- tory to be translated into parent currency at appropriate exchange rates, and the lower of the parent currency cost or parent currency market value is reported on the con- solidated balance sheet. As a result of this procedure, it is possible for inventory to be carried at cost on the foreign currency balance sheet and at market value on the parent currency consolidated balance sheet, and vice versa.

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414 Chapter Eight

Fixed Assets, Depreciation, Accumulated Depreciation Under the temporal method, ! xed assets acquired at different times must be trans- lated at different (historical) exchange rates. The same is true for depreciation of ! xed assets and accumulated depreciation related to ! xed assets.

For example, assume that a company purchases a piece of equipment on Janu- ary 1, Year 1, for FC1,000 when the exchange rate is $1.00 per FC1. Another item of equipment is purchased on January 1, Year 2, for FC4,000 when the exchange rate is $1.20 per FC1. Both pieces of equipment have a ! ve-year useful life. Under the temporal method, the amount at which equipment would be reported on the consolidated balance sheet on December 31, Year 2, when the exchange rate is $1.50 per FC1, would be:

FC1 000 FC4 000

, $ . $ , , $ . $

1 00 1 000 1 20 4,,

, $ ,

800

5 800FC5 000

Depreciation expense for Year 2 under the temporal method would be calculated as follows:

FC 200 FC 800

FC1

$ . $ $ . $

1 00 200 1 20 960

,, $ ,000 1 160

Accumulated depreciation at December 31, Year 2, under the temporal method would be calculated as follows:

FC 400 FC 800

FC

$ . $ $ . $

1 00 400 1 20 960

11 200, $ ,1 360

Similar procedures apply for intangible assets as well. Under the current rate method, equipment would be reported on the December 31,

Year 2, balance sheet at FC5,000  ×  $1.50  =  $7,500. Depreciation expense would be translated at the average Year 2 exchange rate of $1.40: FC1,000  ×  $1.40  =  $1,400, and accumulated depreciation would be FC1,200  ×  $1.50  =  $1,800.

In this example, the foreign subsidiary has only two ! xed assets that require translation. For subsidiaries that own hundreds and thousands of ! xed assets, the temporal method, versus the current rate method, can require substantial addi- tional work.

DISPOSITION OF TRANSLATION ADJUSTMENT

The ! rst issue related to the translation of foreign currency ! nancial statements is selection of the appropriate method. The second issue in ! nancial statement translation relates to where the resulting translation adjustment should be reported in the consolidated ! nancial statements. There are two prevailing schools of thought with regard to this issue:

1. Translation gain or loss in net income. Under this treatment, the translation adjust- ment is considered to be a gain or loss analogous to the gains and losses that

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Translation of Foreign Currency Financial Statements 415

arise from foreign currency transactions and should be reported in income in the period in which the " uctuation in exchange rate occurs.

The ! rst of two conceptual problems with treating translation adjustments as gains/losses in net income is the gain or loss is unrealized; that is, there is no accompanying cash in" ow or out" ow. The second problem is the gain or loss may not be consistent with economic reality. For example, the depreciation of a foreign currency may have a positive impact on the foreign operation’s export sales and income, but the particular translation method used gives rise to a translation loss.

2. Cumulative translation adjustment in stockholders’ equity (other comprehensive income). The alternative to reporting the translation adjustment as a gain or loss in net income is to include it in stockholders’ equity as a component of other comprehensive income. In effect, this treatment defers the gain or loss in stock- holders’ equity until it is realized in some way. As a balance sheet account, other comprehensive income is not closed at the end of the accounting period and will " uctuate in amount over time.

The two major translation methods and the two possible treatments for the translation adjustment give rise to four possible combinations:

Combination Translation Method Disposition of

Translation Adjustment

A Temporal Gain or loss in net income B Temporal Deferred in stockholders’ equity

(other comprehensive income) C Current rate Gain or loss in net income D Current rate Deferred in stockholders’ equity

(other comprehensive income)

U.S. GAAP

Prior to 1975, there were no authoritative rules in the United States as to which translation method to use or where the translation adjustment should be reported in the consolidated ! nancial statements. Different companies used different com- binations, creating a lack of comparability across companies. In 1975, to elimi- nate this noncomparability, the FASB issued SFAS 8, Accounting for the Translation of Foreign Currency Transactions and Foreign Currency Financial Statements. SFAS 8 mandated use of the temporal method with translation gains/losses reported in income by all companies for all foreign operations (Combination A).

U.S. multinational companies were strongly opposed to SFAS 8. Speci! cally, they considered reporting translation gains and losses in income to be inappropri- ate given that the gains and losses are unrealized. Moreover, because currency " uctuations often reverse themselves in subsequent quarters, arti! cial volatility in quarterly earnings resulted.

After releasing two Exposure Drafts proposing new translation rules, the FASB ! nally issued SFAS 52, Foreign Currency Translation, in 1981. This resulted in a com- plete overhaul of U.S. GAAP with regard to foreign currency translation. SFAS 52 was approved by a narrow four-to-three vote of the FASB, indicating how conten- tious the issue of foreign currency translation has been. The guidance provided in SFAS 52 was incorporated into FASB ASC 830, Foreign Currency Matters, in 2009.

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FASB ASC 830 Implicit in the temporal method is the assumption that foreign subsidiaries of U.S. multinational corporations have very close ties to their parent company and would actually carry out their day-to-day operations and keep their books in the U.S. dol- lar if they could. To re" ect the integrated nature of the foreign subsidiary with its U.S. parent, the translation process should create a set of U.S.-dollar translated ! nancial statements as if the dollar had actually been used by the foreign subsid- iary. This is described as the U.S.-dollar perspective to translation.

Subsequently, the FASB recognized that, whereas some foreign entities are closely integrated with their parent and do in fact conduct much of their business in U.S. dollars, other foreign entities are relatively self-contained and integrated with the local economy and primarily use a foreign currency in their daily opera- tions. For the ! rst type of entity, the FASB determined that the U.S.-dollar perspec- tive still applies.

For the second relatively independent type of entity, a local-currency perspective to translation is applicable. For this type of entity, the FASB determined that a different translation methodology is appropriate; namely, the current rate method should be used for translation, and translation adjustments should be reported as a separate component in other comprehensive income (Combination D in the preceding table).

Functional Currency To determine whether a speci! c foreign operation is (1) integrated with its parent or (2) self-contained and integrated with the local economy, the FASB developed the concept of the functional currency. The functional currency is the primary cur- rency of the foreign entity’s operating environment. It can be either the parent’s currency (US$) or a foreign currency (generally the local currency). The functional currency orientation results in the following rule:

Functional Currency Translation Method Translation Adjustment

U.S. dollar Temporal method Gain (loss) in income Foreign currency Current rate method Separate component of stockholders’

equity (accumulated other comprehensive income)

When a foreign operation is sold or otherwise disposed of, the cumulative trans- lation adjustment related to it that has been deferred in a separate component of stockholders’ equity is transferred to income as a realized gain or loss.

In addition to introducing the concept of the functional currency, the FASB also introduced some new terminology. The reporting currency is the currency in which the entity prepares its ! nancial statements. For U.S.-based corporations, this is the U.S. dollar. If a foreign operation’s functional currency is the U.S. dollar, foreign currency balances must be remeasured into U.S. dollars using the temporal method, with translation adjustments reported as remeasurement gains and losses in in- come. When a foreign currency is the functional currency, foreign currency bal- ances are translated using the current rate method and a translation adjustment is reported on the balance sheet.

The functional currency is essentially a matter of fact. However, the FASB states that for many cases, “management’s judgment will be required to determine the functional currency in which ! nancial results and relationships are measured with the greatest degree of relevance and reliability” (FASB ASC 830-10-55-4).

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Translation of Foreign Currency Financial Statements 417

U.S. GAAP provides a list of indicators to guide parent company management in its determination of a foreign entity’s functional currency (see Exhibit 8.2 ). How- ever, no guidance is provided as to how these indicators are to be weighted in determining the functional currency. Leaving the decision about identifying the functional currency up to management allows some leeway in this process.

Different companies approach the selection of functional currency in different ways: “For us it was intuitively obvious” versus “It was quite a process. We took the six criteria and developed a matrix. We then considered the dollar amount and the related percentages in developing a point scheme. Each of the separate criteria was given equal weight (in the analytical methods applied).” 2

Research has shown that the weighting schemes used by U.S. multinationals for determining the functional currency might be biased toward selection of the foreign currency as the functional currency.3 This would be rational behavior for multina- tionals given that, when the foreign currency is the functional currency, the transla- tion adjustment is reported on the balance sheet and does not affect net income.

Highly Infl ationary Economies For those foreign entities located in a highly in" ationary economy, U.S. GAAP man- dates use of the temporal method with translation gains/losses reported in income. A country is de! ned as a highly in" ationary economy if its cumulative three-year in" ation exceeds 100 percent. With compounding, this equates to an average of approximately 26 percent per year for three years in a row. Countries that have met this de! nition in the past include Argentina, Brazil, Israel, Mexico, Turkey, and Zimbabwe. In any given year, a country may or may not be classi! ed as highly in" ationary in accordance with U.S. GAAP, depending on its most recent three-year experience with in" ation.

2 Jerry L. Arnold and William W. Holder, Impact of Statement 52 on Decisions, Financial Reports and Attitudes (Morristown, NJ: Financial Executives Research Foundation, 1986), p. 89. 3 Timothy S. Doupnik and Thomas G. Evans, “Functional Currency as a Strategy to Smooth Income,” Advances in International Accounting, Vol. 2, 1988, pp. 171–182.

Indication That the Functional Currency Is the:

Indicator Foreign Currency (FC) Parent’s Currency

Cash fl ow Primarily in FC and does not affect parent’s cash fl ows

Directly impacts parent’s cash fl ows on a current basis

Sales price Not affected on short-term basis by changes in exchange rates

Affected on short-term basis by changes in exchange rates

Sales market Active local sales market Sales market mostly in parent’s country or sales denominated in parent’s currency

Expenses Primarily local costs Primarily costs for components obtained from parent’s country

Financing Primarily denominated in FC, and FC cash fl ows are adequate to service obligations

Primarily obtained from parent or denominated in parent currency, or FC cash fl ows not adequate to service obligations

Intercompany transaction

Low volume of intercompany transactions; no extensive interrelationships with parent’s operations

High volume of intercompany transactions and extensive interrelationships with parent’s operations

EXHIBIT 8.2 U.S. GAAP Indicators for Determining the Functional Currency

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418 Chapter Eight

One reason for this rule is to avoid a “disappearing plant problem” that exists when the current rate method is used in a country with high in" ation. Remember that under the current rate method, all assets (including ! xed assets) are translated at the current exchange rate. To see the problem this creates in a highly in" ation- ary economy, consider the following hypothetical example: the Brazilian subsid- iary of a U.S. parent purchased land at the end of 1984 for 10,000,000 cruzeiros (CR$) when the exchange rate was $0.001 per CR$1. Under the current rate method, the land would be reported in the parent’s consolidated balance sheet at $10,000.

Historical Cost Current Exchange Rate Consolidated Balance Sheet

1984 CR$10,000,000 × $0.001 = $10,000

In 1985, Brazil experienced roughly 200 percent in" ation. Accordingly, with the forces of purchasing power parity at work, the cruzeiro plummeted against the U.S. dollar to a value of $0.00025 at the end of 1985. Under the current rate method, land now would be reported in the parent’s consolidated balance sheet at $2,500 and a negative translation adjustment of $7,500 would result.

Historical Cost Current Exchange Rate Consolidated Balance Sheet

1985 CR$10,000,000 × $0.00025 5 $2,500

Using the current rate method, land has lost 75 percent of its U.S.-dollar value in one year, and land is not even a depreciable asset!

High rates of in" ation continued in Brazil, reaching the high point of roughly 1,800 percent in 1993. As a result of applying the current rate method, the land, which was originally reported on the 1984 consolidated balance sheet at $10,000, was carried on the 1993 balance sheet at less than $1.00.

In an Exposure Draft preceding the issuance of current authoritative guidance, the FASB proposed requiring companies with operations in highly in" ationary countries to ! rst restate the historical costs for in" ation and then translate using the current rate method. For example, with 200 percent in" ation in 1985, the land would have been written up to CR$40,000,000 and then translated at the current exchange rate of $0.00025. This would have produced a translated amount of $10,000, the same as in 1984.

Companies objected to making in" ation adjustments, however, because of a lack of reliable in" ation indexes in many countries. The FASB backed off from requiring the restate/translate approach. Instead, current U.S. GAAP requires that the temporal method be used in highly in" ationary countries. In our example, land would be translated at the historical rate of $0.001 at each balance sheet date and carried at $10,000, thus avoiding the disappearing plant problem.

INTERNATIONAL FINANCIAL REPORTING STANDARDS

IAS 21, The Effects of Changes in Foreign Exchange Rates, contains guidance for the translation of foreign currency ! nancial statements. To determine the appropriate translation method, IAS 21 originally required foreign subsidiaries to be classi! ed as either (1) foreign operations that are integral to the operations of the reporting enterprise or (2) foreign entities. As part of a comprehensive improvements project, IAS 21 was revised in 2003, adopting the functional currency approach developed years earlier by the FASB. The revised standard de! nes functional currency as the

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Translation of Foreign Currency Financial Statements 419

currency of the primary economic environment in which a subsidiary operates. It can either be the same as the currency in which the parent presents its ! nancial statements or be a different, foreign currency. IAS 21 provides a list of factors that should be considered in determining the functional currency (shown in Exhibit 8.3 ). Unlike U.S. GAAP, IAS 21 provides a hierarchy of primary and secondary factors to be considered in determining the functional currency of a foreign subsidiary. In addition, there are several differences in the factors to be considered under IFRS and U.S. GAAP. As a result of these differences, it is possible that a foreign subsid- iary could be viewed as having one functional currency under IFRS but a different functional currency under U.S. GAAP.

IAS 21 requires the ! nancial statements of a foreign subsidiary that has a func- tional currency different from the reporting currency of the parent to be translated using the current rate method, with the resulting translation adjustment reported as a separate component of stockholders’ equity. Upon disposal of a foreign sub- sidiary, the cumulative translation adjustment related to that particular foreign subsidiary is transferred to income in the same period in which the gain or loss on disposal is recognized. The ! nancial statements of a foreign subsidiary whose functional currency is the same as the parent’s reporting currency are translated using the temporal method, with the resulting translation adjustment reported currently as a gain or loss in income. The same combinations are required under U.S. GAAP.

For foreign subsidiaries whose functional currency is the currency of a hyperin" ationary economy, IAS 21 requires the parent ! rst to restate the for- eign ! nancial statements for in" ation using rules in IAS 29, Financial Reporting in Hyperin" ationary Economies, and then translate the statements into parent com- pany currency using the current exchange rate. All balance sheet accounts, includ- ing stockholders’ equity, and all income statement accounts are translated at the

Factors Considered in Determining the Functional Currency

In accordance with IAS 21, The Effects of Changes in Foreign Exchange Rates, the following factors should be considered fi rst in determining an entity’s functional currency:

1. The currency ( a ) that mainly infl uences sales prices for goods and services and ( b ) of the country whose competitive forces and regulations mainly determine the sales price of its goods and services.

2. The currency that mainly infl uences labor, material, and other costs of providing goods and services.

If the primary factors listed above are mixed and the functional currency is not obvious, the following secondary factors must be considered:

3. The currency in which funds from fi nancing activities are generated. 4. The currency in which receipts from operating activities are usually retained. 5. Whether the activities of the foreign operation are an extension of the parent’s or

are carried out with a signifi cant amount of autonomy. 6. Whether transactions with the parent are a large or a small proportion of the foreign

entity’s activities. 7. Whether cash fl ows generated by the foreign operation directly affect the cash fl ow

of the parent and are available to be remitted to the parent. 8. Whether operating cash fl ows generated by the foreign operation are suffi cient to

service existing and normally expected debt or whether the foreign entity will need funds from the parent to service its debt.

EXHIBIT 8.3 IAS 21 Functional Currency Indicators

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420 Chapter Eight

current exchange rate. This approach is substantively different from U.S. GAAP, which requires translation of ! nancial statements of a foreign subsidiary operat- ing in a highly in" ationary economy using the temporal method. IAS 29 provides no speci! c de! nition for hyperin" ation but suggests that a cumulative three-year in" ation rate approaching or exceeding 100 percent is evidence that an economy is hyperin" ationary. We describe the process of adjusting ! nancial statements for in" ation under IAS 29 in Chapter 9.

THE TRANSLATION PROCESS ILLUSTRATED

To provide a basis for demonstrating the translation procedures prescribed by both IFRS and U.S. GAAP, assume that Multico (a U.S.-based company) forms a wholly owned subsidiary in Italy (Italco) on December 31, Year 0. On that date, Multico invests $1,350,000 in exchange for all of the subsidiary’s capital stock. Given the exchange rate of €1.00  =  $1.35, the initial capital investment is €1,000,000, of which €600,000 is immediately invested in inventory and the remainder is held in cash. Thus, Italco begins operations on January 1, Year 1, with stockholders’ equity (net assets) of €1,000,000 and net monetary assets of €400,000. Italco’s beginning balance sheet on January 1, Year 1, is shown in Exhibit 8.4.

During Year 1, Italco purchased property and equipment, acquired a patent, and made additional purchases of inventory, primarily on account. A ! ve-year loan was negotiated to help ! nance the purchase of equipment. Sales were made, primarily on account, and expenses were incurred. Income after taxes of €825,000 was generated, with dividends of €325,000 declared on December 1, Year 1. Financial statements for Year 1 (in euros) appear in Exhibit 8.5.

To properly translate the euro ! nancial statements into U.S. dollars, we must gather exchange rates between the euro and the U.S. dollar at various times. Relevant exchange rates are as follows:

January 1, Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1.35 Rate when property and equipment were acquired and long-term debt was incurred, January 15, Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.33 Rate when patent was acquired, February 1, Year 1 . . . . . . . . . . . . . . . . . . 1.32 Average Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.30 Rate when dividends were declared, December 1, Year 1 . . . . . . . . . . . . . . 1.27 Average for the month of December . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.26 December 31, Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.25

As can be seen, the euro steadily declined in value against the U.S. dollar dur- ing the year.

ITALCO Beginning Balance Sheet

January 1, Year 1

Assets € Liabilities and Equity € Cash . . . . . . . . . . . . . 400,000 Capital stock . . . . . . . . . . 1,000,000 Inventory . . . . . . . . . 600,000 1,000,000

1,000,000

EXHIBIT 8.4

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Translation of Foreign Currency Financial Statements 421

Income Statement Year 1

€

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000,000 Gross profi t . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000,000 Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . 500,000 Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 Amortization expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180,000 Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,100,000 Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 825,000

Statement of Retained Earnings Year 1

€

Retained earnings, 1/1/Y1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Net income, Y1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 825,000 Less: Dividends, 12/1/Y1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (325,000) Retained earnings, 12/31/Y1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000

Balance Sheet December 31, Year 1

Assets € Liabilities and Equity € Cash . . . . . . . . . . . . . . . . . 550,000 Accounts payable . . . . . . 330,000 Accounts receivable 600,000 Total current liabilities . . 330,000 Inventory* . . . . . . . . . . . . . 800,000 Long-term debt . . . . . . . . 2,000,000 Total current assets . . . . 1,950,000 Total liabilities . . . . . . . 2,330,000 Property and equipment . . . 2,000,000 Capital stock . . . . . . . . . . 1,000,000 Less: Accumulated Retained earnings . . . . . . 500,000 depreciation . . . . . . . . . . (200,000) Total . . . . . . . . . . . . . . 3,830,000 Patents, net . . . . . . . . . . . . 80,000 Total assets . . . . . . . . . . 3,830,000

* Inventory is carried at ! rst-in, ! rst-out (FIFO) cost; ending inventory was acquired evenly throughout the month of December.

EXHIBIT 8.5 Italco’s Financial Statements, Year 1

TRANSLATION OF FINANCIAL STATEMENTS: CURRENT RATE METHOD

The ! rst step in translating foreign currency ! nancial statements is the determina- tion of the functional currency. Assuming that the euro is the functional currency, the income statement and statement of retained earnings would be translated into U.S. dollars using the current rate method, as shown in Exhibit 8.6.

All revenues and expenses are translated at the exchange rate in effect at the date of accounting recognition. The weighted-average exchange rate for Year 1 is used because each revenue and expense in this illustration would have been rec- ognized evenly throughout the year. However, when an income account, such as

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422 Chapter Eight

a gain or loss, occurs at a speci! c time, the exchange rate as of that date is applied. Depreciation and amortization expense are also translated at the average rate for the year. These expenses accrue evenly throughout the year even though the jour- nal entry may have been delayed until year-end for convenience.

The translated amount of net income for Year 1 is transferred from the income statement to the statement of retained earnings. Dividends are translated at the exchange rate that exists on the date of declaration.

Translation of the Balance Sheet Italco’s translated balance sheet is shown in Exhibit 8.7. All assets and liabilities are translated at the current exchange rate. Capital stock is translated at the ex- change rate that existed when the capital stock was originally issued. Retained earnings at December 31, Year 1, is brought down from the statement of retained earnings. Application of these procedures results in total assets of $4,787,500 and total liabilities and equities of $4,922,250. The balance sheet is brought back into balance by creating a negative translation adjustment of $134,750, which is treated as a decrease in stockholders’ equity.

Note that the translation adjustment for Year 1 is a negative $134,750 (debit bal- ance). The sign of the translation adjustment (positive or negative) is a function of two factors: (1) the nature of the balance sheet exposure (asset or liability) and (2) the direction of change in the exchange rate (appreciation or depreciation). In this illustration, Italco has a net asset exposure (total assets translated at the current

EXHIBIT 8.6 Translation of Income Statement and Statement of Retained Earnings: Current Rate Method

Income Statement Year 1

€

Translation Rate* US$

Sales . . . . . . . . . . . . . . . . . . . . . . . . . 8,000,000 $1.30 (A) 10,400,000 Cost of goods sold . . . . . . . . . . . . . . . 6,000,000 1.30 (A) 7,800,000 Gross profi t . . . . . . . . . . . . . . . . . . . . 2,000,000 2,600,000 Selling and administrative expenses . . 500,000 1.30 (A) 650,000 Depreciation expense . . . . . . . . . . . . . 200,000 1.30 (A) 260,000 Amortization expense . . . . . . . . . . . . 20,000 1.30 (A) 26,000 Interest expense . . . . . . . . . . . . . . . . . 180,000 1.30 (A) 234,000 Income before income taxes . . . . . . . . 1,100,000 1,430,000 Income taxes . . . . . . . . . . . . . . . . . . . 275,000 1.30 (A) 357,500 Net income . . . . . . . . . . . . . . . . . . . . 825,000 1,072,500

Statement of Retained Earnings Year 1

€

Translation Rate* US$

Retained earnings, 1/1/Y1 . . . . . . . . . 0 0 Net income, Year 1 . . . . . . . . . . . . . . 825,000 From income

statement 1,072,500 Less: Dividends, 12/1/Y1 . . . . . . . . . . . (325,000) 1.27 (H) (412,750) Retained earnings, 12/31/Y1 . . . . . . . 500,000 659,750

* Indicates the exchange rate used and whether the rate is the current rate (C), the average rate (A), or a historical rate (H).

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Translation of Foreign Currency Financial Statements 423

exchange rate are greater than total liabilities translated at the current exchange rate), and the euro has depreciated, creating a negative translation adjustment.

The translation adjustment can be derived as a balancing ! gure that brings the balance sheet back into balance. The translation adjustment also can be calculated by considering the impact of exchange rate changes on the beginning balance and subsequent changes in the net asset position. The following steps are applied:

1. The net asset balance of the subsidiary at the beginning of the year is translated at the exchange rate in effect on that date.

2. Individual increases and decreases in the net asset balance during the year are translated at the rates in effect when those increases and decreases occur. Only a few events actually change net assets (e.g., net income, dividends, stock issu- ance, and the acquisition of treasury stock). Transactions such as the acquisition of equipment or the payment of a liability have no effect on total net assets.

3. The translated beginning net asset balance ( a ) and the translated value of the individual changes ( b ) are then combined to arrive at the relative value of the net assets being held prior to the impact of any exchange rate " uctuations.

4. The ending net asset balance is then translated at the current exchange rate to determine the reported value after all exchange rate changes have occurred.

5. The translated value of the net assets prior to any rate changes ( c ) is compared with the ending translated value ( d ). The difference is the result of exchange rate changes during the period. If ( c ) is greater than ( d ), then a negative (debit) translation adjustment arises. If ( d ) is greater than ( c ), a positive (credit) transla- tion adjustment results.

Balance Sheet December 31, Year 1

Assets € Translation Rate* US$

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 550,000 $1.25 (C) 687,500 Accounts receivable . . . . . . . . . . . . . . 600,000 1.25 (C) 750,000 Inventory . . . . . . . . . . . . . . . . . . . . . . 800,000 1.25 (C) 1,000,000 Total current assets . . . . . . . . . . . . . 1,950,000 2,437,500 Property and equipment . . . . . . . . . . . 2,000,000 1.25 (C) 2,500,000 Less: Accumulated depreciation. . . . . . (200,000) 1.25 (C) (250,000) Patents, net . . . . . . . . . . . . . . . . . . . . 80,000 1.25 (C) 100,000 Total assets . . . . . . . . . . . . . . . . . . . 3,830,000 4,787,500

Liabilities and Equity

Accounts payable . . . . . . . . . . . . . . . . 330,000 $1.25 (C) 412,500 Total current liabilities . . . . . . . . . . . 330,000 412,500 Long-term debt . . . . . . . . . . . . . . . . . 2,000,000 1.25 (C) 2,500,000 Total liabilities . . . . . . . . . . . . . . . . . 2,330,000 2,912,500 Capital stock . . . . . . . . . . . . . . . . . . . 1,000,000 1.35 (H) 1,350,000 Retained earnings . . . . . . . . . . . . . . . . 500,000 From statement of

retained earnings 659,750 Cumulative translation adjustment . . . — To balance (134,750) Total equity . . . . . . . . . . . . . . . . . . . 1,500,000 1,875,000

3,830,000 4,787,500

EXHIBIT 8.7 Translation of Balance Sheet: Current Rate Method

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424 Chapter Eight

Computation of Translation Adjustment According to the process just described, determination of the translation adjust- ment to be reported for Italco in this example is calculated as follows:

€ US$

Net asset balance, 1/1/Y1 . . . . . . . . . . . . . . . 1,000,000 × 1.35 = 1,350,000 Change in net assets: Net income, Year 1 . . . . . . . . . . . . . . . . . . 825,000 × 1.30 = 1,072,500 Dividends, 12/1/Y1 . . . . . . . . . . . . . . . . . . (325,000) × 1.27 = (412,750) Net asset balance, 12/31/Y1 . . . . . . . . . . . . . 1,500,000 2,009,750

Net asset balance, 12/31/Y1, at current exchange rate . . . . . . . . . . . . . . . . . . . . . . 1,500,000 × 1.25 = 1,875,000 Translation adjustment, Year 1 (negative) . . . 134,750

Since this subsidiary began operations at the beginning of the current year, $134,750 is the amount of cumulative translation adjustment reported on the consolidated balance sheet. The translation adjustment is reported as a separate component of equity only until the foreign operation is sold or liquidated. In the period in which a sale or liquidation occurs, the cumulative translation adjustment related to the particular foreign subsidiary must be removed from equity and reported as part of the gain or loss on the sale of the investment.

REMEASUREMENT OF FINANCIAL STATEMENTS: TEMPORAL METHOD

Now assume that a careful examination of the functional currency indicators leads Multico’s management to conclude that Italco’s functional currency is the U.S. dollar. In that case, the euro ! nancial statements will be remeasured into U.S. dollars using the temporal method and the remeasurement gain or loss will be reported in income. To ensure that the remeasurement gain or loss is reported in income, it is easier to remeasure the balance sheet ! rst (as shown in Exhibit 8.8 ).

According to the procedures outlined in Exhibit 8.1 , under the temporal method, cash, receivables, and liabilities are remeasured into U.S. dollars using the current exchange rate of $1.25. Inventory, carried at ! rst-in, ! rst-out (FIFO) cost; property and equipment; patents; and the capital stock account are remea- sured at historical rates. These procedures result in total assets of $4,945,100, and liabilities and capital stock of $4,262,500. In order for the balance sheet to balance, retained earnings must be $682,600. The accuracy of this amount is veri- ! ed below.

Remeasurement of Income Statement The remeasurement of Italco’s income statement and statement of retained earn- ings is demonstrated in Exhibit 8.9. Revenues and expenses incurred evenly throughout the year (sales, selling and administrative expenses, interest expense, and income taxes) are remeasured at the average exchange rate. Expenses related to assets remeasured at historical exchange rates (depreciation expense and amor- tization expense) are themselves remeasured at relevant historical rates.

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Translation of Foreign Currency Financial Statements 425

EXHIBIT 8.8 Translation of Balance Sheet: Temporal Method

Balance Sheet December 31, Year 1

Assets € Translation Rate* US$

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 550,000 $1.25 (C) 687,500 Accounts receivable . . . . . . . . . . . . . . 600,000 1.25 (C) 750,000 Inventory . . . . . . . . . . . . . . . . . . . . . . 800,000 1.26 (H) 1,008,000 Total current assets . . . . . . . . . . . . . 1,950,000 2,445,500 Property and equipment . . . . . . . . . . . 2,000,000 1.33 (H) 2,660,000 Less: Accumulated depreciation . . . . . (200,000) 1.33 (H) (266,000) Patents, net . . . . . . . . . . . . . . . . . . . . 80,000 1.32 (H) 105,600 Total assets . . . . . . . . . . . . . . . . . . . 3,830,000 4,945,100

Liabilities and Equity

Accounts payable . . . . . . . . . . . . . . . . 330,000 $1.25 (C) 412,500 Total current liabilities . . . . . . . . . . . 330,000 412,500 Long-term debt . . . . . . . . . . . . . . . . . . 2,000,000 1.25 (C) 2,500,000 Total liabilities . . . . . . . . . . . . . . . . . 2,330,000 2,912,500 Capital stock . . . . . . . . . . . . . . . . . . . . 1,000,000 1.35 (H) 1,350,000 Retained earnings . . . . . . . . . . . . . . . . 500,000 To balance 682,600 Total equity . . . . . . . . . . . . . . . . . . . 1,500,000 2,032,600

3,830,000 4,945,100

Income Statement Year 1

€

Translation Rate* US$

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000,000 $1.30 (A) 10,400,000 Cost of goods sold . . . . . . . . . . . . . . . . . 6,000,000 calculation (H) 7,862,000 Gross profi t . . . . . . . . . . . . . . . . . . . . . . . 2,000,000 2,538,000 Selling and administrative expenses . . . . . 500,000 1.30 (A) 650,000 Depreciation expense . . . . . . . . . . . . . . . 200,000 1.33 (H) 266,000 Amortization expense . . . . . . . . . . . . . . . 20,000 1.32 (H) 26,400 Interest expense . . . . . . . . . . . . . . . . . . . 180,000 1.30 (A) 234,000 Income before income taxes . . . . . . . . . . 1,100,000 1,361,600 Income taxes . . . . . . . . . . . . . . . . . . . . . . (275,000) 1.30 (A) (357,500) Remeasurement gain . . . . . . . . . . . . . . . — To balance 91,250

Net income . . . . . . . . . . . . . . . . . . . . . . . 825,000 1,095,350

Statement of Retained Earnings Year 1

€

Translation Rate* US$

Retained earnings, 1/1/Y1 . . . . . . . . . . . . 0 0 Net income, Year 1 . . . . . . . . . . . . . . . . . 825,000 From income

statement 1,095,350 Less: Dividends, 12/1/Y1 . . . . . . . . . . . . . (325,000) 1.27 (H) (412,750) Retained earnings, 12/31/Y1 . . . . . . . . . . 500,000 682,600

EXHIBIT 8.9 Translation of Income Statement and Statement of Retained Earnings: Temporal Method

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426 Chapter Eight

Cost of goods sold is remeasured at historical exchange rates using the following procedure. Beginning inventory was acquired on January 1 and is remeasured at the exchange rate from that date ($1.35). Purchases were made evenly throughout the year and are therefore remeasured at the average rate for the year ($1.30). Ending inventory (at FIFO cost) was purchased evenly throughout the month of December, and the average exchange rate for that month ($1.26) is used to remeasure that component of cost of goods sold. These procedures result in cost of goods sold of $7,862,000, calculated as follows:

€ US$

Beginning inventory . . . . . . . . . . . 600,000 × $1.35 = 810,000 Plus: Purchases. . . . . . . . . . . . . . . . 6,200,000 × $1.30 = 8,060,000 Less: Ending inventory . . . . . . . . . . (800,000) × $1.26 = (1,008,000) Cost of goods sold. . . . . . . . . . . . . 6,000,000 7,862,000

The ending balance in retained earnings on the balance sheet and in the state- ment of retained earnings must reconcile with one another. Given that dividends are remeasured into a U.S.-dollar equivalent of $412,750 and the ending balance in retained earnings on the balance sheet is $682,600, net income must be $1,095,350.

In order for the amount of income reported in the statement of retained earnings and in the income statement to reconcile with one another, a remeasurement gain of $91,250 is required in the calculation of income. Without this remeasurement gain, the income statement, statement of retained earnings, and balance sheet will not be consistent with one another.

The remeasurement gain can be calculated by considering the impact of exchange rate changes on the subsidiary’s balance sheet exposure. Under the temporal method, Italco’s balance sheet exposure is de! ned by its net monetary asset or net monetary liability position. Italco began Year 1 with net monetary assets (cash) of €400,000. During the year, however, expenditures of cash and the incurrence of liabilities caused monetary liabilities (Accounts payable  +  Long-term debt  =  €2,330,000) to exceed monetary assets (Cash  +  Accounts receivable  =  €1,150,000). A net mon- etary liability position of €1,180,000 exists at December 31, Year 1. The remeasure- ment gain is computed by translating the beginning net monetary asset position and subsequent changes in monetary items at appropriate exchange rates and then com- paring this with the U.S.-dollar value of net monetary liabilities at year-end based on the current exchange rate.

Computation of Remeasurement Gain

€

Translation Rate US$

Net monetary assets, 1/1/Y1 . . . . . . . . . . . . . 400,000 $1.35 540,000 Increase in monetary items: Sales, Year 1 . . . . . . . . . . . . . . . . . . . . . . . 8,000,000 1.30 10,400,000 Decrease in monetary items: Purchases of inventory, Year 1 . . . . . . . . . . (6,200,000) 1.30 (8,060,000) Selling and administrative expenses, Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . (500,000) 1.30 (650,000) Payment of interest, Year 1 . . . . . . . . . . . . (180,000) 1.30 (234,000)

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Translation of Foreign Currency Financial Statements 427

Income taxes, Year 1 . . . . . . . . . . . . . . . . . (275,000) 1.30 (357,500) Purchase of property and equipment, 1/15/Y1 . . . . . . . . . . . . . . . . . . . . . . . . . (2,000,000) 1.33 (2,660,000) Acquisition of patent, 2/1/Y1 . . . . . . . . . . . (100,000) 1.32 (132,000) Dividends, 12/1/Y1 . . . . . . . . . . . . . . . . . . (325,000) 1.27 (412,750) Net monetary liabilities, 12/31/Y1 . . . . . . . . . (1,180,000) (1,566,250) Net monetary liabilities, 12/31/Y1, at the current exchange rate . . . . . . . . . . . (1,180,000) 1.25 (1,475,000)

Remeasurement gain . . . . . . . . . . . . . . . . . . (91,250)

€

Translation Rate US$

If Italco had maintained its net monetary asset position (cash) of €400,000 for the entire year, a remeasurement loss of $40,000 would have resulted. (The euro amount held in cash was worth $540,000 [€400,000  ×  $1.35] at the beginning of the year and $500,000 [€400,0000  ×  $1.25] at year-end.) However, the net monetary asset position is not maintained. Indeed, a net monetary liability position arises. The depreciation of the foreign currency coupled with an increase in net monetary liabilities generates a remeasurement gain for the year.

NONLOCAL CURRENCY BALANCES

An additional issue relates to how nonlocal currency balances in the foreign currency ! nancial statements of foreign operations are reported in the consolidated ! nancial statements. For example, if any of the accounts of the Italian subsidiary are denomi- nated in a currency other than the euro, those balances would ! rst have to be restated into euros in accordance with the rules discussed in the previous chapter. Both the foreign currency balance and any related foreign exchange gain or loss would then be translated (or remeasured) into U.S. dollars. For example, assume that Italco borrows 100,000 Swiss francs on January 1, Year 1, and has a 100,000 Swiss franc note payable throughout Year 1. Exchange rates in Year 1 between the Swiss franc (CHF) and the euro (€) and between the euro and the U.S. dollar ($) are as follows:

€ per CHF $ per €

January 1, 2013. . . . . . . . . . . . . . . 0.80 $1.35 Average 2013 . . . . . . . . . . . . . . . . 0.82 $1.30 December 31, 2013. . . . . . . . . . . . 0.85 $1.25

On December 31, Year 1, Italco remeasures the CHF 100,000 note payable into CHF using the current exchange rate as follows: CHF 100,000 3 € 0.85 5 € 85,000. Italco also recognizes a foreign exchange loss of € 5,000 [CHF 100,000 3 (€ 0.85 2 € 0.80)] on the Swiss franc note payable due to the appreciation of the Swiss franc against the euro. To consolidate Italco’s Swiss franc ! nancial statements with those of its parent, the note payable remeasured in euros is then translated into U.S. dollars using the current exchange rate and the related foreign exchange loss in euros is translated into U.S. dollars using the average exchange rate as follows:

Note payable .............................. € 85,000 3 $1.25 (C) 5 $106,250 Foreign exchange loss ................... € 5,000 3 $1.30 (A) 5 $6,500

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428 Chapter Eight

A note payable of $106,250 will be reported on the consolidated balance sheet, and a loss of $6,500 will be re" ected in the measurement of consolidated net income.

COMPARISON OF THE RESULTS FROM APPLYING THE TWO DIFFERENT METHODS

The use of different translation methods can have a signi! cant impact on Multico’s consolidated ! nancial statements. The chart below shows differences for Italco in several key items under the two different translation methods:

Translation Method

Item Current Rate Temporal Difference

Net income . . . . . . . . . . . . . . . . . . . $1,072,500 $1,095,350 +2.1% Total assets . . . . . . . . . . . . . . . . . . . $4,787,500 $4,945,100 +3.3% Total equity . . . . . . . . . . . . . . . . . . . $1,875,000 $2,032,600 +8.4% Return on ending equity . . . . . . . . . 57.2% 53.9% −5.8%

If the temporal method is applied, net income is 2.1 percent greater, total assets are 3.3 percent greater, and total equity is 8.4 percent greater than if the current rate method is applied. Because of the larger amount of equity under the temporal method, return on ending equity (net income/total equity) is only 53.9 percent as opposed to 57.2 percent using the current rate method.

It should be noted that the temporal method does not always result in larger net income (and a greater amount of equity) than the current rate method. For example, if Italco had maintained its net monetary asset position throughout the year, a remea- surement loss would have been computed under the temporal method, leading to lower income than under the current rate method. Moreover, if the euro had appreci- ated during Year 1, the current rate method would have resulted in higher net income.

The important point is that selection of translation method can have a signi! - cant impact on the amounts reported by a parent company in its consolidated ! nancial statements. Different functional currencies selected by different compa- nies in the same industry could have a signi! cant impact on the comparability of ! nancial statements within that industry.

In addition to differences in amounts reported in the consolidated ! nancial statements, the results of the Italco illustration can be used to demonstrate several conceptual differences between the two translation methods.

Underlying Valuation Method Using the temporal method, Italco’s property and equipment was remeasured as follows:

Property and equipment . . . . . . . . . €2,000,000 × $1.33 H = $2,660,000

By multiplying the historical cost in euros by the historical exchange rate, $2,660,000 represents the U.S.-dollar equivalent historical cost of this asset. It is the amount of U.S. dollars that the parent company would have had to pay to acquire assets having a cost of €2,000,000 when the exchange rate was $1.33 per euro.

Property and equipment was translated under the current rate method as follows:

Property and equipment . . . . . . . . . . €2,000,000 × $1.25 C = $2,500,000

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Translation of Foreign Currency Financial Statements 429

The $2,500,000 amount is not readily interpretable. It does not represent the U.S.- dollar equivalent historical cost of the asset; that amount is $2,660,000. It also does not represent the U.S.-dollar equivalent current cost of the asset, because €2,000,000 is not the current cost of the asset in Italy. The $2,500,000 amount is simply the product of multiplying two numbers together!

Underlying Relationships The following table reports the values for selected ! nancial ratios calculated from the original foreign currency ! nancial statements and from the U.S.-dollar trans- lated statements using the two different translation methods.

US$

Ratio € Current Rate Temporal

Current ratio (Current assets/Current liabilities) . . . . . . 5.91 5.91 5.93 Debt/equity ratio (Total liabilities/Total equity) . . . . . . 1.55 1.55 1.43 Gross profi t ratio (Gross profi t/Sales) . . . . . . . . . . . . . . 25.0% 25.0% 24.4% Return on equity (Net income/Total equity) . . . . . . . . . 55.0% 57.2% 53.9%

The temporal method distorts all of the ratios as measured in the foreign cur- rency. The subsidiary appears to be more liquid, less highly leveraged, and less pro! table than it does in euro terms.

The current rate method maintains the ! rst three ratios, but return on equity is distorted. This distortion occurs because income was translated at the average- for-the-period exchange rate, whereas total equity was translated at the current exchange rate. In fact, any ratio that combines balance sheet and income statement ! gures, such as turnover ratios, will be distorted because of the use of the average rate for income and the current rate for assets and liabilities.

Conceptually, when the current rate method is employed, income statement items can be translated either at exchange rates in effect when sales are made and expenses are incurred (approximated by the average rate) or at the current exchange rate at the balance sheet date. IFRS and U.S. GAAP require the average exchange rate to be used. In this illustration, if revenues and expenses had been translated at the current exchange rate, net income would have been $1,031,250 (€825,000  ×  $1.25), and the return on equity would have been 55.0 percent ($1,031,250/$1,875,000), exactly the amount re" ected in the euro ! nancial statements.

HEDGING BALANCE SHEET EXPOSURE

When a foreign operation is determined to have the parent’s reporting currency as its functional currency or is located in a highly in" ationary economy, remea- surement gains and losses will be reported in the consolidated income statement. Management of multinational companies might wish to avoid reporting remea- surement losses in income because of the perceived negative impact this has on the company’s stock price or the adverse effect on incentive compensation. Like- wise, when the foreign operation has a foreign currency as its functional currency, management might wish to avoid reporting negative translation adjustments in stockholders’ equity because of the adverse impact on ratios such as the debt-to- equity ratio.

Translation adjustments and remeasurement gains/losses are a function of two factors: (1) changes in the exchange rate and (2) balance sheet exposure. While individual companies have no in" uence over exchange rates, there are several

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430 Chapter Eight

techniques that parent companies can use to hedge the balance sheet exposures of their foreign operations. Each of these techniques involves creating an equilibrium between foreign currency asset and foreign currency liability balances that are translated at current exchange rates.

Balance sheet exposure can be hedged through the use of a derivative ! nancial instrument such as a forward contract or foreign currency option, or through the use of a nonderivative hedging instrument such as a foreign currency borrowing. To illustrate, assume that Italco’s functional currency is the euro; this creates a net asset balance sheet exposure. Multico believes that the euro will lose value over the course of the next year, thereby generating a negative translation adjustment that will reduce consolidated stockholders’ equity. Multico can hedge this balance sheet exposure by borrowing euros for a period of time, thus creating an offsetting euro liability exposure. As the euro depreciates, a foreign exchange gain will arise on the euro liability that offsets the negative translation adjustment arising from the translation of Italco’s ! nancial statements.

As an alternative to the euro borrowing, Multico might have acquired a euro call option to hedge its balance sheet exposure. As the euro depreciates, the fair value of the call option should increase, resulting in a gain. Both IFRS and U.S. GAAP provide that the gain or loss on a hedging instrument that is designated and effective as a hedge of the net investment in a foreign operation should be reported in the same manner as the translation adjustment being hedged. Thus, the foreign exchange gain on the euro borrowing or the gain on the foreign currency option would be included in other comprehensive income along with the negative trans- lation adjustment arising from the translation of Italco’s ! nancial statements. This is an exception to the general rule that foreign currency gains and losses are taken directly to net income. In the event that the gain on the hedging instrument is greater than the translation adjustment being hedged, the excess is taken to net in- come. Exhibit 8.10 contains disclosures made by International Business Machines Corporation (IBM) in its 2012 annual report with respect to hedging net invest- ments in foreign operations.

The paradox of hedging a balance sheet exposure is that in the process of avoiding an unrealized translation adjustment, realized foreign exchange gains and losses can result. Consider Multico’s foreign currency borrowing to hedge a euro exposure. At initiation of the loan, Multico will convert the borrowed euros into U.S. dollars at the spot exchange rate. When the liability matures,

INTERNATIONAL BUSINESS MACHINES CORPORATION Annual Report

2012

Excerpt from Note D. Financial Instruments

Long-Term Investments in Foreign Subsidiaries (Net Investment)

A large portion of the company’s foreign currency denominated debt portfolio is designated as a hedge of net investment in foreign subsidiaries to reduce the volatility in stockholders’ equity caused by changes in foreign currency exchange rates in the functional currency of major foreign subsidiaries with respect to the U.S. dollar. The company also uses cross-currency swaps and foreign exchange forward contracts for this risk management purpose. At December 31, 2012 and 2011, the total notional amount of derivative instruments designated as net investment hedges was $3.3 billion and $5.0 billion, respectively.

EXHIBIT 8.10

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Translation of Foreign Currency Financial Statements 431

Multico will purchase euros at the spot rate prevailing at that date to repay the loan. The change in exchange rate over the life of the loan will generate a real- ized gain or loss. If the euro depreciates as expected, the result will be a realized foreign exchange gain that will offset the negative translation adjustment in other comprehensive income. Although the net effect on other comprehensive income is zero, there is a net increase in cash as a result of the hedge. If the euro unexpectedly appreciates, a realized foreign exchange loss will occur. This will be offset by a positive translation adjustment in other comprehensive income, but a net decrease in cash will arise. While a hedge of a net investment in a foreign operation eliminates the possibility of reporting a negative translation adjustment in other comprehensive income, the result can be realized gains and losses that affect cash " ow.

Exhibit 8.11 presents an excerpt from the notes to the consolidated ! nancial statements in Nokia Corporation’s 2012 annual report ! led on Form 20-F. Nokia prepares its ! nancial statements in accordance with IFRS, and the excerpt de- scribes Nokia’s compliance with IAS 39 with respect to hedging of net invest- ments. Nokia uses forward contracts, options, and foreign currency borrowings to hedge its balance sheet exposures. Hedge accounting is applied when hedges are properly documented and effective. Changes in fair value of forward contracts at- tributable to changes in the spot rate, changes in the intrinsic value of options, and foreign exchange gains and losses on foreign currency borrowings are deferred in stockholders’ equity until the subsidiary whose balance sheet exposure is being hedged is sold or liquidated. This also is consistent with the guidance provided under U.S. GAAP.

NOKIA CORPORATION Form 20-F

2012

Excerpt from Note 1. Accounting Principles

Hedges of Net Investments in Foreign Operations

The Group also applies hedge accounting for its foreign currency hedging on net investments. Qualifying hedges are those properly documented hedges of the foreign exchange rate risk of foreign currency-denominated net investments that are effective both prospectively and retrospectively.

For qualifying foreign exchange forwards the change in fair value that refl ects the change in spot exchange rates is deferred in translation differences within consolidated shareholders’ equity. The change in fair value that refl ects the change in forward exchange rates less the change in spot exchange rates is recognized in profi t and loss in fi nancial income and expenses. For qualifying foreign exchange options the change in intrinsic value is deferred in translation differences within consolidated shareholders’ equity. Changes in the time value are at all times recognized directly in profi t and loss account as fi nancial income and expense. If a foreign currency–denominated loan is used as a hedge, all foreign exchange gains and losses arising from the transaction are recognized in translation differences within consolidated shareholders’ equity. In all cases, the ineffective portion is recognized immediately in profi t and loss as fi nancial income and expenses.

Accumulated changes in fair value from qualifying hedges are released from translation differences on the disposal of all or part of a foreign group company by sale, liquidation, repayment of share capital, or abandonment. The cumulative amount or proportionate share of the changes in the fair value from qualifying hedges deferred in translation differences is recognized as income or as expense when the gain or loss on disposal is recognized.

EXHIBIT 8.11

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432 Chapter Eight

EXHIBIT 8.12

MCDONALD’S CORPORATION Annual Report

2012