Accounting for Global Enterprises

1. Accounting for Global Enterprises MIM517 Elizabeth Dreike Almer, PhD, CPA Fall 2010 Class 1

2. Learning Objectives • Refresh knowledge of basic U.S. financial statements • Consider why Net Income is not an exact amount • Gain familiarity with F/S and annual filings • Discuss FSA project • Overview GAAP convergence

3. Basic Accounting Concepts How do you evaluate a company? • Products or services? • Company management? • Profitability? • “Financial condition”?

4. Definitions: • Profit: a measure of what is left over from revenues and gains after deducting expenses and losses • Revenue: the money a company either received or is entitled to receive in exchange for goods or services it provided • Expenses: the costs a company incurs in order to generate revenues • Gains/Losses: increases/decreases in co. assets that result from transactions not part of co.’s regular business

5. Thus…. Net income=Revenue-Expenses+Gains-Losses

6. Consider an example: You have decided to form an import company which will purchase inexpensive watches from overseas and sell them to retailers in the Pacific NW. You arrange with a supplier to provide you with an initial shipment of 11,000 watches in your first month of operations. Your cost will be $5 (US) per watch. Because the supplier is interested in gaining your business but knows you are just starting out, he agrees to let you pay 50% on delivery and 50% in 60 days.

7. You now start to line up buyers in the region. You find a retail chain that is interested in buying 10,000 watches at $8 each. The retailer offers to pay $60,000 on delivery and $20,000 in 30 days. You readily agree since the retailer is well known and in good financial condition. This ends your first month of business. In a perfect world (no taxes and no other expenses) what is your profit?

8. What is your profit? • If we calculate profit for each watch sold, we would have $8 revenue and $5 of expenses, for a profit of $3 per watch. • On an overall basis, what is your profit for the first month?

9. What are revenues? Alternative 1: • We sold 10,000 watches at $8 each, so $80,000? Alternative 2: • Will we ever collect the $20,000 due to us (Accounts Receivable)? • If in doubt, should we be conservative? Then only report $60,000 Alternative 3: • Assume we will sell the remaining watches at $8. • Then report $88,000 even though only sold 10,000 watches

10. In order to recognize revenue • Recognition: The earnings process must be complete and the value of the transaction can be measured. • Realization: The revenue must have been collected OR there must be some assurance that it will be collected. • Earned: The seller must have substantially performed its obligation. • So we are left with two possibilities for revenue: $80,000 or $60,000

11. What are expenses? Alternative 1: • We have purchased 11,000 watches at $5 each, so we could say expenses are $55,000. Alternative 2: • Report as expense only the amount we have paid so far, which is $27,500 (the balance of $27,500 still owed is called Accounts Payable) Alternative 3: • Report as expenses only the cost of the 10,000 watches sold. The remaining $5000 of watches would be considered inventory.

12. Possible net income amounts

13. What is “financial condition”? • Earlier we noted that we were willing to extend credit to a retailer because of its strong financial condition. How would we measure financial condition at a particular point in time? • Let’s examine the position of our import company at the end of the first month. What are our resources (assets) and what claims exist against those resources (liabilities and equity)?

14. Definitions: • Assets: Anything of measurable value that will help the company provide its goods and services to its customers. Your watches in inventory are obviously an asset. But so is your telephone, since you use it to contact customers. • Liabilities: Obligations a company owes to creditors, such as your accounts payable. • Equities: The remaining value of assets after liabilities have been accounted for. This represents the ownership position of the shareholders.

15. Accounting Equation Assets = Liabilities + Owners’ Equity Where OE = contributed capital + earned capital

16. Financial Position (Balance Sheet)

17. Important Accounting Concepts • Why don’t we just record revenue when the cash come in, and expense when the cash goes out? • Accrual Basis Accounting – Earnings are determined by recognizing revenues in the accounting period earned and expenses in the period incurred, regardless of when cash changes hands.

18. More Accounting Concepts • So why is inventory valued at $5,000 in our example? Historical Cost Principle- Since estimates of the value of items may vary, transactions are usually measured at their historical cost, or the amount of cash that was originally exchanged for the asset or liability. This number is generally verifiable, and provides an objective measure of value. • The remaining $50,000 of inventory purchased in the first month was matched against the revenues generated by selling those watches. Matching Principle- Revenues and the costs related to those revenues must be reported in the same period.

19. More Accounting Concepts • Why is your personal bank account, computer, debts, etc. not included on the financial statements? Entity concept – Accounts are kept for distinct entities. What is an entity??? This become problematic when we deal with interrelated corporations and subsidiaries especially internationally. • If a subsidiary is “consolidated”, then its assets, liabilities, revenues and expenses are “smooshed” into the parent’s accounts.

20. More Accounting Concepts • Lets say we decided that to keep this watch business going, we need to advertise. So we spend $4000 on print advertisements in retail trade publications. How does this $4000 get recorded? Capitalization vs. expense - Any time we have an expenditure, we must decide if it should be “capitalized” or “expensed” • Capitalized expenditures are an asset. An asset is something with measurable future value. Generally expensed then as value is received. • Other expenditures must be expensed through the I/S

21. More Accounting Concepts • How can we assume that there will be future value to assets (i.e., capitalized expenditures)? • Going concern assumption- We assume that a business has the ability to have a long life. • If the auditors have “substantial doubt” about an entity’s ability to continue, they note that concern in the audit report

22. Question…. • What do you think of this statement? Accounting involves the use of many estimates, and is never exact, even under the best of intentions.

23. Why N/I is not an exact amount • What estimates are in Net Income? • Net Income and “Earnings Quality” • What is earnings quality? • Techniques to increase net income and • Have a “real” impact on the firm’s financial position • Lower quality of reported earnings

24. Statement of Cash Flows • The income statement and balance sheet are prepared using the accrual basis of accounting. This attempts to reflect the economic reality of what has occurred, not the actual cash that has changed hands. • The SCFs details the sources and uses of cash within three categories: operations, investing and financing activities • The SCFs is more (but not totally) objective than the B/S and I/S

25. Real Financial Statements Lets look at Starbucks.

26. Different Accounting Systems Accounting = f (local business environment) • Each country has own GAAP and F/S format • Underlying reasons for differences • Implications for different accounting practices • Terminology & reporting differences • Amount and type of disclosures (especially social & environmental) may differ • Lack of comparability

27. Evolution of GAAP Convergence • Primary Historical GAAPs • U.S. • U.K. • German • Japanese • International (IFRS) • Barriers with different GAAPs • Comparability • Consolidation • Cross-boarder access to capital

28. IFRS required or permitted No action taken/date set for adoption Local GAAP based on legacy IAS In process of adopting or converting to IFRS What is the outlook for IFRS adoption? Global snapshot • Currently, there are 117 countries that either adopted or signed to adopt IFRS: • Brazil – 2010 • Canada – 2011 • Chile – 2009/2010/2011 • India – 2011/2012 • Japan – 2010 (optional) • Mexico – 2012 • The predominance of usage of IFRS around the world provides even greater motivation for IFRS adoption in the US.

29. Timeline for IFRS Adoption in US Pre-2008 Foreign filers reconciled their GAAP to US GAAP via form 20-F 2008 Foreign filers allowed to use IFRS 2008 SEC proposes roadmap for convergence between IFRS and US GAAP 2009 Potential adoption of IFRS by limited number of companies 2009-2011 SEC to monitor progress of convergence milestones 2011 SEC to set a date for requiring all US public companies to use IFRS 2014-2016 Phased-in implementation of IFRS

30. US GAAP Principles based Total standards = 62 (8 IFRS; 29 IAS; IFRC 14; and SIC 11) More judgment required Limited interpretative guidance Similar transactions can lead to different accounting IFRS IFRS vs. US GAAP Rules based Total standards = >750 (160 SFAS; 48 FIN; 4 ARB; 17 APB; 500+ EITF; numerous SOP, SAB & FTB) Significant interpretative guidance available, including industry specific Similar transactions generally accounted for in the same way

31. Which GAAP will we use? • Use US GAAP as starting point, highlight differences with IFRS