Overview of International Financial Reporting Differences and Inflation

1. Overview of International Financial Reporting Differences and Inflation Revsine/Collins/Johnson: Chapter 18

2. Learning objectives • Why financial reporting philosophies and detailed GAAP procedures have differed across countries in the past. • How globalization has relaxed cross-border barriers and prompted convergence of reporting standards across countries. • Why the International Accounting Standards Board (IASB) has become important. • Efforts by the FASB and IASB to converge their respective standards and facilitate cross-border securities transactions. • How to cope with reporting differences that persist.

3. Learning objectives:Concluded • Whether or not the SEC will ease rules that require foreign companies listed on U.S. exchanges to reconcile their reporting methods to U.S. GAAP. • Whether compliance with GAAP is carefully monitored in different companies. • That companies in foreign countries with high inflation rates depart from the historical cost reporting model. • The two major approaches for adjusting financial reports for changing prices—current cost accounting and general price level accounting.

4. Overview:Growth in cross-border securities transactions

5. Overview:Growth in international investment

6. Overview:Largest companies

7. Overview:Why international accounting is important • U.S. companies do not dominate the global economy. • The growth in global investing has been fueled by several factors: • Relaxed security market regulatory rules have made it easier for foreign firms to meet listing requirements. • Improvements in telecommunications and computer technology have given investors access to information on a global scale. • Investors understand that portfolios based on a global investment strategy are less risky than are those composed exclusively of domestic companies.

8. International financial reporting:Two approaches • Before the early 1990s, two widely divergent financial reporting approaches existed. • Differences in financial reporting standards have been greatly reduced in recent years. Economic performance approach • Intended to capture the underlying economic • performance of the business entity. • Examples include the United Kingdom and U.S. Commercial and tax law approach • Intended to conform to mandated laws or detailed • tax rules. • Examples include France, Italy and Belgium.

9. International financial reporting:Why reporting philosophies differ • Financial reporting objectives evolve from the specific legal, political, and financial institutions within a country, as well as from social customs and systems. • Germany developed ultraconservative accounting rules and dividend guidelines to protect companies’ survival prospects and protect jobs. • Canada and the United Kingdom developed financial reporting rules intended to help the many outside debt and equity investors make informed decisions (the economic performanceapproach). • In Japan, financial reporting standards conformed to income tax rules and other commercial laws (an arbitrary legal format) because outside investors were unimportant to how Japanese companies were financed.

10. International financial reporting:Convergence of standards across countries • The “relaxation” of cross-border barriers in markets for goods, labor, and capital has increased international competitiveness. • Many companies in countries that used the commercial and tax law approach felt compelled to provide supplemental U.S. GAAP or IFRS financial statements. Daimler-Benz began issuing U.S. GAAP reports in 1996. • A two-tiered financial reporting system emerged: • Tax-paying and statutory entities comprising the firm. • Statements conform to tax or commercial law. Parent Company • Consolidated statements directed at investors. • Statements conform to U.S. GAAP or IFRS “Group”

11. International Financial Reporting:The IASC and the IASB • Formed in 1973. • Included professional accounting organizations in • 10 countries. International Accounting Standards Committee (IASC) • Establishes high quality, understandable and enforceable • global accounting standards. • Works to achieve convergence throughout the world. • Includes more than 121 countries. • Has issued 41 International Financial Reporting • Standards (IFRS). International Accounting Standards Board (IASB)

12. International Financial Reporting:U.S. GAAP vs. IFRS • Compared to U.S. GAAP, IASB standards allow firms more latitude. • IFRS often permit different accounting treatments for similar economic events. • IFRS frequently follow a more “broad brush” approach than does U.S. GAAP. • Existing differences between U.S. GAAP and IFRS will be narrowed in the future. Benchmark treatment Allowed treatment Preferred May be used

13. International Financial Reporting:Some difference between U.S. GAAP and IFRS

14. International Financial Reporting:Coping with differences that persist • There are at least four different approaches that regulatory commissions in a country can use to deal with foreign issuers of securities: • Compel the use of the host country’s reporting rules. • Create a bilateral arrangement that allows the host to accept statements prepared under the foreign country’s reporting rules. • Allow every foreign issuer to use it home country reporting rules without a requirement to reconcile to host country GAAP. • Require the use of International Financial Reporting Standards.

15. International Financial Reporting:Compel the use of host country GAAP • The U.S. SEC requiresforeign companies that wish to have securities traded on U.S. exchanges to reconcile their own reporting methods to U.S. GAAP. • The reconciliation is called a Form 20-F. • There are two reasons this approach is controversial: • Competitive disadvantages that reconciliation may impose on U.S. capital markets. • Concerns that the reconciliation may not really overcome differences between U.S. and foreign GAAP.

16. International Financial Reporting:Form 20-F example Home company GAAP U.S. GAAP

17. International Financial Reporting:Making bilateral agreements • The U.S. and Canada allow each other’s companies to use foreign GAAP when seeking to issue debt or preferred stock. • The company avoids the cost of reformulating its financial statements. • However, this cost is tempered by the fact that U.S. and Canadian GAAP are somewhat similar. • A reconciliation to host country GAAP is required when the company seeks to issue common stock.

18. International Financial Reporting:Allowing foreign GAAP • This approach imposes no costs on the reporting company. • However, it does impose burdens on analysts in the host country who need to be knowledgeable about a wide range of foreign financial reporting practices. • It is the practice on the London Stock Exchange where foreign listed companies from other EU countries may use their national GAAP, or IFRS, or U.S. GAAP. • The London Stock Exchange does not require a reconciliation to U.K. GAAP.

19. International Financial Reporting:Using international financial reporting standards • The IOSCO has given a “qualified acceptance” to IASB standards. • Individual countries’ securities commissions may choose to: • Accept statements prepared under IASB standards without adjustment. • Require a reconciliation between IASB statements and local GAAP. • Require supplemental disclosures that contain more information than the IASB standards must provide. • Disallow certain IASB accounting treatments. • The U.S. SEC appears willing to consider dropping the Form 20-F reconciliation procedure for firms using improved IFRS. International Organization Of Securities Commissions (IOSCO)

20. International Financial Reporting:Monitoring compliance • Not only do financial reporting rules differ across countries, but also do the mechanisms for monitoring compliance with those rules. • Different countries have different structures for determining whether the stated principles are actually being followed. External auditor Securities commission Accounting court • Competence • Independence • SEC can challenge financial reports • Adequate staff and budget remains an issue • Enterprise chartered in the Netherlands

21. Inflation accounting • Inflation—a decline in the purchasing power of a country’s currency—complicates the analysis of international financial reports. • Financial reporting standards in countries with high rates of inflation (e.g., Mexico) mandate some form of inflation accounting for both tax and financial statement reporting. • Two forms of inflation accounting are required by Mexican GAAP: • Rate of price change for specific items like electronic • components, coffee beans, or natural gas. • Current cost accounting approach. Specific price-change adjustments General price-level adjustments • General rate of inflation for the economy as a whole. • General price-level accounting approach

22. Inflation accounting:Current cost approach • Current cost refers to the market price that an individual firm would have to pay in order to replace the specific assets it owns. • Current cost accounting is designed to accomplish two things: • Reflect all nonmonetary assets (inventory, buildings, and equipment) at their current replacement cost as of the balance sheet date. • Differentiate between: (a) current cost income from continuing operations, and (b) increases or decreases in current cost amounts (holding gains or losses).

23. Inflation accounting:Current cost example

24. Current cost increases by $15: Inventory is now shown at current cost DR Inventory $15 CR Owners’ equity $15 • The inventory is sold for $180 DR Cash $180 DR Cost of goods sold 115 CR Sales $180 CR Inventory 115 Now shown at current cost Inflation accounting:Current cost example—journal entries • One unit of inventory is purchased for $100: DR Inventory $100 CR Cash $100

25. Inflation accounting:A representative current cost disclosure

26. Inflation accounting:SFAS No. 33 • Only nonmonetary assets like inventory, buildings, and equipment were adjusted. • Actual market replacement costs were used where available. • Price-level indices were used if replacement costs were not available. • All monetary assets and liabilities (e.g., cash, receivables, accounts payable) were reported at their face value without adjustment. • Stockholders’ equity was increased as a balancing item:

27. Inflation accounting:SFAS No. 33 (continued) • Current cost adjustments on the income statement were limited to cost of goods sold and depreciation. • Here’s an example:

28. Inflation accounting:Union Carbide’s realized holding gains

29. Inflation accounting:Historical cost income can overstate true profits

30. Inflation accounting:Teléfonos de México’s Form 20-F note

31. Inflation accounting:General price-level accounting • The real amount of goods and services that can be acquired at any moment is what determines the purchasing power of a currency like the U.S. dollar. • General price-level accounting measures changes in purchasing power using a price index for a broad market basket of goods and services. Current cost accounting • Purchasing powers changes linked to special • nonmonetary assets (e.g. computer chips inventory). General price-level accounting • Purchasing powers changes linked to general price • index and broad market basket.

32. Inflation accounting:General price-level accounting illustration • The goal is to adjust all historical amounts into common purchasing power units. • Here’s an example:

33. Inflation accounting:General price-level accounting • To restate historical amounts into current purchasing power units, the nominal dollar amount is multiplied by a restatement factor: • General price-level accounting is not intended to reflect current market values of assets and liabilities. • SFAS No. 33 required firms to use the “Consumer Price Index (CPI) for all urban consumers” as the price-level index. • Cash, receivables, notes payable are fixed dollar claims • Unaffected by price-level changes Nonmonetary items • Inventory, buildings, and equipment • Price will change with price-level changes Monetary items

34. Inflation accounting:GPLA for nonmonetary items • Suppose a firm’s only asset is land, which was purchased for $1,000 on January 1, 2005: • Assume that the general level of prices rose by 4% during 2005. The constant dollar basic accounting equation would look like: The upward adjustment to owners’ equity is not considered to be income

35. Inflation accounting:GPLA for monetary items • Suppose a firm’s only asset is cash of $1,000 on January 1, 2005 and that the general level of prices again rose by 4% during 2005. • At the end of 2005, the constant dollar basic accounting equation would look like:

36. Summary • The financial reporting rules in some countries like the United States, Canada, and the United Kingdom strive to reflect firms’ underlying economic performance. • But reporting rules in many other countries—Germany, France, and Japan—merely complied with taxation or other statutory requirements. • “Globalization” forced many countries using a commercial or tax law approach to seek foreign capital, and to move toward an economic performance approach to reporting. • International reporting differences have narrowed, but differences still exist.

37. Summary concluded • Various mechanisms for coping with cross-border reporting diversity have evolved—reconciliation to host country GAAP, required use of IASB standards, and so on. • Mechanisms for monitoring compliance with GAAP also differ significantly from one country to another—both in terms of the form of monitoring and in its effectiveness. • When inflation is a serious problem, historical cost accounting becomes less meaningful and inflation accounting is used. • Current cost accounting measures changes in specific purchasing power. • By contrast, general price-level accounting strives to reflect overall, average changes in purchasing power.