WEEK 5 LECTURE NOTES Analysis of Financial Statements & Other Reporting Issues This week we will conclude with the following specific financial reporting topics: · Inflation - accounting for changing prices. · Business combinations and consolidated financials. · Segment reporting. Historical cost accounting in a period of inflation understates asset values (and related expenses) and overstates income. It ignores the gains and losses in purchasing power caused by inflation that arise from holding monetary assets and liabilities. Methods of accounting for inflation are · general purchasing power (GPP) accounting, and · current cost (CC) accounting. General Purchasing Power Accounting · Nonmonetary assets and stockholders’ equity accounts are restated for changes in the general price level. · Cost of goods sold and depreciation/amortization are based on restated asset values and the net purchasing power gain/loss on the net monetary liability/asset position is included in income. · Income is the amount that can be paid as a dividend while maintaining the purchasing power of capital. Current Cost Accounting · Nonmonetary assets are revalued to current cost. · Cost of goods sold and depreciation/amortization are based on revalued amounts. · Income is the amount that can be paid as a dividend while maintaining physical capital. IAS 29 Deloitte: IAS 29 Financial Reporting in Hyperinflationary Economies applies where an entity's functional currency is that of a hyperinflationary economy. The standard does not prescribe when hyperinflation arises but requires the financial statements (and corresponding figures for previous periods) of an entity with a functional currency that is hyperinflationary to be restated for the changes in the general pricing power of the functional currency. IAS 29 was issued in July 1989 and is operative for periods beginning on or after 1 January 1990. IAS 21 Deloitte: IAS 21 The Effects of Changes in Foreign Exchange Rates outlines how to account for foreign currency transactions and operations in financial statements, and also how to translate financial statements into a presentation currency. An entity is required to determine a functional currency (for each of its operations if necessary) based on the primary economic environment in which it operates and generally records foreign currency transactions using the spot conversion rate to that functional currency on the date of the transaction. IAS 21 was reissued in December 2003 and applies to annual periods beginning on or after 1 January 2005. IAS 29 requires the use of GPP accounting by firms that report in the currency of a hyperinflationary economy. IAS 21 requires the financial statements of a foreign operation located in a hyperinflationary economy to first be adjusted for inflation in accordance with IAS 29 before translation into the parent company’s reporting currency. IFRS 3 Deloitte: IFRS 3 Business Combinations outlines the acco.

1. WEEK 5 LECTURE NOTES
Analysis of Financial Statements & Other Reporting Issues
This week we will conclude with the following specific
financial reporting topics:
· Inflation - accounting for changing prices.
· Business combinations and consolidated financials.
· Segment reporting.
Historical cost accounting in a period of inflation understates
asset values (and related expenses) and overstates income. It
ignores the gains and losses in purchasing power caused by
inflation that arise from holding monetary assets and liabilities.
Methods of accounting for inflation are
· general purchasing power (GPP) accounting, and
· current cost (CC) accounting.
General Purchasing Power Accounting
· Nonmonetary assets and stockholders’ equity accounts are
restated for changes in the general price level.
· Cost of goods sold and depreciation/amortization are based on
restated asset values and the net purchasing power gain/loss on
the net monetary liability/asset position is included in income.
· Income is the amount that can be paid as a dividend while
maintaining the purchasing power of capital.
Current Cost Accounting
· Nonmonetary assets are revalued to current cost.

2. · Cost of goods sold and depreciation/amortization are based on
revalued amounts.
· Income is the amount that can be paid as a dividend while
maintaining physical capital.
IAS 29
Deloitte: IAS 29 Financial Reporting in Hyperinflationary
Economies applies where an entity's functional currency is that
of a hyperinflationary economy. The standard does not prescribe
when hyperinflation arises but requires the financial statements
(and corresponding figures for previous periods) of an entity
with a functional currency that is hyperinflationary to be
restated for the changes in the general pricing power of the
functional currency.
IAS 29 was issued in July 1989 and is operative for periods
beginning on or after 1 January 1990.
IAS 21
Deloitte: IAS 21 The Effects of Changes in Foreign Exchange
Rates outlines how to account for foreign currency transactions
and operations in financial statements, and also how to translate
financial statements into a presentation currency. An entity is
required to determine a functional currency (for each of its
operations if necessary) based on the primary economic
environment in which it operates and generally records foreign
currency transactions using the spot conversion rate to that
functional currency on the date of the transaction.
IAS 21 was reissued in December 2003 and applies to annual
periods beginning on or after 1 January 2005.
IAS 29 requires the use of GPP accounting by firms that report
in the currency of a hyperinflationary economy.
IAS 21 requires the financial statements of a foreign operation
located in a hyperinflationary economy to first be adjusted for
inflation in accordance with IAS 29 before translation into the

3. parent company’s reporting currency.
IFRS 3
Deloitte: IFRS 3 Business Combinations outlines the
accounting when an acquirer obtains control of a business (e.g.
an acquisition or merger). Such business combinations are
accounted for using the 'acquisition method', which generally
requires assets acquired and liabilities assumed to be measured
at their fair values at the acquisition date.
A revised version of IFRS 3 was issued in January 2008 and
applies to business combinations occurring in an entity's first
annual period beginning on or after 1 July 2009.
Issues that must be resolved in accounting for a business
combination:
A. Selection of an appropriate method
IFRS 3 and US GAAP both require the purchase method in
accounting for business combinations; the pooling of interests
method is not allowed.
B. Recognition and measurement of goodwill
Goodwill is recognized on the consolidated balance sheet as an
asset and tested annually for impairment under both IFRS 3 and
U.S. GAAP.
C. Measurement of minority interest.
When less than 100% of a company is acquired, IFRS 3 requires
the acquired assets and liabilities to be recorded at full fair
value and minority interest is initially measured at the minority
shareholders’ percentage ownership in the fair value of the
acquired company’s net assets. This is known as the economic
unit or entity concept.
Note:
In addition to the economic unit or entity concept, U.S. GAAP
also allows use of the parent company concept in which the

4. acquired assets and liabilities are initially measured at book
value plus the parent’s ownership percentage in the difference
between fair value and book value.
Under this approach, minority interest is initially measured at
the minority shareholders’ percentage ownership in the book
value of the subsidiary’s net assets.
IAS 28
Deloitte: IAS 28 Investments in Associates and Joint
Ventures (as amended in 2011) outlines how to apply, with
certain limited exceptions, the equity method to investments in
associates and joint ventures. The standard also defines an
associate by reference to the concept of "significant influence",
which requires power to participate in financial and operating
policy decisions of an investee (but not joint control or control
of those polices).
IAS 28 was reissued in May 2011 and applies to annual periods
beginning on or after 1 January 2013.
IAS 28 and US. GAAP require use of the equity method when
an investor has the ability to exert significant influence over an
investee; significant influence is presumed when the investor
owns 20% or more of the investee’s voting shares.
IAS 31
Deloitte: AS 31 Interests in Joint Ventures sets out the
accounting for an entity's interests in various forms of joint
ventures: jointly controlled operations, jointly controlled assets,
and jointly controlled entities. The standard permits jointly
controlled entities to be accounted for using either the equity
method or by proportionate consolidation.
IAS 31 was reissued in December 2003, applies to annual
periods beginning on or after 1 January 2005, and is superseded
by IFRS 11Joint Arrangements and IFRS 12Disclosure of

5. Interests in Other Entities with effect from annual periods
beginning on or after 1 January 2013.
In accounting for an investment in a joint venture, IAS 31
prefers the use of proportionate consolidation, but also allows
the equity method. The equity method is required under U.S.
GAAP.
Questions arise as to (a) when an investee should be considered
a subsidiary and (b) which subsidiaries should be consolidated
when a parent company prepares consolidated financial
statements.
IAS 27
Deloitte: IAS 27 Separate Financial Statements (as amended in
2011) outlines the accounting and disclosure requirements for
'separate financial statements', which are financial statements
prepared by a parent, or an investor in a joint venture or
associate, where those investments are accounted for either at
cost or in accordance with IAS 39Financial Instruments:
Recognition and Measurement or IFRS 9Financial Instruments.
The standard also outlines the accounting requirements for
dividends and contains numerous disclosure requirements.
IAS 27 was reissued in May 2011 and applies to annual periods
beginning on or after 1 January 2013,
superseding IAS 27Consolidated and Separate Financial
Statements from that date.
IAS 27 defines a subsidiary as an enterprise controlled by
another enterprise known as the parent.
Control is defined as the power to govern the financial and
operating policies of an entity so as to obtain benefits from its
activities. Control can exist without owning a majority of
shares of stock, for example, when one company has power over
more than half of the voting rights through agreements with
other shareholders.

6. Historically, U.S. companies have relied on majority stock
ownership as evidence of control.
IAS 27 requires a parent to consolidate all subsidiaries unless
(a) the subsidiary was acquired with the intent to dispose of it
within 12 months, and
(b) management is actively seeking a buyer.
U.S. GAAP requires all subsidiaries to be consolidated unless
the parent has lost control due to bankruptcy or severe
restrictions imposed by a foreign government.
The aggregation of all of a company’s activities into
consolidated totals masks the differences in risk and potential
existing across different lines of business and in different parts
of the world. To provide information that can be used to
evaluate these risks and potentials, companies disaggregate
consolidated totals and provide disclosures on a segment basis.
IFRS 8
Deloitte: IFRS 8 Operating Segments requires particular classes
of entities (essentially those with publicly traded securities) to
disclose information about their operating segments, products
and services, the geographical areas in which they operate, and
their major customers. Information is based on internal
management reports, both in the identification of operating
segments and measurement of disclosed segment information.
IFRS 8 was issued in November 2006 and applies to annual
periods beginning on or after 1 January 2009.
IFRS 8 was issued in 2006 to converge with U.S. GAAP. Both
IFRS and U.S. GAAP follow the so-called management
approach in determining operating segments, which are
components of a business that:

7. · Engage in activities from which they earn revenues and incurs
expenses.
· Are regularly reviewed by the chief operating decision maker
to assess performance and make resource allocation decisions.
· Have discrete financial information available.
IFRS and U.S. GAAP also require enterprise-wide disclosures
related to:
I.
Major customers – any customer from which the enterprise
generates 10% or more of revenues.
The existence of major customers must be disclosed along with
the operating segment generating the revenues, but the identity
of the customer need not be revealed.
II.
Products and services – if operating segments are not organized
along these lines.
External revenues derived from each major product or service
line must be disclosed when the company has only one
operating segment or operating segments are based on
something other than products/services.
III.
Geographic areas – if operating segments are not organized
geographically.
If operating segments are not based on geography, revenues and

8. long-lived assets must be disclosed for (a) the domestic country,
(b) all foreign countries in total, and (c) for each foreign
country in which a material amount of revenues or long-lived
assets are located. A quantitative threshold for determining
materiality is not specified.
Analysis of Foreign Financial Statements
Reasons to analyze financials whether the company is US based
or foreign are for the most part the same:
· Portfolio investment decisions
· Merger and acquisition decisions
· Credit decisions about foreign customers
· Evaluation of suppliers
· Benchmarking against competitors
Potential problems or differences when analyzing US-based vs
foreign companies’ financials:
· finding and obtaining financial information about a foreign
company (data accessibility),
· understanding the language in which the financial statements
are presented,
· the currency used in presenting monetary amounts,
· terminology differences that result in uncertainty as to the
information provided,
· differences in format that lead to confusion and missing
information,
· lack of adequate disclosures,

9. · financial statements are not made available on a timely basis
(timeliness),
· accounting differences that hinder cross-country comparisons,
and
· differences in business environments that might make ratio
comparisons or analysis meaningless even if accounting
differences are eliminated.
Solution
s:
· Some of the potential problems can be removed by companies
through their preparation of convenience translations in which
language, currency, and perhaps even accounting principles
have been restated for the convenience of foreign readers
OR
· The analyst can restate foreign financials in terms of a
preferred GAAP through the use of a reconciliation worksheet
in which debit/credit entries summarizing the differences in
GAAP are used to adjust the original reported amounts.
· All income differences also affect stockholders’ equity
through retained earnings.
· In addition to adjustments resulting from differences in

10. GAAP, an adjustment also will be needed for the deferred tax
effect of the aggregate difference in pre-tax income.
Another Perspective on the Challenges and Opportunities in
Cross-Border Analysis
Cross border analysis involves multiple jurisdictions.
Challenges
Nations vary dramatically in …..
· Accounting practices
· Disclosure quality
· Legal and regulatory systems
· Nature and extent of business risk
· Modes of conducting business
· Providing credible information
· Vast differences in financial reporting

11. · Government continuing to publish highly suspect information
Positives
· Accounting harmonization of standards allows for
comparability
· Companies worldwide are disclosing more information
· Improving availability and quality of that information
· Impact of the worldwide web and accessibility to information
· Globalization of capital markets
· Increased competition
· Inter-dependencies are growing
Business Analysis Framework
Four stages of analysis….
1. business strategy analysis
2. accounting analysis

12. 3. financial analysis (ratio and cash flow)
4. prospective analysis
1.
Business Strategy Analysis
Provides a qualitative understanding of a company and its
competitors
in relation to its economic environment.
Ensures analysis is performed using a holistic perspective.
By identifying key profit drivers and business risks, forecasts
are realistic.
2.
Accounting Analysis
The purpose is to assess the extent to which a firm’s report

13. results reflect economic reality.
Need: evaluate the firm’s accounting policies and estimates, and
Assess the nature and extent of a firm’s accounting flexibility
Six Steps in Accounting Analysis
>
Identify key accounting policies
>
Assess accounting flexibility
>
Evaluate accounting strategy

14. >
Evaluate the quality of disclosure
>
Identify potential red flags
>
Adjust for accounting distortions
3.
International Financial Analysis
Goal:
evaluate a firm’s current and past performance, and
to judge whether its performance can be sustained.
Ratio and cash flow analysis are important tools.

15. Ratio analysis
1st – do cross-country differences in accounting principles
cause significant variation in financial statement amounts of
companies from different countries?
2nd – how do differences in local culture and economic and
competitive conditions affect the interpretation of accounting
measures in financial ratios, even if account measurements from
different countries are restated to achieve “accounting
comparability”?
Cash flow analysis
Cash-flow related measures are especially useful in
international analysis because they are less affected by
accounting principle differences than are earnings-based
measures.

16. 4.
International Prospective Analysis
Two steps:
1. Forecasting – analysts make explicit forecasts of a firm’s
prospects based on its business strategy.
2. Valuation – analysts convert quantitative forecasts into an
estimate of a firm’s value.
All four stages of business analysis (business strategy,
accounting, financial and prospective analysis may be affected
by the following:
· Information access
· More widely available due to the world wide web
· Timeliness of information
· Varies dramatically by country

17. · In the U.S. quarterly financial reporting is generally accepted;
this is seldom the case elsewhere.
· Financial reporting lags can also be estimated by comparing a
company’s fiscal year end with its audit report date, an
indication of when financial information becomes public.
· Language and terminology barriers
· Language and accounting terminology differences can cause
difficulty.
· Foreign currency issues
· Reader convenience; i.e., financials presented in dollars vs
foreign currency
· Information content
· Differences in types and formats of financial statements
· Balance sheet and income statement format varies from
country to country
· Classification differences abound internationally.

18. Homework Assignment:
The week’s discussion covered the following International
Accounting Standards (IAS):
#21
The Effects of Changes in Foreign Exchange Rates
#27
Consolidated and Separate Financial Statements
#28
Investments in Associates
#29
Financial Reporting in Hyperinflationary Economies
#31
Interests in Joint Ventures
and
IFRS 8 Operating Segments
Research your MNC and report which, if any, of these standards
are applicable for your MNC. Then select one that is applicable

19. and explain how your MNC handles it.
Part II of the homework assignment, you are required to read at
least one other posting and make a substantive comment.
Part III of the homework….
Question: What companies might your MNC include in a
benchmarking study and in which countries are those companies
located. Your answer should include, at least, four other
companies for the comparison. As an example of the response
for this assignment, consider Ford Motor Company.
Ford might want to include the following companies in a
benchmarking study:
U.S. – General Motors, Chrysler
Japan – Honda, Toyota, Subaru
Germany – BMW, Volkswagen, Audi
Korea – Hyundai, Kia

20. France – Renault, Peugeot
Homework is to be posted in this week’s discussion.