Chapter 5 Solutions



CHAPTER 8

ADDITIONAL FINANCIAL REPORTING ISSUES

Chapter Outline

I. In addition to issues involving the accounting for foreign currency, three financial reporting issues of international importance are: (a) accounting for changing prices (inflation accounting), (b) accounting for business combinations and consolidated financial statements, and (c) segment reporting.

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

III. Two methods of accounting for inflation have been used in different countries – general purchasing power (GPP) accounting and current cost (CC) accounting.

A. Under GPP 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. GPP income is the amount that can be paid as a dividend while maintaining the purchasing power of capital.

B. Under CC accounting, nonmonetary assets are revalued to current cost, and cost of goods sold and depreciation/amortization are based on revalued amounts. CC income is the amount that can be paid as a dividend while maintaining physical capital.

IV. 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.

V. Issues that must be resolved in accounting for a business combination relate to (a) selection of an appropriate method, (b) recognition and measurement of goodwill, and (c) measurement of minority interest.

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

B. 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. 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.

1. In addition to the economic unit or entity concept, U.S. GAAP also allows use of the parent company concept in which the acquired assets and liabilities are initially measured at book value plus the parent’s ownership percentage in the difference between fair value and book value. Under this approach, minority interest is initially measured at the minority shareholders’ percentage ownership in the book value of the subsidiary’s net assets.

VI. 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.

VII. 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.

VIII. 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.

A. 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.

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

B. 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.

1. 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.

IX. 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. Segment reporting is an area in which considerable diversity exists internationally.

X. IAS 14 requires companies to disclose disaggregated information by business segment and geographic segment, one of which is designated as the primary reporting format.

A. A business segment or a geographic segment is reportable if a majority of its revenues are generated from external customers and it meets one of three significance tests. The segment must have: 10% or more of combined segment revenues, 10% or more of combined segment profits, or 10% or more of combined segment assets.

B. A sufficient number of segments must be separately reported to disclose at least 75% of consolidated revenues.

C. Disclosures to be provided for each primary reporting format reportable segment include: revenue, profit or loss, assets, liabilities, capital expenditures, depreciation and amortization, other significant noncash expenses, and equity method profit or loss.

D. Disclosures to be provided for each secondary reporting format reportable segment include: revenue from external customers, assets, and capital expenditures.

XI. U.S. GAAP requires extensive disclosure to be made for operating segments, which can be based either on product lines or geographic regions.

A. Disclosures should reflect what is reported internally to the chief operating officer, even if this is on a non-GAAP basis.

B. If operating segments are not based on geography, revenues and long-lived assets must be disclosed for (a) the domestic country, (b) all foreign countries in total, and (c) for each foreign country in which a material amount of revenues or long-lived assets are located. A quantitative threshold for determining materiality is not specified.

Answers to Questions

1. Historical cost accounting causes assets to be significantly understated in a country experiencing high inflation. Understated assets, such as inventory and fixed assets, leads to understated expenses, such as cost of goods sold and depreciation, which in turn leads to overstated income and stockholders’ equity.

Understated asset values can have a negative impact on a company’s ability to borrow because the collateral is understated. Understated asset values also can be an invitation for a hostile takeover to the extent that the current market price of a company’s stock does not reflect the current value of assets.

Overstated income results in more taxes being paid to the government than would otherwise be paid, and could lead to stockholders demanding a higher level of dividend than would otherwise be expected. Through the payment of taxes on inflated income and the payment of dividends out of inflated net income, both of which result in cash outflows, a company may find itself in a liquidity crisis.

To the extent that companies are exposed to different rates of inflation, the understatement of assets and overstatement of income will differ across companies; this can distort comparisons across companies. For example, a company with older fixed assets will report a higher return on assets than a company with newer assets because income is more overstated and assets are more understated than for the comparison company. Because inflation rates tend to vary across countries, comparisons made by a parent company across its subsidiaries located in different countries can be distorted.

2. Non-monetary assets and non-monetary liabilities are restated for changes in the general purchasing power of the monetary unit. Most non-monetary items are carried at historical cost. In these cases, the restated cost is determined by applying to the historical cost the change in general price index from the date of acquisition to the balance sheet date. Some non-monetary items are carried at revalued amounts, for example, property, plant and equipment revalued according to the allowed alternative treatment in IAS 16, “Property, Plant and Equipment.” These items are restated from the date of the revaluation.

All components of owners’ equity are restated by applying the change in the general price index from the beginning of the period or the date of contribution, if later, to the balance sheet date.

Monetary assets and monetary liabilities (cash, receivables, and payables) are not restated because they are already expressed in terms of the monetary unit current at the balance sheet date.

All income statement items are restated by applying the change in the general price index from the dates when the items were originally recorded to the balance sheet date.

The gain or loss on net monetary position (purchasing power gain or loss) is included in net income.

3. Monetary assets (cash and receivables) give rise to purchasing power losses and monetary liabilities (payables) give rise to purchasing power gains.

4. Historical costs of nonmonetary assets (inventory, fixed assets, intangibles) are replaced with current replacement cost and expenses (cost of goods sold, depreciation, amortization) are based on these current costs. The amount by which nonmonetary assets are revalued to replacement cost on the balance sheet is also reflected in stockholders’ equity as a revaluation surplus (or reserve).

5. Current cost accounting generally results in a larger amount of nonmonetary assets, as well as a larger amount of stockholders’ equity, being reported on the balance sheet. Expenses based on the current cost of nonmonetary assets (carried at larger amounts) generally results in a smaller amount of net income being reported under current cost accounting. With smaller income and larger stockholders’ equity, return on equity measured under current cost accounting is generally smaller than under historical cost accounting.

6. IAS 15, “Information Reflecting the Effects of Changing Prices,” required supplementary disclosure of the following items reflecting the effects of changing prices:

1. the amount of adjustment to depreciation expense,

2. the amount of adjustment to cost of sales,

3. the amount of purchasing power gain or loss on monetary items,

4. the aggregate of all adjustments reflecting the effects of changing prices, and

5. if current cost accounting is used, the current cost of property, plant, and equipment.

The standard only applied to enterprises “whose levels of revenues, profits, assets or employment are significant in the economic environment in which they operate,” and allowed those enterprises to choose between making adjustments on a GPP or a CC basis. Because of a lack of international support for inflation accounting disclosures, in 1989, the IASC decided to make IAS 15 optional. However, the IASB encourages presentation of inflation-adjusted information as required by IAS 15.

IAS 29, “Financial Reporting in Hyperinflationary Economies,” was issued in 1989 and applies to the primary financial statements of any company that reports in a currency of a hyperinflationary economy. IAS 29 requires the use of GPP accounting following procedures outlined above in the answer to question 2.

IAS 21, “The Effects of Changes in Foreign Exchange Rates,” requires application of IAS 29 to restate the foreign operation’s financial statements to a GPP basis. The GPP adjusted financial statements are then translated into the parent company’s reporting currency using the current rate method of translation. This approach is referred to as the restate/translate method.

7. IAS27, “Consolidated Financial Statements and Accounting for Investments in Subsidiaries,” defines a group as a parent and all its subsidiaries, and requires parents to present consolidated financial statements.

8. The concept of a group relates to a business combination in which one company obtains control over another company but the acquired company continues its separate legal existence.

9. IAS 27 states that control exists when the investor owns more than 50 of the stock of another company. However, control also can exist for an investor owning less than 50% of the stock of another company when the investor has power:

• Over more than half of the voting rights through agreements with other shareholders,

• To set the company’s financial and operating policies because of existing statutes or agreements,

• To appoint or remove majority of the members of the governing body (board of directors or equivalent group), or

• To cast the majority of votes at meetings of the company’s governing body.

10. Because of their extensive cross-ownership of companies, identifying the legal ownership patterns of Japanese company groups (Keiretsu) can be extremely difficult.

11. IAS 27 requires a parent to consolidate all subsidiaries, foreign and domestic, unless (a) control of the subsidiary is temporary because it is held with a view to its disposal in the near future, or (b) the subsidiary operates under severe long-term restrictions that significantly affect its ability to send funds to its parent. IAS 27 does not allow a subsidiary to be excluded from consolidated financial statements solely because its operations are dissimilar to those of the other companies that comprise the group. 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.

12. In some cases, two companies will jointly control another entity as a joint venture. IAS 31, “Financial Reporting of Interests in Joint Ventures,” prefers proportional consolidation for joint ventures (benchmark treatment), while equity accounting is allowed as an alternative. The effect of the proportional consolidation method is to remove the “investment in joint venture” account from the investor’s balance sheet and replace it with the proportion of all the individual items that it represents. In contrast, the full consolidation method replaces the “investment in subsidiary” account on the parent’s balance sheet with 100% of the value of the subsidiary’s balance sheet items. If the parent owns less than 100% of the subsidiary, a minority interest account is reflected on the parent’s consolidated balance sheet. There is no minority interest reported under proportional consolidation.

Proportional consolidation is prohibited in the U.S. and the U.K., except for unincorporated joint ventures. Instead, the equity method is used to account for investments in joint ventures. In Germany, proportional consolidation was not allowed before the implementation of the Seventh Directive, which permits its use for joint ventures. On the other hand, proportional consolidation has been relatively common in both France and in the Netherlands.

13. IAS 14 defines a business segment as a distinguishable component of a company that is engaged in providing an individual product or service or groups of related products or services and that is subject to risks and returns that are different from those of other business segments. A geographical segment is a distinguishable component of a company that is engaged in providing products or services within a particular economic environment and is subject to risks and returns that differ from those of components operating in other economic environments. Geographical segments can be a single country or groups of countries. Factors to consider in identifying geographical segments include:

• similarity of economic and political conditions,

• geographical proximity,

• special risk associated with operations in a particular area,

• exchange control regulations, and

• currency risks.

A business segment or a geographical segment is a reportable segment if (1) a majority of its revenues are generated from external customers and (2) it meets any one of the following three significance tests:

• Revenue test. Segment revenues, both external and intersegment, are 10% or more of the combined revenue, internal and external, of all segments.

• Profit or loss test. Segment result (profit or loss) is 10% or more of the greater (in absolute value terms) of the combined profit of segments with a profit or combined loss of segments with a loss.

• Asset test. Segment assets are 10% or more of the combined assets of all segments.

In applying these tests, segment result is defined as segment revenue less segment expense. Segment revenue includes revenue directly attributable to a segment and a portion of enterprise revenue that can be allocated on a reasonable basis to a segment. Segment expense includes expenses directly attributable to a segment and a portion of enterprise expense that can be allocated on a reasonable basis to a segment. IAS 14 defines segment assets as those operating assets that are employed by a segment in its operating activities and that either are directly attributable to the segment or can be allocated to the segment on a reasonable basis.

If total external revenue attributable to reportable segments constitutes less than 75% of the total consolidated revenue, additional segments should be reported even if they do not meet the 10% threshold. All segments that are neither separately reported nor combined should be included in the segment reporting disclosures as an unallocated reconciliation item or in an “all other” category.

14. The information required to be reported by geographic area under IAS 14 depends on whether geographic segments represent the primary reporting format or the secondary reporting format. The following information must be provided for each reportable primary reporting format segment, whether business segment or geographic segment:

• segment revenue,

• segment profit or loss,

• carrying amount of segment assets,

• segment liabilities,

• cost during the period to acquire property, plant, and equipment, and intangible assets (capital expenditures),

• depreciation and amortization,

• significant noncash expenses, other than depreciation and amortization, and aggregate share of profit or loss and aggregate investment in equity method associates and joint ventures.

When business segments are the primary reporting format, the following geographical segment information also should be provided:

• revenue from external customers for each geographical segment whose revenue from sales to external customers is 10% or more of total external revenue,

• carrying amount of segment assets for each geographical segment whose assets are 10% or more of total assets of all geographical segments, and

• capital expenditures for each geographical segment whose assets are 10% or more of total assets of all geographical segments.

Under IAS 14, geographical segments can be a single country or groups of countries.

Under SFAS 131, companies must identify operating segments based on its internal reporting system. Operating segments can be based on geography. Items disclosed by operating segment under U.S. GAAP are the same as those items required to be disclosed for the primary reporting format under IAS 14, with a few exceptions. U.S. GAAP does not require disclosure of liabilities by segment, but does require disclosure of interest, taxes, and unusual items (discontinued operations and extraordinary items). Whereas IAS 14 requires segment information to be presented in accordance with the company’s accounting policies, SFAS 131 requires segment disclosures to be the same as what is reported internally even if this is on a non-GAAP basis.

If operating segments are not based on geography, then companies must also provide information about their foreign operations. Companies must disclose revenues and long-lived assets for:

1. the domestic country,

2. all foreign countries in which the company derives revenues or holds assets, and

3. each foreign country in which a material amount of revenues is derived or long-lived assets are held.

The SFAS 131 requirement to provide disclosures by individual foreign country is a significant difference from IAS 14.

15. The major concern of some companies with respect to segment disclosures is that it could provide information that competitors can use to better compete with the company. Information about the revenues and profits earned in specific lines of business and/or geographic areas that otherwise would be undisclosed, could be of interest to competing firms as they are looking for lines of business and/or geographic areas in which to expand.

Solutions to Exercises and Problems

1. Sorocaba Company

December 31, Year 1

Original Restated

Purchase Historical Restatement Historical

Date Item Cost Ratio Cost

1/15/Y1 Machine X $ 20,000 140/100 $ 28,000

3/20/Y1 Machine Y 55,000 140/110 70,000

10/10/Y1 Machine Z 130,000 140/130 140,000

$205,000 $238,000

December 31, Year 2

Original Restated

Purchase Historical Restatement Historical

Date Item Cost Ratio Cost

3/20/Y1 Machine Y $ 55,000 180/110 $ 90,000

10/10/Y1 Machine Z 130,000 180/130 180,000

$185,000 $270,000

Alternatively, the restated historical cost at December 31, Year 2 could be determined as follows:

December 31, Year 2

Restated Restated

Historical Historical

Purchase Cost Restatement Cost

Date Item (12/31/Y1) Ratio (12/31/Y2)

3/20/Y1 Machine Y $ 70,000 180/140 $ 90,000

10/10/Y1 Machine Z 140,000 180/140 180,000

$210,000 $270,000

Ignoring depreciation, machinery and equipment would be reported on the balance sheet at:

12/31/Y1 $238,000

12/31/Y2 $270,000

2. Antalya Company

a. The nominal interest expense is TL 600,000 (TL 1,000,000 x 60% x 1 year).

b. The purchasing power gain is TL 550,000 (TL 1,000,000 x 387.5/250 = TL 1,550,000 – 1,000,000).

c. The real interest expense is TL 5,000, which equates to a real interest rate of 0.5% (TL 5,000/ TL 1,000,000)

3. Doner Company

Calculation of Purchasing Power Loss

Net monetary assets, 1/1/Y1 $5,000 x 150/100 = $ 7,500

Plus: Increase in net monetary assets 15,000 x 150/120 = 18,750

Net monetary assts, 12/31/Y1 $20,000 $26,250

20,000

Purchasing power loss $ 6,250

GPP Income Statement

Year 1

Revenues $50,000 x 150/120 = $ 62,500

Depreciation (5,000) x 150/100 = (7,500)

Other expenses (incl. income taxes) (35,000) x 150/120 = (43,750)

Purchasing power loss (6,250)

Net income $ 5,000

4. Petrodat Company

Subsidiary in Mexico

|GPI | | | |

|1/1/Y1 | | |100 |

|Average | | |105 |

|12/31/Y1 | | |110 |

a.

|Balance Sheet, 1/1/Y1 | |Historical |Restatement |Restated to |

| | |Cost |Factor |12/31/Y1 GPP |

|Machinery and equipment | |1,000,000.00 |110/100 |1,100,000.00 |

|Total assets | |1,000,000.00 | |1,100,000.00 |

| | | | | |

|Contributed capital | |1,000,000.00 |110/100 |1,100,000.00 |

|Total stockholders’ equity | |1,000,000.00 | |1,100,000.00 |

|Income Statement, Year 1 | | | |

| | |Historical |Restatement |Restated to |

| | |Cost |Factor |12/31/Y1 GPP |

|Revenues | |400,000.00 |110/105 |419,047.62 |

|Depreciation expense | |(200,000.00) |110/100 |(220,000.00) |

|Other expenses | |(150,000.00) |110/105 |(157,142.86) |

|Purchasing power loss | | | |(11,904.76) |

|Income | |50,000.00 | |30,000.00 |

|Calculation of Purchasing Power Loss | | |

|Net monetary assets, 1/1 | |0.00 |110/100 |0.00 |

|plus: Increase in NMA, Y1* |250,000.00 |110/105 |261,904.76 |

|Net monetary assets, 12/31 |250,000.00 | |261,904.76 |

| | | | |250,000.00 |

|Purchasing power loss | | | |(11,904.76) |

|* Revenues less other expenses | | | |

|Balance Sheet, 12/31/Y1 |Historical |Restatement |Restated to |

| | |Cost |Factor |12/31/Y1 GPP |

|Cash | |250,000.00 |none |250,000.00 |

|Machinery and equipment | |1,000,000.00 |110/100 |1,100,000.00 |

|Less: accumulated depreciation | |(200,000.00) |110/100 |(220,000.00) |

|Total assets | |1,050,000.00 | |1,130,000.00 |

| | | | | |

|Contributed capital | |1,000,000.00 |110/100 |1,100,000.00 |

|Retained earnings | |50,000.00 |above |30,000.00 |

|Total stockholders' equity | |1,050,000.00 | |1,130,000.00 |

|Calculation of Average Stockholders' Equity | | |

|January 1, Year 1 (restated) | | |1,100,000.00 |

|December 31, Year 1 | | | |1,130,000.00 |

| | | | |2,230,000.00 |

|Average stockholders’ equity | | |1,115,000.00 |

|b. Calculation of profit margin and return on equity on an inflation-adjusted basis |

|Profit margin | |30,000.00 |7.16% | |

| | |419,047.62 | | |

| | | | | |

|Return on Equity | |30,000.00 |2.69% | |

| | |1,115,000.00 | | |

Subsidiary in Venezuela

|GPI | | | | |

|1/1/Y1 | | |100 | |

|Average | | |115 | |

|12/31/Y1 | | |130 | |

a.

|Balance Sheet, 1/1/Y1 | |Historical |Restatement |Restated to |

| | |Cost |Factor |12/31/Y1 GPP |

|Machinery and equipment | |150,000,000.00 |130/100 |195,000,000.00 |

|Total assets | |150,000,000.00 | |195,000,000.00 |

| | | | | |

|Contributed capital | |150,000,000.00 |130/100 |195,000,000.00 |

|Total stockholders’ equity | |150,000,000.00 | |195,000,000.00 |

|Income Statement, Year 1 | | | |

| | |Historical |Restatement |Restated to |

| | |Cost |Factor |12/31/Y1 GPP |

|Revenues | |60,000,000.00 |130/115 |67,826,086.96 |

|Depreciation expense | |(30,000,000.00) |130/100 |(39,000,000.00) |

|Other expenses | |(22,500,000.00) |130/115 |(25,434,782.61) |

|Purchasing power loss | | | |(4,891,304.35) |

|Income | |7,500,000.00 | |(1,500,000.00) |

|Calculation of Purchasing Power Loss | | |

|Net monetary assets, 1/1 | |0.00 |130/100 |0.00 |

|plus: Increase in NMA, Y1* |37,500,000.00 |130/115 |42,391,304.35 |

|Net monetary assets, 12/31 |37,500,000.00 | |42,391,304.35 |

| | | | |37,500,000.00 |

|Purchasing power loss | | | |(4,891,304.35) |

|* Revenues less other expenses | | | |

|Balance Sheet, 12/31/Y1 |Historical |Restatement |Restated to |

| | |Cost |Factor |12/31/Y1 GPP |

|Cash | |37,500,000.00 |none |37,500,000.00 |

|Machinery and equipment | |150,000,000.00 |130/100 |195,000,000.00 |

|Less: accumulated deprec | |(30,000,000.00) |130/100 |(39,000,000.00) |

|Total assets | |157,500,000.00 | |193,500,000.00 |

| | | | | |

|Contributed capital | |150,000,000.00 |130/100 |195,000,000.00 |

|Retained earnings | |7,500,000.00 |above |(1,500,000.00) |

|Total stockholders' equity | |157,500,000.00 | |193,500,000.00 |

|Calculation of Average Stockholders' Equity | | |

|January 1, Year 1 (restated) | | |195,000,000.00 |

|December 31, Year 1 | | | |193,500,000.00 |

| | | | |388,500,000.00 |

|Average stockholders’ equity | | |194,250,000.00 |

|b. Calculation of profit margin and return on equity on an inflation-adjusted basis |

|Profit margin | |(1,500,000.00) |-2.21% | |

| | |67,826,086.96 | | |

| | | | | |

|Return on Equity | |(1,500,000.00) |-0.77% | |

| | |194,250,000.00 | | |

c. Both subsidiaries had the same profit margin and return on equity when these ratios were calculated from unadjusted historical cost information. After adjusting for inflation, the Mexican subsidiary appears to be substantially more profitable than the Venezuelan subsidiary.

5. Auroral Company

| |Name of Company |% Voting | | |

| | |Rights |IFRSs |U.S. GAAP |

| |Accurcast |100% |Full consolidation |Full consolidation |

| |Bonello |45% |Equity method – unless there is evidence that |Equity method |

| | | |Auroral exercises effective control | |

| |Cromos |30% |Equity method |Equity method |

| |Fidelis |100% |Do not consolidate – fair value method |Do not consolidate – fair value method |

| |Jenna |100% |Full consolidation |Full consolidation |

| |Marek |40% |Full consolidation |Equity method |

| |Phenix |90% |Full consolidation |Full consolidation |

| |Regulus |50% |Proportional consolidation or equity method |Equity method |

| |Synkron |15% |Fair value method |Fair value method |

| |Tiksed |70% |Full consolidation |Full consolidation |

| |Ypsilon |51% |Full consolidation |Full consolidation |

6. Sandestino Company

a. Restated financial statements:

1. Proportionate Consolidation Method

Sandestino Company

Income Statement

Year 1

Revenues $840,000

Expenses 475,000

Income before tax 365,000

Tax expense 105,000

Net income $260,000

Sandestino Company

Balance Sheet

December 31, Year 1

Cash $150,000 Liabilities $280,000

Inventory 230,000 Common stock 600,000

Property, plant, & equipment (net) 810,000 Retained earnings 310,000

Total $1,190,000 Total $1,190,000

2. Equity Method

Sandestino Company

Income Statement

Year 1

Revenues $800,000

Expenses (450,000)

Equity in Grand Sand’s net income 10,000

Income before tax 360,000

Tax expense (100,000)

Net income $260,000

Sandestino Company

Balance Sheet

December 31, Year 1

Cash $130,000 Liabilities $250,000

Inventory 200,000 Common stock 600,000

Property, plant, & equipment (net) 650,000 Retained earnings 310,000

Investment in Grand Sand 180,000 Total $1,160,000

Total $1,160,000

b. Calculation of ratios:

Proportionate Consolidation Equity Method

Profit margin 260,000/840,000 = 0.3095 260,000/800,000 = 0.325

Debt/equity 280,000/910,000 = 0.3077 250,000/910,000 = 0.275

Sandestino’s profit margin would be higher and its debt-to-equity ratio would be lower if it used the equity method to account for its investment in Grand Sand.

7. Horace Jones Company

The first step in determining which business segments must be reported separately is to determine whether a majority of revenues are generated from external customers. As shown below, this criterion is met by all segments other than C. Therefore, segment C will not be reported separately.

|Majority of Revenues Test |A |B |C |D |E |F |

|Revenues: | | | | | | |

| External sales revenue | 1,030 | 350 | 20 | 140 |130 | 120 |

| Intersegment sales revenue | 30 | 20 | 200 | 10 | 0 | 0 |

|Total revenues | 1,060 | 370 | 220 | 150 |130 | 120 |

|External revenues as % of total revenues |97% |95% |9% |93% |100% |100% |

The next step is to apply the three significance tests to determine whether the second criterion for a reportable segment is met.

|Revenue Test |Total |Percentage | |

|Segment | Revenues | of Total | |

|A | 1,060 |52% |reportable |

|B | 370 |18% |reportable |

|C | 220 |11% | |

|D | 150 |7% | |

|E | 130 |6% | |

|F | 120 |6% | |

| Total | 2,050 |100% | |

|Profit or Loss Test | Segment | Segment |Segment Result | |

|Segment | Revenues | Expenses |Profit |Loss | |

|A |1,060 |824 | 236 | |reportable |

|B | 370 | 560 | | (190) |reportable |

|C | 220 | 158 | 62 | | |

|D | 150 | 144 | 6 | | |

|E | 130 | 73 | 57 | |reportable |

|F | 120 | 101 | 19 | | |

| Total | 2,050 | 1,860 | 380 | (190) | |

|Asset Test | Total |Percentage | |

|Segment |Assets |of Total | |

|A |1,650 |47% |reportable |

|B | 650 |19% |reportable |

|C | 500 |14% | |

|D | 280 |8% | |

|E | 300 |9% | |

|F | 120 |3% | |

| Total | 3,500 |100% | |

Of the five business segments that meet the criterion of having a majority of revenues from external sources, only three segments meet at least one of the significance tests. Segments A, B, and E will be reported separately; segments C, D, and F will be combined into Other Segments. However, if total external revenues attributable to separately reportable segments is less than 75% of total consolidated revenue, additional segments must be reported even if they do not meet any of the significance tests.

|75% Test | External | Percentage of |

|Segment | Revenues | Consolidated Revenues |

|A | 1,030 |58% |

|B | 350 |20% |

|C | 20 |n/a |

|D | 140 |n/a |

|E | 130 |7% |

|F | 120 |n/a |

| Total consolidated revenues | 1,790 |84% |

Because A, B, and E collectively comprise more than 75% of total consolidated revenues, segments C, D, and F will be combined.

The schedule below provides a suggestion for how the information items required to be presented for primary format segments might be presented. A reconciliation is provided for the amounts that appear in the consolidated income statement.

| |Segment |Segment |Segment |Other |Corp- |Elimin- |Consoli- |

| |A |B |E |Segments |orate |ations |dated |

| | 1,060 |370 | 130 | 490 | - | (260) |1,790 |

|Total revenues | | | | | | | |

|Cost of goods sold | 600 |300 |60 | 300 | -| (200) | 1,060 |

|Depreciation and amortization |80 |100 | 5 |35 | 10 | | 230 |

|Other operating expenses | 120 |150 |5 | 55 | 50 | | 380 |

|Allocated corporate expense | 24 | 10 | 3 | 13 | -| (50) | - |

|Segment profit or loss |236 | (190) | 57 | 87 | | | 120 |

|Interest expense | | | | | | | 30 |

| | | | | | | |30 |

|Income taxes | | | | | | | |

| | | | | | | | 60 |

|Net income | | | | | | | |

| | | | | | | | |

|Other information: | | | | | | | |

|Segment assets | 1,650 |650 |300 | 900 | 100 | | 3,600 |

|Segment liabilities | 750 |300 |140 |510 |- | | 1,700 |

|Capital expenditures | 200 | 50 | 20 | 105 | 10 | | 385 |

|Depreciation and amortization | 80 | 100 | 5 | 35 | 10 | |230 |

8. Schering AG

Schering’s Primary Reporting Format is geographic. The following table indicates the heading used by Schering to report information required by IAS 14 for each reportable primary reporting format segment:

|IAS 14 Requirement |Schering heading |

|Segment revenue |Segment net sales |

|Segment profit or loss |Segment result |

|Carrying amount of segment assets |Segment assets |

|Segment liabilities |Segment liabilities |

|Cost during the period to acquire property, plant, and equipment, and |Investments in intangibles and property, plant and equipment |

|intangible assets | |

|Depreciation and amortization |Depreciation |

|Significant noncash expenses, other than depreciation and amortization|Other significant non-cash expenses |

|Aggregate share of profit or loss and aggregate investment in equity |Not found, might not be applicable |

|method associates and joint ventures. | |

IAS 14 also requires a reconciliation between the information disclosed for primary segments and the aggregate information in the consolidated financial statements. Schering provides this reconciliation; consolidated amounts are referred to as “Schering AG Group.”

When the primary reporting format is geographical segments, three items of information as shown below should be provided for each business segment whose external revenues are 10% of total external revenues or whose segment assets are 10% or more of total segment assets.

|IAS 14 Requirement |Schering heading |

|Revenue from external customers |External net sales |

|Carrying amount of segment assets |Segment assets |

|Capital expenditures |Investments in intangibles and property, plant and equipment |

Geographical segments can be determined on the basis of where assets are located or on the basis of where customers are located. If the primary reporting format is geographical segments based on location of assets and customer location is different from asset location, the company should disclose revenues from external customers for each customer-based geographical segment that has 10% or more of total external revenues. If the primary reporting format instead is geographical segments based on customer location and assets are located in geographical areas different from customers, the company should disclose:

• the carrying amount of segment assets for each asset-based geographical segment that has 10% or more of total external revenues, and

• capital expenditures during the period for each asset-based geographical segment that has 10% or more of total capital expenditures.

Schering’s geographic segments are based on customer location. The company complies with the above requirements by reporting “Segment assets by geographic location” and “Investments by geographic location.”

In conclusion, Schering AG complies fully with the primary and secondary reporting format requirements of IAS 14.

9. IBM, Johnson & Johnson, and General Motors

a. A commonly used measure of multinationality is the percentage of total sales that are generated in countries other than the United States: Foreign Sales/Total Sales. This ratio can be calculated for each company by subtracting U.S. sales from total sales and then dividing by total sales:

IBM ($96,293 - $35,637) / $96,293 = 63.0%

Johnson & Johnson ($47,348 - $27,770) / $47,348 = 41.3%

General Motors ($193,517 - $134,380) / $193,517 = 30.6%

Based on this measure, IBM is the most multinational company among the three in Exhibit 8.8.

b. International diversification refers to the extent to which a company’s operations are spread across different countries and regions of the world. General Motors appears to be concentrated in a relatively small number of countries, and is therefore not very diversified internationally. Almost 90% of GM’s sales are generated from operations in only eight countries (U.S., Canada and Mexico, France, Germany, Spain, U.K., and Brazil). From Johnson & Johnson’s segment disclosure, it is impossible to know the number of countries in which the company has operations. For example, “Europe” could imply operations in anywhere from one to 30+ countries. One can determine that about 50% of IBM’s revenues are generated in only two countries (U.S. and Japan), but it is impossible to know where in the world the remaining 40% of its sales are generated. We do know that there are no other countries in which IBM believes it has a material amount of revenues, because it would be required to disclose this country separately. This exercise demonstrates the difficulty in assessing international diversification given current segment reporting practices.

10. BMW and Volkswagen

a. A commonly used measure of multinationality is the percentage of total sales that are generated in countries other than the home country: Foreign Sales/Total Sales. This ratio can be calculated for each company by subtracting sales in Germany from total sales and then dividing by total sales:

BMW (€44,335 – €11,961) / €44,335 = 73.0%

Volkswagen (€88,963 – €24,504) / €88,963 = 72.5%

Based on this measure, BMW is slightly more multinational than Volkswagen. Both companies rely very heavily on sales made outside of Germany.

Note that the internationality of the two companies can be directly compared by collapsing VW’s North America and South America segments into one region – America – and by collapsing its Africa and Asia/Oceania segments into one region – Africa, Asia, Oceania.

b. One way to measure international diversification is the extent to which sales are spread out over different regions of the world. Column B in the table below shows that BMW’s sales are more evenly spread over the four segments than are VW’s. Whereas VW generates 72% of its sales in Europe including Germany, BMW generates only 63% of its sale in Europe.

|External Sales |Col. A |Col. B |Col. C |Col. D |Col. E |

| | | | | |Year-to-year |

|BMW |2004 |% |2003 |% |% change |

|Germany | 11,961 |27.0% | 10,590 |25.5% |12.9% |

|Rest of Europe | 15,823 |35.7% | 13,389 |32.2% |18.2% |

|America | 10,648 |24.0% | 11,620 |28.0% |-8.4% |

|Africa, Asia, Oceania | 5,903 |13.3% | 5,926 |14.3% |-0.4% |

| | 44,335 |100.0% | 41,525 |100.0% |6.8% |

| | | | | | |

|Volkswagen | | | | | |

|Germany | 24,504 |27.5% | 23,298 |27.5% |5.2% |

|Rest of Europe | 39,755 |44.7% | 35,723 |42.1% |11.3% |

|America | 17,257 |19.4% | 18,084 |21.3% |-4.6% |

|Africa, Asia, Oceania | 7,447 |8.4% | 7,708 |9.1% |-3.4% |

| | 88,963 |100.0% | 84,813 |100.0% |4.9% |

c. BMW experienced a growth in 2004 revenues of 6.8% (Col. E in table above). Revenues grew in Germany and the Rest of Europe only. The greatest decrease in revenues incurred in America.

Volkswagen experienced an overall increase in sales in 2004 of 4.9% (Col. E). The pattern of revenue growth for Volkswagen is similar to that for BMW. Sales for VW also grew in Germany and the Rest of Europe, with a decline in America and Africa/Asia/Oceania. The largest year-to-year % decline was in America (Col. E).

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download