Case Study
Read the case study attached, and answer the following questions:
James, M. L. (2010). Accounting for business combinations and the convergence of International Financial Reporting Standards with U.S. Generally Accepted Accounting Principles: A case study. Journal of the International Academy for Case Studies, 16(1), 95-108. Retrieved from
https://search-proquest-com.libraryresources.columbiasouthern.edu/docview/845495985?accountid=33337
- What key financial ratios will be affected by the adoption of FAS 141R and FAS 160? What will be the likely effect?
- Could any of the recent and forthcoming changes affect the company’s acquisition strategies and potentially its growth?
- What were FASB’s primary reasons for issuing FAS 141R and FAS 160?
- What are qualifying SPEs? Do they exist under IFRS? What is the effect of FAS 166 eliminating the concept of qualifying SPEs on the convergence of accounting standards?
- If the company adopts IFRS, what changes should management be aware of?
- What are the principle differences between IFRS and U.S. GAAP?
Your submission should be a minimum of three pages in length in APA style; however, a title page, a running head, and an abstract are not required. Be sure to cite and reference all quoted or paraphrased material appropriately in APA style.
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Journal of the International Academy for Case Studies, Volume 16, Special Issue, Number 1, 2010
ACCOUNTING FOR BUSINESS COMBINATIONS
AND THE CONVERGENCE OF INTERNATIONAL
FINANCIAL REPORTING STANDARDS WITH U.S.
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES:
A CASE STUDY
Marianne L. James, California State University, Los Angeles
CASE DESCRIPTION
The primary subject matter of this case concerns changes in accounting for business
combinations and the convergence of International Financial Reporting Standards (IFRS) with U.S.
Generally Accepted Accounting Principles (GAAP). The case focuses on the effect of the changes
on financial statements of global entities, as well as strategic decisions made by company
executives.
Secondary, continuing significant differences between U.S. GAAP and IFRS and future
potential developments in accounting for consolidated multinational entities are explored. This case
has a difficulty level of three to four and can be taught in about 50 minutes. Approximately three
hours of outside preparation is necessary to fully address the issues and concepts. This case can be
utilized in an Advanced Accounting course, either on the graduate or undergraduate level to help
students understand changes in and differences between U.S. GAAP and IFRS. Two sets of questions
address U.S. GAAP and IFRS and include researchable questions that are especially useful for a
graduate level course. The case has analytical, critical thinking, conceptual, and research
components. Utilizing this case can enhance students’ oral and written communication skills.
CASE SYNOPSIS
Financial reporting in the U.S. is changing dramatically. Consistent with the Securities and
Exchange Commission’s proposed “Roadmap” (SEC, 2008), the U.S. likely will join the more than
100 nations worldwide that currently utilize International Financial Reporting Standards (IFRS),
and require the use of IFRS in the U.S.
Because of the globally widespread use of IFRS, multinational entities with subsidiaries that
prepare IFRS-based financial statements already have to be knowledgeable about IFRS as well as
the current differences between U.S. GAAP and IFRS. Fortunately, the Financial Accounting
Standards Board (FASB) and the International Accounting Standards Board (IASB) are working
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Journal of the International Academy for Case Studies, Volume 16, Special Issue, Number 1, 2010
together to bring about convergence between the two sets of accounting standards.
Recently, FASB and the IASB issued new and revised several existing standards that
eliminate many differences between U.S. GAAP and IFRS with respect to business combinations and
consolidated financial statements. However, some significant differences persist. Until the SEC
makes a final decision regarding the mandatory use of IFRS, and during the proposed multi-year
transition period, current and future accounting professionals must continue to keep abreast of
changes in U.S. GAAP, be knowledgeable about differences between U.S. GAAP and IFRS, and, at
the same time, prepare for the likely transition to IFRS. In addition, company executives should be
cognizant of developments that may affect their strategic decisions as the U.S. moves toward a likely
adoption of IFRS during the next five years.
This case focuses on the effect of changes in financial reporting for business combinations.
Changes as well as continuing differences between U.S. GAAP and IFRS are explored. Secondarily,
strategic decisions arising from the changes and the likely future adoption of IFRS are addressed.
This case, which can be utilized in Advanced Accounting on either the graduate or undergraduate
level can enhance students’ analytical, technical, critical thinking, research, and communication
skills.
INTRODUCTION
Financial accounting and reporting in the U.S. is changing rapidly. During the past six
months, the Financial Accounting Standards Board, the primary accounting standard setter in the
U.S., issued twelve (12) new standards and launched its on-line “Accounting Standards
Codification,” which organizes existing GAAP into 90 topics (FASB, 2009). At the same time, a
significantly more dramatic change is on the horizon for accounting professionals, company
executives, and financial statement users.
Consistent with the SEC’s 2008 proposal entitled, “Roadmap for the Potential Use of
Financial Statements Prepared in Accordance With International Financial Reporting Standards by
U.S. Issuers,” (Roadmap) in approximately five years, public companies likely will have to utilize
IFRS, instead of U.S. GAAP (SEC, 2008). In fact, some large global U.S.-based entities are
permitted to early-adopt IFRS starting in 2009. The SEC expects to reach a final decision regarding
the mandatory adoption of IFRS in 2011 (SEC, 2008).
If the U.S. indeed adopts IFRS as the required standard for financial accounting and
reporting, the U.S. will join the more than 100 nations worldwide that currently permit or mandate
the use of IFRS. For example, starting with the 2005 reporting period, all European public
companies listed on any European stock exchange must prepare IFRS-based financial statements.
Other nations, such as Canada, are planning to adopt IFRS in the near future.
Currently, U.S. GAAP and IFRS are not identical. However, since signing their
Memorandum of Understanding, commonly referred to as the “Norwalk Agreement,” in 2002, FASB
and the IASB have been working together to develop a set of high-quality globally acceptable
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Journal of the International Academy for Case Studies, Volume 16, Special Issue, Number 1, 2010
financial accounting standards and to bring about convergence of U.S. GAAP and IFRS. Since the
Norwalk Agreement was signed, many new and revised standards issued by FASB and the IASB
have served the purpose of eliminating existing differences. However, while many differences have
been eliminated, others persist.
Accounting for and reporting by global entities is quite complex. U.S., as well as
international accounting rules require that a parent company consolidates its subsidiaries’ financial
statements with the parent company’s financial statements. Recent standards issued by the IASB
and FASB have eliminated many differences between U.S. GAAP and IFRS in accounting for
business combinations and financial reporting for consolidated entities. However, some significant
differences continue to exist.
KLUGEN CORPORATION
Irma Kuhn, CPA, CMA holds the position of Chief Financial Officer (CFO) of Klugen
Corporation, a global telecommunications company. Klugen is a consolidated entity headquartered
in the U.S. with four majority-owned European subsidiaries. The company has expanded primarily
by acquiring majority interest in European companies and holds between 51% and 70% of the
outstanding voting stock of its subsidiaries. Three of these subsidiaries were acquired in stages and
consolidated once the company achieved majority ownership.
Consistent with current accounting rules, Klugen consolidates all four of its subsidiaries. In
addition, Klugen also holds financial interests in several unconsolidated entities and accounts for
those as investments.
Klugen’s European subsidiaries currently prepare their financial statements consistent with
International Financial Reporting Standards (IFRS), which are promulgated by the International
Accounting Standards Board (IASB). Klugen, the parent company, issues consolidated financial
statements, which include the results of its majority-owned subsidiaries in conformity with U.S.
GAAP. Preparation of Klugen’s consolidated financial statements requires that Irma and her staff
convert the subsidiaries’ IFRS-based financial statements into U.S. GAAP prior to consolidating the
numbers. This process is quite complex and requires many of the accounting departments’ resources.
Irma is well aware of efforts between the FASB and the IASB to bring about convergence
between U.S. GAAP and IFRS. She expects that consistent with the SEC’s “Roadmap,” (SEC, 2008)
within the next five years, U.S. public companies likely will have to apply IFRS, rather than U.S.
GAAP. Irma welcomes this development and believes that in the long-run, use of IFRS by the parent
company as well as its subsidiaries will preserve and strengthen the company’s global financial
competitiveness. In addition, she believes that it will simplify the accounting and consolidation
process significantly and, in the long-run, reduce financial reporting costs. She is aware, however,
that in the short-run many challenges, such as conversion of the accounting and IT systems and
extensive staff training will increase costs. Knowing that the SEC’s Roadmap proposes a phased-in
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adoption by public companies between 2014 and 2016, Irma plans to recommend adoption of IFRS
at the earliest permitted time.
As the person who ultimately is responsible for financial reporting, Irma is very
knowledgeable about current and proposed changes in U.S. GAAP as well as IFRS. She knows that
the IASB and FASB have issued new and revised standards applicable to business combinations that
affect the company’s consolidated financial statements. After in depths analysis of the new and
revised standards, she determined that many of the past differences between U.S. GAAP and IFRS
where eliminated when the FASB issues FAS 141 R “Business Combinations” and FAS 160 “Non-
controlling interest in consolidated financial statements” (FASB, 2007) and the IASB revised IFRS
3 “Business Combinations” and IAS 27 “Consolidated and Separate Financial Statements” (IASB,
2008). She also realizes that some significant differences still persist. Klugen Corporation has
properly adopted FAS 141R and FAS 160 (now codified in sections 805 and 810 of FASB’s 2009
Standards Codification) for the 2009 fiscal period and its forthcoming annual report will reflect
those changes.
Irma regularly conducts in-house seminars to instruct her accounting staff regarding new
developments in financial reporting. In fact, her seminars meet the Continuing Professional
Education (CPE) sponsor requirements set forth by the National Association of State Boards of
Accountancy (NASBA) and the Quality Assurance Service (QAS), which is required by State
Boards of Accountancy and other licencing organizations for the renewal of CPA, CMA and other
professional certifications.
Irma’s CPE seminars entitled “Financial Reporting Updates” are always well received by
her staff. During the past six months, Irma already has held several seminars to inform her staff
regarding IFRS. Those who attended all her seminars are already familiar with the SEC’s Roadmap
that proposes adoption of IFRS starting in 2014, and also know about some of the most significant
differences between U.S. GAAP and IFRS.
Since in about five (5) months, Klugen Corporation will issue its consolidated financial
statements, which will, for the first time, incorporate FAS 160 and FAS 141R, Irma decides to
schedule a seminar on “Business Combinations – Consolidated Financial Statements” for October
15, 2009. The following is a brief agenda for Irma’s Seminar:
Business Combinations – Consolidated Financial Statements – Financial Reporting Update
October 15, 2009 – Agenda
1. Review of fundamental concepts of business combinations and consolidated financial
statements
2. Changes to U.S. GAAP (FAS 141R and FAS 160)
3. Significant continuing differences between U.S. GAAP and IFRS
4. Developments with potential impact on future fiscal periods
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5. Questions
The seminar will be highly beneficial for staff members who are currently involved or
planning to become involved in critical aspects of financial reporting and also for those who want
to develop their knowledge of IFRS. During the seminar, Irma distributes several handouts,
including the company’s prior year income statement and balance sheet for reference.
Table 1
Klugen Corporation
Consolidated Statement of Income
for the year ended December 31, 2008
Numbers are in million (except share amounts)
Operating Revenues
Business service $15,500
Residential service 10,200
Wireless service 18,000 $ 43,700
Operating Expenses
Cost of services (excludes depreciation & amortization) $ 15,200
Selling, general, administrative expenses 11,
100
Depreciation and amortization 7,150 $ 33,450
Operating Income $ 10,250
Other Income (Expense)
Interest expense (820)
Minority interest (1,010)
Investment income 405 (1,425)
Income Before Income Taxes $ 8,825
Income Tax 3,250
Net Income 5,575
Basic Earnings Per Share $2.08
Diluted Earnings Per Share $1.92
The accompanying notes are an integral part of the consolidated financial statements
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Table 2
Klugen Corporation
Consolidated Balance Sheet
December 31, 2008
(Numbers are in millions)
Assets
Current Assets
Cash and cash equivalents $ 519
Accounts receivables (net of allowances of $310) 4,200
Prepaid expenses 400
Other current assets 520
Total Current Assets $ 5,639
Non-Current Assets
Property, plant & equipment (net) 25,600
Goodwill 18,500
Licenses 12,900
Customer relationships (net) 3,100
Investments in non-consolidated entities 1,000
Dividends receivables 300
Other assets 1,200
Total Non-Current Assets $62,600
Total Assets $68,239
Liabilities and
Stockholders’ Equity
Current Liabilities
Accounts payable and accrued liabilities 5,200
Advanced billings and deposits 920
Accrued taxes 420
Total Current Liabilities $ 6,540
Non-Current Liabilities
Long-term debt 25,500
Post-retirement benefits 2,300
Deferred taxes 3,200
Total Non-Current Liabilities $31,000
Total Liabilities $37,540
Minority Interest 5,000
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Table 2
Klugen Corporation
Consolidated Balance Sheet
December 31, 2008
(Numbers are in millions)
Journal of the International Academy for Case Studies, Volume 16, Special Issue, Number 1, 2010
Stockholders’ Equity
Common stock ($1 par, 100,000,000 authorized, 60,000,000
issued)
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Additional paid in capital 13,095
Retained earnings 14,588
Accumulated other comprehensive income (2,044)
Total Stockholders’ Equity 25,699
Total Liabilities and Stockholders’ Equity $68,239
The accompanying notes are an integral part of the consolidated financial statements.
The Seminar
Agenda Item 1 Fundamental Concepts of Business Combinations – Consolidated
Financial Statements
During the first part of the seminar, Irma reviews several fundamental concepts
relating to accounting for business combinations. She emphasizes that these concepts are
common to both U.S. GAAP and IFRS.
Fundamental Concepts common to both U.S. GAAP and IFRS
‚ The parent company issues consolidated financial statements that include the results
for all subsidiaries that the company controls.
‚ Control is usually assumed when the parent holds a controlling financial interest
(generally, more than 50% ownership of the outstanding voting common stock.
‚ Consolidated financial statements include 100% of the subsidiaries’ assets, liabilities,
revenue, expense, gains, and losses, even if the subsidiary is only partially owned.
‚ Subsidiaries’ previously unrecognized assets are identified at time of business
combination and are recognized in the consolidated financial statements.
‚ Goodwill is recognized on the consolidated balance sheet if the acquisition cost
exceeds the fair value of the subsidiaries’ identifiable net assets.
‚ Goodwill is not amortized, but periodically tested for impairment.
‚ Non-controlling interest (formerly called minority interest) is recognized on the
consolidated balance sheet.
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Agenda Item 2 Changes in U.S. GAAP
Irma discusses the most important changes in accounting and financial reporting for
consolidated entities consistent with FAS 141R and FAS 160. She prepares a handout for
the seminar participants, consisting of a comparative table that contrast the new rules
(effective for the 2009 financial statements) with the prior rules.
Table 3
Recent Changes to U.S. GAAP – effective 2009 – FAS 141R and FAS 160
Issue E f f e c t i v e 2 0 0 9 F i n a n c i a l
Statements
Pre-2009 Financial Statements
Subsidiaries’ assets and liabilities All assets and liabilities are
revalued to fair market value at
acquisition date (100%
revaluation).
Assets and liabilities were
revalued based on the parent’s
ownership percentage
Negative goodwill Recognized as gain for year of
acquisition.
Recognized as a proportionate
reduction of long-term assets.
Balance sheet classification of non-
controlling interest (NCI)
NCI is classified as equity. NCI is recognized as liability,
equity, or between liabilities and
equity.
Income statement presentation of
NCI’s share of income
Presented as a separate deduction
from consolidated income to
derive income to controlling
stockholders.
NCI was presented as part of
“Other income, expenses, gains,
and losses.”
NCI valuation Is carried at fair market value of
subsidiaries’ net assets, multiplied
by NCI percentage.
Carried at book value of
subsidiaries’ net assets, multiplied
by NCI percentage.
Cost of business combinations Direct costs are expensed during
year of acquisition
Direct costs were capitalized as
part of acquisition cost.
In process research and development
(R&D)
Are capitalized at time of
acquisition.
Could be expensed at time of
acquisition.
Acquisition in stages Previously acquired equity interest
is remeasured when acquiring
company achieves control; gain or
loss is recognized in the income
statement.
Measurement was based on
values at time of individual equity
acquisition
Terminology Minority interest is now referred
to as “non-controlling interest.”
The commonly used term was
“minority interest.”
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Agenda Item 3 Significant Continuing Differences Between U.S. GAAP and IFRS
Irma highlights continuing significant differences between U.S. GAAP and IFRS.
This information is particularly important for those staff members who are involved in the
consolidation process and those who wish to prepare for the future adoption of IFRS. The
following table represents a handout based on Irma’s PowerPoint presentation:
Table 4
Summary of Current Differences Between U.S. GAAP and IFRS
Issue U.S. GAAP IFRS
Definition of control Defined as “controlling financial
interest” (ARB 51).
Usually interpreted as majority
voting interest.
Focuses on “power to govern
financial and operating policies”
(IFRS 3, par. 19); The goal is that
activities generate “benefits” for
controlling entity.
Shares considered for determining
control
Only existing voting rights are
considered.
May include exercisable shares.
Calculation of non-controlling
interest (NCI)
NCI interest is measured at fair
value of total net assets and
includes share of goodwill.
Choice between (1) fair value
and (2) proportionate share of fair
value of identifiable net assets.
Calculation of goodwill at time of
acquisition
Goodwill (if it exists) also includes
share attributed to NCI.
If second option is chosen,
goodwill is only attributed to
controlling interest (parent).
Contingencies – initial measurement Contractual contingent assets or
liabilities are valued at fair market
value. Non-contractual contingent
assets and liabilities that meet the
‘more likely than not’ test are
accounted for consistent with SFAC
6.
Non-contractual assets and
liabilities: If they do not meet ‘more
likely than not test’ are accounted
for consistent with FAS 5.
Recognition of contingent liability:
Contingent liability is recognized
even if it is does not meet the
‘probable’ test if the present
obligation
arises from a past event and is
reliably measured.
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Table 4
Summary of Current Differences Between U.S. GAAP and IFRS
Issue U.S. GAAP IFRS
Journal of the International Academy for Case Studies, Volume 16, Special Issue, Number 1, 2010
Goodwill impairment test Two-step approach: (1) compare
book value of reporting unit to fair
market value of reporting unit; (2) if
book value is larger, impairment is
equal to book value less implied
fair value of goodwill.
One-step approach
Compare book value to larger of
cash generating unit’s (a) fair value
less selling cost and (b) value in use
[value in use = PV of expected
future cash flows].
Agenda Item 4 Developments with Potential Impact on Future Fiscal Periods
Irma briefly mentions other developments in the consolidation area. She mentions
that in June 2009, FASB issued FAS 166, “Accounting for Transfers of Financial Assets,”
and FAS 167, “Amendments to FASB Interpretation No. 46R” (FASB, 2009). FAS 166
eliminates the concept of qualifying special purpose entities (SPE); FAS 167 deals with the
consolidation aspects of this elimination. Specifically, companies with formerly classified
qualifying SPEs must now assess these entities for possible consolidation.
FAS 167 focuses on control and the primary beneficiary of the SPE in determining
whether a company, such as Klugen Corp., must consolidate its SPE. A primary beneficiary
is (1) able to direct activities of the SPE and is required to absorb significant gains and
losses. A company is assumed to have control if (1) it has the power to direct activities, (2)
has the most significant impact on the entity’s performance, and (3) is required to absorb
losses, and benefit from gains (FAS 167, par. 14A-G). Irma reminds her staff that currently
Klugen Corporation does not have investments in qualifying SPE’s; thus, the new standards
will not affect the company.
Irma also mentions that in December 2008, the IASB issued Exposure Draft 10 (ED
10) “Consolidated Financial Statements,” (IASB, 2008), which proposes a single definition
of control that is very similar to the FAS 167 definition. Once this exposure draft is finalized,
convergence between U.S. GAAP and IFRS likely will be further enhanced. Irma promises
to keep her staff informed about developments in that area.
Agenda Item 5 Questions
At the end of the seminar, many questions arise from the staff and some from the
CEO, who attended the second half of the seminar. Irma answers as many questions as
possible and promises to prepare a short question/answer briefing sheet for all those who
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Journal of the International Academy for Case Studies, Volume 16, Special Issue, Number 1, 2010
were present at the seminar. During the seminar she summarizes the following questions as
shown in the Assignments section.
ASSIGNMENTS
Answer the questions specifically assigned by your instructor.
U.S. GAAP Questions
1. How will adoption of the new accounting standards (FAS 141R and FAS 160) affect Klugen
Corporation’s financial statements in the forthcoming reporting period?
2. Utilizing the 2008 numbers, prepare (1) a partial income statement starting at income from
operations and (2) the equity section of the balance sheet consistent with the requirements
of FAS 141R and FAS 160 (FASB Accounting Standards Codification sections 805 and
810).
3. How will adoption of FAS 141R and FAS 160 affect Klugen Corporation’s financial
statements in the long-run?
4. What key financial ratios will be affected by the adoption of FAS 141R and FAS 160? What
will be the likely effect?
5. What additional estimates have to be made consistent with the new accounting standards?
6. Could any of the recent and forthcoming changes affect the company’s acquisition strategies
and potentially its growth?
7. What were FASB’s primary reasons for issuing FAS 141R and FAS 160? (Research
question)
8. What are qualifying SPEs? Do they exist under IFRS? What is the effect of FAS 166
eliminating the concept of qualifying SPEs on the convergence of accounting standards?
9. FASB and IASB recently issued an updated Memorandum of Understanding. Retrieve the
updated memorandum and identify several issues that the two standard setting boards are
jointly focusing on to facilitate convergence. (Research Question)
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IFRS Questions
1. From the consolidation perspective, what would be the likely overall effect of adopting IFRS
on the company’s financial statements?
2. What potential effect would arise if Klugen were to select the option under IFRS 3 to value
non-controlling interest at the proportionate share of its subsidiaries’ net identifiable assets?
3. Do you believe that an impairment of goodwill would be more likely under IFRS or under
U.S. GAAP? Why, or why not?
4. What challenges would arise for the accounting staff if the company adopts IFRS? Do you
believe that he company is making progress toward meeting some of these challenges?
5. What opportunities would arise for the accounting staff if the company adopts IFRS?
6. What other (non-staff related) factors should Klugen Corporation consider prior to adopting
IFRS? Differentiate between advantages and disadvantages.
7. Two of Klugen’s non-consolidated entities regularly grant stock options to its employees.
How could this affect Klugen’s accounting for these entities under IFRS?
8. As indicated in the case, Irma previously highlighted some other significant differences
between IFRS and U.S. GAAP. Research the issue and find three (3) differences other than
those related to business combinations. You may want to consider accounting for inventory,
extraordinary items, property, plant and equipment, and research and development.
9. Assume that the SEC provides a choice in the timing of the adoption of IFRS. What ethical
issues could arise for the CFO in deciding whether to adopt IFRS at the earliest possible, or
at a later required date? (Research question)
10. Review comment letters received by the SEC regarding its Roadmap. List two concerns
mentioned by those offering comments. (Research question)
REFERENCES
Committee on Accounting Procedures (1959). Accounting Research Bulletin No. 51. Consolidated Financial Statements.
Original Pronouncement. Financial Accounting Standards Board: Stamford: CT.
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Financial Accounting Standards Board (2009). FASB Accounting Standards Codification. Http://www.fasb.org.
Financial Accounting Standards Board (2009). FASB Statement No. 167. Amendments to FASB Interpretation 46R.
Retrieved on July 7, 2009, from http://www.fasb.org.
Financial Accounting Standards Board (2009). FASB Statement No. 166. Accounting for the Transfer of Financial
Assets – an amendment of FASB Statement No. 140. Retrieved on July 7, 2009, from http://www.fasb.org.
Financial Accounting Standards Board (2007). FASB Statement No. 160. Non-Controlling Interest in Consolidated
Financial Statement. Retrieved on January 5, 2008, from http://www.fasb.org.
Financial Accounting Standards Board (2007). FASB Statement No. 141R. Business Combinations. Retrieved on
January 5, 2008, from http://www.fasb.org.
Financial Accounting Standards Board (2002). Memorandum of Understanding. The Norwalk Agreement. September
18. Retrieved on June 18, 2008, from fasb.org/newsmemoradum .
International Accounting Standards Board (2008). ED 10 Consolidated Financial Statements. December 2008. Retrieved
on March 30, 2009, from http://www.iasb.org.
International Accounting Standards Board (2008). International Financial Reporting Standard No. 3. Business
Combinations. London, England: IASB.
International Accounting Standards Board (2008). International Accounting Standard No. 27. Consolidated and Separate
Financial Statements. London, England: IASB.
Securities and Exchange Commission (2008). Roadmap for the Potential Use of Financial Statements Prepared in
Accordance With International Financial Reporting Standards by U.S. Issuers. Release No.: 33-8982, File No.
S7-27-08. Retrieved on November 19, from http://www.sec.gov.
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AUTHOR’S NOTE
This is a fictitious case. Any similarities with real companies, individuals, and situations are solely
coincidental.
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
MBA 6601, International Business 1
Course Learning Outcomes for Unit VII
Upon completion of this unit, students should be able to:
9. Compare the accounting concepts of Generally Accepted Accounting Principles (GAAP) and
International Financial Reporting Standards (IFRS).
Reading Assignment
In order to access the following resource(s), click the link(s) below:
Fuller, C., & Crump, R. (2016). There may be trouble ahead. Financial Director, 30–33. Retrieved from
https://libraryresources.columbiasouthern.edu/login?url=http://search.ebscohost.com/login.aspx?direc
t=true&db=bth&AN=113496250&site=ehost-live&scope=site
Herz, R. (2015). U.S. financial reporting: How are we doing? Compliance Week, 12(142), 39–41. Retrieved
from http://link.galegroup.com/apps/doc/A434530135/ITBC?u=oran95108&sid=ITBC&xid=c5c69fe6
Mishler, M. D. (2015). Don’t let foreign currency fluctuations impair performance measurements. Journal of
Accountancy, 220(6), 60–66.Retrieved from
https://libraryresources.columbiasouthern.edu/login?url=http://search.ebscohost.com/login.aspx?direc
t=true&db=bth&AN=111314570&site=ehost-live&scope=site
Click here to view the Unit VII Presentation. Click here to access a PDF of the presentation, which includes
slide images and audio transcript.
Unit Lesson
International Accounting Issues
In a corporation’s senior management, the finance and accounting functions fall under the same person. Both
the treasurer and the controller report to the chief financial officer (CFO). The treasurer is responsible for
finance, while the controller handles the accounting side.
So, what does the controller control? While they are responsible for accounting standards and procedures,
their job duties go much further. They provide data to evaluate potential acquisitions abroad, disposition of
assets, managing cash flow, hedging currency, internal auditing, tax planning, preparation of financial
statements, and assistance in implementing corporate strategy. A large combination of these duties may only
be found in large multinational enterprises (MNEs), but even small companies that import or export will have
to occasionally handle foreign currency transactions or conduct currency hedging strategies.
One of the big headaches that controllers have to deal with is the differences in the presentation of the
financial information. Under normal conditions, each branch or subsidiary is required to have a financial
statement completed on their operations so that local taxes are computed and paid. Each country has its own
type of accounting procedures that an MNE must follow. Financial statements written in the local language
show financial transactions stated in the local currency. Other considerations include the statement layout and
the Generally Accepted Accounting Principles (GAAP) provided by the local government’s comptroller’s office.
UNIT VII STUDY GUIDE
Managing International Operations, Part 2:
Accounting and Financial Issues
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MBA 6601, International Business 2
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It is important to note that both the United States and global authorities have organizations that have issued
standardized accounting rules.
U.S. Accounting: The Financial Accounting Standards Board (FASB) is the organization that
establishes the accounting standards for the private sector in the United States. Its rules are the
Generally Accepted Accounting Principles (U.S. GAAP).
Global Accounting: The International Accounting Standards Board (IASB) is the organization that
establishes accounting standards for the global community. Its rules are the International Ffinancial
Reporting Standards (IFRS).
U.S. GAAP is to FASB as IFRS is to IASB. In a few international countries, neither IFRS nor U.S. GAAP are
required; in a few other international countries, either IFRS or U.S. GAAP is required. However, as many as
120 countries currently require or permit IFRS use (Solomonzori, 2013).
Global Convergence to International Standards
Prior to the rise of global capital markets, many foreign countries accepted U.S. accounting standards as a
qualified substitute. Both the U.S. and other global nations mutually recognized accounting standards from
the other. Since the 1970s, efforts have been made to harmonize accounting standards that anyone in the
world could use. Several trends have come together to push this convergence:
Capital markets have spread throughout the world as evidenced by over 60 stock markets.
MNEs have the ability to sell equity and debt at lower transaction costs in foreign countries.
Foreign countries need standard accounting data for tax purposes.
There is pressure from investors, MNEs, and foreign governments for more uniform standards in
financial reporting that are easier to understand.
In the early 2000s, FASB and IASB began working together to eliminate differences in accounting standards.
While there is some similarity between the two accounting standards, it is still felt by the U.S. Securities
Exchange Commission that FASB needs to be stringent and transparent as it relates to U.S. corporations;
characteristics that IASB has yet to embrace for international MNEs.
Transactions in Foreign Currencies
Subsidiaries and branches that operate in foreign countries must convert all of their transactions in foreign
currencies to the currency of the home office at the end of the accounting year. For example, an importer
purchases the service of a freight forwarder to assist with freight going through customs in the foreign country.
The importer will sell its domestic currency to purchase the foreign currency of the freight forwarder.
Depending on the fluctuations of the currency, the importer might gain or lose on the transaction. Those gains
or losses translate into the net income of the importer (Financial Accounting Standards Board, 1981).
The process of restating those gains or losses into the currency of the importer is translation. In the United
States, translation is a two-step process. First, for each country in which the importer was conducting
business, the importer would need to convert the foreign financial statement to a GAAP financial statement in
U.S. dollars. Second, now that all of the financial statements are in U.S. dollars, the importer would combine
them into one financial statement. This combination process is consolidation of all individual operations
(Financial Accounting Standards Board, 1981).
Even in this process, there are similarities between FASB and IASB. For U.S. companies, this process is
outlined in Financial Accounting Statement Number 52 (Financial Accounting Standards Board, 1981). This
same process is outlined for other global companies in the International Accounting Standard Number 21
(Deloitte, 2015).
International Financial Issues
Earlier, we discussed the functions that fall under the accounting side; the treasury side is no less important.
Treasury functions include capital budgeting, cash management, and foreign exchange risk management.
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Capital Budgeting in a Global Context
Every company, big or small, has projects that it would want to complete if it had the resources to do so.
Some projects increase revenues, some decrease costs, and some, like capital maintenance expenditures,
allow the company to keep operating. Companies may not have enough money to pay for all of the projects,
thus they must prioritize them and only finance the top ones that they can afford. Each project gets its ranking
in one of three ways.
Payback method: One method is to determine how long the project will take to repay the initial investment.
For example, a project with an investment of $100,000 and an estimated $20,000 return each year would
have a payback of five years. When compared with other similar projects, the one with the shortest payback is
preferred. The disadvantages of this method are that it ignores the benefits after year five and that it ignores
the time value of money.
Net present value method (NPR): This method estimates the free cash flow for each accounting period of
the project’s economic life and discounts that cash flow by a specified hurdle rate. The discounted cash flows
must exceed the initial cost of investment, or the project is not economically viable. The hurdle rate or
discount rate is the expected rate of return for similar projects with the same amount of risk. An example
would be a small machine costing $75,000 to get it up and running with an expected free cash flow of $20,000
at the end of each year for five years. If the hurdle rate is 10%, then NPV is $75,815 or $815 to the positive.
The disadvantages to this method lie in the forecasts. Forecasting sales and costs is difficult—especially for
factories and plants and especially forecasting 10-20 years into the future. There is more to forecast and more
to go wrong.
Internal rate of return method: The IRR method is similar to the NPR method. The difference is the variable
being calculated is the discount rate. The initial investment is known, and the free cash flow per accounting
period is known. What is not known is the discount rate that will make the free cash flow equal to the initial
investment. For example, using the previous example, if a small machine costing $75,000 will generate free
cash flows of $20,000 per year for five years, what is the discount rate that makes the free cash flow equal to
the initial investment? The answer is 10.42%. Using this method to compare capital projects will allow the
user to compare discount rates on capital. Higher discount rates mean more return on your investment.
Again, the main problem with the method is forecasting revenues and expenses far into the future.
As the methods pertain to global expenditures, it is difficult to know whether foreign currencies will strengthen
or weaken. Capital projects usually span long periods, and while domestic capital projects have economic
risk, foreign projects have economic and political risk.
Cash Management
One responsibility of the treasurer is to determine whether capital project financing should come from internal
sources of funds or external sources of funds such as debt or equity. Large companies can move resources
and assets between branches and subsidiaries. Internal funds grow when deferring payment on expenses.
Taxes decline when payments to the parent company are loans and not dividends. In other words, funds
become available by knowing how to legally declare and transfer assets.
Foreign Exchange Risk Management
If foreign currencies did not constantly strengthen or weaken, companies would not need risk management.
However, the movement of currencies in relation to a company’s domestic currency constantly occurs. A
change in the exchange rate causes a currency risk. That is, a company may lose money due to foreign
exchange losses. This risk exposure is broken down into three categories:
Translation exposure: It is normal practice to create financial statements in the subsidiary’s foreign location.
That means the financial statements post its value in foreign currency. At the end of the accounting period,
the parent company has to consolidate all of the financial statements, which means that the foreign currencies
convert into domestic currency. Generally, there is a gain or a loss from currency translation. That gain or loss
is the translation exposure.
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An example would be if a Japanese subsidiary sold some products to another Japanese company and had a
profit of 1,133,530 yen. At the time of the transaction, the exchange rate was 113.5300 yen to the dollar. The
parent company, in the United States, would need to consolidate all financial statements at the end of the
accounting period. When the time came to consolidate, the yen’s exchange rate was 118.0260 to the dollar.
The parent company would show $9,584.06 profit on its operating statement and a currency loss of $414.94
under its expenses. In actual practice, the company still has the original yen in the bank, so the loss is not an
actual loss; it does not become an actual loss until the yen convert to dollars.
Transaction exposure: Actual transactions that occur between businesses in the international market can
show losses when payment is made in a devaluing currency. Transaction exposure is the risk incurred when
exchange rates change for the worse after the financial obligation has occurred.
For example, a U.S. company sells product to a Japanese company with payment to be in U.S. dollars upon
delivery. The sales contract calls for a $10,000 price, so the Japanese company can immediately buy $10,000
in U.S. currency at an exchange rate of 113.530 yen per dollar or it can wait until closer to delivery. As it turns
out, upon delivery, the exchange rate is 118.0260 yen per dollar. If the Japanese company waited to buy the
U.S. currency, it would lose 44,960 yen or about $381. Transaction exposure measures cash (realized) gains
and losses from a change in exchange rate.
Economic exposure: International companies have cash flows from their different subsidiaries and
branches. These cash flows are subject over time to exchange-rate fluctuations. For example, a company
with factories in countries with weak currencies will make more money when it sells its product in countries
with strong currencies. However, if the countries with weak currencies become strong, and its currency
becomes strong, the product costs will increase. Increasing product cost will change the value of the cash
flow and even the value of the company itself.
An example of this comes from Volkswagen AG. To take advantage of the strong euro versus the U.S. dollar,
in 2011, Volkswagen opened an automobile factory in Chattanooga, TN. Volkswagen found that exporting
cars from Germany to the U.S. was costly. Manufacturing costs were in euros while revenues were in dollars.
Manufacturing cars in the U.S. cut Volkswagen’s economic exposure and boosted its earnings (Ramsey,
2011).
Exposure Management
International companies with exposure to foreign currency exchange have developed sophisticated methods
to protect themselves. The steps are outlined below:
1. Forecast the degree of transaction exposure by currency.
2. Forecast the trend of exchange rates. Short-term trends (weekly and monthly) are difficult to forecast,
but long-term forecasts (yearly) are easy.
3. Report all currency-exchange purchases when they occur. This is an advantage of a centralized
organization structure. Have all subsidiaries report their currency-exchange transactions to a
centralized point.
4. Have the strategic planning department share its plans to expand subsidiaries in the international
market with the treasury department.
5. Formulate hedging strategies.
Transaction hedging strategies: Have sales contracts denominate the price and payment in the subsidiary’s
home currency. A secondary plan would be to denominate any purchases in a weak currency and
denominate any sales in a strong currency. If just the opposite occurs, the corporate office can take out
forward contracts or spot agreements to balance the inflows and outflows.
A lead strategy is another transaction hedging strategy that includes providing incentives to pay early when
collecting receivables. A lag strategy is just the opposite. When collecting receivables in a foreign currency
that is expected to strengthen, provide incentives to delay payment. The lead and lag concepts work for
paying off payables as well.
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Operational hedging strategies: As described previously in the Volkswagen example, the strategy is to build
products in countries with weak currencies and sell the product in countries with strong currencies. In that
manner, costs are lower but revenues are higher.
Another operational hedging strategy is the use of forward contracts and options, as discussed in the Unit IV
lesson.
Exposure management is a form of risk management that international companies use to protect themselves
from currency exchange losses.
References
Bank for International Settlements. (2013). Triennial central bank survey. Retrieved from
http://www.bis.org/publ/rpfx13fx
Deloitte. (2015). IAS 21–The effects of changes in foreign exchange rates. Retrieved from
http://www.iasplus.com/en/standards/ias/ias21
Financial Accounting Standards Board. (1981). Statement of financial accounting standards No. 52. Retrieved
from
http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1218220126851&acceptedDisclaime
r=trueRamsey, M. (2011, May 23). VW chops labor costs in U.S. The Wall Street Journal. Retrieved
from http://www.wsj.com/articles/SB10001424052748704083904576335501132396440
Solomonzori. (2013). Who pays and who free rides? International free rider reporting standards or
International Financial Reporting Standards. Retrieved from http://governancexborders.com/tag/ifrs/