Chapter 3
International Convergence of
Financial Reporting
Learning Objectives
▪ Explain the meaning of convergence
▪ Identify the arguments for and against international convergence of
financial reporting standards
▪ Discuss major harmonization and convergence efforts under the IASC and
IASB, respectively.
▪ Explain the principles-based approach in setting accounting standards
▪ Describe the difference in approaches taken by the IASC and FASB in
setting accounting standards
▪ Describe the support for, and the use of, IFRS across countries
Learning Objectives
▪ Examine the issues related to international convergence of financial
reporting standards
▪ Describe the progress made with regard to IASB/FASB convergence
project
▪ Explain the meaning of “Anglo-Saxon” accounting
International Accounting Standard-setting
▪The evolution of the IASC and the IASB shows international accounting
standard setting has been in the private sector
▪With the support of the accounting bodies, standard-setters, capital
market regulators, government authorities, and financial statement
preparers
▪It is responsible for developing International Financial Reporting
Standards (IFRS Standards), previously known as International
Accounting Standards (IAS) and promoting the use and application of
these standards
▪The IASB was founded on April 1, 2001, as the successor to
the International Accounting Standards Committee (IASC).
International Accounting Standard-setting
▪Harmonization allows countries to have different standards as long as
they do not conflict
▪Accounting harmonization considered in two ways
▪Harmonization of accounting regulations or standards
▪Harmonization of accounting practices
International Accounting Standard-setting
▪Other factors leading to noncomparable accounting numbers despite
similar accounting standards
▪Quality of audits
▪Enforcement mechanisms
▪Culture
▪legal requirements
▪Socioeconomic and political systems
▪International convergence of accounting standards refers to both a goal
and the process adopted to achieve it
Harmonization and Convergence
▪International standard setting is associated with the word harmonization
▪ It means different things to different people
▪ Reduction of alternatives while maintaining a high degree of flexibility in
accounting practices
▪Convergence
▪ Enforcement of single set of accepted standards by several regulatory bodies
▪ Efforts towards convergence include projects that aim to improve the
respective accounting standards, and those that aim to reduce the differences
between them.
Harmonization
▪Can be considered in two ways
▪Harmonization of accounting regulations and standards
▪Harmonization of accounting practice
▪Ultimate goal of international harmonization efforts
▪Harmonization of standards may or may not result in harmonization of practice
▪Different from standardization
▪Standardization involves using the same standards in different countries
▪Standardization implies the elimination of alternatives in accounting for economic
transactions and other events.
▪Allows for different standards in different countries as long as they do not conflict
Arguments for Convergence
▪Facilitate better comparability of financial statements
▪Financial statement comparability would make it easier for investors to evaluate
potential investments in foreign securities
▪Facilitate international mergers and acquisitions
▪Reduce financial reporting costs
▪Cost-listing would allow access to less expensive capital
▪Reduce investor uncertainty and the cost of capital
▪Reduce cost of preparing worldwide consolidated financial statements
▪The auditing of these statement would be simplified
▪Easy transfer of accounting staff internationally
Arguments for Convergence
▪Raise the quality level of accounting practices internationally
▪Increase credibility of financial information
▪Enable developing countries to adopt a ready-made set of high- quality standards
with minimum cost and effort
Arguments against Convergence
▪Significant differences in existing standards
▪Enormous political cost of eliminating differences
▪Nationalism and traditions
▪Arriving at universally accepted principles is difficult: indifference born of economic
power, or resistance to intrusion of foreign influence, some say that national entities
will not bow to any international body.
▪The need for common standards is not universally accepted
▪Well-developed global capital market exists already
Arguments against Convergence
▪May cause standards overload as a result of requiring some companies to
comply with a set of standards not relevant to them.
▪Differences in accounting across countries might be necessary. For example,
countries that are at different stages of economic development or that rely
on different sources of financing perhaps should have differently oriented
accounting systems.
Harmonization Efforts
▪Several organizations were involved at global and regional levels in
harmonization effort
▪International Organization of Securities Commissions (IOSCO)
▪International Federation of Accountants (IFAC)
▪European Union (EU)
▪International Forum on Accountancy Development (IFAD)
▪International Accounting Standards Committee(IASC)
▪International Accounting Standard Board (IASB)
International Organization of Securities Commissions
(IOSCO)
▪Established in 1974
▪Initially limited its membership to regulatory agencies in America
▪Opened membership to agencies in other parts of the world in 1986
▪Aims at ensuring a better regulation of markets on both domestic and
international levels
▪Works to facilitate cross-border securities offering and listings by multinational
issuers
▪Advocates the adoption of a set of high-quality accounting standards
▪ To this end, IOSCO supported the effort of IASC in developing IAS that foreign issuers
could use in lieu of local accounting standards when entering capital markets outside
of their home country.
International Federation of Accountants (IFAC)
▪Established in October1977 at 11th World Congress of Accountants in Munich
▪Promotes adherence to high-quality professional standards of auditing, ethics,
education, and training
▪Launched International Forum on Accountancy Development (IFAD) to
▪Enhance the accounting profession in emerging nations
▪Promote transparent financial reporting, duly audited to high standards by a strong
accounting and auditing profession
▪In May 2000, IFAC and the large international accounting firms established
the Forum of Firms with an aim of
▪Protecting the interests of cross-border investors
▪Promoting international flows of capital
European Union (EU)
▪Founded in March 1957 with the signing of the Treaty of Rome by six European
nations
▪Issued two directives aimed at harmonizing accounting
▪Fourth Directive: Dealt with valuation rules, disclosure requirements, and the
format of financial statements
▪Established the true and fair view principle
▪Provided considerable flexibility
▪Allowed countries to choose from among acceptable alternatives
▪Opened the door for noncomparability in financial statements
▪Seventh Directive: Dealt with consolidated financial statements
European Union (EU)
▪Directives helped reduce differences in financial statements
▪Complete comparability was not achieved
▪European Commission decided not to issue additional accounting directives
▪In 1995 the European Commission indicated that it would associate itself with
efforts undertaken by the IASC toward a broader international harmonization of
accounting standards
International Forum on Accountancy Development
(IFAD)
▪IFAD was created as a working group between the Basel Committee, the
IFAC, IOSCO, the large accounting firms, the OECD, the UNCTAD, and the
world bank
▪Its mission was to improve the market security and transparency, and
financial stability on a global basis
▪Assists in defining expectations from accountancy profession
▪Encourages governments to focus on the needs of developing
economies in transition
▪Harness funds and expertise to build accounting and auditing capacity in
developing countries
International Accounting Standards Committee (IASC)
▪Established in 1973 by leading professional accounting bodies in 10 countries (Australia,
Canada, France, Germany, Ireland, Japan, Mexico, Netherlands, UK, and the U.S)
▪Broad objective of formulating international accounting standards
▪ Harmonization efforts evolved in three mail phases
▪Lowest-common-denominator approach
▪Issuance of 26 generic International Accounting Standards, many of which allowed
multiple options
▪Comparability project
▪Publication of Framework for the Preparation and Presentation of Financial Statements
▪Comparability of Financial Statements Project: the purpose is to eliminate most of the
choices of accounting treatment currently permitted under IAS.
▪IOSCO agreement: the main activity during this phase is the development of one core set of
international standards that could be endorsed by IOSCO for cross listing purposes.
International Accounting Standards Board (IASB)
▪Replaced IASC in 2001
▪IFRS Foundation appoints board of 16 members
▪13 full and 3 part-time
▪Board approves standards, exposure drafts, and interpretations
▪Shift in emphasis from harmonization to global standard-setting or convergence
▪Main aim is to develop a set of high-quality financial reporting standards for global
use
EXHIBIT 3.2—The Structure of the IASB
Principles-Based Approach to International Financial
Reporting Standards
▪IASB follows a principles-based approach to standard setting vs a rulesbased approach
▪Standards establish general principles for recognition, measurements,
and reporting requirements for transactions
▪Limits guidance and encourages professional judgment in applying
general principles to entities or industries
▪ Rules-based accounting is basically a list of detailed rules that must be
followed when preparing financial statements
IASB Framework
▪Created to develop accounting standards systematically
▪The framework for Preparation and Presentation of Financial
Statement was first approved by the IASC board in 1989.
▪The scope of Framework
▪Objective of financial statements and underlying assumptions
▪Qualitative characteristics that affect the usefulness of financial
statements
▪Definition, recognition, and measurement of the financial statements
elements
▪Concepts of capital and capital maintenance
Qualitative Characteristics of Financial Statements
▪Understandability: Understandable to people with reasonable financial
knowledge
▪Relevance: Useful for making predictions and confirming existing
expectations
▪Affected by nature and materiality of information: an information is
material if its misstatement or omission could influence the decision
▪Reliability: Neutral and represents faithfully (free of bias)
▪Reflecting items based on economic substance rather than their legal
form
▪Comparability
Definition, recognition, and measurement of the
financial statements elements
• Assets: should be recognized only when it is probable that future economic
benefits will flow to the enterprise and the cost has a cost or value that can
be measured (definition and recognition).
• Different measurement base may be used to measure assets
• Historical cost
• Current asset
• Realizable value
• Present value
Concepts of capital and capital maintenance
• The IASB Conceptual Framework identifies two concepts of capital:
• A financial concept of capital: whereby capital is linked to the net assets
or equity of a company.
• A physical concept of capital: where capital is linked to the productive
capacity of the entity.
• They lead to different basis for measuring assets (historical cost vs current
cost)
Proposed Changes to existing frameworks by IASB and
FASB
▪IASB and FASB work on existing frameworks to provide basis for developing future
standards by boards. They commenced a joint project to develop an updated and
improved common conceptual framework that would build on their existing frameworks.
▪ Phases of project
▪Objectives and qualitative characteristics
▪Elements and recognition
▪Measurement
▪Reporting entity
▪Presentation and disclosure
▪Purpose and status
▪Application to not-for-profits
▪Finalization
Elements of Financial Statements
▪Definition
▪Assets, liabilities, and other financial statement elements are defined
▪Recognition
▪Guidelines as to when to recognize revenues and expenses
▪Measurement
▪Various bases are allowed: historical cost, current cost, realizable value,
and present value
The Norwalk Agreement
▪In September 2002, at a meeting in Norwalk, the FASB and IASB pledged to
use their best efforts to make their financial reporting standards fully
compatible as soon as practicable.
▪The following are key FASB initiatives to further convergence between IFRS
and U.S. GAAP:
▪Joint projects: sharing staff resources and working on a similar time schedule. Revenue
recognition, business combination,…
▪Short-term convergence project: convergence is expected to occur by selecting either
existing U.S. GAAP or IFRS requirements as the high-quality solution.
The Norwalk Agreement
• Liaison IASB member: a full time IASB member is in residence at the FASB
offices. This facilitates information exchange and cooperation
• Monitoring of IASB projects: the FASB monitors IASB projects according to
the FASB’s level of interest in the topic being addressed
• The convergence research project: the FASB staff have embarked on a
project to identify all the substantive differences between U.S. GAAP and
IFRS and catalog differences according to the FASB’s strategy for resolving
them
• Consideration of convergence potential in board agenda decisions
Presentation of Financial Statements (IAS 1)
▪IAS 1 is a single standard providing guidelines for the presentation of financial statements
▪ It provides guidance in the following areas:
▪Purpose of financial statements
▪Components of financial statements
▪Overriding principle of fair presentation
▪Requires the faithful representation of the effects of transactions and events
▪Accounting policies
▪Management should select and apply accounting policies to be consistent with all IASB
standards
▪When specific guidance is lacking, management may use standards on similar issues,
and definitions of the financial statement elements
Presentation of Financial Statements (IAS 1)
▪Basic principles and assumptions
▪Adds to the guidance provided in the Framework
▪Immaterial items should be aggregated
▪Assets and liabilities, and income and expenses should not be offset and
reported at a net amount unless specifically permitted by a standard or
interpretation
▪Structure and content of financial statements
▪Distinction between current/noncurrent
▪Items to be included on face of financial statements
▪Items to be disclosed in the notes
First Time Adoptions of IFRS (IFRS 1)
▪Provides guidance to companies that are adopting IFRS for the first time
▪Requires compliance with all effective IFRS at the reporting date of an
entity’s first IFRS financial statements
▪Allows exemptions when costs outweigh benefits
The adoption of IFRS
▪Evidence of support for IFRS
▪Adoption by the EU – public companies in the EU were required to begin
using IFRS in 2005
▪IOSCO has endorsed IFRS for cross-listings
▪IFAC G20 accountancy summit in July 2009 issued renewed mandate for
adoption of global accounting standards
▪Latest IFAC Global Leadership Survey—emphasized that investors and
consumers deserve simpler and more useful information
▪Adoption of IFRS in 2011: Japan, Canada, India, Brazil and Korea
International Convergence Issues
▪The complicated nature of standards such as financial instruments
and fair value accounting
▪The tax-driven nature of the national accounting regime
▪Disagreement with significant IFRS, such as financial statements
and fair value accounting
▪Insufficient guidance on first time application of IFRS
▪Limited capital markets are less beneficial
▪Investor satisfaction with national accounting standards
▪IFRS difficulties in language translation
Anglo-Saxon Accounting
▪Accounting systems prevalent in English-speaking countries including
U.S., U.K., Canada, Australia and New Zealand
▪Fundamental features:
▪Micro orientation (firm level) with emphasis on professional rules and
self-regulation
▪Investor orientation
▪Primary aim is efficient operation of capital markets
▪Very transparent
▪Less emphasis on prudence and measurement of taxable income or
distributable income
▪Substance over form
What did we Learn ?
•Accounting harmonization is a process that reduces
alternatives while retaining a high degree of flexibility in
accounting practices.
•There are many arguments for international
harmonization of
accounting
standards
(more
comparable, easier for investors to evaluate foreign firms,
less cost, high level of accounting practices, ..)
•There also are several arguments against international
harmonization of accounting standards (socio-politicoeconomic systems, Nationalism, standards overload, ..)
37
Next Class
▪ Required readings:
▪Chapter 4 & 5
▪S. Li, 2010, “Does mandatory adoption of international financial reporting
standards in the European Union reduce the cost of equity capital?” The
Accounting Review, 607-636.
Does mandatory IFRS adoption improve
information comparability?
Overview
There has been an increase in the demand for accounting information to become internationally
comparable across countries due to accelerated growth in cross-country investment. A reflection of this
widespread trend is shown through the widespread employment of IFRS in the 17 countries across in
the European Union in 2005. Although the intention of mandatory IFRS adoption is to make information
among regions comparable, the extent of information comparability has never been fully examined.
In this presentation, we all assess the effect of the mandatory IFRS adoption in the European Union
under three focal points for information comparability. The three research questions presented in the
article are:
1.
What is the similarity of accounting functions that translate economic events into accounting
data?
2.
What is the degree of information transfer?
3.
What is the similarity of the information content of earnings and of the book value of equity to
measure information comparability?
How has the mandatory IFRS adoption altered
comparability of accounting data among
countries in the EU?
●
Information comparability differs from the pre to the post-IFRS period. Mandatory IFRS
adoption has illustrated that there was a significant improvement in the similarity facet
of the accounting data, but not in the difference facet of cross-country comparability.
●
A positive information transfer takes place when a positive earnings surprise for an
announcing firm indicates an unexpected improvement in market condition, which
positively affects the stock prices of similar firms. A negative information transfer
occurs when the opposite conditions exist.
●
For different firms within different countries within the EU, the mean comparability
scores for the information content of earnings and of the book value of equity illustrates
that the mandatory IFRS adoption increases the similarity facet of cross-country
information comparability.
Research Design
● IFRS during 2004 and 2005, we exclude these two years by defining the
pre-IFRS period as 2002–2003 and the post–IFRS period as 2006–2007.
● The mean correlation is significantly lower in the post-IFRS period
(0.134) than in the pre-IFRS period (0.314), suggesting that firms'
responses to economic shocks become less similar in the post-IFRS
period = no effect
CON’T
● In the return model the mean comparability score in the post-IFRS period
(0.990) is significantly higher than that in the pre-IFRS period (0.945).
● Non-price based comparability measures the mean comparability score in
the post-IFRS period (0.861) is significantly higher than that in the pre-IFRS
period (0.764)
Results
-
IFRS adoption improves information comparability across countries
A significant increase in the similarity facet of cross-country comparability
in the post-IFRS period.
Mandatory IFRS adoption is not sufficient to achieve a full enhancement in
comparability in the EU
Comparability improvement is more likely to occur among firms from similar
environments
Accounting convergence and higher quality accounting information are likely
to be the mechanisms underlying the observed comparability
Legal origins have an effect on comparability
Post-IFRS period effects on countries
-
-
IFRS adoption reduces information acquisition cost and estimation risk with
its increased comparability (Habib, Hasan, & Al-Hadi, 2017)
It provides auditors and managers greater ability to spot mistakes in the
financial statements. (Gross & Perotti, 2017)
IFRS adoption increases the ability to recognize long term trends of financial
statements for their users and other stakeholders. (Gross & Perotti, 2017)
120 nations permit or require IFRS in domestically listed companies
although only 90 actually acknowledge that conformity in audit reports
(IFRS.com)
China, the second largest insurance market in the world has decided to
adopt IFRS 17 in their revised Chinese accounting standards (Globe & Mail)
Real World Examples
Chapter 4
International Financial
Reporting Standards
Learning Objectives
▪ Discuss the types of differences that exist between International Financial
Reporting Standards (IFRS) and U.S. generally accepted accounting principles
(GAAP)
▪ Describe IFRS requirements related to the recognition and measurement of
assets, specifically inventories; property, plant, and equipment, and leased
assets
▪ Explain major differences between IFRS and U.S. GAAP on the recognition and
measurement of assets
▪ Analyze the impact that differences in asset recognition and measurement rules
have on financial statements
▪ Explain how investment property and biological assets differ from PPE and what
special rules govern their accounting treatment under IFRS
Learning Objectives (2)
▪ Describe IFRS requirements related to business combinations, goodwill,
and non-controlling interests.
▪ Describe IFRS requirements for determining effective control and the
scope of consolidation.
Types of Differences Between IFRS and U.S. GAAP
▪
▪
▪
▪
▪
▪
▪
Definition differences
Recognition differences
Measurement differences
Alternatives
Lack of requirements or guidance
Presentation differences
Disclosure differences
IFRS and U.S. GAAP
▪ IFRS more flexible in many cases
▪ Choice between alternative treatments in accounting
▪ IFRS generally have less bright-line guidance
▪ More judgment is required in applying IFRS
▪ IFRS is a principles-based accounting system:
▪ whereas U.S. GAAP is a rules-based system
IAS 2, Inventories
IFRS
US GAAP
IAS2 provides more extensive
guidance than U.S. GAAP
▪ Cost of inventories include:
▪ Costs of purchase
▪ Costs of conversion
▪ Other costs
▪ design, interest if takes time
to
bring
to
saleable
condition
▪ Cost of inventories exclude:
▪ Abnormal waste
▪ Storage, unless necessary for
the production process
▪ Administrative overhead
▪ Selling costs
▪ An entity must use same cost
formula for similar inventory
items
US GAAP allows much choice with
regard to cost formulas.
US GAAP does not require use of a
uniform inventory valuation method
for inventories having a similar
nature.
U.S. GAAP now uses same approach
without allowing reversal of writedowns
▪
Inventories
IAS 2, Inventories
▪ IAS 2 requires inventory to be
reported on the balance sheet
at the lower of cost or net
realizable value
▪ Net realizable value is
defined as estimated
selling price in the
ordinary
course
of
business
less
the
estimated
costs
of
completion
and
the
estimated costs necessary
to make the sale
▪ Write-downs are reversed
when selling price increases
IAS 2, Inventories
• Example:
Assume that Distributor Company Inc. has the following item on hand at
December 31, Year 1:
Historical Cost
Estimated selling price
Estimated costs to complete and sell
$1,000
880
50
Net realizable value
Normal profit margin- 15%
Net realizable value less normal profit margin
830
124,50
$705,50
Net realizable value is $830, which is lower than historical cost. In accordance with IFRS, inventory must be written
down by $170. The journal entry at December 31, Year 1, is:
IAS 2, Inventories
Inventory Loss
$170
inventory
$170
To record the write down on inventory due to decline in net realizable value
Assume that at the end of the first quarter in Year 2, replacement has increased to $900, the estimated selling price
has
Increased to $980, and the estimated cost to complete and sell remains at $50. The item now has a net realizable
value of $930. This is$100 greater than the carrying amount (and $70 less than historical cost). Under IFRS, $100 of the
write down that was made at December 31, Year 1, is reversed through the following journal entry:
Inventory
Recovery of inventory loss
$100
$100
To record a recovery of inventory loss taken in the previous period
IAS 16, Property, Plant, and Equipment
• IAS 16 covers the following aspects of accounting for fixed assets:
1. Recognition of initial costs
2. Recognition of subsequent costs
3. Measurement at initial recognition
4. Measurement after initial recognition
5. Depreciation
6. Derecognition
• IAS 16 allows companies to choose between the historical cost method and
a fair value method known as the revaluation model.
IAS 16, Property, Plant, and Equipment
IFRS
US GAAP
▪
▪ US GAAP allows much choice with
Recognition of initial costs
▪ Cost includes
▪ Purchase price
▪ All costs needed for asset to perform as
intended
▪ Estimate of cost of dismantling and
removing asset along with restoring
site
▪ Exchange of assets for a non monetary
asset or combination of monetary and
nonmonetary assets should be measured
at:
▪ Fair value unless no commercial
substance or fair value can’t be
determined
regard to cost formulas.
IAS 16, Property, Plant, and Equipment
• Caylor Corporation constructs a powder coating at a cost of $3,000,000:
1,000,000 for the building and 2,000,000 for machinery and equipment.
local law requires the company to dismantle and remove the plant assets
at the end of their useful life. Caylor estimates that the net cost for removal
of the equipment, after deducting salvage value will be $100,000 and the
net cost for dismantling and removing the building will be $400,000. The
useful life of the facility is 20 years, and the company uses a discount rate
of 10% in determining present values.
• The initial cost of the machinery and equipment and the building must be
include the estimated dismantling and removal cost discounted to present
value
IAS 16, Property, Plant, and Equipment
Building
Machinery and Equipment
$1,059,457
$ 2,014,864
Cash
3,000,000
Provision for dismantling and removal
74,321
IAS 16, Property, Plant, and Equipment
IFRS
▪ Measurement subsequent to initial recognition
• An entity may choose 2 accounting models for its
property plant and equipment:
1. Cost model: An entity shall carry an asset at
its cost less any accumulated depreciation and
any accumulated impairment losses.
2. Revaluation model: An entity shall carry an
asset at a revalued amount. Revalued amount is
its fair value at the date of the revaluation less
any subsequent accumulated depreciation and
subsequent accumulated impairment losses.
▪ Different useful lives or depreciation methods are
appropriate to be split into components for
purposes of depreciation.
US GAAP
▪ US GAAP does not permit use of the
revaluation model.
IAS 16, Property, Plant, and Equipment
The change of asset’s carrying amount as a result of revaluation shall be treated in the following way:
Change in Carying Amount
Where
Increase
Other comprehensive income
(heading “Revolution surplus”),
are credited
Profit or loss if reverses previous
revaluation decrease of the same
value
Profit or loss
Other comprehensive income if
reduces previously recognized
revaluation surplus (heading
“Revaluation surplus”)
Decrease
IAS 16, Property, Plant, and Equipment
Two alternative treatments are described in IAS16 for the treatment of accumulated
depreciation when a class of PPE is revalued:
1.by adjusting the gross book value of the asset and accumulated depreciation
2.by eliminating accumulated depreciation and adjusting the gross book value of the asset
to equal revalued amount
Example: Treatment of Accumulated Depreciation at revaluation
Assume that Kiely Company Inc. has building that cost $1,000,000, with accumulated
depreciation of $600,000 and a carrying amount of $400,000 on December 31, Year 1. On
that date , the company determines that the market value for these building is $750,000.
The company wishes to carry buildings on the December 31, Year 1, balance sheet at a
revalued amount.
IAS 16, Property, Plant, and Equipment
• Under treatment one, the company would restate both the buildings
account and accumulated depreciation on buildings.
Building
Accumulated Depreciation
Revaluation Surplus
$875,000
$525,000
350,000
IAS 16, Property, Plant, and Equipment
Under treatment 2, accumulated depreciation of 600,000 is first eliminated
against the buildings account, and then the buildings account is increased by
350,000 to result in a net carrying amount of $750,000. The necessary journal
entries are as follows:
IAS 16, Property, Plant, and Equipment
IFRS
• When dealing with the depreciation please do
have 3 basic things in mind:
• Depreciable amount: Depreciable amount is
simply HOW MUCH you are going to
depreciate. It is the cost of an asset, or other
amount substituted for cost, less its
residual value.
• Depreciation period: Depreciation period is
simply HOW LONG you are going to
depreciate and it is basically asset’s useful life.
• Useful life is the period over which an asset is
expected to be available for use by an entity;
or the number of production or similar units
expected to be obtained from the asset by
an entity.
▪ Different useful lives or depreciation methods
are appropriate to be split into components for
purposes of depreciation.
US GAAP
▪ Component
depreciation
uncommon in US GAAP.
is
IAS 16, Property, Plant, and Equipment
Derecognition
• IAS 16 prescribes that the carrying amount of an item of property, plant
and equipment shall be derecognized on disposal; or when no future
economic benefits are expected from its use or disposal.
• The gain (not classified as revenue!) or loss arising from the derecognition
of an item of property, plant and equipment shall be included in profit or
loss when the item is derecognized. The gain or loss from the
derecognition is calculated as the net disposal proceeds (usually income
from sale of item) less the carrying amount of the item.
IAS 40, Investment Property
IFRS
▪
▪
▪
IAS 40 Investment Property applies to the
accounting for property (land and/or
buildings) held to earn rentals or for
capital appreciation (or both).
Investment properties are initially
measured at cost and, with some
exceptions. May be subsequently
measured using a cost model or fair value
model, with changes in the fair value
under the fair value model being
recognised in profit or loss
Revaluation gains and losses included in
the income statement.
US GAAP
▪ US GAAP does not apply special
accounting rules for investment
properties.
▪ U.S. GAAP generally requires use of
the cost model for investment
property.
Biological Assets
• IAS 41 impacts those agricultural activities where the income-producing biological
assets are living animals or plants and will include the harvested produce of these
assets. For example if the biological asset is dairy cattle, the agricultural produce is
milk or the same distinction could be made with trees in a plantation/felled trees or
sugarcane/harvested cane. Biological assets do not include bearer plants.
Recognition
• IAS 41 specifies the usual tests in order that a biological asset or agricultural produce
be recognised on the statement of financial position, namely:
Control: the enterprise must have ownership or rights of control akin to ownership
that result from a past event
Value: future economic benefits are expected to flow to the enterprise from its
ownership or control of the asset
Measurement: the cost or fair value of the asset can be measured reliably.
Biological Assets
IFRS
▪ IAS 41 allows fair value
accounting for biological
assets
▪ Revaluation gains and
losses included in the
income statement.
US GAAP
▪ US GAAP allows cost method.
▪ it ignores growth of biological
asset and no income until final
product sold.
Relevance-Reliability Trade-Off
• Relevance requires that the financial accounting information should be such
that the users need it and it is expected to affect their decisions.
• Reliability requires that the information should be accurate, true and fair.
• Relevance and reliability are both critical for the quality of the financial
information, but both are related such that an emphasis on one will hurt the
other and vice versa.
• Hence, we have to trade-off between them. Accounting information is
relevant when it is provided in time, but at early stages information is
uncertain and hence less reliable. But if we wait to gain while the information
gains reliability, its relevance is lost.
Relevance-Reliability Trade-Off
▪ IASB: requirement to apply for fair value, relevance at the risk of less
reliability
▪ FASB: cost method, reliability over relevance
▪ Reliability challenges with fair value
▪ Illiquidity of markets, resulting in the need to use valuation modeling instead
of observed prices used
▪ Competing valuation frameworks and models that lead to different results
▪ Subjectivity in estimates of modeling
▪ Long forecasting horizon, which add to uncertainty of the subjective estimates
▪ Management incentives to exploit model choices to improve perceptions of
the company’s performance and financial health.
IAS 36, Impairment of Assets
IFRS
▪
US GAAP
Must test annually for impairment to plant,
▪ Under US GAAP, impairment exists
property and equipment; intangible assets;
goodwill; investments in subsidiaries;
associates, and joint ventures.
▪ Events that might indicate an asset is
impaired are:
▪ External events such as a decline in market
value, an increase in market interest rates,
or economic, legal, or technological
changes that adversely affect the value of
an asset.
▪ Internal events such as physical damage,
obsolescence, idleness of an asset, or the
restructuring of part of an asset
If indicators of impairment are present, an entity must estimate the recoverable amount of
the asset and compare the amount with asset’s carrying amount.
IAS 36, Impairment of Assets
IFRS
▪
An asset is impaired when its
carrying amount >> recoverable
amount.
Recoverable amount is the greater of
net selling price and value in use.
▪
▪
▪
.
Value in use: is determined as the
present value of future net cash flows
expected to arise from continued use
of the asset over its remaining useful
life and upon disposal.
Impairment more likely under IFRS
since discounted cash flows are used
US GAAP
▪ Under US GAAP, impairment exists when
an asset’s carrying amount > the future
cash flows expected to arise from its
continued use and disposal.
▪ Net selling price is not involved in the test
▪ Future cash flow are not discounted to
their present value
IAS 36, Impairment of Assets
IFRS
▪
Impairment loss: carrying value> recoverable
amount
A review should be undertaken to determine
if impairment losses have reversed
▪
▪
▪
▪
If subsequent to recognizing an impairment
loss, the recoverable amount of an asset is
determined to exceed its new carrying amount,
the impairment loss should be reversed.
The loss should be reversed only if there are
changes in the estimates used to determine the
original impairment loss or there is a change in
the basis for determining the recoverable
amount
Recognize reversal in income immediately
(increase)
US GAAP
▪ Impairment loss: carrying value> fair
value
▪ Fair value may be determined by
reference to quoted market prices in
active markets, estimated based on
the values of similar assets.
▪ U.S. GAAP allows no reversal
IAS 36, Impairment of Assets
• At December 31, Year1, Delta Cuisine Company has specialized
equipment with the following characteristics:
Carrying amount
Selling price
Costs of disposal
Expected future cash flows
Present value of expected futures cash flows
70,000
40,000
1,000
75,000
50,0000
IAS 36, Impairment of Assets
• In applying IAS 36, the asset's recoverable amount would be
determined as follows
Net selling price
value in use
recoverable amount (greater of the two)
39,000
50,000
50,000
• The determination and measurement of impairment loss would be
Carrying amount
70,000
Recoverable amount
50,000
impairment loss
20,000
IAS 36, Impairment of Assets
• The journal entry is the following:
impairment loss
Equipment
To recognize an impairment loss
20,000
20,000
IAS 38, Intangible Assets
▪ Applies to purchased intangibles, intangibles acquired in business
combination, internally generated intangibles
▪ Goodwill is covered separately under IFRS 3
▪ Intangible asset is identifiable, nonmonetary asset without physical
substance:
▪ Held for production of goods or services, rental to others, or for administrative
purposes
▪ Controlled by enterprise as result of past events from which future economic
benefits are expected to be realized
▪ Must be expensed immediately if it does not meet the definition
▪ Except when obtained in business combination
IAS 38, Intangible Assets (2)
▪ Purchased intangibles measured at cost
▪ Useful life could be assessed as finite or indefinite
▪ Distinction between intangibles with finite life and indefinite life is made in IAS 38
▪ An intangible asset is deemed to have an indefinite life when there is no
foreseeable limit to the period over which it is expected to generate cash flows for
the entity. If the useful life of an intangible assets is indefinite, no amortization
should be taken until the life is determined to be definite.
IAS 38, Intangible Assets (2)
▪ Intangibles can be acquired:
▪ by separate purchase
▪ as part of a business combination
▪ by a government grant
▪ by exchange of assets
▪ by self-creation (internal generation)
Intangibles Acquired in Business Combination
▪ Patents, trademarks, customer lists, computer software, databases and
trade secrets recognized as assets measured at fair value
▪ The three critical attributes of an intangible asset are:
• Identifiability
• Control (power to obtain benefits from the asset)
• Future economic benefits (such as revenues or reduced future costs)
▪ Must have finite or infinite life
Internally Generated Intangibles
▪ Major difference with U.S. GAAP
▪ IFRS allows some development costs to be capitalized
▪ U.S. GAAP expenses all research and virtually all development
• Examples of internally generated intangible assets:
• All costs directly attributable to development activities and those that can be reasonably
allocated to such activities, including:
• Personal costs
• Materials and services costs
• Depreciation of PPE
• Overhead costs, other than general administrative costs
• Amortization of patents and licences
▪ Special treatments for in-process research and development
▪ Capitalize when certain criteria is met
▪ Otherwise include in goodwill
Internally Generated Intangibles
▪ Criteria for development cost capitalization:
▪ Technical feasibility of completion
▪ Intention to complete asset for use or sale
▪ Ability to use or sell the asset
▪ How probable future economic benefits will be generated
▪ Market or internal use
▪ Available adequate technical, financial, and other resources to complete the
asset for use or sale
▪ Ability to reliably measure expenditures pegged to development
Internally Generated Intangibles
Example: Capitalized Development costs
In year 1: Development Cost: 300,000. Of that amount, $250,000 was incurred up to the point
at which the technical feasibility of the product should be demonstrated and other recognition
criteria were met.
In year 2: additional development cost$300,000
In year 3: the product is ready for sale
In year 3: sales of the product are expected to continue for 4 years, at which time it is
expected that a replacement product will need to be developed.
The total number of units expected to be produced over the product’s 4 year economic life is
2,000,000. The number of units produced in year 3 is 800,000.
Required: Record the journal entries in Year 1, 2, and 3.
Internally Generated Intangibles
▪ Financial Statement Effects
▪ Income Statement effects
▪ With increasing R&D expenditures….higher income
▪ Therefore inflates shareholder equity (retained earnings)
▪ Balance sheet effects
▪ Inflates intangible assets net of accumulated amortization
▪ Offset is higher shareholder equity (retained earnings)
▪ Cash Flow Statement effects
▪ Capital expenditure consists of investments in new PPE as well as in new intangible assets:
the decision to begin capitalizing R&D expenditures reclassifies this spending as capex
(capital expenditure) outflow
▪ Expenditure is investing instead of operating outflow
Internally Generated Intangibles
▪ Other issues:
▪ Revaluation model is allowed with finite-lived intangibles
▪ If there is a price on an active market
▪ Impairment of intangibles
▪ If carrying amount can’t be recovered on finite-lived assets—need to look at
changes in events or circumstances
▪ For indefinite-lived intangibles and goodwill
▪ Test annually
▪ Under special circumstances can reverse as per IAS 36
▪ Goodwill not subject to reversal of impairment
Acquisition Method of Combinations
▪ Used by both IFRS and GAAP
▪ Must have acquirer and acquire
▪ Acquiree’s assets and liabilities shown at FMV
▪ Business combination: is a transaction or other event in which an acquirer
obtains control of one or more businesses. Transactions sometimes
referred to as 'true mergers' or 'mergers of equals' are also business
combinations as that term is used in [IFRS 3]
Business Combinations
▪ Steps in applying the acquisition method (business combinations) are:
▪ Identification of the 'acquirer’
▪ Determination of the 'acquisition date'
▪ Recognition and measurement of the identifiable assets acquired, the liabilities
assumed and any non-controlling interest (NCI, formerly called minority interest) in
the acquiree
▪ Recognition and measurement of goodwill or a gain from a bargain purchase
Business Combinations
▪ Recognize goodwill only in business combinations
▪ Goodwill is Difference between:
▪ Consideration paid by acquirer plus noncontrolling interest
▪ Fair value of net assets acquired
Goodwill = Consideration transferred + Amount of non-controlling interests + Fair value of previous equity interests Net assets recognised
▪ Negative goodwill must be recognized as income
Business Combinations (2)
▪ Not amortized as it is an indefinite-lived intangible asset
▪ Impairment of goodwill must be tested annually
▪ Impairment is tested at the level of the cash-generating unit (CGU)
▪ Compare carrying value of CGU, including goodwill, with recoverable amount
▪ U.S. GAAP is tested at level of the reporting unit which can be different and
typically larger than CGU
▪ U.S. GAAP only requires a bottom-up test
IAS 23, Borrowing Costs
▪ Similar to U.S. GAAP in general approach
▪ Capitalize all borrowing costs to extent they are attributable to
acquisition, construction, or production of a qualifying asset
▪ Expense all other borrowing costs
▪ Borrowing costs include interest and other costs incurred in connection
with borrowing
▪ IAS 23 includes foreign currency exchange to the extent they related to
interest costs
▪ Under IAS 23, inventories qualify if they require substantial period to
manufacture
IAS 23, Borrowing Costs (2)
▪ Capitalize interest that could have been avoided in absence of
expenditure on the qualifying asset
▪ Amount capitalized determined by multiplying weighted-average
accumulated expenditures by appropriate interest rate
▪ Can use actual interest rate if average expenditures are less than specific
borrowing total
▪ Interest income on temporary investment of specific new borrowing
offsets interest capitalized under IFRS…no netting allowed under GAAP
Current Liabilities
▪ IAS 1, Presentation of Financial Statements, requires classification of
liabilities
▪ Current liabilities
▪ Noncurrent liabilities
▪ Current liabilities
▪ Expected to settle in normal operating cycle
▪ Held primarily for purpose of trading
▪ Settled within 12 months of balance sheet date
▪ No right to defer until 12 months after balance sheet date
Differences in IFRS and U.S. GAAP: Current
Liabilities
▪ Refinanced short-term debt may reclassified as
▪ IFRS: Long-term, if refinancing is completed prior to balance sheet date
▪ U.S. GAAP: Long-term, if refinancing is agreed prior to balance sheet being issued
▪ Accounts payable on demand due to violation of debt covenants must be
classified as
▪ IFRS: Current, unless lender issued waiver of 12 months by balance sheet date
▪ U.S. GAAP: Current, unless lender issued waiver obtained by annual report issuance
date
▪ Bank overdrafts are classified as
▪ IFRS: Long-term, if integral part of cash management netted against cash
▪ U.S. GAAP: Always treated as current liabilities
Provisions, Contingent Liabilities, and
Contingent Assets
▪ IAS 37, Provisions, Contingent Liabilities and Contingent Assets, provides
guidance for:
▪ Reporting liabilities and assets of uncertain timing, amount, or existence
▪ Specific rules related to onerous contracts and restructuring costs
▪ Environmental and nuclear decommissioning costs
Contingent Liability
▪ IFRS; contingent liability not on balance sheet provision is:
▪ Provision Recognized under IFRS, when:
▪ There is a present obligation from past events
▪ It is probable that there will be an outflow of resources
▪ A reliable estimate of the obligation can be made
▪ Constructive obligation: arise from past actions or current statements
indicating that a company will accept certain responsibilities
▪ No concept of constructive obligation in U.S. GAAP
Contingent Liability (2)
▪ As defined by IAS 37
▪ Possible obligation confirmed by occurrence or nonoccurrence of future event
▪ Present obligation not recognized because:
▪ No probable outflow of resources
▪ Amount cannot be measured reliably
▪ Recognized under U.S. GAAP when outflow is probable
▪ Only disclosed if outflow possible, and not probable
▪ GAAP: probable usually means 70% IFRS ‘more likely than not’ over 50%
Provisions
▪ IAS 37
▪ The best estimate of the expenditure required to settle the present obligation
▪ Probability-weighted expected value
▪ Provisions must be discounted to present value
▪ Recognized under U.S. GAAP at the low end of the range of possible amounts
▪ No present value unless amount and timing fixed or reliably determinable
▪ Provision is reversed when outflow of resources is not probable
▪ IFRS: can omit disclosure that ‘can be expected to prejudice seriously the
position of the enterprise in a dispute with other parties” GAAP: no such
exemption
Contingent Asset
▪ Contingent asset: probable asset that arises from past events and whose
existence will be confirmed by occurrence or nonoccurrence of future event
▪ Not recognized (IFRS) disclosed when inflow of economic benefits is probable
▪ IFRS: is recognized if realization is virtually certain
▪ GAAP: asset realized before it can be recognized
▪ An example of a contingent asset (and its related contingent gain) is a lawsuit filed
by Company A against a competitor for infringing on Company A's patent. Even if it
is probable (but not certain) that Company A will win the lawsuit, it is a contingent
asset and a contingent gain. As such, it will not be recorded in Company A's general
ledger accounts until the lawsuit is settled. (At most, Company A could prepare a
carefully worded disclosure stating that it has filed the lawsuit but the outcome is
uncertain.)
Income Taxes
▪ IAS 12, Income Taxes, similar to U.S. GAAP
▪ Asset-and-liability approach
▪ Deferred tax assets and liabilities
▪ For temporary differences
▪ For operating loss and tax credit carry forwards
▪ Under IFRS, measure on the basis of tax laws and rates enacted or substantively
enacted
▪ Under U.S. GAAP, measure on the basis of actually enacted tax laws and rates
▪ Account for double taxation effects and differences in rates
Income Taxes (2)
▪ Recognition of Deferred Tax Asset
▪ Under IFRS, recognize if future realization of tax benefit probable
▪ IAS 12 provides a more stringent threshold
▪ U.S. GAAP, recognize if realization is more likely than not
▪ Disclosures
▪ IFRS requires
▪ Extensive disclosures of tax expense
▪ Explanation of hypothetical expense based on two approaches
▪ Compare statutory tax expense in the home country and effective tax expense
▪ Compare weighted-average statutory tax rate across jurisdictions and tax expense based on the
effective tax rate
▪ IFRS vs. U.S. GAAP
▪ IFRS application can cause temporary differences unknown under U.S GAAP
Income Taxes (3)
▪ Financial Statement Presentation
▪ U.S. GAAP
▪ Deferred tax assets and liabilities
▪ Current
▪ Non-current
▪ Based on underlying asset or liability
▪ Tax loss or credit carry-forwards
▪ Timing of expected realization
▪ IAS 1
▪ Deferred tax assets and liabilities
▪ Only classified as noncurrent
Revenue Recognition
▪ Most significant example of cross-border cooperation in accounting
standard-setting
▪ 5 Steps in recognition of revenue
▪ Identify contract with a customer
▪ Identify the separate performance obligations in the contract
▪ Determine the transaction price
▪ Allocate the transaction price to the separate performance obligations
▪ Recognize the revenue allocated to each performance obligation when the
entity satisfies each performance obligation
▪ Shift from evaluation of risk and rewards of ownership to transferal of control
Revenue Recognition (2)
▪ Bill-and-Hold Sales: seller segregates inventory meant for a customer but
still maintains physical possession of it.
▪ Has product been separately identified as belonging to the customer?
▪ Is the product ready for shipment to the customer?
▪ Can the seller use the product or reallocate it to another customer?
▪ Is there a substantive business reason for the bill-and-hold arrangement such
as that the customer’s warehouse if full?
Revenue Recognition (3)
▪ Customer Loyalty Programs
▪ IFRS 15: award credits should be treated as a separately identifiable
component of the sales transaction in which they are granted
▪ Revenue allocated between awards credit and current sale
Disclosure and Presentation Standards
▪ Statement of Cash Flows
▪ Required statement
▪ IAS 7 requirements
▪
▪
▪
▪
▪
▪
▪
▪
▪
Operating, investing and financing activities
Operating: direct or indirect; no reconciliation with direct method
Cash from interest, taxes, dividends reported separately
Interest/dividends paid can be operating or financing
Interest dividends received can be operating or investing
Income tax is operating unless specific to investing/financing activity
Noncash investing/financing excluded but disclosed elsewhere within the financial statements
Cash and cash equivalents reconciled with balance sheet but not necessarily 1 number
Distinction between bank borrowings and overdrafts; latter may be considered reduction of cash
or financing activity
Disclosure and Presentation Standards (2)
▪ Statement of Cash Flows
▪ Differences with U.S. GAAP
▪
▪
▪
▪
Interest paid, interest received, dividends received operating under GAAP
Dividends paid financing under U.S. GAAP
Direct method must have reconciliation U.S. GAAP
Cash and cash equivalents on cash flow statement MUST reconcile to cash and cash
equivalents on balance sheet
Disclosure and Presentation Standards (3)
▪ Events after reporting period
▪ 2 types
▪ Adjusting events: provide evidence of conditions that existed at the end of the
reporting period….recognized through adjustment of financial statements
▪ Non adjusting events: conditions arisen after balance sheet date but before
statements have been issued…not recognized on financial statements but disclosure
required
▪ Nature of event
▪ Estimate of financial effect (or statement that estimate can’t be made)
Accounting Policies, Changes in Accounting
Estimates, and Errors
▪ Selection of Accounting policy
▪ Hierarchy of authoritative pronouncements
▪
▪
▪
▪
1) IASB Standard or Interpretation of transaction/event
2) IASB Standard or Interpretation of similar transaction/event
3) IASB Framework
4) Most recent pronouncements of other standard-setting bodies that use similar
conceptual framework
▪ Changes in Accounting Policy
▪ Allowed ONLY if
▪ Required by IFRS
▪ Results in statements that are more relevant/reliable
Accounting Policies, Changes in Accounting
Estimates, and Errors (2)
▪
Change in Estimates: prospectively
▪
Correction of Error: errors corrected retrospectively by restating all prior reported accounts through retained
earnings
▪
Related Party Disclosures: must be disclosed in footnotes
▪
Earnings per Share: both basic and fully diluted reported on income statement
▪
Interim Financial Reporting:
▪ No mandate on:
▪ Who needs to do them
▪ How frequently
▪ Time from end of period to release of interim report
▪ Does define minimum content as required by national jurisdiction
▪
Noncurrent Assets Held for Sale
▪ Shown separately on balance sheet
▪ Not depreciated
▪ Shown at lower of: carrying value or fair value less cost to sell
Accounting Policies, Changes in Accounting
Estimates, and Errors (3)
▪ Operating Segments
▪ Operating Segment is component of business
▪ Generates revenues and expenses
▪ Operating results regularly reviewed by chief operating officer
▪ Separate financial information available
▪ 3 tests to be operating segment
▪ Revenue test
▪ Asset test
▪ Profit/loss test
Accounting Policies, Changes in Accounting
Estimates, and Errors (4)
▪ Disclosures
▪ Assets
▪ Capital expenditures
▪ Liabilities
▪ Profit/loss
▪ External revenue
▪ Intercompany revenues
▪ Interest expense/income
▪ Depreciation/amortization
▪ Equity method income
▪ Income tax expense
▪ Noncash expenses
▪ Revenue of all segments must be at least 75% of total
What did we Learn ?
•Prior agreements between IASB and U.S. Financial
Accounting Standards Board (FASB) to work together to
reduce differences between IFRS and U.S. GAAP have
resulted in convergence in many areas—notably,
inventories, revenue recognition, and leases.
•There are several types of differences between IFRS and
U.S. GAAP (Definition differences, Recognition differences,
Measurement
differences,
Alternatives,
Lack
of
requirements or guidance, Presentation differences,
Disclosure differences)
• IFRS requirements’ related to the financial reporting of
current liabilities, provisions, income taxes, and revenue.
• The effect of major differences between IFRS and U.S.
GAAP related to the financial reporting of current liabilities,
provisions, income taxes and revenue.
67
End of Chapter 4
Foreign Currency
Transactions and Hedging
Foreign Exchange Risk
Chapter 6
Introduction
• Developing an overview of the foreign exchange market
• Accounting for foreign currency transactions
• Understanding foreign exchanges risks
• How to hedge against foreign exchange risk
• Contracts involved in foreign currency
The price at which the
foreign currency can be
acquired
(exchanged for another)
What is the
Foreign
Exchange
Rate?
Exchange rates have the
ability to fluctuate
Value of one country’s
currency in relation to
another
Independent float
Currency arrangements:
Pegged to another
currency
European Monetary
System
Spot and
Forward
Exchange
Rates
There are two ways foreign currency trades can
occur:
• Spot Rate: price at which a foreign currency can be
purchased or sold today
• Forward Rate: price today at which foreign
currency can be purchased sold in the future
Currencies can sell at a discount or a premium due to the difference in interest rates between countries
Foreign Currency Transactions
What is Transaction Exposure?
• the risk that currency exchange rates will fluctuate after a firm has already undertaken a
financial obligation
Export Sale:
Import Purchase:
Foreign currency can decrease in
Foreign currency can increase in price
value between the date of sale
between the date of purchase and the
and the date of payment, resulting
date of payment, resulting in an
in a loss of domestic currency
increase of domestic currency owed
How does one account for the change in value of foreign
currency?
Foreign Currency
Transactions
• One-transaction perspective
• Two-transaction perspective
*Both U.S. GAAP and IFRS do not accept the one-transaction
perspective
• International Accounting Standard (IAS) 21 and FASB ASC 830 both only
accept the two-transaction perspective in accounting for foreign currency
transactions
How do companies account for gains and losses
that happen at the balance sheet date when
payment is happening in the next fiscal year?
I.
Deferral Approach
II.
Accrual Approach
* Both IFRS and U.S. GAAP do not accept the
deferral approach
Balance
Sheet Date
before Date
of Payment
Need to be reported under balance sheet at fair
value
“Hedge Accounting” needs to have a relationship
clearly defined, be measurable, and effective
Derivatives
Issues involved in accounting for derivatives:
Determination of fair value
How to treat unrealized gains and losses that arise
from adjustments of the fair value
Exposure to Foreign Exchange Risk
How can we tell if a MNC is exposed to Foreign Exchange
Risk?
We look at:
Profitability
Net Cash-flows
Market Value of the
firm
Transaction Risk
Types of
Foreign
Exchange
Risk
Operating Risk
Translation Exposure Risk
Tax Exposure Risk
Hedging Against Foreign
Exchange Risk
Types of Financial Instruments used to
Hedge against Foreign Exchange Risk:
•
•
•
•
Forward Contracts
Futures Contracts
Options Contracts
SWAP Contracts
Forward Contracts
Features of a Forward contract:
a.
b.
c.
d.
Contract is customized
Contract is legally binding
Contract has massive counterparty risk
Contract is free
Futures Contracts
Features of Futures contracts:
a.
b.
c.
d.
Contract is standardized
Contract is legally binding
Contract does not have any counterparty risk
Contract is free
Option Contracts
Features of an Options contract:
a.
b.
c.
d.
Contract is standardized
Contract is not legally binding
Contract does not have any counterparty risk
Contract is costly
SWAPS Contracts
Features of a SWAPS contract:
a.
b.
c.
d.
Contract is customized
Contract is legally binding
Contract as counterparty risk
Contract is free
Thank You!
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