Transcript Analyzing Investing Activities

Analyzing Investing Activities-II
Intercompany and International
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Classification of Investment Securities
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Accounting for Investment SecuritiesStocks
The accounting for investments depends on the purpose of the
investment and the percentage of voting stock held.
Investor Corporation
Minority, Passive
Investments (less than
20% ownership)
held as
current assets-,
marketable
securities
Trading securities
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held as
long-term
InvestmentsAvailable for sale
Minority, Active
Investments (typically
between 20% and
50% ownership)
Equity method
of accounting
Majority, Active
Investments
(greater than
50% ownership)
acquired in
Purchaseconsolidation
Classification and Accounting for Equity
Securities
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Accounting for Debt Securities
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Investment Securities
Accounting for Transfers between Security Classes
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Accounting for and Classification of
Financial Instruments (Assets)
Financial assets at fair value through profit or loss: has two
subcategories:
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Trading securities: Marketable securities – both equity and debt securities
– that are held for short-term profit purposes; and
Derivatives: financial instruments that do not have a value by themselves
but derive their value from the underlying security or asset such as
shares, foreign exchange, commodities etc.- except for cash flow hedges
that are accounted for similar to trading securities;

Held to Maturity: Debt securities for which a firm has both the
positive intent and ability to hold to maturity

Available for Sale Securities: Neither trading securities nor
securities held to maturity- usually classified as long term
investments.
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Investment Securities
Two main objectives:
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To separate operating performance from investing (and financing)
performance
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To analyze accounting distortions from securities
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Opportunities for gains trading-unrealized gains and losses- income statement
vs comprehensive income
Liabilities recognized at cost- amortized
Inconsistent definition of equity securities
Classification based on intent
How to determine operating vs investing purpose investments?
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Remove all gains (losses) relating to investing activities- dividends, interest
income, realized and unrealized holding gains(losses)
Separate operating and non-operating assets when determining Return on
Net-operating Assets
no definite answer
Determine if the investment is strategic in the operations or not
Equity Method Accounting
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Required for intercorporate investments in which the investor
company can exert significant influence over, but does not
control, the investee.
– Reports the parent’s investment in the subsidiary, and
the parent’s share of the subsidiary’s results, as line items
in the parent’s financial statements (one-line consolidation)
Generally used for investments representing 20 to 50 percent
of the voting stock of a company’s equity securities--main
difference between consolidation and equity method
accounting rests in the level of detail reported in financial
statements
Equity Method Accounting
Investment account:
•
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–
–
Initially recorded at acquisition cost
Increased by % share of investee earnings
Decreased by dividends received
Income:
•
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–
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Investor reports % share of investee company earnings as
“equity earnings” in its income statement
Dividends are reported as a reduction of the investment
account, not as income
Equity Method Accounting
Example
• Assume that Global Corp.
acquires for cash a 25% interest in
Synergy, Inc. for $500,000,
representing one-fourth of
Synergy’s stockholders’ equity as
of the acquisition date.
• Acquisition entry:
Investment
Cash
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500,000
500,000
Synergy, Inc.
Current assets
PP&E
Total assets
700,000
5,600,000
6,300,000
Current liabilities 300,000
Long-term debt
4,000,000
Stockholders’ Equity 2,000,000
Total liabs and equity 6,300,000
Equity Method Accounting
Example
• Subsequent to the
acquisition date, Synergy
reports net income of
$100,000 and pays
dividends of $20,000. Global
records its proportionate
share of Synergy’s earnings
and the receipt of dividends
as follows:
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Investment
25,000
Equity earnings
25,000
(to record proportionate share of
investee company earnings)
Cash 5,000
Investment
5,000
(to record receipt of dividends)
Business Combinations
The merger, acquisition, reorganization, or restructuring of two or more
businesses to form another business entity
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WHY?
enhance company image and growth potential
acquiring valuable materials and facilities
acquiring technology and marketing channels
securing financial resources
strengthening management
enhancing operating efficiency
encouraging diversification
rapidity in market entry
achieving economies of scale
acquiring tax advantages
management prestige and perquisites
management compensation
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Accounting for Business Combinations
• Purchase method of accounting
– Companies are required to recognize on their balance
sheets the fair market value of the (tangible and
intangible) assets acquired together with the fair market
value of any liabilities assumed.
• Tangible assets are depreciated and the identifiable intangible
assets amortized over their estimated useful lives.
• Non-amortization of goodwill
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Business Combinations
Consolidated Financial Statements
Consolidated financial statements report the results of operations and
financial condition of a parent corporation and its subsidiaries in one set of
statements
Basic Technique of Consolidation
Consolidation involves two steps: aggregation and elimination
Aggregation of assets, liabilities, revenues, and
expenses of subsidiaries with the parent
Elimination of intercompany transactions
(and accounts) between subsidiaries and the parent
Note: Minority interest represents the portion of a subsidiary’s equity
securities owned by other than the parent company
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Business Combinations
Consolidation Illustration
On December 31,Year 1, Synergy Corp. purchases 100% of Micron
Company by exchanging 10,000 shares of its common stock ($5 par
value, $77 market value) for all of the common stock of Micron.
On the date of the acquisition, the book value of Micron is
$620,000. Synergy is willing to pay the market price of $770,000
because it feels that Micron’s property, plant, and equipment (PP&E)
is undervalued by $20,000, it has an unrecorded trademark worth
$30,000 and intangible benefits of the business combination
(corporate synergies, market position, and the like) are valued at
$100,000.
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Business Combinations
Consolidation Illustration
The purchase price is, therefore, allocated as follows:
Purchase price
770,000
Book value of Micron
620,000
Excess
150,000
Excess allocated to –
useful life
annual
deprec/amort.
Undervalued PP&E
20,000
10
2,000
Trademark
30,000
5
6,000
Goodwill
100,000 indefinite
-0150,000
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Business Combinations
Synergy Corp and Micron Company
Consolidated Income Statement Steps
The four consolidation entries are
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1.
2.
3.
4.
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Replace $620,000 of the investment account with the book value of
the assets acquired. If less than 100% of the subsidiary is owned, the
credit to the investment account is equal to the percentage of the
book value owned and the remaining credit is to a liability account,
minority interest.
Replace $150,000 of the investment account with the fair value
adjustments required to fully record Micron’s assets at fair market
value.
Eliminate the investment income recorded by Synergy and replace
that account with the income statement of Micron. If less than 100%
of the subsidiary is owned, the investment income reported by the
Synergy is equal to its proportionate share, and an additional expense
for the balance is reported for the minority interest in Micron’s
earnings.
Record the depreciation of the fair value adjustment for Micron’s
PP&E and the amortization of the trademark. Note, there is no
amortization of goodwill under current GAAP.
Business Combinations
Synergy Corp and Micron Company
Consolidated Income Statement Steps
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Income statement of Synergy is combined with that of Micron.
Depreciation / amortization of excess of purchase price over the book
value of Micron’s assets is recorded as an additional expense in the
consolidated income statement.
Any intercompany profits on sales of inventories held by the
consolidated entity at year-end, along with any intercompany profits on
other asset transactions, are eliminated.
Equity investment account on Synergy’s balance sheet is replaced with
the Micron assets / liabilities to which it relates.
Consolidated assets / liabilities reflect the book value of Synergy plus
the book value of Micron, plus the remaining undepreciated excess of
purchase price over the book value of Micron assets.
Goodwill, which was previously included in the investment account
balance, is now broken out as a separately identifiable asset on the
consolidated balance sheet.
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Additional Limitations of Consolidated
Financial Statements
• Financial statements of the individual companies composing the larger
entity are not always prepared on a comparable basis.
• Consolidated financial statements do not reveal restrictions on use of
cash for individual companies. Nor do they reveal intercompany cash
flows or restrictions placed on those flows.
• Companies in poor financial condition sometimes combine with
financially strong companies, thus obscuring analysis.
• Extent of intercompany transactions is unknown unless the procedures
underlying the consolidation process are reported.
• Accounting for the consolidation of finance and insurance subsidiaries
can pose several problems for analysis. Aggregation of dissimilar
subsidiaries can distort ratios and other relations.
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Business Combinations
Impairment of Goodwill
• Goodwill recorded in the consolidation process is subject to
annual review for impairment.
– The fair market value of Micron is compared with the book value of
its associated investment account on Synergy’s books.
– If the current market value is less than the investment balance,
goodwill is deemed to be impaired and an impairment loss must be
recorded in the consolidated income statement.
– Impairment loss reported as a separate line item in the operating
section of Synergy’s consolidated income statement.
– A portion of the goodwill contained in Synergy’s investment account
is written off, and the balance of goodwill in the consolidated balance
sheet is reduced accordingly.
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Business Combinations
Consequences of Accounting for Goodwill
• Superior competitive position is subject to change.
– Goodwill is not permanent.
• Residual goodwill - measurement problems.
• Timing of goodwill write-off seldom reflects prompt recognition
of this loss in value.
• In many cases goodwill is nothing more than mechanical
application of accounting rules giving little consideration to value
received in return.
• Goodwill on corporate balance sheets typically fails to reflect a
company’s entire intangible earning power
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International Investments
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Investments in subsidiaries in foreign countries
Translation Exposure
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Transaction Exposure
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The effect that unanticipated changes in exchange rates has on
the firm’s consolidated financial statements.
Before a foreign sub can be consolidated with the parent its
financial statements are converted into home currency
Functional currency – currency of the primary economic
environment of the subsidiary
An accounting issue.
The effect that unanticipated changes in exchange rates has on
the firm’s cash flows.
A finance issue
It is generally not possible to eliminate both translation
exposure and transaction exposure
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Foreign Exchange Risk Management
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
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Exposure refers to the degree to which a company is
affected by exchange rate changes.
Exchange rate risk is defined as the variability of a
firm’s value due to uncertain changes in the rate of
exchange.
Managing accounting exposure centers around the
concept of hedging, which means:


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Entering into an offsetting currency position so whatever is
lost/gained on the original currency exposure is exactly offset
by a corresponding currency gain/loss on the currency hedge.
The coordinated buying or selling of a currency to minimize
exchange rate risk.
Types of Exposures

Translation Exposure
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
Transaction Exposure
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It stems from the possibility of incurring exchange gains or losses on transactions already
entered into and denominated in a foreign currency.
Real exchange gains or losses
Operating Exposure
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

It arises from the need, for purposes of reporting and consolidation, to convert the results
of foreign operations from the local currency to the home currency.
Fictitious exchange gains or losses
It arises because currency fluctuations combined with price level changes can alter the
amounts and riskiness of a firm’s future revenues and costs.
Real exchange gains or losses
Tax Exposure
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The tax consequence of foreign exposure varies by countries.
As a general rule:
Only realized foreign exchange losses are tax deductible.
Only realized foreign exchange gains create taxable income
Transaction Exposure

It arises from the various types of transactions that
require settlement in a foreign currency.
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
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Purchasing or selling on credit goods or services denominated
in foreign currency.
Borrowing and lending funds with repayment made in foreign
currency.
Acquiring assets denominated in foreign currency.
Balance Sheet Exposure-translation
exposure
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Balance sheet items translated at current exchange rates
change in home currency value from one balance sheet to the
next are exposed to translation adjustments.
Balance sheet items translated at historical exchange rates
do not change in home currency value from one balance sheet
to the next and are NOT subject to balance sheet exposure
Net Asset Balance Sheet Exposure-When assets translated at
current rates > liabilities translated at current rates- When
foreign currency appreciates, a net asset exposure results in a
positive translation adjustment
Net Liability Balance Sheet Exposure-When liabilities
translated at current rates > assets translated at current ratesWhen foreign currency appreciates, a net liability exposure results in
a negative translation adjustment
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Functional Currency Concept
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
The standard includes a list of indicators as guidance
for the foreign currency decision.
The concept is :
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
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If there was close ties between the subsidiary and parents
(integrated with)
Functional currency is parent
currency
Use Temporal Method
If the subsidiary integrated with its local economy
Functional currency is its country currency
Use
Current rate Method
Which one is the functional currency?
Indicator
Cash Flow
Sales Price
Sales Market
Expenses
Financing
Intercompany
Transactions
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Indication that the Functional Currency is the
Foreign Currency
Parent's Currency
Primarily in FC and do not affect parent's Directly impact parent's cash flows on a
cash flows.
current basis.
Not attected on short-term basis by
Affected on short-term basis by changes in
changes in exchange rate
exchange rate.
Active local sales market.
Sales market mostly in parent's country or
sales denominated in parent's currency.
Primarily local costs
Primarily costs for components obtained
from parent's country.
Primarily denominated in foreign currency Primarily from parent or denominated in
and FC cash flows adequate to service
parent currency or FC cash flows not
obligations.
adequate to service adequate to service
obligations.
Low volume of intercompany transactions, High volume of intercompany transactions
not extensive interrelationship with
and extensive interrelationship with parent's
parent's operations.
operations.
Functional Currency Indicators
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Parent currency is the functional currency when
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Foreign currency is the functional currency when
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Foreign operation are an extension of parent’s operations
Operations are dependent on parent’s economic environment
Change in assets and liabilities directly impact parent’s cash flows
Foreign operation relatively self-contained
Operations not dependent on parent’s economic environment
Operating unit generates and expends foreign currency
Net cash flows can be reinvested or converted and distributed to
parent
If functional currency is the local currency- use current rate
method Gains and losses disclosed directly under
stockholder’s equity
If functional currency is home currency, use the temporal
method and fully recognize gains/losses into earnings.
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Disclosure of translation adjustment
Two issues related to the translation of foreign
currency financial statements :

1.
2.
Selection of appropriate method based on functional currency.
Where the resulting translation adjustment should be
reported in the consolidated financial statement.
There are two disclosure procedures based on the
functional currency and thus the translation method

1.
2.
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Translation adjustment should be reported in the consolidated
income statement-if functional currency is home currency and
temporal method is used
Translation adjustment should be reported in stock holder
equity – if functional currency is local currency and current
method is used
Current Rate Method
All assets and liabilities are translated at the rate in effect
on the balance sheet date.
2. All items on the income statement are translated at an
appropriate average exchange rate or at the rate
prevailing when the various revenues, expenses, gains and
losses were incurred (historical rate).
3. Dividends paid are translated at the rate in effect on the
payment date.
4. Common stock and paid-in capital accounts are
recorded at historical rates.Year-end retained earnings
consist of Beginning RE plus or minus any income or loss
for the year.
 Gains and losses resulting from translation are reported
in a special reserve account on the consolidated
balance sheet with such title as cumulative
translation adjustment (CTA).
 Translation adjustment included in equity.
1.
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Current Rate Method- Example
On January 1, 2008, Trenten Systems, a U.S.-based
company, purchased a controlling interest in Grant
Management Consultants located in Zurich,
Switzerland.
Direct exchange rates for Swiss franc are:
Dollars per Franc
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January 1, 2008
$.5987
December 31, 2008
.5321
Average for 2008
.5654
Dividend declaration and payment date
.5810
Current Rate Method- Example
Grant Management Consultants
Income Statement and Retained Earnings Statement
Revenue
Operating expenses: depreciation of (3,000) franc
Net income
Dividends
Increase in retained earnings
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SFR75,000
(30000)
45,000
15000
30000
Current Rate Method- Example
Balance Sheet
Cash and receivables
Net property, plant, equipment
Total assets
Accounts payable
Common stock
Retained earnings
Total liab. & equity
Jan. 1
20,000
40,000
60,000
30,000
20,000
10,000
60,000
Dec. 31
55,000
37,000
92,000
32,000
20,000
40,000
92,000
Required: Translate the year-end balance sheet and
income statement of the foreign subsidiary using
the current rate method of translation.
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Current Rate Method- Example
1- Translate Income statement
Income Statement
Revenue
Operating expenses
Net income
Retained earnings 1/1
Dividends
Retained earnings 12/31
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Swiss
Francs
75,000
(30,000)
45,000
10,000
55,000
(15,000)
40,000
Translation
Rate
0.5654
0.5654
0.5987
0.5810
U.S. Dollars
42,405
(16,962)
25,443
5,987
31,430
(8,715)
22,715
Current Rate Method- Example
2- Translate Balance Sheet
Balance Sheet
Cash and receivables
Net property, plant, equipment
Total assets
Accounts payable
Common stock
Retained earnings
Cumulative translation adjustment
Total liab. & equity
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Swiss
Francs
55,000
37,000
92,000
Translation
Rate
0.5321
0.5321
32,000
20,000
40,000
92,000
0.5321
0.5987
92,000
1371000
U.S. Dollars
29,266
19,688
48,954
17,027
11,974
22,715
51,716
(2,762)
48,954
Current Rate Method- Example
Income Statement
Revenue
Operating expenses
Net income
Retained earnings 1/1
Dividends
Retained earnings 12/31
Balance Sheet
Cash and receivables
Net property, plant, equipment
Total assets
Accounts payable
Common stock
Retained earnings
Cumulative translation adjustment
Total liab. & equity
7-39
Swiss
Francs
Translation
Rate
U.S. Dollars
75,000
(30,000)
45,000
10,000
55,000
(15,000)
40,000
0.5654
0.5654
55,000
37,000
92,000
0.5321
0.5321
29,266
19,688
48,954
32,000
20,000
40,000
92,000
0.5321
0.5987
92,000
1371000
17,027
11,974
22,715
51,716
(2,762)
48,954
0.5987
0.5810
42,405
(16,962)
25,443
5,987
31,430
(8,715)
22,715
Translation Procedures Internationally
Canada – very similar to U.S., however under the temporal
method, some translations adjustments can be deferred and
amortized.
Mexico – standards are silent, but SFAS 52 is commonly
followed. In cases where it is not, practice varies widely.
Brazil – current rate method is used with gains and losses
included in income.
Japan – significantly different from U.S. GAAP and IFRSs, with
cumulative translation adjustment reported as an asset or
liability.
Korea – only the current rate method is used.
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Temporal Method
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Monetary assets (cash, marketable securities, AR) and monetary
liabilities (current liabilities and LTD) are translated at the current
ER (exchange rate at the balance sheet date).
Non-monetary assets (inventory, fixed assets, etc.) and nonmonetary liabilities are translated at their historical rate.
Income statement items are translated at the average ER over the
period, except for items that are associated with non-monetary
assets or liabilities, such as COGS (inventory) and depreciation
(fixed assets), which are translated at their historical rate.
Dividends paid are translated at the rate in effect on the payment
date.
Equity items are translated at their historical rate, and include any
imbalance.
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Temporal Method
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Logic behind differentiating monetary and non-monetary
assets:
Translation gains and losses on monetary accounts are
presumed meaningful components of expenses or revenue
because monetary accounts closely approximate market
values.
Translation gains and losses on non-monetary accounts are
less meaningful since non-monetary accounts reflect historical
costs.
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Temporal Method
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Gains and losses resulting from translation are carried directly
to current consolidated income
Unlike the current rate method these gains and losses do not
go to an equity reserve account.
FX gains and losses introduce volatility of consolidated
earnings.
This volatility is damped to the extent that many items in the
temporal approach are translated at their historical costs.
The main advantage of this method is that it complies with the
accounting principle of carrying balance sheet accounts at
historical cost.
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The Temporal Method: An Example
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The Temporal Method: An Example
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The Temporal Method: An Example
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The Temporal Method: An Example
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The Temporal Method: An Example
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The Temporal Method: An Example
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Hedging Translation Exposure
The managers have two methods for dealing with translation
exposure.
1. Balance Sheet Hedge
Eliminates the mismatch between net assets and net liabilities
denominated in the same currency.
May create transaction exposure, however.
2. Derivatives Hedge:
An example would be the use of forward contracts with a
maturity of the reporting period to attempt to manage the
accounting numbers.
Using a derivatives hedge to control translation exposure really
involves speculation about foreign exchange rate changes,
however.
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Derivative Securities
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Hedges are contracts that seek to insulate
companies from market risks—securities such as
futures, options, and swaps are commonly used as
hedges
Derivative securities, or simply derivatives are
contracts whose value is derived from the value of
another asset or economic item such as a stock, bond,
commodity price,
interest rate, or currency exchange rate
they can expose companies to considerable risk
because it can be difficult to find a derivative that
entirely hedges the risks or because the parties to the
derivative contract fail to understand the risk
exposures
Derivative Securities
Definitions
Futures contract—an agreement between two or more parties to purchase
or sell a certain commodity or financial asset at a future date (called
settlement date) and at a definite price.
Swap contract—an agreement between two or more parties to exchange
future cash flows. It is common for hedging risks, especially interest rate and
foreign currency risks.
Option contract—grants a party the right, not the obligation, to execute a
transaction. A call option is a right to buy a security (or commodity) at a
specific price on or before the settlement date. A put option is an option to
sell a security (or commodity) at a specific price on or before the settlement
date.
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Derivative Securities
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Derivative Securities
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Derivative Securities
Analysis of Derivatives
• Identify Objectives for Using Derivatives
• Risk Exposure and Effectiveness of Hedging Strategies
• Transaction Specific versus Companywide Risk
Exposure
• Inclusion in Operating or Nonoperating Income
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The Fair Value Option
Fair Value Reporting Requirements
Eligible assets and liabilities investments in debt and equity securities,
financial instruments, derivatives, and
various financial obligations.
Not allowed: investment in subsidiaries
that need to be consolidated,
postretirement benefit assets and
obligations, lease assets/ obligations, certain
types of insurance contracts, loan
commitments; equity method investments
under certain conditions.
Selective Application
Substantial flexibility exists to selectively
apply the fair value option to individual
assets or liabilities.
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Reporting Requirements
1. Carrying amount of the asset (or
liability) in the balance sheet will always
be at its fair value on the measurement
date.
2. All changes in the fair value of the asset
(or liability), including unrealized gain and
losses, will be included in net income.
3. Can choose to report the unrealized
gain/loss portion differently from cash
flow components or together.