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Analyzing Investing Activities-II Intercompany and International 1.

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Presentation on theme: "Analyzing Investing Activities-II Intercompany and International 1."— Presentation transcript:

1 Analyzing Investing Activities-II Intercompany and International 1

2 Classification of Investment Securities 2

3 Accounting for Investment Securities- Stocks 3 Investor Corporation Minority, Active Investments (typically between 20% and 50% ownership) Minority, Active Investments (typically between 20% and 50% ownership) Majority, Active Investments (greater than 50% ownership) Majority, Active Investments (greater than 50% ownership) Minority, Passive Investments (less than 20% ownership) Minority, Passive Investments (less than 20% ownership) held as current assets-, marketable securities Trading securities held as current assets-, marketable securities Trading securities held as long-term Investments- Available for sale held as long-term Investments- Available for sale acquired in Purchase- consolidation acquired in Purchase- consolidation The accounting for investments depends on the purpose of the investment and the percentage of voting stock held. Equity method of accounting Equity method of accounting

4 Classification and Accounting for Equity Securities 4

5 Accounting for Debt Securities 5

6 Investment Securities Accounting for Transfers between Security Classes 6

7 Accounting for and Classification of Financial Instruments (Assets) 7  Financial assets at fair value through profit or loss: has two subcategories:  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.

8 Investment Securities Two main objectives: – To separate operating performance from investing (and financing) performance 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 – To analyze accounting distortions from securities 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? no definite answer Determine if the investment is strategic in the operations or not 8

9 Equity Method Accounting  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 9

10 Equity Method Accounting Investment account: – Initially recorded at acquisition cost – Increased by % share of investee earnings – Decreased by dividends received Income: – 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 10

11 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: Investment500,000 Cash500,000 Synergy, Inc. Current assets 700,000 PP&E 5,600,000 Total assets 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 11

12 Equity Method Accounting 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: Investment25,000 Equity earnings 25,000 (to record proportionate share of investee company earnings) Cash5,000 Investment5,000 (to record receipt of dividends) Example 12

13 The merger, acquisition, reorganization, or restructuring of two or more businesses to form another business entity Business Combinations 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 13

14 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 14

15 Business Combinations Consolidated financial statements report the results of operations and financial condition of a parent corporation and its subsidiaries in one set of statements 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 Consolidated financial statements report the results of operations and financial condition of a parent corporation and its subsidiaries in one set of statements 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 Consolidated Financial Statements Basic Technique of Consolidation 15

16 Business Combinations 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. 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. Consolidation Illustration 16

17 Business Combinations The purchase price is, therefore, allocated as follows: Purchase price770,000 Book value of Micron620,000 Excess150,000 Excess allocated to – useful life annual deprec/amort. Undervalued PP&E 20, ,000 Trademark 30, ,000 Goodwill100,000 indefinite ,000 The purchase price is, therefore, allocated as follows: Purchase price770,000 Book value of Micron620,000 Excess150,000 Excess allocated to – useful life annual deprec/amort. Undervalued PP&E 20, ,000 Trademark 30, ,000 Goodwill100,000 indefinite ,000 Consolidation Illustration 17

18 18

19 Business Combinations  The four consolidation entries are 1. 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. 2. Replace $150,000 of the investment account with the fair value adjustments required to fully record Micron’s assets at fair market value. 3. 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. 4. 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. Synergy Corp and Micron Company Consolidated Income Statement Steps 19

20 Business Combinations  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. Synergy Corp and Micron Company Consolidated Income Statement Steps 20

21 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. 21

22 Business Combinations 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. Impairment of Goodwill 22

23 Business Combinations 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 Consequences of Accounting for Goodwill 23

24 International Investments 24  Investments in subsidiaries in foreign countries  Translation Exposure  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.  Transaction Exposure  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

25 Foreign Exchange Risk Management 25  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:  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.

26 26 Types of Exposures  Translation Exposure  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  Transaction Exposure  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  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  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

27 27 Transaction Exposure  It arises from the various types of transactions that require settlement in a foreign currency.  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.

28 Balance Sheet Exposure-translation exposure 28  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 rates- When foreign currency appreciates, a net liability exposure results in a negative translation adjustment

29 Functional Currency Concept  The standard includes a list of indicators as guidance for the foreign currency decision.  The concept is :  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 29

30 Which one is the functional currency? 30

31 Functional Currency Indicators  Parent currency is the functional currency when  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 currency is the functional currency when  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. 31

32 Disclosure of translation adjustment  Two issues related to the translation of foreign currency financial statements : 1. Selection of appropriate method based on functional currency. 2. 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. Translation adjustment should be reported in the consolidated income statement-if functional currency is home currency and temporal method is used 2. Translation adjustment should be reported in stock holder equity – if functional currency is local currency and current method is used 32

33 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.

34 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 January 1, 2008 $.5987 December 31, Average for Dividend declaration and payment date.5810 Current Rate Method- Example 34

35 Current Rate Method- Example Grant Management Consultants Income Statement and Retained Earnings Statement Revenue SFR75,000 Operating expenses: depreciation of (3,000) franc (30000) Net income 45,000 Dividends Increase in retained earnings

36 Current Rate Method- Example Balance Sheet Jan. 1 Dec. 31 Cash and receivables 20,000 55,000 Net property, plant, equipment40,000 37,000 Total assets 60,000 92,000 Accounts payable30,000 32,000 Common stock 20,000 20,000 Retained earnings 10,000 40,000 Total liab. & equity 60,000 92,000 Required: Translate the year-end balance sheet and income statement of the foreign subsidiary using the current rate method of translation. 36

37 1- Translate Income statement Current Rate Method- Example 37

38 2- Translate Balance Sheet Current Rate Method- Example 38

39 Current Rate Method- Example 7-39

40 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. 40

41 Temporal Method 41  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 non- monetary 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.

42 Temporal Method 42  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.

43 Temporal Method 43  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.

44 The Temporal Method: An Example 44

45 The Temporal Method: An Example 45

46 The Temporal Method: An Example 46

47 The Temporal Method: An Example 47

48 The Temporal Method: An Example 48

49 The Temporal Method: An Example 49

50 Hedging Translation Exposure 50 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.

51 Derivative Securities 51  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

52 Derivative Securities 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. 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. Definitions 52

53 Derivative Securities 53

54 Derivative Securities 54

55 Identify Objectives for Using Derivatives Risk Exposure and Effectiveness of Hedging Strategies Transaction Specific versus Companywide Risk Exposure Inclusion in Operating or Nonoperating Income Derivative Securities Analysis of Derivatives 55

56 The Fair Value Option Fair Value Reporting Requirements 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. 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. 56


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