3 Accounting for Investment Securities-Stocks The accounting for investments depends on the purpose of the investment and the percentage of voting stock held.Investor CorporationMinority, PassiveInvestments (less than20% ownership)Minority, ActiveInvestments (typicallybetween 20% and50% ownership)Majority, ActiveInvestments(greater than50% ownership)held ascurrent assets-,marketablesecuritiesTrading securitiesheld aslong-termInvestments-Available for saleacquired inPurchase-consolidationEquity methodof accounting
4 Classification and Accounting for Equity Securities
6 Investment Securities Accounting for Transfers between Security Classes
7 Accounting for and Classification of Financial Instruments (Assets) 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; andDerivatives: 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 maturityAvailable 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) performanceRemove 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 AssetsTo analyze accounting distortions from securitiesOpportunities for gains trading-unrealized gains and losses- income statement vs comprehensive incomeLiabilities recognized at cost- amortizedInconsistent definition of equity securitiesClassification based on intentHow to determine operating vs investing purpose investments?no definite answerDetermine if the investment is strategic in the operations or not
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
10 Equity Method Accounting Investment account:Initially recorded at acquisition costIncreased by % share of investee earningsDecreased by dividends receivedIncome:Investor reports % share of investee company earnings as “equity earnings” in its income statementDividends are reported as a reduction of the investment account, not as income
11 Equity Method Accounting ExampleAssume 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 500,000Cash 500,000Synergy, Inc.Current assets 700,000PP&E ,600,000Total assets ,300,000Current liabilities 300,000Long-term debt ,000,000Stockholders’ Equity 2,000,000Total liabs and equity 6,300,000
12 Equity Method Accounting ExampleSubsequent 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:Investment 25,000Equity earnings 25,000(to record proportionate share of investee company earnings)Cash 5,000Investment 5,000(to record receipt of dividends)
13 Business Combinations The merger, acquisition, reorganization, or restructuring of two or more businesses to form another business entityWHY?enhance company image and growth potentialacquiring valuable materials and facilitiesacquiring technology and marketing channelssecuring financial resourcesstrengthening managementenhancing operating efficiencyencouraging diversificationrapidity in market entryachieving economies of scaleacquiring tax advantagesmanagement prestige and perquisitesmanagement compensation
14 Accounting for Business Combinations Purchase method of accountingCompanies 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
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 statementsConsolidation involves two steps: aggregation and eliminationAggregation of assets, liabilities, revenues, andexpenses of subsidiaries with the parentElimination of intercompany transactions(and accounts) between subsidiaries and the parentNote: Minority interest represents the portion of a subsidiary’s equity securities owned by other than the parent companyConsolidated Financial StatementsBasic Technique of Consolidation
16 Business Combinations Consolidation IllustrationOn 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.
17 Business Combinations Consolidation IllustrationThe purchase price is, therefore, allocated as follows:Purchase price 770,000Book value of Micron 620,000Excess 150,000Excess allocated to – useful life annual deprec/amort.Undervalued PP&E 20, ,000Trademark , ,000Goodwill 100,000 indefinite150,000
19 Business Combinations Synergy Corp and Micron CompanyConsolidated Income Statement StepsThe four consolidation entries areReplace $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.
20 Business Combinations Synergy Corp and Micron CompanyConsolidated Income Statement StepsIncome 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.
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.
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
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 powerConsequences of Accounting for Goodwill
24 International Investments Investments in subsidiaries in foreign countriesTranslation ExposureThe 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 currencyFunctional currency – currency of the primary economic environment of the subsidiaryAn accounting issue.Transaction ExposureThe effect that unanticipated changes in exchange rates has on the firm’s cash flows.A finance issueIt is generally not possible to eliminate both translation exposure and transaction exposure
25 Foreign Exchange Risk Management 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 Types of Exposures Translation Exposure Transaction 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 lossesTransaction ExposureIt 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 lossesOperating ExposureIt arises because currency fluctuations combined with price level changes can alter the amounts and riskiness of a firm’s future revenues and costs.Tax ExposureThe 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 Transaction ExposureIt 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 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 exposureNet 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 adjustmentNet 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 MethodIf the subsidiary integrated with its local economy Functional currency is its country currency Use Current rate Method
31 Functional Currency Indicators Parent currency is the functional currency whenForeign operation are an extension of parent’s operationsOperations are dependent on parent’s economic environmentChange in assets and liabilities directly impact parent’s cash flowsForeign currency is the functional currency whenForeign operation relatively self-containedOperations not dependent on parent’s economic environmentOperating unit generates and expends foreign currencyNet cash flows can be reinvested or converted and distributed to parentIf functional currency is the local currency- use current rate method Gains and losses disclosed directly under stockholder’s equityIf functional currency is home currency, use the temporal method and fully recognize gains/losses into earnings.
32 Disclosure of translation adjustment Two issues related to the translation of foreign currency financial statements :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 methodTranslation adjustment should be reported in the consolidated income statement-if functional currency is home currency and temporal method is usedTranslation adjustment should be reported in stock holder equity – if functional currency is local currency and current method is used
33 Current Rate MethodAll assets and liabilities are translated at the rate in effect on the balance sheet date.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).Dividends paid are translated at the rate in effect on the payment date.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 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 FrancJanuary 1, $.5987December 31,Average forDividend declaration and payment date .5810
35 Current Rate Method- Example Grant Management ConsultantsIncome Statement and Retained Earnings StatementRevenue SFR75,000Operating expenses: depreciation of (3,000) franc (30000)Net income ,000DividendsIncrease in retained earnings
36 Current Rate Method- Example Balance SheetJan. 1 Dec. 31Cash and receivables , ,000Net property, plant, equipment 40, ,000Total assets , ,000 Accounts payable 30, ,000Common stock , ,000Retained earnings , ,000Total liab. & equity , ,000Required: Translate the year-end balance sheet and income statement of the foreign subsidiary using the current rate method of translation.
37 Current Rate Method- Example 1- Translate Income statement
38 Current Rate Method- Example 2- Translate Balance Sheet
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.
41 Temporal MethodMonetary 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 MethodLogic 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 MethodGains and losses resulting from translation are carried directly to current consolidated incomeUnlike 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.
50 Hedging Translation Exposure The managers have two methods for dealing with translation exposure.1. Balance Sheet HedgeEliminates 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 Hedges are contracts that seek to insulate companies from market risks—securities such as futures, options, and swaps are commonly used as hedgesDerivative 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 ratethey 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 DefinitionsFutures 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.
55 Derivative Securities Identify Objectives for Using DerivativesRisk Exposure and Effectiveness of Hedging StrategiesTransaction Specific versus Companywide Risk ExposureInclusion in Operating or Nonoperating IncomeAnalysis of Derivatives
56 Fair Value Reporting Requirements The Fair Value OptionFair Value Reporting RequirementsEligible 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.Reporting Requirements1. 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.Selective ApplicationSubstantial flexibility exists to selectively apply the fair value option to individual assets or liabilities.