3 INVESTMENT SECIRITIES Companies invest assets in investment securities (also called marketable securities).Investment securities vary widely in terms of the type of securities that a company invests in and the purpose of such investment. Some investments are temporary repositories of excess cash held as marketable securities.
4 INVESTMENT SECIRITIES… Investment securities can be in the form of either debt or equity.Debt securities are securities representing a creditor relationship with another entity—examples are corporate bonds, government bonds, notes, and municipal securities.Equity securities are securities representing ownership interest in another entity—examples are common stock and nonredeemable preferred stock.
5 Debt SecuritiesDebt securities represent creditor relationships with other entities. Examples are government and municipal bonds, company bonds and notes, and convertible debt.Debt securities are classified as trading, held to maturity, or available for sale.Accounting guidelines for debt securities differ depending on the type of security.
6 Held-to-Maturity Securities. These are debt securities that management has both the ability and intent to hold to maturity.They could be either short term (in which case they are classified as current assets) or long term (in which case they.
7 Trading Securities.Trading securities are debt (or no influential equity) securities purchased with the intent of actively managing them and selling them for profit in the near future.Trading securities are current assets. Companies report them at aggregate fair value at each balance sheet date. Unrealized gains or losses (changes in fair value of the securities held) and realized gains or losses (gains or losses on sales) are included in net income.
8 Available-for-Sale Securities. These are debt (or no influential equity) securities not classified as either trading or held-to-maturity securities.These securities are included among current or noncurrent assets, depending on their maturity and/or management’s intent regarding their sale. These securities are reported at fair value on the balance sheet.
9 Fair ValueFair value of an asset is the amount the asset can be exchanged for in a current normal transaction between willing parties. When an asset is regularly traded, its fair value is readily determinable from its published market price. If no published market price exists for an asset, fair value is determined using historical cost.
10 Equity SecuritiesEquity securities represent ownership interests in another entity. Examples are common and preferred stock and rights to acquire or dispose of ownership interests such as warrants, stock rights, and call and put options.
11 Equity Securities…Redeemable preferred stock and convertible debt securities are not considered equity securities (they are classified as debt securities).The two main motivations for a company to purchase equity securities areto exert influence over the directors and management of another entity (such as suppliers, customers, subsidiaries) orto receive dividend and stock price appreciation income.
12 No Influence - Less than 20% Holding. When equity securities are nonvoting preferred or when the investor owns less than 20% of an investee’s voting stock, the ownership is considered non influential.In these cases, investors are assumed to possess minimal influence over the investee’s activities.
13 Significant Influence - Between 20% and 50% Holding. Security holdings, even when below 50% of the voting stock, can provide an investor the ability to exercise significant influence over an investee’s business activities.Evidence of an investor’s ability to exert significant influence over an investee’s business activities is revealed in several ways, including management representation and participation or influence conferred as a result of contractual relationships.
14 Controlling Interest - Holdings of More than 50%. Holdings of more than 50% are referred to as controlling interests - where the investor is known as the holding company and the investee as the subsidiary. Consolidated financial statements are prepared for holdings of more than 50%.
15 The Fair Value OptionA recent standard (SFAS 159) allows companies to selectively report held-to-maturity and available-for-sale securities at fair value.If a company chooses this option, then the accounting for all available-for-sale and held-to-maturity securities will be similar to that accorded to trading securities under SFAS 115.Specifically, for all investment securities (trading, available for sale, and held to maturity),
16 Analyzing Investment Securities Analysis of investment securities has at least two main objectives:To separate operating performance from investing (and financing) performanceTo analyze accounting distortions due to accounting rules and/or earnings management involving investment securities. We limit our analysis to debt securities and non influential (and marketable) equity securities. Analysis of the remaining equity securities is discussed later in this chapter.
17 Transfers between Categories. When management’s intent or ability to carry out the purpose of investment securities significantly changes, securities usually must be reclassified (transferred to another class).Normally, debt securities classified as held-to-maturity cannot be transferred to another class except under exceptional circumstances
18 Investment Income (Loss) The components of investment income (loss) are as follows:Year Ended June 30 (in millions)Dividends and interest $2,119 $1,957 $1,892Net recognized gains (losses) on investments (1,807) 44 1,563Net losses on derivatives (617) (424) (268)Investment income (loss) $ (305) $1,577 $3,187
19 Investment Income (Loss) Performance: for this purpose, it is important for an analyst to remove all gains (losses) relating to investing activities including dividends, interest income, and realized and unrealized gains and losses when evaluating operating performance. An analyst also needs to separate operating and no operating assets when determining the return on net operating assets (RNOA).As a rule of thumb, all debt securities and marketable no influential equity securities, and their related income streams, are viewed as investing activities. Still, an analyst must review the nature of a company’s business and the objectives behind different investments before classifying them as operating or investing. Here are two cases where the rule of thumb does not always apply:
20 Analyzing Accounting Distortions from Securities SFAS 115 takes an important step towards fair value accounting for investment securities.However, this standard does not fully embrace fair value accounting.Instead, the standard is a compromise between historical cost and fair value, leaving many unresolved issues along with opportunities for earnings management.
21 Opportunities for gains trading: The standard allows opportunities for gains trading with available-for-sale and held-to-maturity securities.Because unrealized gains and losses on available-for-sale and held-to-maturity securities are excluded from net income, companies can increase net income by selling those securities with unrealized gains and holding those with unrealized losses.However, the standard requires unrealized gains and losses on available-for-sale securities be reported as part of comprehensive income.An analyst must therefore examine comprehensive income disclosures to ascertain unrealized losses (if any) on unsold available-for-sale securities.
22 Liabilities recognized at cost Accounting for investment securities is arguably one-sided. That is, if a company reports its investment securities at fair value, why not its liabilities?For many companies, especially financial institutions, asset positions are not managed independent of liability positions.
23 Inconsistent definition of equity securities There is concern that the definition of equity securities is arbitrary and inconsistent. For instance, convertible bonds are excluded from equity securities. Yet convertible bonds often derive much of their value from the conversion feature and are more akin to equity securities than debt.This means an analyst should question the exclusion of convertible securities from equity. Redeemable preferred stocks also are excluded from equity securities and, accordingly, our analysis must review their characteristics to validate this classification.
24 Classification based on intent Classification of (and accounting for) investment securities depend on management intent, which refers to management’s objectives regarding disposition of securities.This intent rule can result in identical debt securities being separately classified into one or any combination of all three classes of trading, held-to-maturity, and available-for-sale securities.
25 EQUITY METHOD OF ACCOUNTING Equity method accounting is required for interoperate investments in which the investor company can exert significant influence over, but does not control the investee. In contrast with passive investments, which we discussed earlier in this chapter, equity method investments are reported on the balance sheet at adjusted cost, not at market value.Equity method accounting is generally used for investments representing 20% to 50% of the voting stock of a company’s equity securities.
26 EQUITY METHOD OF ACCOUNTING… Analysis Implications of Interoperate Inves- tmentsOur analysis continues with several important considerations relating to interoperate investments. This section discusses the more important implications.Recognition of Investee Company EarningsEquity method accounting assumes that a dollar earned by an investee company is equivalent to a dollar earned for the investor, even if not received in cash.
27 EQUITY METHOD OF ACCOUNTING… Unrecognized Capital InvestmentThe investment account is often referred to as a one-line consolidation.This is because it represents the investor’s percentage ownership in the investee company stockholders’ equity.Behind this investment balance are the underlying assets and liabilities of the investee company.
28 EQUITY METHOD OF ACCOUNTING… Provision for Taxes on Undistributed Subsidiary EarningsWhen the undistributed earnings of a subsidiary are included in the pretax accounting income of a parent company (either through consolidation or equity method accounting), it can require a concurrent provision for taxes.This provision depends on the action and intent of the parent company. Current practice assumes all undistributed earnings transfer to the parent and, thus, a provision for taxes is made by the parent in the current period.
29 BUSINESS COMBINATIONS Definition of Business Combination
30 DefinitionBusiness combination is defined by the IAS as the joining together of two or more entities. For accounting purposes a combination is treated as an acquisition.The combination of business entities by merger or acquisition is very frequent for various reasons including-
31 Definition…achieving economies of scale and saving of time in entering a new market.A business combination can also be defined as the bringing together of separate entities or business into one reporting entity.The results of nearly all business combinations is that one entity the acquirer obtains control of one or more other businesses the acquire.
32 Definition…If an entity obtains control of one or more other entities that are not businesses, the bringing together of those entities is not a business combination.When an entity acquires a group of asset or net assets that does not constitute a business it shall allocated the cost of the group between the individual identifiable assets and liabilities in the group based on them fair values at the date of acquisition.
33 Definition…A business combination may be structured in a variety of ways for legal, taxation or other reasons. It may involve the purchase of some of the net assets of another entity that together from one or more businesses. It may be affected by the issue of equity treatments, the transfer of cash, cash equivalents or other assets, or a combination there of.
34 Parties involvedThe transaction may be between the shareholder of the combining entities or between one entity and the share holders of another entity. It may involve the establishment of a new entity to control the combining entities or net assets transferred, or the restructuring of one or more of combining entities.
35 Accounting for Business Combination The combination must be accounted for using the purchase method also referred to as an acquisition.The acquiring firm records the identifiable assets and liabilities at fair value at the date of acquisition.The difference between the fair values of the identifiable asserts and liabilities and the amount paid is recorded as goodwill.
36 Accounting for Business Combination.. When the acquiring firm picks up the income of the acquired firm from the date of acquisition, retained earnings of the acquired firm do not continue.The objective of IFRS is to specify the financial reporting by entity when it undertakes a business combination.
37 Accounting for Business Combination.. IAS in particular specifies that all business combination should be accounted for by applying the purchase method, Therefore the acquirer recognize the acquires identifiable assets, liabilities and contingent liabilities at their fair value at the acquisition date and also recognize good will, which is subsequently tested for impairment rather than autmotised
38 Accounting for Business Combination.. A business combination may result in parent- subsidiary relationship in which the acquirer is the parent and the acquire is subsidiary of the acquirer. In such circumstances, the acquirer applies IFRS in its consolidated financial statements. It includes its interests in the acquire in any separate financial statements it issues as an investment in a subsidiary.
39 Accounting for Business Combination.. A business combination may involve the purchase of assets, including any goodwill of another entity rather than the purchase of the equity of the other entity such a combination does not result in a parent-subsidiary relationship.
40 Steps in applying the acquisition method: Identification of the acquirerDetermination of the acquisition dateRecognition and measurement of the identifiable assets acquired, the liabilities assumed and any non-controlling interest (NCI, formerly called minority interest) in the acquireeRecognition and measurement of goodwill or a gain from a bargain purchase
41 Measurement of acquired assets and liabilities. /Measurement of NCI. Assets and liabilities are measured at their acquisition-date fair value (with a limited number of specified exceptions). [IFRS 3.18]IFRS 3 allows an accounting policy choice, available on a transaction by transaction basis, to measure NCI either at:fair value orthe NCI's proportionate share of net assets of the acquiree.
42 Example:X Ltd pays 800 to purchase 80% of the shares of Y Ltd. Fair value of 100% of Y's identifiable net assets is 600. If X elects to measure noncontrolling interests as their proportionate interest in the net assets of Y of 120 (20% x 600), the consolidated financial statements show goodwill of 320 ( ). If X elects to measure noncontrolling interests at fair value and determines that fair value to be 185, then goodwill of 385 is recognized ( ). The fair value of the 20% noncontrolling interest in Y will not necessarily be proportionate to the price paid by X for its 80%, primarily due to control premium or discount. (paragraph B45 of IFRS 3).
43 Acquired intangible assets./ Goodwill Intangible assets must always be recognized and measured at fair value. There is no 'reliable measurement' exceptionGoodwill is measured as the difference between:the aggregate of (i) the acquisition-date fair value of the consideration transferred, (ii) the amount of any NCI, and (iii) in a business combination achieved in stages, the acquisition-date fair value of the acquirer's previously-held equity interest in the acquiree; and
44 Acquired intangible assets./Goodwill.. the net of the acquisition-date amounts of the identifiable assets acquired and the liabilities assumed (measured in accordance with IFRS 3).If the difference above is negative, the resulting gain is recognized as a bargain purchase in profit or loss.
45 Goodwill & non-controlling interest… Goodwill - these are intangible assets acquired by a company upon its full or partial acquisition of another company. It may arise if the amount paid for that company in the name of acquisition exceeds the book value. Non-Controlling interest refers to the portion of equity ownership in the subsidiary company net the portion of equity attributable to the parent company.Goodwill upon acquisition can be computed using two methods;Partial method.Full method.
46 Goodwill & non-controlling interest… Partial method entails obtaining the difference between the consideration paid and the purchaser’s share of the net identifiable net assets & NCI is recognized at its share of identifiable net assets and does not include any good will.Full goodwill method this method entails including of goodwill in for NCI in subsidiary as well as the controlling interest.The following formula is applicable when computing goodwill through full goodwill method.Full goodwill.
47 Full goodwill/. Partial goodwill Purchase consideration……………………………..…………….……XXXXXAdd fair value of NCI…………………………………………………XXXXXLess fair value of net identifiable assetsIn NCI………………………………………………………..…….…..(XXXX)Goodwill …………………………………………………….….….….XXXXXPartial goodwill computation method.Purchase consideration…………………………………………..…..…XXXXXFair value of interest in NCI………………………………….……..…XXXXXLess fair value of net identifiable assets in NCI…………………..…(XXXXX)Less fair value of identifiable assets attributedTo NCI…………………………………………………………..……..(XXXXX)Goodwil……………………………………………………………….XXXXXX
48 Example IIExample IIMissile acquires a subsidiary on 1 January The fair value of the identifiable net assets of the subsidiary was $2,170m. Missile acquired 70% of the shares of the subsidiary for $2.145m. The NCI was fair valued at $683m. Requirement:Compare the value of goodwill under the partial and full methods.
49 Example II…SolutionGoodwill based on the partial and full goodwill methods under IFRS 3(Revised) would be:Partial goodwill $mPurchase consideration ………….………….2, 145Fair value of identifiable net assets……….. (2,170)NCI (30% x 2,170) …………………………..651Goodwill …………………………………….626Full goodwill $mPurchase consideration …………………….2, 145NCI …………………………………………..683…………………………………………… 2,828Fair value of identifiable net assets……… (2,170)Goodwill …………………………………658The difference between the goodwill computed using full goodwill method & partial goodwill method gives the goodwill attributable to the NCI.
50 FAIR VALUATION OF ASSETS & LIABILITIES. Existing requirements is that all assets and liabilities be recognized at fair value at the time of acquisition. Most assets are recognized at fair value with exception to deferred tax assets and pension obligations. Contingent assets are not recognized and contingent liabilities are measured at fair value.
51 FAIR VALUATION OF ASSETS & LIABILITIES… In cases where an asset is valued upwards, the resulting entries affect the balance sheet as well as the income statement. Example, Company X acquired 80% of shares in AB. Prior to acquisition the motor vehicles had a value of Ksh. 600,000. Upon acquisition, the motor vehicles were valued at Ksh. 700,000. Depreciation is on straight line basis for 4 years.
52 FAIR VALUATION OF ASSETS & LIABILITIES… The resulting accounting entries should be DR ASSET account with Ksh. 100,000 & CR Revaluation account with Ksh. 100,000 to reflect the asset revaluation. Any depreciation expense incident to revaluation must be reflected on income statement whereby the following entries shall be applicable.DR - Income statement Depreciation exp. Ksh 150,000DR - Income statement, Dep. on revaluation Ksh. 25,000CR - Motor vehicle Asset Acc; Ksh 175,000
53 Consolidating & separating financial statements. (IAS27) Revised standard moves the IFRS towards the use of economic entity approach (current practice is parent company approach). Economic entity approach treats all providers of equity capital as shareholders even though they are not shareholders of the parent company.
54 Consolidating & separating financial statements. (IAS27)… Disposal of partial interest in subsidiary in which the parent company retains control does not result in gain or loss but increase or decrease in equity under economic entity approach. Purchase of some or all NCI is treated as treasury transaction therefore accounted for in equity.Disposal of partial interest in a subsidiary which the parent company losses control but retain interest as an associate creates the recognition of gain or loss on the entire interest. A gain or loss is realized on the part that has been disposed off.
56 DERIVATIVE SECURITIES A derivative is a financial instrument whose value is derived from the value of another asset, class of assets, or economic variable such as a stock, bond, commodity price, interest rate, or currency exchange rate.However, a derivative contracted as a hedge can expose companies to considerable risk.
57 DERIVATIVE SECURITIES… …This is either because it is difficult to find a derivative that entirely hedges the risk exposure, because the parties to the derivative contract fail to understand the potential risks from the instrument, or because the counterparty (the other entity in the hedge) is not financially strong. Companies have been known to use derivatives to speculate.
58 Defining a Derivative… A variety of financial instruments are used for hedging activities, including the following:Futures contractAn 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. Futures exist for most commodities and financial assets.Swap contractAn agreement between two or more parties to exchange future cash flows. It is common for hedging risks, especially interest rate and foreign currency risks.
59 Defining a Derivative… Option contract- grants a party the right, not the obligation, to execute a transaction. To illustrate, an option to purchase a security at a specific contract price at a future date is likely to be exercised only if the security price on that future date is higher than the contract price. An option also can be either a call or a put. 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.
60 Accounting for Derivatives All derivatives, regardless of their nature or purpose, are recorded at market value on the balance sheet.the accounting for derivatives effects both sides of transaction (wherever applicable) by marking to market.This means if a derivative is an effective hedge, the effects of changes in fair values usually should cancel out and have a minimal effect on profits and stockholders’ equity.
61 Disclosures for Derivatives Companies are required to disclose qualitative and quantitative information about derivatives both in notes to financial statements and elsewhere (usually in the Management’s Discussion and Analysis section). The purpose of these disclosures is to inform analysts about potential risks underlying derivative securities.
62 Analysis of Derivatives Objectives for Using DerivativesIdentifying a company’s objectives for use of derivatives is important because risk associated with derivatives is much higher for speculation than for hedging.In the case of hedging, risk does not arise through strategic choice
63 Analysis of Derivatives… Instead it arises from problems with the hedging instrument, either because the hedge is imperfect or because of unforeseen events. In the case of speculation, a company is making a strategic choice to bear the risk of market movements.Some companies take on such risk because they are in a position to diversify the risk (in a manner similar to that of an insurance company). More often, managers speculate because of “informed hunches” about market movements.
64 Analysis of Derivatives… Risk Exposure and Effectiveness of Hedging StrategiesOnce an analyst concludes a company is using derivatives for hedging, the analyst must evaluate the underlying risks for a company, the company’s risk management strategy, its hedging activities, and the effectiveness of its hedging operations.SFAS 133 was principally designed to provide readers with current values of derivative instruments and the effect of changes in these values on reported profitability. Oftentimes, however, the fair market values are immaterial and the notional amounts do not provide information necessary to evaluate the effectiveness of the company’s hedging activities.
65 Analysis of Derivatives… Transaction-Specific versus Companywide Risk ExposureCompanies hedge specific exposures to transactions, commitments, assets, and/or liabilities.While hedging specific exposures usually reduces overall risk exposure of the company to an underlying economic variable, companies rarely use derivatives with an aim to hedge overall companywide risk exposure.
66 Analysis of Derivatives… The relevant analysis question is whether rational managers enter into derivative contracts that increase overall companywide risk. In some cases the answer is yes.Such actions can arise because of the size and complexity of modern businesses and the difficulty of achieving goal congruence across different divisions of a company.
67 Analysis of Derivatives… Inclusion in Operating or Non operating IncomeAnother analysis issue is whether to view unrealized (and realized) gains and losses on derivative instruments as part of operating or non operating income.To the extent derivatives are hedging instruments, then unrealized and realized gains and losses should not be included in operating income.Also, the fair value of such derivatives should be excluded from operating assets.
68 Analysis of Derivatives… Do derivates reduce risk?Researchers have investigated managerial motivations for using derivatives, along with the impacts of derivative use, for company risk.While there is mixed evidence about whether derivatives are used for hedging or speculative purposes, the preponderance of evidence suggests that managers use derivatives to hedge overall companywide risk.
69 Analysis of Derivatives… Global HedgeBy locating plants in countries where it does business, so its costs are in the same currency as its revenues, IBM reduces the impact of currency swings without hedging. That is, gains and losses (and fair values) from derivatives is none operating when:Hedging activities are not a central part of a company’s operations and
70 Analysis of Derivatives… Global Hedge…Including effects of hedging in operating income conceals the underlying volatility in operating income or cash flows.However, when a company offers risk management services as a central part of its operations (as many financial institutions do), we must view all speculative gains and losses (and fair values) as part of operating income (and operating assets or liabilities).
72 Fair Value OptionIn accounting, fair value is a rational and unbiased estimate of the potential market price of a good, service or asset.It encompasses acquisition/production/distribution costs, replacement costs or costs of close substitutes.Fair value also takes into account other objective factors like actual utility at a given level of development of social productive capability and also supply and demand.
73 Fair Value OptionUnder the fair value accounting, asset and liability values are determined on the basis of their fair values (typically market prices) on the measurement date.Financial Accounting Standards Board (FASB) towards greater convergence of international accounting standards to one based more on the information that are provided by prevailing market prices sometimes known as a “fair value” or “market to market reporting system (Hansen 2004).
74 Scope of the Fair Value Option for Financial Assets and Financial Liabilities This statement permits entities to choose to measure many financial instruments and certain other items at fair value.The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions.
75 Scope of the Fair Value Option for Financial Assets and Financial Liabilities... Eligible items for the measurement option established by this statement:Recognized financial assets and financial liabilities except:An investment in a subsidiary that the entity is required to consolidate.An interest in a variable interest entity that the entity is required to consolidate.
76 Scope of the Fair Value Option for Financial Assets and Financial Liabilities... Employers and plans obligations for pension benefits, other post retirement benefits including health care and life insurance benefits, post employment benefits, employees stock option and stock purchase plans and other forms of differed compensation arrangements as defined in FASB statement No. 35, No. 87, No. 106, No. 112, No. 123, No. 43, No 146 and No. 158.Financial assets and financial liabilities recognized under leases as defined in FASB statement No. 13(Accounting for Leases).
77 Scope of the Fair Value Option for Financial Assets and Financial Liabilities... Deposit liabilities, withdraw able on demand of banks, savings and loan associations, credit unions and other similar depository institutions.Financial instruments that is in whole or in part classified by the issuer as a component of shareholders equity.Firm commitments that would otherwise not be recognized at inception and that involve only financial instruments.
78 Scope of the Fair Value Option for Financial Assets and Financial Liabilities... Non financial insurance contracts and warranties that the insurer can settle by paying a third party to provide those goods and services.Host financial instruments resulting from separation of an embedded non financial derivative instrument from a non financial hybrid instrument.
79 Reporting Requirements (How this statement changes current accounting practices) If a company chooses the fair value option for an asset or liability, then the following reporting rules apply:The fair value option established by this statement permits all entities to choose to measure eligible items at fair value at specified election dates.
80 Reporting Requirements (How this statement changes current accounting practices) A business entity shall report unrealized gains and losses on items on which the fair value option has been elected in earnings (or another performance indicator if the business entity does not report earnings) at each subsequent reporting date.A not for profit organization shall report unrealized losses and gains in its statement of activities or similar statements.
81 Therefore the fair value option: May be applied instrument by instrument with a few exceptions such as investments otherwise accounted for by the equity method.Is irrevocable (unless a new election date occurs).Is applied only to instruments and not pockets of instruments.
82 Fair value measurement – IFRS 13 Existing requirements is that all assets and liabilities be recognized at fair value at the time of acquisition.Most assets are recognized at fair value with exception to deferred tax assets and pension obligations. Contingent assets are not recognized and contingent liabilities are measured at fair value.
83 Fair value measurement – IFRS 13 In cases where an asset is valued upwards, the resulting entries affect the balance sheet as well as the income statement. Example, Company X acquired 80% of shares in AB. Prior to acquisition the motor vehicles had a value of Ksh. 600,000. Upon acquisition, the motor vehicles were valued at Ksh. 700,000. Depreciation is on straight line basis for 4 years.
84 Fair value measurement – IFRS 13… The resulting accounting entries should be DR ASSET account with Ksh. 100,000 & CR Revaluation account with Ksh. 100,000 to reflect the asset revaluation. Any depreciation expense incident to revaluation must be reflected on income statement whereby the following entries shall be applicable.DR - income statement Depreciation exp. Ksh 150,000DR - Income statement, Dep. On revaluation Ksh. 25,000CR -Motor vehicle Asset Acc; Ksh 175,000
85 Consolidating & separating financial statements. (IAS27) Revised standard moves the IFRS towards the use of economic entity approach (current practice is parent company approach). Economic entity approach treats all providers of equity capital as shareholders even though they are not shareholders of the parent company.
86 Consolidating & separating financial statements… Disposal of partial interest in subsidiary in which the parent company retains control does not result in gain or loss but increase or decrease in equity under economic entity approach. Purchase of some or all NCI is treated as treasury transaction therefore accounted for in equity.Disposal of partial interest in a subsidiary which the parent company losses control but retain interest as an associate creates the recognition of gain or loss on the entire interest. A gain or loss is realized on the part that has been disposed off.
87 Consolidating & separating financial statements… Worked example.On 1 January 2008, Rage acquired 70% of the equity interests of Pin, a public limited company. The purchase consideration comprised cash of $360m. The fair value of the identifiable net assets was $480m. The fair value of the NCI in Pin was $210m on 1 January Rage wishes to use the full goodwill method for all acquisitions. Rage acquired a further 10% interest from the NCIs in Pin on 31 December 2008 for a cash consideration of $85m. The carrying value of the net assets of Pin was $535m at 31 December 2008.
88 Consolidating & separating financial statements… KSH (M)Fair value of consideration for 70% interest ………….…………360Fair value of NCI ………………………………………………Fair value of identifiable net assets …..…………………………. (480)Goodwill …………………………………………………………….90Acquisition of further interestThe net assets of Pin have increased by $( ) mie $55m and therefore the NCI has increased by 30% of $55m, i.e. $16.5m. However,Rage has purchased an additional 10% of the shares and this is treated as a treasury transaction. There is no adjustment to goodwill on the further acquisition.
89 Worked example…KSH (M) Pin NCI, 1 January 2008 ………….………………………………………………210 Share of increase in net assets in post-acquisition period…………16.5 Net assets, 31 December 2008 ………………………………………… Transfer to equity of Rage (10/30 x 226.5) ………………………….… (75.5) Balance at 31 December 2008 – NCI ……………………………………..151 Fair value of consideration ………………………………………………..…….85 Charge to NCI ……………………………………………………………………. (75.5) Negative movement in equity ……………………..………………………..9.5
91 INTERNATIONAL TRANSACTIONS - IAS 21 The Effects of Changes in Foreign Exchange Rates outlines how to account for foreign currency transactions and operations in financial statements, and how to translate financial statements into a presentation currency.An entity is required to determine a functional currency for each of its operations if necessary based on the primary economic environment in which it operates and generally records foreign currency transactions using the spot conversion rate to that functional currency on the date of the transaction.
92 History of IAS 21December Exposure Draft E11 Accounting for Foreign Transactions and Translation of Foreign Financial StatementsMarch E11 was modified and re-exposed as Exposure Draft E23 Accounting for the Effects of Changes in Foreign Exchange RatesJuly IAS 21 Accounting for the Effects of Changes in Foreign Exchange Rates1 January Effective date of IAS 21 (1983)IAS 21 (1983) was revised as part of the comparability of financial statements project
93 History of IAS 21…May Exposure Draft E44 The Effects of Changes in Foreign Exchange RatesDecember IAS 21 (1993) The Effects of Changes in Foreign Exchange Rates (revised as part of the 'Comparability of Financial Statements' project)1 January Effective date of IAS 21 (1993)18 December Revised version of IAS 21 issued by the IASB1 January Effective date of IAS 21 (Revised 2003)December Minor Amendment to IAS 21 relating to net investment in a foreign operation 1 January Effective date of the December 2005 amendments
94 History of IAS 21… Effective date of the December 2005 amendments Effective date of the December 2005 amendments10 January Some revisions of IAS 21 as a result of the Business Combinations Phase II Project relating to disposals of foreign operations1 July Effective date of the January 2008 amendments
95 Summary of IAS 21 Objective of IAS 21 The objective of IAS 21 is to prescribe how to include foreign currency transactions and foreign operations in the financial statements of an entity and how to translate financial statements into a presentation currency. The principal issues are which exchange rate(s) to use and how to report the effects of changes in exchange rates in the financial statements
96 Key definitions IAS 21Functional currency: the currency of the primary economic environment in which the entity operates. (The term 'functional currency' was used in the 2003 revision of IAS 21 in place of 'measurement currency' but with essentially the same meaning.)Presentation currency: the currency in which financial statements are presented.Exchange difference: the difference resulting from translating a given number of units of one currency into another currency at different exchange rates.Foreign operation: a subsidiary, associate, joint venture, or branch whose activities are based in a country or currency other than that of the reporting entity.
97 Basic steps for translating foreign currency amounts into the functional currency Steps apply to a stand-alone entity, an entity with foreign operations (such as a parent with foreign subsidiaries), or a foreign operation (such as a foreign subsidiary or branch).The reporting entity determines its functional currencyThe entity translates all foreign currency items into its functional currencyThe entity reports the effects of such translation in accordance with reporting foreign currency transactions in the functional currency and reporting the tax effects of exchange differences.
98 Foreign currency transactions A foreign currency transaction should be recorded initially at the rate of exchange at the date of the transaction use of averages is permitted if they are a reasonable approximation of actual.At each subsequent balance sheet dates:Foreign currency monetary amounts should be reported using the closing rate
99 Foreign currency transactions… Non-monetary items carried at historical cost should be reported using the exchange rate at the date of the transactionNon-monetary items carried at fair value should be reported at the rate that existed when the fair values were determinedIf a gain or loss on a non-monetary item is recognized in other comprehensive income (for example, a property revaluation under IAS 16), any foreign exchange component of that gain or loss is also recognized in other comprehensive income. [IAS 21.30]
100 Translation from the functional currency to the presentation currency The results and financial position of an entity whose functional currency is not the currency of a hyperinflationary economy are translated into a different presentation currency using the following procedures: [IAS 21.39]Assets and liabilities for each balance sheet presented (including comparatives) are translated at the closing rate at the date of that balance sheet
101 Translation from the functional currency to the presentation currency… Income and expenses for each income statement (including comparatives) are translated at exchange rates at the dates of the transactions; andAll resulting exchange differences are recognized in other comprehensive income.
102 Disposal of a foreign operation When a foreign operation is disposed of, the cumulative amount of the exchange differences recognized in other comprehensive income and accumulated in the separate component of equity relating to that foreign operation shall be recognized in profit or loss when the gain or loss on disposal is recognized. [IAS 21.48]
103 Tax effects of exchange differences These must be accounted for using IAS 12 Income Taxes.DisclosureThe amount of exchange differences recognized in profit or loss (excluding differences arising on financial instruments measured at fair value through profit or loss in accordance with IAS 39) [IAS 21.52(a)]Net exchange differences recognized in other comprehensive income and accumulated in a separate component of equity, and a reconciliation of the amount of such exchange differences at the beginning and end of the period [IAS 21.52(b)]
104 Tax effects of exchange differences… When the presentation currency is different from the functional currency, disclose that fact together with the functional currency and the reason for using a different presentation currency [IAS 21.53]A change in the functional currency of either the reporting entity or a significant foreign operation and the reason therefore [IAS 21.54]
105 Convenience translations Sometimes, an entity displays its financial statements or other financial information in a currency that is different from either its functional currency or its presentation currency simply by translating all amounts at end-of-period exchange rates.This is sometimes called a convenience translation. A result of making a convenience translation is that the resulting financial information does not comply with all IFRS, particularly IAS 21. In this case, the following disclosures are required: [IAS 21.57]
106 Convenience translations… Clearly identify the information as supplementary information to distinguish it from the information that complies with IFRSDisclose the currency in which the supplementary information is displayedDisclose the entity's functional currency and the method of translation used to determine the supplementary information
107 OBJECTIVE OF IAS 21An entity may carry on foreign activities in two ways.It may have transactions in foreign currencies or it may have foreign operations.In addition, an entity may present its financial statements in a foreign currency.The objective of this Standard is to prescribe how to include foreign currency transactions and foreign operations in the financial statements of an entity and how to translate financial statements into a presentation currency.
108 Statement of cash flows. The following terms are used in this Standard with the meanings specified:Closing rate is the spot exchange rate at the end of the reporting period.Exchange difference is the difference resulting from translating a given number of units of one currency into another currency at different exchange rates.Exchange rate is the ratio of exchange for two currencies.Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.Foreign currency is a currency other than the functional currency of the entity.