Analyzing Investing Activities-II Intercompany and International 1

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Analyzing Investing Activities-II

Intercompany and International

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Classification of Investment Securities

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Accounting for Investment Securities-Stocks

Investor CorporationInvestor Corporation

Minority, ActiveInvestments (typically

between 20% and50% ownership)

Minority, ActiveInvestments (typically

between 20% and50% ownership)

Majority, ActiveInvestments(greater than

50% ownership)

Majority, ActiveInvestments(greater than

50% ownership)

Minority, PassiveInvestments (less than

20% ownership)

Minority, PassiveInvestments (less than

20% ownership)

held ascurrent assets-,

marketablesecurities

Trading securities

held ascurrent assets-,

marketablesecurities

Trading securities

held aslong-term

Investments- Available for sale

held aslong-term

Investments- Available for sale

acquired inPurchase-

consolidation

acquired inPurchase-

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

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Classification and Accounting for Equity Securities

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Accounting for Debt Securities

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Investment Securities

Accounting for Transfers between Security Classes

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Accounting for and Classification of Financial Instruments (Assets) Financial assets at fair value through profit or

loss: has two subcategories: Trading securities: Marketable securities – both equity and

debt securities – that are held for short-term profit purposes; and

Derivatives: financial instruments that do not have a value by themselves but derive their value from the underlying security or asset such as shares, foreign exchange, commodities etc.- except for cash flow hedges that are accounted for similar to trading securities;

Held to Maturity: Debt securities for which a firm has both the positive intent and ability to hold to maturity

Available for Sale Securities: Neither trading securities nor securities held to maturity- usually classified as long term investments.

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Investment Securities• Two main objectives:

– 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

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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

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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

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Example

• Assume that Global Corp. acquires for cash a 25% interest in Synergy, Inc. for $500,000, representing one-fourth of Synergy’s stockholders’ equity as of the acquisition date.

• Acquisition entry:

Investment 500,000Cash

500,000

Synergy, Inc.

Current assets 700,000

PP&E 5,600,000

Total assets 6,300,000

Current liabilities 300,000Long-term debt

4,000,000Stockholders’ Equity

2,000,000Total liabs and equity

6,300,000

Equity Method Accounting

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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:

Investment 25,000Equity earnings 25,000

(to record proportionate share of investee company earnings)

Cash 5,000Investment

5,000(to record receipt of

dividends)

Example

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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

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Accounting for Business Combinations

• Purchase method of accounting – Companies are required to recognize on their

balance sheets the fair market value of the (tangible and intangible) assets acquired together with the fair market value of any liabilities assumed. • Tangible assets are depreciated and the identifiable

intangible assets amortized over their estimated useful lives.

• Non-amortization of goodwill

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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

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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

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The purchase price is, therefore, allocated as follows: Purchase price 770,000 Book value of Micron 620,000 Excess 150,000 Excess allocated to – useful life annual

deprec/amort. Undervalued PP&E 20,000 10 2,000 Trademark 30,000 5 6,000 Goodwill 100,000 indefinite -0-

150,000

The purchase price is, therefore, allocated as follows: Purchase price 770,000 Book value of Micron 620,000 Excess 150,000 Excess allocated to – useful life annual

deprec/amort. Undervalued PP&E 20,000 10 2,000 Trademark 30,000 5 6,000 Goodwill 100,000 indefinite -0-

150,000

Consolidation Illustration

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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

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Income statement of Synergy is combined with that of Micron.

Depreciation / amortization of excess of purchase price over the book value of Micron’s assets is recorded as an additional expense in the consolidated income statement.

Any intercompany profits on sales of inventories held by the consolidated entity at year-end, along with any intercompany profits on other asset transactions, are eliminated.

Equity investment account on Synergy’s balance sheet is replaced with the Micron assets / liabilities to which it relates.

Consolidated assets / liabilities reflect the book value of Synergy plus the book value of Micron, plus the remaining undepreciated excess of purchase price over the book value of Micron assets.

Goodwill, which was previously included in the investment account balance, is now broken out as a separately identifiable asset on the consolidated balance sheet.

Synergy Corp and Micron Company Consolidated Income Statement Steps

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Additional Limitations of Consolidated Financial Statements

• Financial statements of the individual companies composing the larger entity are not always prepared on a comparable basis.

• Consolidated financial statements do not reveal restrictions on use of cash for individual companies. Nor do they reveal intercompany cash flows or restrictions placed on those flows.

• Companies in poor financial condition sometimes combine with financially strong companies, thus obscuring analysis.

• Extent of intercompany transactions is unknown unless the procedures underlying the consolidation process are reported.

• Accounting for the consolidation of finance and insurance subsidiaries can pose several problems for analysis. Aggregation of dissimilar subsidiaries can distort ratios and other relations.

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• 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

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• 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

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International Investments 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

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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.

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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

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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.

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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 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

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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

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Which one is the functional currency?

Indicator Foreign Currency Parent's CurrencyCash Flow Primarily in FC and do not affect parent's

cash flows.Directly impact parent's cash flows on a current basis.

Sales Price Not attected on short-term basis by changes in exchange rate

Affected on short-term basis by changes in exchange rate.

Sales Market Active local sales market. Sales market mostly in parent's country or sales denominated in parent's currency.

Expenses Primarily local costs Primarily costs for components obtained from parent's country.

Financing Primarily denominated in foreign currency and FC cash flows adequate to service obligations.

Primarily from parent or denominated in parent currency or FC cash flows not adequate to service adequate to service obligations.

Intercompany Transactions

Low volume of intercompany transactions, not extensive interrelationship with parent's operations.

High volume of intercompany transactions and extensive interrelationship with parent's operations.

Indication that the Functional Currency is the

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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.

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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 method1. 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

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Current Rate Method

1. 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.

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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, 2008 .5321

Average for 2008 .5654

Dividend declaration and payment date.5810

Current Rate Method- Example

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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 15000

Increase in retained earnings 30000

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Current Rate Method- ExampleBalance Sheet

Jan. 1 Dec. 31

Cash and receivables 20,000 55,000

Net property, plant, equipment 40,000 37,000

Total assets 60,000 92,000 Accounts payable30,000 32,000Common stock 20,000

20,000Retained 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.

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Swiss TranslationIncome Statement Francs Rate U.S. Dollars

Revenue 75,000 0.5654 42,405

Operating expenses (30,000) 0.5654 (16,962)

Net income 45,000 25,443

Retained earnings 1/1 10,000 0.5987 5,987

55,000 31,430

Dividends (15,000) 0.5810 (8,715) Retained earnings 12/31 40,000 22,715

1- Translate Income statement


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Swiss TranslationBalance Sheet Francs Rate U.S. Dollars

Cash and receivables 55,000 0.5321 29,266

Net property, plant, equipment 37,000 0.5321 19,688 Total assets 92,000 48,954

Accounts payable 32,000 0.5321 17,027

Common stock 20,000 0.5987 11,974

Retained earnings 40,000 22,715

92,000 51,716

Cumulative translation adjustment (2,762) Total liab. & equity 92,000 1371000 48,954

2- Translate Balance SheetCurrent Rate Method- Example


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Swiss TranslationIncome Statement Francs Rate U.S. Dollars

Revenue 75,000 0.5654 42,405

Operating expenses (30,000) 0.5654 (16,962)

Net income 45,000 25,443

Retained earnings 1/1 10,000 0.5987 5,987

55,000 31,430

Dividends (15,000) 0.5810 (8,715) Retained earnings 12/31 40,000 22,715

Balance Sheet

Cash and receivables 55,000 0.5321 29,266

Net property, plant, equipment 37,000 0.5321 19,688 Total assets 92,000 48,954

Accounts payable 32,000 0.5321 17,027

Common stock 20,000 0.5987 11,974

Retained earnings 40,000 22,715

92,000 51,716

Cumulative translation adjustment (2,762) Total liab. & equity 92,000 1371000 48,954

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Translation Procedures Internationally

Canada – very similar to U.S., however under the temporal method, some translations adjustments can be deferred and amortized.Mexico – standards are silent, but SFAS 52 is commonly followed. In cases where it is not, practice varies widely.Brazil – current rate method is used with gains and losses included in income.Japan – significantly different from U.S. GAAP and IFRSs, with cumulative translation adjustment reported as an asset or liability.Korea – only the current rate method is used.

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Temporal Method 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.

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Temporal Method Logic behind differentiating monetary and non-

monetary assets: Translation gains and losses on monetary

accounts are presumed meaningful components of expenses or revenue because monetary accounts closely approximate market values.

Translation gains and losses on non-monetary accounts are less meaningful since non-monetary accounts reflect historical costs.

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Temporal Method Gains and losses resulting from translation are

carried directly to current consolidated income Unlike the current rate method these gains and

losses do not go to an equity reserve account. FX gains and losses introduce volatility of

consolidated earnings. This volatility is damped to the extent that many

items in the temporal approach are translated at their historical costs.

The main advantage of this method is that it complies with the accounting principle of carrying balance sheet accounts at historical cost.

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The Temporal Method: An Example

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Hedging Translation ExposureThe 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.

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Derivative Securities 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

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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

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• Identify Objectives for Using Derivatives• Risk Exposure and Effectiveness of Hedging

Strategies • Transaction Specific versus Companywide

Risk Exposure• Inclusion in Operating or Nonoperating

Income


Analysis of Derivatives

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The Fair Value OptionFair Value Reporting Requirements

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.

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 ApplicationSubstantial flexibility exists to selectively apply the fair value option to individual assets or liabilities.

Documents

Analyzing Investing Activities-II Intercompany and International 1