Financial

Statement
Analysis

K R Subramanyam
John J Wild

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 5-2

Analyzing Investing Activities:

Intercorporate Investments

05
CHAPTER
 5-3

Investment Securities
Composition
Investment
Investment (marketable)
(marketable) securities:
securities:
Debt
Debt Securities
Securities
•• Government
Government or
orcorporate
corporatedebt
debtobligations
obligations
Equity
Equity Securities
Securities
••Corporate
Corporatestock
stockthat
thatis
isreadily
readilymarketable
marketable
 5-4

Investment Securities
Accounting for Investment Securities

• SFAS 115.
– Departure from the traditional lower-of-cost-or-
market principle.
– Prescribes that investment securities be reported on
the balance sheet at cost or fair (market) value,
depending on the type of security and the degree of
influence or control that the investor company has
over the investee company.
– Accounting is determined by its classification.
 5-5

Investment Securities

Accounting for Debt Securities

 5-6

Investment Securities
Accounting for Transfers between Security Classes
 5-7

Investment Securities
Classification and Accounting for Equity Securities
 5-8

Investment Securities
Analyzing Investment Securities
• Two main objectives:
– To separate operating performance from investing (and
financing) performance
• Remove all gains (losses) relating to investing activities
• Separate operating and nonoperating assets when
determining RNOA
– To analyze accounting distortions from securities
• Opportunities for gains trading
• Liabilities recognized at cost
• Inconsistent definition of equity securities
• Classification based on intent
 5-9

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)

Note: 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
 5-10

Equity Method Accounting

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
 5-11

Equity Method Accounting

Equity Method Mechanics
• Assume that Global Corp. Synergy, Inc.
acquires for cash a 25%
interest in Synergy, Inc. for Current assets 700,000
$500,000, representing one-
fourth of Synergy’s PP&E 5,600,000
stockholders’ equity as of the Total assets 6,300,000
acquisition date.
Current liabilities 300,000
• Acquisition entry: Long-term debt 4,000,000
Stockholders’ Equity 2,000,000
Investment 500,000 Total liabs and equity 6,300,000
Cash 500,000
 Equity Method Accounting
5-12

Equity Method Mechanics

• Subsequent to the Investment 25,000
acquisition date, Synergy Equity earnings 25,000
reports net income of (to record proportionate share of
$100,000 and pays investee company earnings)
dividends of $20,000.
Global records its
Cash 5,000
proportionate share of
Synergy’s earnings and Investment 5,000
the receipt of dividends (to record receipt of dividends)
as follows:
 5-13

Equity Method Accounting

• Important points:
– Investment account reported at an amount equal to the proportionate
share of the stockholders’ equity of the investee company. Substantial
assets and liabilities may not be recorded on balance sheet unless the
investee is consolidated.
– Investment earnings should be distinguished from core operating
earnings (unless strategic).
– Investments are reported at adjusted cost, not at market value.
– Should discontinue equity method when investment is reduced to zero
and should not provide for additional losses unless the investor has
guaranteed the obligations of the investee or is otherwise committed to
providing further financial support to the investee.
• Resumes once all cumulative deficits have been recovered via investee
earnings.
– Excess of initial investment over the proportionate share of the book
value is allocated to identifiable tangible and intangible assets that are
depreciated/amortized over their respective useful lives. Investment
income is reduced by this additional expense. The excess not allocated in
this manner is treated as goodwill and is no longer amortized.
 5-14

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

Motivations
 
• 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
 5-15

Business Combinations
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.

• Nonamortization of goodwill
 5-16

Business Combinations
Consolidated Financial Statements
Consolidated
Consolidatedfinancial
financialstatements
statementsreport
reportthe
theresults
resultsof
ofoperations
operationsand
and
financial
financialcondition
conditionof
ofaaparent
parentcorporation
corporationand
andits
itssubsidiaries
subsidiariesin
inone
oneset
setof
of
statements
statements
   Basic Technique of Consolidation
Consolidation
Consolidationinvolves
involvestwo
twosteps:
steps:aggregation
aggregationand
andelimination
elimination
  
Aggregation
Aggregationof ofassets,
assets,liabilities,
liabilities,revenues,
revenues,and
and
expenses of subsidiaries with the parent
expenses of subsidiaries with the parent
  
Elimination
Eliminationofofintercompany
intercompanytransactions
transactions
(and
(andaccounts)
accounts)between
betweensubsidiaries
subsidiariesand andthe
theparent
parent
    
Note:Minority
Note: Minorityinterest
interestrepresents
representsthe theportion
portionof
ofaasubsidiary’s
subsidiary’sequity
equity
securities
securitiesowned
ownedby byother
otherthan
thanthetheparent
parentcompany
company
 5-17

Business Combinations
Consolidation Illustration
On
OnDecember
December31,31,Year
Year 1,
1,Synergy
SynergyCorp.
Corp.purchases
purchases100% 100%of
of
Micron
MicronCompany
Company byby exchanging
exchanging10,000
10,000 shares
shares ofof its
itscommon
common
stock
stock($5
($5par
par value,
value, $77
$77market
marketvalue)
value)for
forall
allof
of the
thecommon
common
stock
stockof
ofMicron.
Micron.

On
Onthethedate
dateofofthe
theacquisition,
acquisition,the
thebook
bookvalue
valueof
ofMicron
Micronisis
$620,000.
$620,000.Synergy
Synergyisiswilling
willingto
topay
paythe
themarket
marketprice
priceofof
$770,000
$770,000because
becauseititfeels
feelsthat
thatMicron’s
Micron’sproperty,
property,plant,
plant, and
and
equipment
equipment(PP&E)
(PP&E)isisundervalued
undervaluedby by$20,000,
$20,000,itithas
hasanan
unrecorded
unrecorded trademark
trademarkworth
worth$30,000
$30,000and
andintangible
intangiblebenefits
benefits
of
of the
thebusiness
businesscombination
combination(corporate
(corporate synergies,
synergies,market
market
position,
position,and
andthethelike)
like)are
arevalued
valuedatat $100,000.
$100,000.
 5-18

Business Combinations
Consolidation Illustration
The
Thepurchase
purchaseprice
priceis,
is,therefore,
therefore,allocated
allocatedas
asfollows:
follows:
Purchase
Purchaseprice
price 770,000
770,000
Book
Bookvalue
valueof
ofMicron
Micron 620,000
620,000
Excess
Excess 150,000
150,000
Excess
Excessallocated
allocatedtoto–– useful
usefullife
life annual
annual
deprec/amort.
deprec/amort.
Undervalued
UndervaluedPP&E
PP&E 20,000
20,000 10
10 2,000
2,000
Trademark
Trademark 30,000
30,000 55 6,000
6,000
Goodwill
Goodwill 100,000
100,000 indefinite
indefinite -0-
-0-
150,000
150,000
5-19
 5-20

Business Combinations
Synergy Corp and Micron Company
Consolidated Income Statement Steps
• 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.
 5-21

Business Combinations
Synergy Corp and Micron Company
Consolidated Income Statement Steps
• 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.
 5-22

Business Combinations
Impairment of Goodwill
• Goodwill recorded in the consolidation process is subject to
annual review for impairment.
– The fair market value of Micron is compared with the book
value of its associated investment account on Synergy’s books.
– If the current market value is less than the investment balance,
goodwill is deemed to be impaired and an impairment loss
must be recorded in the consolidated income statement.
– Impairment loss reported as a separate line item in the
operating section of Synergy’s consolidated income statement.
– A portion of the goodwill contained in Synergy’s investment
account is written off, and the balance of goodwill in the
consolidated balance sheet is reduced accordingly.
 5-23

Business Combinations
Issues in Business Combinations

Contingent
ContingentConsideration
Consideration--aacompanycompanyusually
usuallyrecords
recordsthetheamount
amountof of
any
anycontingent
contingentconsideration
considerationpayable
payableininaccordance
accordancewith withaapurchase
purchase
agreement
agreementwhen whenthe thecontingency
contingencyisisresolved
resolvedandandthetheconsideration
considerationisis
issued
issuedororissuable.
issuable.
Allocating
AllocatingTotalTotalCost Cost--once
onceaacompany
companydetermines
determinesthe thetotal
totalcost
costofofan
an
acquired
acquiredentity,
entity,ititisisnecessary
necessaryto toallocate
allocatethis
thiscost
costtotoindividual
individualassets
assets
received;
received;thetheexcess
excessof oftotal
totalcost
costover
overthe
theamounts
amountsassigned
assignedto toidentifiable
identifiable
tangible
tangibleand
andintangible
intangibleassets
assetsacquired,
acquired,less
lessliabilities
liabilitiesassumed,
assumed,is isrecorded
recorded
as
asgoodwill.
goodwill.
In-Process
In-ProcessResearch
Research& &Development
Development(IPR&D)(IPR&D)--some somecompanies
companiesare are
writing
writingoff
offaalarge
largeportion
portionofofan
anacquisition’s
acquisition’scosts
costsas aspurchased
purchasedresearch
research
and
anddevelopment.
development.Pending Pendingaccounting
accountingstandard
standardwill
willrequire
requirecapitalization
capitalizationofof
IRR&D
IRR&Dandandannual
annualtesting
testingfor
forimpairment.
impairment.
Debt
Debtin inConsolidated
ConsolidatedFinancial FinancialStetements
Stetements--Liabilities
Liabilitiesin
in
consolidated
consolidatedfinancial
financialstatements
statementsdo donot
notoperate
operateas asaalien
lienupon
uponaacommon
common
pool
poolofofassets.
assets.
 5-24

Business Combinations
Issues in Business Combinations

Gain
Gainononsubsidiary
subsidiarystock
stocksales
sales --The
Theequity
equityinvestment
investmentaccount
accountis
is
increased
increasedvia
viasubsidiary
subsidiarystock
stocksales.
sales.Companies
Companiescan canrecord
recordthe
thegain
gaineither
either
to
toincome
incomeor
orto
toAPIC
APIC

Consequences
Consequencesof ofAccounting
Accountingfor forGoodwill
Goodwill--goodwill
goodwillis isnot
notpermanent
permanent
and
andthe
thepresent
presentvalue
valueofofsuper
superearnings
earningsdeclines
declinesas asthey
theyextend
extendfurther
furtherinto
into
the
thefuture
future––future
futureimpairment
impairmentlosses
lossesare
arelikely
likely
  
Push
Push‑‑Down
DownAccounting
Accounting --aacontroversial
controversialissue
issueis ishow
how thetheacquired
acquired
company
company(from
(fromaapurchase)
purchase)reports
reportsassets
assetsand
andliabilities
liabilitiesin
inits
itsseparate
separate
financial
financialstatements
statements(if(ifthat
thatcompany
companysurvives
survivesas asaaseparate
separateentity)
entity)
 5-25

Business Combinations
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.
 5-26

Business Combinations
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.
 5-27

Business Combinations
Consequences of Accounting for Goodwill

• Superior competitive position is subject to change.

– Goodwill is not permanent.
• Residual goodwill - measurement problems.
• Timing of goodwill write-off seldom reflects prompt
recognition of this loss in value.
• In many cases goodwill is nothing more than mechanical
application of accounting rules giving little consideration to
value received in return.
• Goodwill on corporate balance sheets typically fails to reflect
a company’s entire intangible earning power
 5-28

Business Combinations
Pooling Accounting
• Used prior to the passage of the current business
combination accounting standards.
– Disallowed for combinations initiated post June 30, 2001.
– Companies may continue its use for acquisitions accounted for
under that method prior to the effective date of the standard.

Under the purchase method, the investment account is debited for the
purchase price. Under the pooling method, this debit is in the amount of
the book value of the acquired company. Assets are not written up from
the historical cost balances reported on the investee company balance
sheet, no new intangible assets are created in the acquisition, and no
goodwill is reported. The avoidance of goodwill was the principle attraction
of this method.
 5-29

Business Combinations
Pooling method Illustration
On
OnDecember
December31,31,Year
Year 1,
1,Synergy
SynergyCorp.
Corp.purchases
purchases100% 100%of
of
Micron
MicronCompany
Company byby exchanging
exchanging10,000
10,000 shares
shares ofof its
itscommon
common
stock
stock($5
($5par
par value,
value, $77
$77market
marketvalue)
value)for
forall
allof
of the
thecommon
common
stock
stockof
ofMicron.
Micron.

On
Onthethedate
dateofofthe
theacquisition,
acquisition,the
thebook
bookvalue
valueof
ofMicron
Micronisis
$620,000.
$620,000.Synergy
Synergyisiswilling
willingto
topay
paythe
themarket
marketprice
priceofof
$770,000
$770,000because
becauseititfeels
feelsthat
thatMicron’s
Micron’sproperty,
property,plant,
plant, and
and
equipment
equipment(PP&E)
(PP&E)isisundervalued
undervaluedby by$20,000,
$20,000,itithas
hasanan
unrecorded
unrecorded trademark
trademarkworth
worth$30,000
$30,000and
andintangible
intangiblebenefits
benefits
of
of the
thebusiness
businesscombination
combination(corporate
(corporate synergies,
synergies,market
market
position,
position,and
andthethelike)
like)are
arevalued
valuedatat $100,000.
$100,000.
 5-30

Business Combinations
Pooling method Illustration
 5-31
Pooling method Illustration
 5-32

Derivative Securities
Background
Hedges
Hedgesare arecontracts
contractsthat
thatseek
seekto
toinsulate
insulatecompanies
companiesfrom
from
market
marketrisks—securities
risks—securitiessuch
suchasasfutures,
futures,options,
options,and
andswaps
swapsare
are
commonly
commonlyusedusedasashedges
hedges
  
Derivative
Derivativesecurities,
securities,or
orsimply
simplyderivatives
derivativesare
arecontracts
contractswhose
whose
value
valueis
isderived
derivedfrom
fromthe
thevalue
valueofofanother
anotherasset
assetor
oreconomic
economicitem
item
such
suchasasaastock,
stock,bond,
bond,commodity
commodityprice,
price,
interest
interestrate,
rate,or
orcurrency
currencyexchange
exchangerate
rate

——they
theycan
canexpose
exposecompanies
companiesto toconsiderable
considerable
risk
riskbecause
becauseititcan
canbe
bedifficult
difficultto
tofind
findaa
derivative
derivativethat
thatentirely
entirelyhedges
hedgesthe therisks
risksor
or
because
becausethetheparties
partiesto
tothe
thederivative
derivativecontract
contract
fail
failto
tounderstand
understandthe therisk
riskexposures
exposures
 5-33

Derivative Securities
Definitions

Futures
Futurescontract—an
contract—anagreement
agreementbetween
betweentwotwoorormore
moreparties
partiestoto
purchase
purchaseor orsell
sellaacertain
certaincommodity
commodityor orfinancial
financialasset
assetat
ataafuture
futuredate
date
(called
(calledsettlement
settlementdate)
date)and
andat
ataadefinite
definiteprice.
price.

Swap
Swapcontract—an
contract—anagreement
agreementbetweenbetweentwotwoorormore
moreparties
partiesto
to
exchange
exchangefuture
futurecash
cashflows.
flows.ItItisiscommon
commonfor forhedging
hedgingrisks,
risks,especially
especially
interest
interestrate
rateand
andforeign
foreigncurrency
currencyrisks.
risks.

Option
Optioncontract—grants
contract—grantsaaparty
partythetheright,
right,not
notthe
theobligation,
obligation,to
toexecute
execute
aatransaction.
transaction.AAcall
calloption
optionisisaaright
rightto
tobuy
buyaasecurity
security(or
(orcommodity)
commodity)at at
aaspecific
specificprice
priceon
onor
orbefore
beforethethesettlement
settlementdate.
date.AAput
putoption
optionisisan
an
option
optionto
tosell
sellaasecurity
security(or
(orcommodity)
commodity)at ataaspecific
specificprice
priceononor
orbefore
before
the
thesettlement
settlementdate.
date.
 5-34

Derivative Securities
 5-35

Derivative Securities
 5-36
Derivative Securities

Qualitative Disclosures
Disclosures generally outline the
types of hedging activities
conducted by the company
and the accounting methods
employed.

Quantitative Disclosures
Campbell Soup provides
quantitative information relating to
its interest rate and foreign
exchange hedging activities in the
MD&A section of the annual report.
These disclosures are provided in
Exhibit 5.8.
 5-37

Derivative Securities
Analysis of Derivatives
• Identify Objectives for Using Derivatives
• Risk Exposure and Effectiveness of Hedging
Strategies
• Transaction Specific versus Companywide Risk
Exposure
• Inclusion in Operating or Nonoperating Income

The Fair Value Option
Fair Value Reporting Requirements
Eligible assets and liabilities -
investments in debt and equity
securities, financial instruments,
derivatives, and various financial
obligations.
Not allowed: investment in
subsidiaries that need to be
consolidated, postretirement benefit
assets and obligations, lease assets/
obligations, certain types of insurance
contracts, loan commitments; equity
method investments under certain
conditions.
Selective Application
Substantial flexibility exists to selectively
apply the fair value option to individual
assets or liabilities.
5-38
Reporting Requirements
1. Carrying amount of the asset (or
liability) in the balance sheet will
always be at its fair value on the
measurement date.
2. All changes in the fair value of the
asset (or liability), including unrealized
gain and losses, will be included in net
income.
3. Can choose to report the unrealized
gain/loss portion differently from cash
flow components or together.
 5-39

The Fair Value Option

Analysis Implications
• Reliability of fair value measurements
• Opportunistic adoption of SFAS 159
– SFAS 159 allows considerable discretion to companies in
choosing the specific assets or liabilities for which they
exercise the fair value option.
– An analyst needs to verify whether the fair value election has
been opportunistic with an aim to window dressing the financial
statements.