Financial

Statement
Analysis
 
 
K.R. Subramanyam

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 5-2

Analysing Investing Activities:

Inter-corporate Investments

05
CHAPTER
 5-3

Overviews of Topics
Investment Securities
Various types
Different methods of recording

Equity method of accounting for securities

Business Combinations
Derivative Securities
The Fair Value Option
 5-4

Investment Securities

What
What are
are the
the two
two main
main reason
reason to
to
Analyzing
Analyzing Marketable
Marketable Investment
Investment
securities?
securities?
 5-5

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 (Return on operating assets)
– To analyze accounting distortions from securities
• Opportunities for gains trading
• Liabilities recognized at cost
• Inconsistent definition of equity securities
• Classification based on intent
 5-6

Investment Securities

Composition

What
What are
are the
the two
two types
types of
of Marketable
Marketable
Investment
Investment securities?
securities?
 5-7

Investment Securities
Composition

What
What are
are the
the two
two types
types of
of Marketable
Marketable
Investment
Investment securities?
securities?

Debt
Debt Securities
Securities

Equity
Equity Securities
Securities
 5-8

Investment Securities
Composition

What
What are
are examples
examples of
of the
the two
two types
types of
of
Marketable
Marketable Investment
Investment securities?
securities?
 5-9

Investment Securities

Composition

Investment
Investment (marketable)
(marketable) securities:
securities:
Debt
Debt Securities
Securities
•• Government
Governmentor
orcorporate
corporatedebt
debt obligations
obligations
Equity
Equity Securities
Securities
••Corporate
Corporatestock
stockthat
that is
isreadily
readilymarketable
marketable
 5-10

Investment Securities

Accounting for Investment Securities

ASC
ASC 320
320 and
and ASC
ASC 825
825 ––
Significantly
Significantly alter
alter (changed)
(changed) the
the
accounting
accounting and
and reporting
reporting of
of investment
investment
securities.
securities.
 5-11

Investment Securities
Accounting for Investment Securities

ASC
ASC 320
320 and
and ASC825
ASC825
–– No
Nolonger
longerthe
thetraditional
traditionallower-of-cost-or-market
lower-of-cost-or-market
principle.
principle.
–– Accounting
Accountingisisdetermined
determinedby byits
its classification.
classification.
 5-12

Investment Securities
Accounting for Investment Securities
ASC
ASC 320
320 and
and ASC
ASC 825
825
Prescribes
Prescribesthat
that investment
investmentsecurities
securitiesbe
bereported
reportedon
onthe
the
balance
balance sheet
sheet at
at either
either––Cost
Costor
orFair
Fair Market
Market Value.
Value.
The
The decision
decisiondepends
dependson onthe
thefollowing:
following:
••the
thetype
typeof
of security
security
••management
managementintend
intendof
ofowning
owningthethesecurity
security
••the
thedegree
degreeofofinfluence
influence(“control”)
(“control”)over
overthe
thecompany.
company.
 5-13

Investment Securities
Composition
 5-14

Investment Securities
Accounting for Debt Securities
 5-15

Investment Securities
Classification and Accounting for Equity Securities
 5-16

Equity Method Accounting

Required
Required for
for intercorporate
intercorporate investments
investments inin which
which
the
the investor
investor company
company can can exert
exert significant
significant influence
influence
over,
over, but
but does
does not
not control,
control, the
the investee.
investee.
–– Reports
Reportsthe
theparent’s
parent’sinvestment
investmentininthe
thesubsidiary,
subsidiary,and
and
the parent’s
the parent’sshare
shareof
ofthe
thesubsidiary’s
subsidiary’sresults,
results,as
asline
lineitems
itemsin
in
the
theparent’s
parent’sfinancial
financialstatements
statements(one-line
(one-lineconsolidation
consolidation

Note:
Note:Generally
Generallyused
usedfor
forinvestments
investmentsrepresenting
representing20
20toto50
50percent
percent
ofofthe
thevoting
votingstock
stockofofaacompany’s
company’sequity
equitysecurities--main
securities--maindifference
differencebetween
between
consolidation
consolidationand andequity
equitymethod
methodaccounting
accountingrests
restsininthe
thelevel
levelofofdetail
detail
reported
reportedininfinancial
financialstatements
statements
 5-17

Equity Method Accounting

Equity Method Accounting
•• Investment
Investment account:
account:
–– Initially
Initiallyrecorded
recordedat
atacquisition
acquisitioncost
cost
–– Increased
Increasedby by%%share
shareof
ofinvestee
investeeearnings
earnings
–– Decreased
Decreasedby bydividends
dividendsreceived
received
•• Income:
Income:
–– Investor
Investorreports
reports% %share
shareof ofinvestee
investeecompany
companyearnings
earningsas
as
“equity
“equityearnings”
earnings”in inits
itsincome
incomestatement
statement
–– Dividends
Dividendsare
arereported
reportedas asaareduction
reductionof
ofthe
theinvestment
investment
account,
account,not
notas
asincome
income
 5-18

Equity Method Accounting

Equity Method Mechanics
• Assume that Global Corp. Synergy, Inc.
acquires for cash a 25% interest
in Synergy, Inc. for $500,000, Current assets 700,000
representing one-fourth of
Synergy’s stockholders’ equity PP&E 5,600,000
as of the acquisition date. Total assets 6,300,000

• Acquisition entry: Current liabilities 300,000

Long-term debt 4,000,000
Investment 500,000 Stockholders’ Equity 2,000,000
Cash 500,000 Total liabs and equity 6,300,000
 Equity Method Accounting
5-19

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:
 5-20

Equity Method Accounting

•• Important
Importantpoints:
points:
–– Investment
Investmentaccount
accountreported
reportedatatan anamount
amountequal
equaltotothe
theproportionate
proportionateshare
shareofofthethe
stockholders’ equity of the investee company. Substantial assets and
stockholders’ equity of the investee company. Substantial assets and liabilities may liabilities may
not
notbe berecorded
recordedon onbalance
balancesheetsheetunless
unlessthe
theinvestee
investeeisisconsolidated.
consolidated.
–– Investment
Investment earnings should be distinguished from core operatingearnings
earnings should be distinguished from core operating earnings(unless
(unless
strategic).
strategic).
–– Investments
Investmentsare arereported
reportedatatadjusted
adjustedcost,
cost,not
notatatmarket
marketvalue.
value.
–– Should
Shoulddiscontinue
discontinueequity
equitymethod
methodwhenwheninvestment
investmentisisreduced
reducedtotozero
zeroandandshould
should
not provide for additional losses unless the investor has guaranteed
not provide for additional losses unless the investor has guaranteed the obligations the obligations
ofofthe
theinvestee
investeeor orisisotherwise
otherwisecommitted
committedtotoproviding
providingfurther
furtherfinancial
financialsupport
supporttoto
the
theinvestee.
investee.
•• Resumes
Resumesonce onceall allcumulative
cumulativedeficits
deficitshave
havebeen
beenrecovered
recoveredvia viainvestee
investee
earnings.
earnings.
–– Excess
Excessofofinitial
initialinvestment
investmentover overthe
theproportionate
proportionateshare
shareofofthe
thebook
bookvalue
valueisis
allocated
allocatedtotoidentifiable
identifiabletangible
tangibleandandintangible
intangibleassets
assetsthat
thatare
are
depreciated/amortized
depreciated/amortized over their respective useful lives. Investmentincome
over their respective useful lives. Investment incomeisis
reduced
reducedby bythis
thisadditional
additionalexpense.
expense.The Theexcess
excessnot notallocated
allocatedininthis
thismanner
mannerisis
treated
treatedas asgoodwill
goodwilland andisisnonolonger
longeramortized.
amortized.
 5-21

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
 5-22

Business Combinations
Accounting for Business Combinations

•• Purchase
Purchase method
method of
of accounting
accounting
–– Companies
Companiesarearerequired
requiredto torecognize
recognizeonontheir
theirbalance
balancesheets
sheetsthe
the
fair
fairmarket
marketvalue
valueofofthe
the(tangible
(tangibleand
andintangible)
intangible)assets
assetsacquired
acquired
together
togetherwith
withthe
thefair
fairmarket
marketvalue
valueof
ofany
anyliabilities
liabilitiesassumed.
assumed.
•• Tangible
Tangibleassets
assetsare aredepreciated
depreciatedand andthe
theidentifiable
identifiableintangible
intangibleassets
assets
amortized
amortizedoverovertheir
theirestimated
estimateduseful
usefullives.
lives.
•• Excess
Excessofofinitial
initialinvestment
investmentoveroverthe
theproportionate
proportionateshare
shareofofthe
thebook
book
value
valueisisallocated
allocatedtotoidentifiable
identifiabletangible
tangibleand
andintangible
intangibleassets
assetsthat
thatare
are
depreciated/amortized
depreciated/amortizedover overtheir
theirrespective
respectiveuseful
usefullives.
lives.
•• The
Theexcess
excessnot notallocated
allocatedininthis
thismanner
mannerisistreated
treatedasasgoodwill
goodwilland
andisis
no
nolonger
longeramortized.
amortized.
 5-23

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
Aggregationofofassets,
assets,liabilities,
liabilities,revenues,
revenues,and
and
expenses
expensesofofsubsidiaries
subsidiarieswith
withthe
the parent
parent
  
Elimination
Eliminationof
ofintercompany
intercompanytransactions
transactions
(and
(andaccounts)
accounts)between
betweensubsidiaries
subsidiariesandandthe
theparent
parent
    
Note:Minority
Note: Minorityinterest
interestrepresents
representsthetheportion
portionof
ofaasubsidiary’s
subsidiary’sequity
equity
securities
securitiesowned
ownedby byother
otherthan
thanthe
theparent
parentcompany
company
 5-24

Business Combinations
Consolidation Illustration
On
OnDecember
December31,31,Year
Year1,
1,Synergy
SynergyCorp.
Corp.purchases
purchases100%100%of
of
Micron
MicronCompany
Companyby byexchanging
exchanging10,000
10,000shares
sharesofofits
itscommon
common
stock
stock($5
($5par
parvalue,
value, $77
$77market
marketvalue)
value)for
forall
allof
ofthe
thecommon
common
stock
stockof
ofMicron.
Micron.

On
Onthe
thedate
dateof ofthe
theacquisition,
acquisition,the
thebook
bookvalue
valueof
ofMicron
Micronisis
$620,000.
$620,000.Synergy
Synergyisiswilling
willingto
topay
paythe
themarket
marketprice
priceofof$770,000
$770,000
because
becauseititfeels
feelsthat
thatMicron’s
Micron’sproperty,
property,plant,
plant,and
andequipment
equipment
(PP&E)
(PP&E)isisundervalued
undervaluedby by$20,000,
$20,000,itithas
hasananunrecorded
unrecorded
trademark
trademarkworth
worth$30,000
$30,000and
andintangible
intangiblebenefits
benefitsofofthe
thebusiness
business
combination
combination(corporate
(corporatesynergies,
synergies,market
marketposition,
position,and
andthe
thelike)
like)
are
arevalued
valuedatat$100,000.
$100,000.
 5-25

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
5-26
 5-27

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.
 5-28

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.
 5-29

Business Combinations
Impairment of Goodwill
•• Goodwill
Goodwillrecorded
recordedin inthe
theconsolidation
consolidationprocess
processis issubject
subjecttoto
annual
annualreviewreviewforforimpairment.
impairment.
–– The
Thefairfairmarket
marketvalue
valueof ofMicron
Micronisiscompared
comparedwith withthe
thebook
bookvalue
value
ofofits
itsassociated
associatedinvestment
investmentaccount
accounton onSynergy’s
Synergy’sbooks.
books.
–– IfIfthe
thecurrent
currentmarket
marketvalue
valueisisless
lessthan
thanthe
theinvestment
investmentbalance,
balance,
goodwill
goodwillisisdeemed
deemedto tobe
beimpaired
impairedand andananimpairment
impairmentloss lossmust
must
beberecorded
recordedininthe
theconsolidated
consolidatedincome
incomestatement.
statement.
–– Impairment
Impairmentloss lossreported
reportedas asaaseparate
separatelinelineitem
itemininthe
theoperating
operating
section
sectionof ofSynergy’s
Synergy’sconsolidated
consolidatedincomeincomestatement.
statement.
–– AAportion
portionof ofthe
thegoodwill
goodwillcontained
containedininSynergy’s
Synergy’sinvestment
investment
account
accountisiswritten
writtenoff,
off,and
andthe
thebalance
balanceof ofgoodwill
goodwillininthe
the
consolidated
consolidatedbalance
balancesheet
sheetisisreduced
reducedaccordingly.
accordingly.
 5-30

Business Combinations
Issues in Business Combinations

Contingent
ContingentConsideration
Consideration--aacompanycompanyusually
usuallyrecords
recordsthetheamount
amountof of
any
anycontingent
contingentconsideration
considerationpayable
payablein inaccordance
accordancewith withaapurchase
purchase
agreement
agreementwhen whenthe thecontingency
contingencyisisresolved
resolvedandandthetheconsideration
considerationisis
issued
issuedororissuable.
issuable.
Allocating
AllocatingTotalTotalCostCost--once
onceaacompany
companydetermines
determinesthe thetotal
totalcost
costof
ofan
an
acquired
acquiredentity,
entity,ititis
isnecessary
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 is
recorded
recordedas 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.PendingPendingaccounting
accountingstandard
standardwill
willrequire
requirecapitalization
capitalization
of
ofIRR&D
IRR&Dand andannual
annualtesting
testingfor
forimpairment.
impairment.
Debt
Debtin inConsolidated
ConsolidatedFinancialFinancialStetements
Stetements--Liabilities
Liabilitiesin
in
consolidated
consolidatedfinancial
financialstatements
statementsdo donot
notoperate
operateas asaalien
lienupon
uponaacommon
common
pool
poolofofassets.
assets.
 5-31

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
goodwillisisnotnot
permanent
permanentand andthe
thepresent
presentvalue
valueof
ofsuper
superearnings
earningsdeclines
declinesas asthey
theyextend
extend
further
furtherinto
intothe
thefuture
future––future
futureimpairment
impairmentlosses
lossesarearelikely
likely
  
Push
Push‑‑Down
DownAccounting
Accounting --aacontroversial
controversialissue
issueisishow
how the theacquired
acquired
company
company(from
(fromaapurchase)
purchase)reports
reportsassets
assetsand
andliabilities
liabilitiesininits
itsseparate
separate
financial
financialstatements
statements(if(ifthat
thatcompany
companysurvives
survivesasasaaseparate
separateentity)
entity)
 5-32

Business Combinations
Additional Limitations of Consolidated Financial Statements
•• Financial
Financialstatements
statementsof ofthe
theindividual
individualcompanies
companiescomposing
composingthe the
larger
largerentity
entityare
arenotnotalways
alwaysprepared
preparedon onaacomparable
comparablebasis.
basis.
•• Consolidated
Consolidatedfinancial
financialstatements
statementsdo donotnotreveal
revealrestrictions
restrictionsononuse
useof
of
cash
cashfor
forindividual
individualcompanies.
companies.Nor Nordodothey
theyreveal
revealintercompany
intercompanycash cash
flows
flowsororrestrictions
restrictionsplaced
placedononthose
thoseflows.
flows.
•• Companies
Companiesininpoor poorfinancial
financialcondition
conditionsometimes
sometimescombine
combinewith with
financially
financiallystrong
strongcompanies,
companies,thusthusobscuring
obscuringanalysis.
analysis.
•• Extent
Extentofofintercompany
intercompanytransactions
transactionsisisunknown
unknownunless
unlessthethe
procedures
proceduresunderlying
underlyingthe theconsolidation
consolidationprocess
processarearereported.
reported.
•• Accounting
Accountingfor forthe
theconsolidation
consolidationof offinance
financeand andinsurance
insurancesubsidiaries
subsidiaries
can
canpose
poseseveral
severalproblems
problemsfor foranalysis.
analysis.Aggregation
Aggregationof ofdissimilar
dissimilar
subsidiaries
subsidiariescancandistort
distortratios
ratiosand
andother
otherrelations.
relations.
 5-33

Business Combinations
Consequences of Accounting for Goodwill
•• Superior
Superiorcompetitive
competitiveposition
positionisissubject
subjectto
tochange.
change.
–– Goodwill
Goodwillisisnot
notpermanent.
permanent.
•• Residual
Residualgoodwill
goodwill--measurement
measurementproblems.
problems.
•• Timing
Timingof ofgoodwill
goodwillwrite-off
write-offseldom
seldomreflects
reflectsprompt
promptrecognition
recognition
of
ofthis
thisloss
lossin
invalue.
value.
•• In
Inmany
manycases
casesgoodwill
goodwillisisnothing
nothingmore
morethan
thanmechanical
mechanical
application
applicationofofaccounting
accountingrules
rulesgiving
givinglittle
littleconsideration
considerationto to
value
valuereceived
receivedininreturn.
return.
•• Goodwill
Goodwillon oncorporate
corporatebalance
balancesheets
sheetstypically
typicallyfails
failsto
toreflect
reflectaa
company’s
company’sentire
entireintangible
intangibleearning
earningpower
power
 5-34

Business Combinations
Pooling Accounting
•• Used
Usedprior
priorto
tothe
thepassage
passageofofthe
thecurrent
currentbusiness
business
combination
combinationaccounting
accountingstandards.
standards.
–– Disallowed
Disallowedfor
forcombinations
combinationsinitiated
initiatedpost
postJune
June30,30,2001.
2001.
–– Companies
Companiesmay maycontinue
continueits
itsuse
usefor
foracquisitions
acquisitionsaccounted
accountedfor
for
under
underthat
thatmethod
methodprior
priorto
tothe
theeffective
effectivedate
dateofofthe
thestandard.
standard.

Under
Underthe
thepurchase
purchasemethod,
method,thetheinvestment
investmentaccount
accountisisdebited
debitedfor forthe
the
purchase
purchaseprice.
price.Under
Underthethepooling
poolingmethod,
method,this
thisdebit
debitisisininthe
theamount
amount
of
ofthe
thebook
bookvalue
valueofofthe
theacquired
acquiredcompany.
company.Assets
Assetsare
arenotnotwritten
writtenup
up
from
fromthe
thehistorical
historicalcost
costbalances
balancesreported
reportedon
onthe
theinvestee
investeecompany
company
balance
balancesheet,
sheet,nononew
newintangible
intangibleassets
assetsare
arecreated
createdininthe
the
acquisition,
acquisition,and
andnonogoodwill
goodwillisisreported.
reported.The
Theavoidance
avoidanceof ofgoodwill
goodwill
was
wasthe
theprinciple
principleattraction
attractionofofthis
thismethod.
method.
 5-35

Derivative Securities

Background

Hedges
Hedgesare arecontracts
contractsthat
thatseek
seekto
toinsulate
insulatecompanies
companiesfrom
frommarket
marketrisks—
risks—
securities
securitiessuch
suchas
asfutures,
futures,options,
options,and
andswaps
swapsare
arecommonly
commonlyused
usedas
as
hedges
hedges
  
Derivative
Derivativesecurities,
securities,ororsimply
simplyderivatives
derivativesare arecontracts
contractswhose
whose
value
valueis
isderived
derivedfrom
fromthe
thevalue
valueofofanother
anotherasset
assetororeconomic
economicitem
itemsuch
suchas
asaa
stock,
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
partiestotothe
thederivative
derivativecontract
contract
fail
failto
tounderstand
understandthetherisk
riskexposures
exposures
 5-36

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

Swap
Swapcontract—an
contract—anagreement
agreementbetween
betweentwo
twoorormore
moreparties
partiestotoexchange
exchange
future
futurecash
cashflows.
flows.ItItisiscommon
commonfor
forhedging
hedgingrisks,
risks,especially
especiallyinterest
interestrate
rate
and
andforeign
foreigncurrency
currencyrisks.
risks.

Option
Optioncontract—grants
contract—grantsaaparty partythe
theright,
right,not
notthe
theobligation,
obligation,to
toexecute
executeaa
transaction.
transaction.AAcall
calloption
optionisisaaright
rightto
tobuy
buyaasecurity
security(or
(orcommodity)
commodity)at ataa
specific
specificprice
priceon
onororbefore
beforethethesettlement
settlementdate.
date.AAput
putoption
optionisisan
anoption
optionto
to
sell
sellaasecurity
security(or
(orcommodity)
commodity)at ataaspecific
specificprice
priceon
onororbefore
beforethe
the
settlement
settlementdate.
date.
 5-37

Derivative Securities
 5-38

Derivative Securities
 5-39
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.
 5-40

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.
5-41
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.
 5-42

The Fair Value Option

Analysis Implications
• Reliability of fair value measurements
• Opportunistic adoption of ASC 825-10-25
– 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.