Finance test 3

Pension Obligation (Liability)

Projected Benefit Obligation (PBO): Actuarially determined present value of estimated retirement payments to employees. Calculated according to the benefit formula (using expected future salary levels). Discount rate used is the rate at which an outside party would effectively settle the obligation.

Distributions to shareholders:

are simply a transfer (usually of cash) to shareholders of a portion of what they really own, namely, net assets of the firm

Subscription Agreement:

- A strategy to market shares in initial public offerings. - Is an agreement whereby the companies agree to issue shares in the future and potential buyers agree to pay for the shares in the future. - Results in subscription receivable to the extent cash is not collected when subscription agreement is reached. 1. As common equity: fair value of subscribed shares. 2. As contra-equity: fair value of the subscriptions receivable.

Software development costs:

- Accounting: 1. until "technological feasibility" is achieved, all costs incurred internally are expensed. 2. On achieving "technological feasibility": capitalized and additional costs are subsequently amortized. - Area of caution for analyst: computer software development costs

Goodwill in corporation acquisition:

- Acquiring firms allocate purchase price to: Step 1: the fair value of identifiable tangible assets and liabilities Step 2: identifiable intangible assets Step 3: remainder is allocated to goodwill - Mangers' choice of acquisition costs allocation: investing-like activities such as R&D, pre-technological feasibility software costs, etc., are expensed

Alternative share-based compensation: cash-settled share-based plan

- Are compensation plans that provide cash compensation to employees based on share-price appreciation. - Often called stock appreciation rights plans. - Accounting for estimated cash payments: 1. An increase in operating liability 2. A corresponding increase in compensation expense

Stock split:

- Are distributions => 100% - Accounting: 1. Depends on appropriate state law. 2. Accounting rule: total par value after the stock split = total par value before the split

Non-controlling interests

- Arises if an investing firm acquires less than 100% of another firm. - Also termed as minority interest. - Disclosure -Income Statement: Is deducted from the net income of the parent. -Balance Sheet: A component of shareholders' equity of the parent. Subsidiary's fair value less book value at the date of acquisition is allocated to identifiable assets and to goodwill. Fair value amortization must be reflected in consolidated net income each year. Tax effect adjustment is not necessary for non-controlling interest as it is an after-tax net income.

Converting operations leases to capital leases:

- By analyst: 1. to avoid understanding the short-term liquidity or long-term solvency risk of the firm. 2. for various firms' cross-sectional comparisons. 3. if the purpose appears to be financing rather than acquisition. - provides a more conservative measure of liabilities. - balance sheet restatements are more significant than income statement restatements.

Accounting for Treasury Stock:

- Cost method - Accounting: 1. At repurchase: cash disbursement and increase in treasury stock account. 2. At subsequent issue: if reissue price is not equal to cost of treasury stock, increase (or decrease) additional paid-in capital. 3. Par value method (rarely used)

Stock Option: Elements and cash flows

- Elements of (theoretical) value of a stock option: 1. Benefit element 2. Time value element - Option events create two cash flows on exercise of an option: 1. Receipt of cash from employee. 2. Tax savings (tax deduction as per a recent FASB rule).

Alternative share-based compensation: restricted stock and RSUs

- Eliminates a manager's need to pay the exercise price. - Types: 1. Restricted stock: shares of stock rather than options are given, which cannot be traded until the vesting period is completed. 2. Restricted stock units (RSU): non-tradable rights for a number of shares of stock given once the vesting period is completed.

Replacement:

- Gain/loss on disposal or sale or trade-ins is reported in operating income. - cash inflow from sale of assets is reported in investing section of cash flow statement.

Stock options: accounting

- Grant date: no financial statement efforts occur. - Recognition of compensation expense: an increase in compensation expense (a decrease in net income, which is also a decrease in retained earnings) - Exercise: transfer of the stock option plus exercise price from employee to firm. - Expiration: the capital contributed to the firm by the manager's employee is reclassified as a permanent contribution to shareholders' equity. - Revocation: estimates must be revised going forward.

Troubled debt:

- Handing of troubled debt: from a debtor's perspective: settlement in cash or by issue of capital stock; modification of terms - Accounting: 1. Is conservative 2. Ignores the present value in restructuring model

Consolidated Financial Statements at the Date of Acquisition

- Investment in subsidiary - Subsidiary's equity accounts - Individual assets & liabilities of subsidiary - Goodwill - Acquisition "Reserves" Management has some latitude in managing earnings, given the estimates required to establish reserves.

Consolidated Financial Statements Subsequent to the Date of Acquisition

- Investment in subsidiary - Subsidiary's equity accounts - Individual assets & liabilities of subsidiary - Goodwill component to consolidated totals - Related-party transactions eliminations

Summary and interpretation of equity:

- Market-to-Book Ratio = market price per share/book value per share - Generally, market-to-book ratio > 1 because book value is less than market value due to: 1. Conservatism of accounting. 2. Not accounting for future growth opportunities

Investments by shareholders: preferred stock issuance

- Measurement: fair value - Accounting: the fair value received is split between two contributed capital accounts: 1. Preferred stock (par value) 2. Additional paid-in capital (amount of fair value received that exceeds par value) - Convertible into common shares or callable at scheduled dates (or at the firm's discretion).

Investments by shareholders: common equity issuance

- Measurement: fair value of what the corporation initially receives. - Accounting: the fair value received is split between two contributed capital accounts: 1. Common stock (par value) 2. Additional paid-in capital (amount of fair value received that exceeds par value) - Common shareholders bear both residual upside and downside risk, sometimes limited by contracts as under a special-purpose entity (SPE).

Earned capital:

- Net income and retained earnings - Accumulated other comprehensive income: e.g., unrealized fair value gains or losses on securities deemed available for sale, unrealized foreign currency gain or loss. - reserves: e.g., account titled reserve for contingencies

Equity issued as compensation: Stock options

- Stock options: 1. The right, or option, given by firms to employees. 2. To acquire shares of common stock. 3. At a fixed price (the market price of the stock at the time the firm grants the stock option) - Exercised at a later time if the stock price increases above the stock option exercise price. - A part of a sign-on or retention package. - No use of cash.

Accounting for cash, scrip, and property dividends:

- Total shareholders' equity: reduces retained earnings and reduces assets or increases current liabilities (if unpaid) - Retained earnings and contributed capital: changes.

Accounting for research and development costs:

- U.S. GAAP 1. Internally incurred r&D costs are expensed. 2. Externally acquired R&D are capitalized - for industries with high R&D expenditures, U.S. GAAP requirement to expense is troublesome - because a major asset never appears on the balance sheet. - IFRS 1. research costs are expensed. 2. product development costs are capitalized

Upward revaluation:

- U.S. GAAP does not permit upward revaluations. - IFRS allows revaluation of both tangible and intangible long-lived assets.

Stock options: fair value method and required disclosures

- Various pronouncements and methods of pricing: 1. Opinion No. 25 (1972): intrinsic value method 2. Statements No. 123 and No. 123 (revised 2004): fair value - Disclosure requirements as per Statement No. 123 (Revised 2004): 1. Stock options grants 2. Effect on total compensation expense 3. Methodology (model) used for valuation 4. Key assumptions for estimating the value

Cash-flows from acquisition of property, plant, and equipment:

- When cash is paid... 1. it is a cash outflow. 2. reported in the investing activities section of the statement of cash flows. - When debt is incurred or equity is issued... 1. it is a non-cash, investing and financing activity. 2. reported in a separate schedule, accompanying the statement of cash flows.

debt securities held-to-maturity:

- at amortized cost. - difference between acquisition cost and maturity value is an adjustment to interest revenue (effective interest rate method). - fair values are disclosed in notes.

financial reporting of long-term debt

- balance sheet: 1. maturity period > 1 year: long-term debt: at the present value of future cash flows. 2. maturity period <= 1 year, current liability - impacts current ratio drastically - to reduce the impact: sinking fund in liquid assets is set up to pay debt and entering into a refinance agreement

What Changes the FMV of Pension Plan Assets?

- cash contributions to plan assets by employers - actual return on plan assets - benefit payments to retirees

Derivative classification

- classified under U.S. GAAP and IFRS as: 1. speculative investments 2. fair value hedges 3. cash flow hedges

Costs of self-contruction:

- cost of self-constructed asset = fair value of all costs incurred to produce asset. - fair value includes materials, labor, and overhead (variable and fixed). - if internal expenditure > cost of acquiring externally: 1. amount = cost of external purchase. 2. excess costs incurred are recorded as loss

exploration costs:

- costs incurred to discover the existence and location of natural resource.

Accounting for acquisition of property, plant, and equipment:

- costs incurred to yield future benefits imply asset. - asset is recorded at fair value. - fair value includes cash paid, fair value of debt incurred, fair value of lease payments.

Acquisition costs:`

- costs of acquiring natural resources. - reclamation cost of restoration costs.

Debt financing:

- critical for understanding the profitability and risk of the firm. - reporting for debt involves: 1. principles of liability recognition: - involves a probable future sacrifice of economic benefits - a present obligation - transaction or event has already occurred 2. principles of liability valuation 3. application of criteria for liability recognition

Cost allocation methods:

- differences in methods: 1. US firms 2. use accelerated methods for tax purpose than for financial reporting purposes. 3. other countries. 4. accelerated method for both tax and financial reporting - analyst must restate the amounts - an addition to net income in the operating section of cash flows

Accounting quality issues and derivatives:

- fair market values reported for derivative instruments not reliable when active markets do not exist. - classification of derivatives as 'fair value' hedges versus 'cash flow' hedges by firms questionable. - different impact on earnings due to gains or losses from each kind of hedge

The use of derivatives to hedge interest rate risk:

- help a firm mitigate the following risks: 1. interest rate risk 2. foreign currency exchange rate risk 3. commodity price risk - nature and use 1. derive value from some other financial instrument 2. typically used to hedge against losses from above mentioned risks - their change in value offset changes in value of an asset or a liability, or changes in future cash flows, thereby neutralizing losses - reported as assets or liabilities depending on rights and obligations under a contract - must be revalued to fair value each period with revaluation amount affecting net income or some other compressive income

financing with long-term debt:

- in the form of: 1. notes payable (primarily to banks and other financial institutions) 2. bonds payable (to any type of bondholder, including open-market debt investors) 3. leases (entered into with property owners, equipment dealers, or finance companies) - is evidence by a bond indenture, promissory note, or lease agreement

Accounting for minority passive investments:

- initially recorded investments at acquisition cost. - interest and dividend received/receivable each year are recorded as revenue. - classification of securities.

investment categories:

- investments in long-lived operating assets: 1. long-lived tangible fixed assets 2. amortizable intangible assets 3. non-amortizable intangible assets - investments in the securities of other firms

available-for-sale:

- marked to market - unrealized gain or loss: as a part of OCI - sale of security: realized gain or loss on income statement and other than temporarily impaired securities.

trading security:

- marked-to-market - unrealized gain or loss: as a part of NI - sale of security: gain or loss (selling price less book value) in NI

Analysts approach to R&D costs:

- modify financial statements: 1. if the R&D costs have a future service potential, capitalize and subsequently amortize expenditures on R&D; else, expense. 2. when R&D costs are expensed - effect on ROA should be examined - look for volatility and growth 3. consolidate firms shares of R&D project for joint ventures and partnerships

cash flows of long-term debt

- net cash flow = cash inflow at issue - total cash interest - cash outflow at retirement date - terms: 1. coupon rates or stated rate 2. cash interest 3. effective interest (yield, yield-to-maturity, rate of return) - calculated by saving for I in: present value

financial reporting of long-term debt: pronouncements

- reporting under FASB (SFAS 159) and IASB (IAS 39): 1. financial liabilities and financial assets: options to value at fair value 2. instead of amortized cost 3. interest expense of such financial instruments: if nothing mentioned, effective interest rate method applied generally

Disclosures related to derivative instruments (FASB Statement 133):

- risk management strategy of the firm distinguishing the derivative instruments used. - net gains or losses under fair value and cash flow hedges due to ineffective hedging. - transactions resulting in re-classification of gains and losses from other comprehensive income to net income - net gains or losses when a: 1. hedged firm commitment no longer qualifies as a fair value hedge 2. hedged forecasted transaction no longer qualifies as a cash flow hedge

Additional Issues: Hybrid securities (i.e., compound financing instruments)

- securities have both debt and equity characteristics - methods of recording conversion under U.S. GAAP and IFRS 1. book value method 2. market value method (rarely used)

What Changes the Economic Status of the Plan?

- service cost - interest cost - prior service cost - actuarial gains and losses - benefit payment to retirees

Stock dividends:

- small stock dividends (<20-25%) - large stock dividends-

accounting for exploration costs:

- successful efforts method: 1. cost of successful wells are capitalized as assets; unsuccessful wells are expensed. 2. used by larger producers. - full costing method: 1. costs of successful and unsuccessful wells are capitalized 2. used by smaller producers

development costs:

- tangible costs (capitalized) - intangible costs (expensed)

New lease standard:

- the FASB's new lease standard took effect on Jan. 1, 2019. - the balance sheet reporting of operating leases changed so that a leased asset and lease liability will not appear. - this new reporting removed the need to effectively capitalize operating leases using footnote information

impact of accounting for operating leases as capital leases:

- though individually impact is relatively small, cumulatively can be significant - thus, it is important for analyst to: 1. assess the risk and accounting quality of a firm's financial statements. 2. determine the capital structure weights and debt costs for the weighted average cost of capital calculations in entity valuation

Treatment of hiding gains and losses:

- under fair value hedges: 1. gains and losses recognized in net income 2. asset or liability revalued with a corresponding amount. - under cash flow hedges: 1. gains and losses recognized in other comprehensive income. - gain or loss out of ineffective hedges included in net income - accumulated amount in other comprehensive income is transferred to net income periodically.

The declaration of dividends is formalized by three important dates:

1. Date of declaration 2. Date of record 3. Date of payment

Shareholders' equity is affected by:

1. Investment by shareholders 2. Distributions to shareholders 3. Profitable operating and investing activities

costs of acquiring intangible assets:

1. U.S. GAAP and IFRS: cost of internally developing intangibles is expensed. 2. Intangibles acquiring in a business combination have fair values and are capitalized. 3. Most analysts prefer immediate expensing of all intangible assets.

Benefits to lessees:

1. ability to shift the tax benefits 2. flexibility to change capacity 3. ability to reduce the risk of technological obsolescence 4. ability to finance the "acquisition" of an asset

types of costs:

1. acquisition costs 2. exploration costs 3. development costs

costs of acquiring natural resources for analysts:

1. analyst should consider the differential treatment of exploration costs. 2. firms disclose the method in accounting policies note to financial statements.

Managers make three primary choices:

1. choose an allocation method 2. estimated useful life 3. estimated salvage value

Conditions for a capital lease:

1. extends for at least 75 percent of the asset's total expected economic life. 2. transfers ownership to the lessee 3. the "bargain purchase" option will be used. 4. the present value of the contractual minimum lease payments equals or exceeds 90 percent of the fair market value of the asset at the time of signing

throughout the life of the asset, book value is tested for:

1. impairment under U.S. GAAP & IFRS (for intangible assets with indefinite life) 2. appreciation only under IFRS

Subsequent expenditures for enhancement or improvements:

1. involves additional expenditures to add or improve long-lived operating assets. 2. capitalize expenditures that increase service life beyond the original life of the asset. 3. expense repairs and maintenance to maintain expected service potential. 4. management judgment in this area creates opportunity for earnings management

reducing debt: early retirement

1. method of reducing debt 2. method to retire early 3. accounting - income statement: realized gain or loss: the difference between the amounts used to extinguish the debt and the book value of the debt. - cash flows from financing activities: cash flows used to reduce debt

Accounting methods for leases:

1. operating lease method 2. capital lease method

Reporting for research and development costs:

1. reported in the statement of cash flows as operating activity. 2. reduces current period net income

Accounting for majority, active investments:

Accounting for corporate acquisitions - SFAS 141,141R, 160 (FASB codification topics 805 and 810) and IFRS 3. Consolidated financial statements are prepared. Business combinations can be statutory mergers and acquisitions - acquisition method. - Goodwill Measure the fair value of the consideration transferred to acquire the company and the fair values of the identifiable assets acquired, liabilities assumed and non-controlling interests (if any). Assign any excess consideration to goodwill or record a gain from a bargain purchase.

Pension Benefit formula:

Annual Benefits=Annual Credit x Years of Service x Salary at Retirement Date

SG&A (Selling, General, and Administrative) Costs

Bear a less direct relationship with sales. Represent the consumption of assets and incurrence of liabilities to carry on corporate functions other than production. Examples: Advertising, Marketing, Administration, Accounting, Information systems, Warranty expense and Credit functions.

Benefits

Benefits provided by employers after employees retire. 'Pension Benefit' plans are sponsored by employers: -Employers place a certain percentage of employee's earnings into an investment vehicle as specified by employee. -Employer's obligation under the plan is satisfied once funds are placed into the investment account. -Fund balance at retirement depends on the investing success of the investment company.

Special-Purpose or Variable-Interest Entity (VIE)

Can be a corporation, partnership, trust or any other legal structures for business purpose. May be passive or active. The sponsoring firm would not consolidate a VIE under the percentage of ownership criterion. Also called a bankruptcy remote entity.

Consolidation of Unconsolidated Subsidiaries and Affiliates

Companies do not consolidate the financial statements of joint ventures or minority-owned affiliates. Under U.S. GAAP, firms use the equity method to account for joint ventures. IFRS permits use of proportionate consolidation for joint ventures.

Required Income Tax Disclosures (GAAP)

Components of deferred tax assets and liabilities -Uncollectible Accounts Receivable -Warranties -Pensions -Leases -Net operating losses -Net operating losses -Depreciable assets -Inventories -Installment receivables -Intangible Drilling and Development Costs Information regarding uncertain tax positions and related reserves. -Report reserves for the tax benefits of uncertain tax positions.

Components of income tax expense

Current expense -Deferred expense Reconciliation of income taxes at statutory rate with income tax expense -Reconciling tax rate differences -Permanent difference Content

Economic Status of Pension Plan

Determined by comparing two economic amounts: -Projected Benefit obligation -Fair market value of Plan Assets Economic status of plan reflected on the balance sheet: insert image Changes in the economic status of plan reported in comprehensive income.

Types of dividends:

Dividends are paid in the form of: 1. Cash 2. Scrip dividends (dividends with an interest-bearing promise to pay dividends) 3. Property dividends 4. Stock dividends 5. Liquidating dividends (where payments to shareholders exceed the retained earnings balance)

Operating Profit

Financial revenues and expenses along with equity in the earnings of affiliates are disclosed. Income tax expense is subtracted to obtain Net Income.

Consolidating VIE

Firm must consolidate if it is the primary beneficiary of the VIE. -FIN 46R- Firm is primary beneficiary if it has The direct or indirect ability to make decisions about the entity's activities. The obligation to absorb the entity's expected losses if they occur. The right to receive the entity's expected residual returns if they occur.

Characteristics of LIFO Adopters

Firms Following U.S. GAAP. -IFRS does not permit the use of LIFO Direction and Rate of Factor Price Changes for Inventory Items. -Rapidly increasing prices for raw materials, labor, or other product costs result in greater tax benefits from LIFO. Variability in the Rate of Inventory Growth. -LIFO adopters with variable rates of inventory growth can more easily accomplish an income-smoothing reporting objective using LIFO than if they use FIFO or average cost Tax Savings Opportunities. -LIFO adopters tend to adopt LIFO to provide future tax savings. Industry Membership. Asset Size. Industry Membership. -Firms in certain industries are more likely to adopt LIFO. Asset Size. -Larger firms are more likely to adopt LIFO than are smaller firms.

Restricted stock and RSUs accounting:

Grant date - Restricted stock: issue of common stock recorded - RSUs: no entry Recognition of compensation expense - Reduces retained earnings and reduces deferred compensation - a contra-equity account Expiration - Restricted stock: restrictions placed on trading already issued stock will be removed. RSUs: issue of common stock recorded.

5 Steps for Revenue Recognition:

Identify the contract with a customer. Identify the separate performance obligations in the contract. Determine the transaction price. Allocate the transaction price to the separate performance obligations in the contract. Recognize revenue when (or as) the entity satisfies a performance obligation.

Conversion from LIFO to FIFO

If LIFO inventory valuation results in low out-of-date inventory values, this reflects poor accounting information quality. Inventory turnover ratio based on LIFO gives poor indication of the actual inventory turnover. LIFO measure of the inventory turnover ratio does not accurately portray the number of days inventories are held if LIFO costs are very old.

accounting for minority, active investments:

Implied Goodwill Related Party Transactions -Sales, purchases, receivables & payables must be disclosed in notes to financial statements. -Profits arising from inter-company transactions should be eliminated. Reported at acquisition cost in non-IFRS statements.

Distributions to shareholders: share repurchases

Purpose: 1. To service the possible exercise of options. 2. To shift the mix of debt and equity financing. 3. To signal to investors that corporate management believes the stock is undervalued. 4. To tackle a takeover attempt.

Application of the New Revenue Recognition Method

Revenue models: Retail sales Sales of bundled products Sales with variable consideration Sales with warranties Sales with delayed delivery Principal-Agent relationships Long-term contracts

Working Capital Investments

Revenues and cash inflows are not necessarily equal. Cash inflows occurring after revenue is recognized results in: -Working capital asset or Accounts receivable. Cash inflows occurring before revenue is recognized results in: -Working capital liability or Deferred revenues. Inventory purchases affect Cash flow from operations due to: -Increase in Accounts Payable or -Decrease in Cash.

operating profit before tax =

Sales revenue - Cost of sales - SG&A expenses

Cost-Flow Assumptions by Firms

Should be ascertained by any analyst without regard to: -Rapid Inventory Turnover and Price Stability. -Liquidation of LIFO Inventory Layers. -Obsolete or Damaged Inventory. -Inventory Financing Arrangements.

Cost of Sales

Single largest expense for most retail and manufacturing firms. An expense is recognized when inventory is consumed. Expense recognition becomes difficult when unit costs are small and inventory items similar: -In such cases, cost of goods sold is measured by making assumptions about the flow of costs, i.e., LIFO, FIFO, Average Cost.

Corporate Acquisitions and Income Taxes

The acquired company does not restate its assets & liabilities for tax purpose. The tax basis of assets & liabilities of the acquired company before acquisition carries over after the acquisition, called nontaxable reorganization. Deferred taxes would be recognized as a difference between fair and book values.

Accounting for stock dividends:

Total shareholders' equity: as per accounting rules and jurisdictional legal requirements. Retained earnings and contributed capital: no change

Foreign Currency Translation

Types of Foreign Entities -A foreign entity operates as a self-contained & integrated unit (All current method). -The operations of a foreign entity are a direct & integral extension of the parent company's operations (Monetary/Non-monetary methods). Exception to these guidelines - U.S. GAAP -If the foreign entity operates in a highly inflationary country (FASB Statement No.52).

Market value vs. book value: impairment of goodwill

U.S. GAAP - record impairment if: carrying amount > fair value of reporting unit. - implied goodwill = fair value of reporting unit - fair value of identifiable assets IFRS: - record impairment if: carrying amount > recoverable amount (higher or fair value or sale) - implied goodwill = fair value of reporting unit - fair value of identifiable assets

Grant Date:

a firm gives a stock option to an employee.

Investment activities:

includes acquisition of long-term tangible and intangible assets and disposition of assets.

minority, active investments:

between 20 and 50 percent ownership

IFRS impairment charge =

book value - [higher of (fair value less estimated costs to sell) or (present value of estimated future cash flows)]

Tangible development costs:

capitalized as part of the equipment (or another property, plant, and equipment) account

intangible development costs:

capitalized as part of the natural resources account, because the costs are not separable from the natural resource

U.S. GAAP Record impairment if:

carrying amount > undercounted cash flows from the asset - impairment charge = carrying value - fair value

change in estimate:

changes current and future depreciation expense. no retroactive change in past expense

Exercise date:

date on which employees elect to exchange the options plus cash for shares of common stock.

Vesting Date:

earliest date at which employees can exercise their stock options.

majority, active investments:

greater than 50 percent ownership

Minority, passive investments:

less than 20 percent ownership

Treasury stock:

stock repurchased for reissue at a later date

Book value of shareholders' equity:

the amount of shareholders' equity reported in the balance sheet. It is the investment base for equity/net assets used in profitability analysis, risk analysis and residual income-based equity valuation.

A gain on debt settlement:

the difference between the book value of the debt settled (principal plus any accrued interest) and the fair market value of the non-cash asset or cash transferred to retire the debt

Compensation expense:

the fair value of stock options as the grant date

Market price:

the price of the stock as it trades in the market

Exercise price:

the price specified in the stock option contract for purchasing the common stock.

To report higher earnings:

useful lives or salvage value of assets are revised upward.