4250-Module 9

Accounting for Acquired Intangible Assets Subsequent to Acquisition— Heinz —

1 Once recognized, intangible assets with definite useful lives are amortized over their remaining lives. -or example, Heinz will amortize the customer relationships over 29 years. 2.Other intangible assets that are considered to be indefinite-lived assets (such as the indefinite-lived trademarks) remain on the balance sheet at their initial value. 3.These assets are tested annually for impairment and written down accordingly, similar to the accounting for all fixed assets and goodwill.

Accounting for Investments with Control-Under the equity method, the investor's

1. Investment balance represents the proportion of the investee's equity owned by the investor, and the 2. Investor company's income statement includes its proportionate share of the investee's income. Once controlover the investee company is achieved, GAAP requires consolidationfor financial statements issued to the public (but not for the internal financial records of the separate companies).

Equity Method Accounting Issues (part 1)

1. There can be a substantial difference between the book value of an equity method investment and its fair value. -An increasein value is not recognized until the investment is sold. -If the fair value of the investment has permanently declined, the investment is deemed impaired and written down to that lower fair value.

Held-To-Maturity (HTM) Debt Securities (part 2)

1.The company records the investment at its acquisition cost (like any other asset) and amortizes any discount or premium over the remaining life of the held-to-maturity investment. 2. At any point in time, the acquirer's balance sheet carries the investment at "amortized cost," which is never adjusted for subsequent market value changes.

Equity Method Accounting Issues (part 2)

2. Recognition of equity income by the investor does not mean it has received that income in cash. -Cash is only received if the investee pays a dividend. -The investor's statement of cash flows will include a reconciling item (a deduction from net income in computing operating cash flow) for its percentage share of the investee's net income. -This is typically reported net of any cash dividends received.

Consolidation Summarized-Intercompany sales

All intercompany sales and expenses, and receivables and payables, are eliminated in the consolidation process to avoid double counting. -For example, when goods are sold from the investee (called a subsidiary) to the investor (called the parent company) for resale to the parent's ultimate customers.

Consolidation Summarized

Consolidation accounting includes: -100% of the investee's assets and liabilities on the investor's balance sheet and -100% of the investee's sales and expenses on the investor's income statement.

Analysis Implications-FL

Financial leverage (FLEV =Net nonoperating obligations/Average equity). 1.Financial leverage is understated due to the absence of investee liabilities in the numerator.

Analysis Implications-NOAT

Net operating asset turnover (NOAT =Sales/Average NOA). 1. Investee's sales are excluded from the NOAT numerator, and net operating assets in excess of the investment balance are excluded from the denominator. 2. This means the impact on NOAT is indeterminate.

Equity Method Accounting Summary-Investments

are recorded at their purchase cost

Equity Method Accounting Summary-Dividens

received are treated as a recovery of the investment and, thus, reduce the investment balance (dividends are not reported as income).

Passive Investments in Marketable Securities

-Marketable securities are financial instruments that can be bought and sold on a public exchange. -

Intercorporate Equity Investments

-It is common for one company to purchase the voting stock of another. -The level of ownership interest the investor (the purchaser) acquires, directly affects the level of influence or control the investor has over the investee company (the company whose securities are purchased).

Accounting for Acquired Intangible Assets-Common types of intangible assets recognized during acquisitions

-Marketing-related assets such as trademarks and Internet domain names -Customer-related assets such as customer lists and customer contracts -Artistic-related assets such as plays, books, and videos -Contract-based assets such as licensing, lease contracts, and franchise and royalty agreements -Technology-based assets such as patents, in-process research and development, software, databases, and trade secrets

Non-Marketable Equity Securities

-Non-marketable equity securitiesrefers to the stock of privately held companies with no publicly available stock price. 1.Despite these securities being non-marketable, the new accounting standard requires companies to report them on the balance sheet at fair value. 2. This requires companies to obtain necessary cash flow information and other data to support a Level-3 valuation, a time-consuming and imprecise process. 3. Consequently, the new rules give companies the option to measure their non-marketable equity investments at cost, plus or minus changes resulting from observable price changes in orderly transactions for an identical or similar investment of the same issuer.

ROE and Equity Method Accounting

-ROE is unaffected by equity method accounting because the correct amount of investee net income and equity is included in the ROE numerator and denominator, respectively. -Still, the evaluation of the quality of ROE is affected. 1.Analysis using reported equity method accounting numbers would use an overstated NOPM and an understated FLEV because the numbers are based on net balance sheet and net income statement numbers. 2.As we discuss in a later module, analysts should adjust reported financial statements for these types of items before conducting analysis.

Significant Influence

-Significant influence is the ability of the investor to affect the financing, investing, and operating policies of the investee. -Ownership levels of 20% to 50% of the outstanding common stock of the investee typically convey significant influence. -Significant influence can also exist when ownership is less than 20%. Evidence of such influence can be that 1.The investor company is able to gain a seat on the board of directorsof the investee, or 2.The investor controls technical know-how or patents that are used by the investee, or 3.The investor is able to exert significant influence by virtue of legal contracts with the investee.

Accounting for Acquired Intangible Assets-The purchase price is first allocated to the assets acquired and the liabilities assumed.

-Tangible assets, such as PPE and inventory, are identified and valued. -Then, intangible assets are identified and valued. -All these assets are recorded on the acquirer's consolidated balance sheet at fair market value just like any other purchased asset. -Finally, any excess purchase price is allocated to Goodwill.

Levels of Influence or Control-Significant influence.

-The investor can exert "significant influence" over the investee by virtue of the percentage of the outstanding voting stock it owns or owing to legal agreements between the investor and investee, such as a license to use technology. -Absent evidence to the contrary, significant influence is presumed when the investor owns between 20% and 50% of the outstanding voting shares.

Levels of Influence or Control-Little or no influence (passive investments).

-The investor has a relatively small investment and cannot exert influence over the investee. -Generally, the investor is deemed to have little to no influence if it owns less than 20% of the investee's outstanding voting stock.

Indicators of Control-economic powers

-The investor has the ability to influence the investee's decision making. -The investor can influence the investee's financial results through contractual rights and obligations. -The investor is exposed to variable returns; that is, the investor will absorb any losses as well as benefit from any gains. -The investor has the right to receive residual returns.

Equity Method Accounting Summary-Income reporting

-The investor reports income equal to its percentage share of the investee's reported net income; 1. The investment account is increased by the percentage share of the investee's income or 2. Decreased by the percentage share of any loss.

Levels of Influence or Control-Control.`

-When a company has control over an investee, it has the ability to elect a majority of the board of directors and, as a result, the ability to affect the investee's strategic direction and the hiring of executive management. -Control is generally presumed if the investor company owns more than 50% of the outstanding voting stock of the investee company but can sometimes occur at less than 50% stock ownership by virtue of legal agreements, technology licensing, or other contractual means. -The determining factor is the ability to control strategic decisions.

Passive Investments in Marketable Securities-Acquisition and Sale

-When a company makes a passive investment, it records the shares acquired on the balance sheet at fair value; that is, the purchase price. -When investments are sold, any recognized gain or loss on sale is equal to the difference between the proceeds received and the book (carrying) value of the investment on the balance sheet as follows.

Investments Adjusted to Fair Value-All passive investments

-in equity securities where there is a readily determinable fair value are reported on the balance sheet at fair value. -Changes in the fair value of the investment during the accounting period are reported in earnings. --This is a relatively new accounting treatment that is effective in 2018. --Our discussion takes the new standard as a given and we describe the previous standard below.

Consolidation of Foreign Subsidiaries (Cumulative Translation Adjustment)-Foreign subsidiaries

-that are headquartered outside of the U.S. typically conduct business and maintain their accounting records in their own domestic currencies rather than in U.S. dollars. Before the U.S. parent company can consolidate the foreign subsidiary, the foreign currency denominated financial statements must be translated into $US. As the $US value of foreign subs assets and liabilities increase or decrease, Stockholders' equity will increase or decrease as well. -The change in Stockholders' equity is called the translation adjustment -The cumulative translation adjustment account is included in the Accumulated Other Comprehensive income (AOCI)account as a component of Stockholders' equity.

Definitions of Fair Value

Assets and liabilities recorded at fair value are measured in one of three ways based on the 1.Level 1.Quoted market prices if the security is traded in active markets. 2.Level 2.Quoted market prices in active markets for similar securities and model-based valuation techniques for which all significant inputs are observable in the market or can be derived from observable market data. 3.Level 3.Unobservable inputs that are supported by little or no market activities.

Analysis Implications

Because the assets and liabilities are left off the investor's balance sheet, and because the sales and expenses are omitted from the investor's income statement, the components of ROE are markedly affected as follows.

Equity Method Accounting Summary- Change in fair value

Changes in fair value do not affect the investment's carrying value.

Accounting for Investments with Significant Influence

Companies must use the equity method when significant influence exists. -The equity method reports the investment on the balance sheet at an amount equal to the percentage of the investee's equity owned by the investor (hence, the name equity method).

Purchase Price > Book Value

Companies often pay more than book value when they make equity investments.

Investments in Debt Securities

Companies often purchase debt securities, including 1.Corporate bonds, U.S. government agency bonds, and Municipal securities. 2.Companies can choose to classify investments in debt securities as either: -Trading securities. Changes in fair value reflected in current income. -Available-for-sale securities. Changes in fair value deferred in Accumulated other Comprehensive Income. -Held-to-maturity securities.Changes in fair value not reflected in either the balance sheet nor the income statement.

Indicators of Control

Controlis exercised through economic power.

Indicators of Control(continued)

If these items are in play, the investment is a variable interest entity (VIE) where the investor is the primary beneficiary. -All VIEs must be consolidated. If the VIE test is not met, there is a second test: the voting interest test. -If the investor holds more than 50% of the voting stock of the investee, then economic control is in evidence and the investment must be consolidated.

Analysis Implications-NOPAT

Net operating profit margin (NOPM =NOPAT/Sales). 1. Most analysts include equity income (sales less expenses) in NOPAT because it relates to operating investments. 2. However, investee's sales are not included in the NOPM denominator. 3. The reported NOPM is, thus, overstated.

Held-To-Maturity (HTM) Debt Securities

The cost method applies to held-to-maturity securities. -Changes in fair value of held-to-maturity securities do not affect either the balance sheet or the income statement. 1. The presumption is that these investments will indeed be held to maturity, at which time their market value will be exactly equal to their face value. 2.Fluctuations in fair value, as a result, are less relevant.

Other Comprehensive Income (or Loss)

The year-over-year change in AOCI is formally called other comprehensive income (or loss).