Level 2 SS6

LOS 20.b:Explain and calculate measures of a defined benefit pension obligation

(i.e. present value of the defined benefit obligation and projected benefit obligation) and net pension liability (or asset).

goodwill: page 85

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There are four important effects on the balance sheet and income statement items that result from the choice of accounting method (in most situations):

1. All three methods report the same net income 2. equity and proportionate consolidation report the same equity. Acquisition method equity will be higher by the amount of minority interest. 3. Assets and liabilities are higher under the acquisition method and lowest under the equity method; proportionate consolidation is in-between. 4. sales are highest under the acquisition method and lowest under the equity method; proportionate consolidation is in-between. • usually, the equity method provides the most favorable results, acquisition the least favorable, with proportionate consolidation somewhere in-between, as shown in Figure 10.

Capitalizing Pension Costs

◦pension costs included in the cost of production of goods may be capitalized as part of the valuation of ending inventory. ◦When this inventory is eventually sold, such costs are expensed as a component of cost of gods sold.

Phantom Stock

◦phantom stock is similar to stock appreciation rights except the payoff is based on the performance of hypothetical stock instead of the firm's actual shares. ◦phantom stock can be used in privately held firms and firms with highly illiquid stock

Other Post-Employment Benefits

◦primarily healthcare benefits for retired employees, are similar to a defined benefit pension plan: the future benefit is defined today but is based on a number of unknown variables. ◦pension funds are typically funded at some level, but some others are not. In case of unfunded plan, the employer recognizes expense in the income statement as the benefits are earned; however, the employer's cash flow is not affected until the benefits are actually paid to the employee.

Qualifying Special Purpose Entities

◦prior to recent revisions, US GAAP permitted a sponsor to avoid consolidating asset securitizations by creating a qualifying special purpose entity (QSPE) .IFRS did not permit QSPEs. ◦A QSPE could only hold financial assets, usually receivables that were transferred from the sponsor. As a legally separate, independent entity, the QSPE had total control of the assets. ◦The sponsor was not expected to receive a beneficial interest, and the sponsor's financial risk was limited to its initial investment or recourse obligation- beyond reach of bankruptcy, not considered a QSPE. ◦when the sponsor removed the transferred assets from its balance sheet, gain or loss could be recognized in some cases.

Applying the current rate method

◦the current rate method is applied using the following procedures: ‣ all income statement accounts are translated at the average rate. ‣ all balance sheet accounts are translated at the current rate except for common stock, which is translated at the historical (actual) rate that applied when the stock was issued. ‣ Dividends are translated at the rate that applied when they were paid. ‣ Translation gain or loss is reported in shareholder's equity as a part of the cumulative translation adjustment (CTA)

Stock appreciation rights

◦the difference between a stock appreciation right and an option is the form of payment. ◦a stock appreciation award gives the employee the right to receive compensation based on the increase in the price of the firm's stock over a predetermined amount. ◦the firm might pay the appreciation in cash, equity, or a combination of both. ◦With stock appreciation rights, employees have limited downside risk and unlimited upside potential, thereby limiting the risk aversion problem discussed earlier. ◦also, since no shares are actually issued, there is no dilution to existing shareholders

Funded status of the plan

◦the difference in the benefit obligation and the plan assets is referred to as the funded status of the plan. ◦if the plan assets exceed the pension obligation, the plan is said to be "overfunded". Conversely, if the pension obligation exceeds the plan assets, the plan is "underfunded"

What does the firm disclose in its pension calculations?

◦the discount rate ◦he rate of compensation growth ◦the expected return on plan assets

Expected return on plan assets

◦the employer contributes assets to a separate entity (trust) to be used to satisfy the pension obligation in the future. ◦the return on the plan assets has no effect on the PBO. ◦however, the expected return on the assets reduces pension expense. ◦under IFRS, the expected return on plan assets is implicitly assumed to be the same as the discount rate used for computation of PBO. ◦hence, under IFRS, expected rate of return is not assumed and is not subject to managerial discretion. ◦the difference in the expected return and the actual return is combined with other items related to changes in actuarial assumptions into the "actuarial gains and losses" account.

Determining fair value (stock grants and stock options)

◦the fair value of the option is based on the observable market price of a similar option if one is available. ◦absent a market-based instrument, the firm can use an option-pricing model such as Black-Scholes or the binomial model. ◦there is no preference of a specific model in either IFRS or U.S. GAAP.

Balance Sheet Effects

◦the funded status reflects the economic standing of a pension plan: ‣ funded status = fair value of plan assets - PBO ◦the balance sheet presentation under both US GAAP and IFRS is as follows: ‣ balance sheet asset (liability) = funded status ‣ if the funded status is negative, it is reported as a liability. If the funded status is positive, it is reported as an asset subject to a ceiling of present value of future economic benefits (such as future refunds or reduced contributions)

How can foreign currency affect a multinational firm's financial statements?

◦the multinational firm may engage in business transactions that are denominated in a foreign currency ◦the multinational firm may invest in subsidiaries that maintain their books and records in a foreign currency.

Current Service Cost

◦the present value of benefits earned by the employees during the current period. Service cost includes an estimate of compensation growth (future salary increases) if the pension benefits are based on future compensation.

Presentation of pension expense

◦the presentation of pension expense differs between IFRS and US GAAP ◦under US GAAP, all components of net pension expense that are reported in the income statement are aggregated and presented as a single line item. ◦Under IFRS, components may be presented separately ◦both US GAAP and IFRS require disclosure of total pension expense in the notes to financial statements.

What are the accounting methods for business combinations?

◦the purchase method ◦pooling of interests method ◦but now only the acquisition method is required.

LOS 20 c. Describe the components of a company's defined benefit pension costs.

◦total pension expense (total periodic pension cost) for a period is the employers contribution adjusted for changes in funded status. ◦in other words, the expense to the company is either paid (via contributions) or deferred (via a decrease in the plan's funded status) ◦total periodic pension cost = employer contributions - (ending funded status - beginning funded status) ‣ the main difference between US GAAP and IFRS is the allocation of total periodic pension cost between the income statement and OCI

Transaction with the Investee

◦transactions can be described as upstreamed (investee to the investor) or downstream (investor to the investee) ‣ in an upstream sale, the investee has recognized all of the profit in its income statement. However, for profit that is unconfirmed (goods have not been used or sold by the investor), the investor must eliminate its proportionate share of the profit from the equity income of the investee. ‣ in a downstream sale, the investor has recognized all of the profit in its income statement. Like the upstream sale, the investor must eliminate the proportionate share of the profit that is unconfirmed. ‣ example: investor owns 30% of investee. during year, investor sold $40K of goods to investor for $50K. Investee sold 90% of the goods by year-end. investors profit is 10k (50-40). investee has sold 90% of the goods; thus, 10% of the profit remains in investees inventory. investor must reduce its equity income by the proportionate share of the unconfirmed profit of $300 (10K x 10% x 30% ownership). once investee sells the remaining inventory, investor can recognize $300 of profit

Adjustments for comparability: difference in assumption used:

◦two companies in same industry... both have defined benefit plan but assume different discount rates. ◦the company assuming a higher discount rate would be underestimating its pension liabilities (i.e. PBO) and underestimating pension expense (and hence reporting higher net income)

Business Combinations

◦under IFRS, business combinations are not differentiated based on the structure of the surviving entity. Under US GAAP business combinations are categorized as: ‣ merger: the acquiring firm absorbs all the assets and liabilities of the acquired firm, which ceases to exist. The acquiring firm is the surviving entity. ‣ acquisition: both entities continue to exist in a parent-subsidiary relationship. Recall that when less than 100% of the subsidiary is owned by the parent, the parent prepares consolidated financial statements but reports the unowned minority or non-controlling) interest on its financial statements. ‣ consolidation: a new entity is formed that absorbs both of the combining companies ‣ special purpose entities: A special purpose (or variable interest) entity is typically created for a single purpose by a sponsoring company. The equity investors may lack control and when control effectively remains with the sponsoring company. IFRS requires that the sponsor report the investment by consolidation.

Pooling of Interests method (AKA uniting of interests method)

◦under IFRS, combined the ownership interests of the two firms and viewed the participants as equals - neither firm acquired the other. ◦key attributes: ‣ two firms are combined using historical book values ‣ operating results for prior periods are restated as though the two firms were always combined ‣ ownership interest continue, and former accounting bases are maintained

Joint Ventures

◦under IFRS, proportionate consolidation is the preferred accounting method for joint ventures, although the equity method is permitted. Under US GAAP, the equity method is required except in very limited situations, primarily unincorporated entities in the construction industry. ◦proportionate consolidation is similar to a business acquisition, except the investor only reports the proportionate share of the assets, liabilities, revenues, and expenses of the joint venture. Since only the proportionate share is reported, no minority owners interest is necessary. ◦pg 86 for an example

Impairment of Financial Assets (US GAAP)

◦under US GAAP, a security is considered impaired if its decline in value is determined to be other than temporary. For both HTM and AFS securities, the write-down to fair value is treated as a realized loss (i.e. recognized on the income statement)

LOS 20.a: Describe the types of post-employment benefit plans and the implications for financial reports.

◦A defined contribution plan ◦Defined benefit plans

Option pricing models typically incorporate the following six inputs:

◦Exercise price ◦stock price as the grant date ◦expected term ◦expected volatility ◦expected dividends ◦risk-free rate

Reporting on financial assets (Designated at fair value)

◦firms can choose to report debt and equity securities that would otherwise be treated as held-to-maturity or available for sale securities at fair value. ◦designating financial assets and liabilities at fair value can reduce volatility and inconsistencies that result from measuring assets and liabilities using different valuation bases. ◦unrealized gains and losses on designated financial assets and liabilities are recognized on the income statement, similar to the treatment of held for trading securities. ‣ US GAAP uses the term "designated at fair value" while IFRS uses the term "fair value through profit or loss". On the exam, either term may be used and mean the same thing.

Acquisition method

◦all of the assets, liabilities, revenues and expenses of the subsidiary are combined with the parent. Intercompany transactions are excluded. ◦if parent owns less than 100% of the subsidiary, it is necessary to create a non-controlling (minority) interest account for the proportionate share of the subsidiary's net assets that are not owned by the parent.

Amortization of actuarial gains and losses

◦an increase or decrease in the PBO from a change in actuarial assumptions is combined with the deferred gains and losses that result from the differences between the expected return and actual return on plan assets. ◦combined, these are called actuarial gains and losses. ◦actuarial gains and losses are recognized in other comprehensive income (OCI) ◦under IFRS, actuarial gains and losses are not amortized. Under US GAAP; actuarial gains and losses are amortized using the corridor approach.

Stock Grants

◦compensation expense for stock granted to an employee is based on the fair value of the stock on the grant date. ◦The compensation expense is allocated over the employee's service period. ◦a stock grant can involve an outright transfer of stock without conditions, restricted stock, and performance stock. ‣ with restricted stock, the transferred stock cannot be sold by the employee until vesting has occurred. ‣ performance stock is contingent on meeting performance goals, such as accounting earnings or other financial reporting metrics like return on assets or return on equity. ‣ unfortunately, tying performance to accounting earnings and other metrics may result in manipulation of the accounting metric used.

Stock Options

◦compensation expense is based on the fair value of the options on the grant date based on the number of options that are expected to vest. ◦the vesting date is the first date the employee can actually exercise the options ◦the compensation expense is allocated in the income statement over the service period, which is the time between the grant date and the vesting date. ◦Recognition of compensation expense will decrease net income and retained earnings; however, paid-in capital is increased by an identical amount. This results in no change to total equity.

Adjustments for comparability: differences between IFRS and US GAAP in recognizing pension expense (in income statement vs. OCI)

◦could just simply use comprehensive income (i.e., net income plus OCI) as the metric for comparison

Exchange Rate Definitions

◦current rate: the exchange rate on the balance sheet date ◦average rate: the average exchange rate over the reporting period ◦historical rate: the actual rate that was in effect the original transaction occurred. For example, if a firm bought machinery on january 2, 2008, the historical rate for that transaction at every balance sheet date in the future would be the exchange rate on jan 2, 2008.

What are the different categories of intercorporate investments in marketable securities?

◦investments in financial assets (when the investing firm has no significant control over the operations of the investee firm) ◦investments in associates (when the investing firm has significant influence over the operations of the investee firm, but not control ◦business combinations (when the investing firm has control over the operations of the investee firm)

Inventory and COGS under the temporal method

• historical rate is the actual rate in effect when the original translation occurred... so can have many with all the different assets over time. also cost flow assumption must also be considered. • ending inventory under FIFO has most recent costs - thus fifo ending inventory is remeasured based on more recent exchange rates. One other hand, FIFO COGS consists of costs that are older; thus, the exchange rates used to remeasure COGS are older • under LIFO, ending inventory consists of older cots; thus the inventory is remeasured at older exchange rates. LIFO COGS, however, consists of costs from the most recently purchased goods, thus, cogs is remeasured based on more recent exchange rates. • weighted average method, ending inv and cogs are measured at the weighted average exchange rate for the period.

Adjustments for comparability: Gross vs. net pension assets/liabilities

• there are two reasons for netting pension assets and liabilities ◦the employer largely controls the plan assets and the obligation and, therefore, bears the risks and potential rewards. ◦the company's decisions regarding funding and accounting for the pension plan are more likely to be affected by the net pension obligation, not the gross amounts, because the plan assets can only be used for paying pension benefits to its employees. ◦this netting process causes ROA to be higher and lower leverage numbers.

Reclassification of Investments in Financial Assets

◦IFRS typically says no ◦debt securities classified as available for sale can be reclassified as held to maturity if the holder intents to (and is able to) hold the debt to its maturity date. the security's balance sheet value is remeasured to reflect its fair value at the time it is reclassified. Any difference between this amount and the maturity value, and any gain or loss that had been recorded in other comprehensive income, is amortized over the security's remaining life. ◦held to maturity securities can be reclassified as available for sale if the holder no longer intends or is no longer able to hold the debt to maturity. The carrying value is remeasured to the security's fair value, with any difference recognized in other comprehensive income. ◦GAAP: does permit securities to be reclassified into or out of held-for trading or designated at fair value. ‣ unrealized gains are recognized on the income statement at the time the security is reclassified. ‣ for investments transferring out of available-for-sale category into held for trading category, the cumulative amount of gains and losses previously recorded under other comprehensive income is recognized in income. ‣ for a debt security transferring out of available for sale category into held to maturity category, the cumulative amount of gains and losses previously recorded under other comp income is amortized over the remaining life of the security. ‣ for transferring investments into available for sale category from held to maturity category, the unrealized gain/loss is transferred to comprehensive income.

Financial Reporting Requirements for defined-contribution plans

◦Pension expense is simply equal to the employer's contribution. There is no future obligation to report on the balance sheet.

Decreasing the compensation growth rate will:

◦Reduce future pension payments; hence, PBO is lower. A lower PBO improves the funded status of the plan ◦reduce current service cost and lower interest cost; thus, pension expense will decrease.

Asset Securitization

◦SPEs are often created to securitize assets, usually receivables of the sponsor. Typically, the SPE issues debt to purchase the receivables from the sponsor and the debt is repaid as the receivables are collected. ◦when the receivables are securitized, the sponsor removes the receivables from the balance sheet and reports the cash inflow as an operating activity in the cash flow statement. IF the sponsor still has recourse, the transaction is nothing more than collateralized borrowing. In this case, the analyst should consider making adjustments to the sponsors operating cash flow and leverage. Consolidation of SPE would lead to an increase in the sponsor's account receivable (SPEs asset) and an increase in the sponsor's long term liabilities the SPE liability

Applying the Temporal Method

◦The temporal method is applied using the following procedures: ‣ monetary assets and liabilities are remeasured using the current exchange rate. Monetary assets and liabilities are fixed in the amount of currency to be received or paid and include: cash, receivables, payables, and short-term and long-term debt. ‣ All other assets and liabilities are considered nonmonetary and are remeasured at the historical (actual) rate. The most common nonmonetary assets include inventory, fixed assets, and intangible assets. An example of a nonmonetary liability is unearned (deferred) revenue. ‣ just like the current rate method, common stock and dividends paid are remeasured at the historical (actual) rate ‣ Expenses related to nonmonetary assets such as COGS, depreciation expense and amortization expense are remeasured based on the historical rates prevailing at the time of purchase. ‣ revenues and all other expenses are translated at the average rate. ‣ remeasurement gain or loss is recognized in the income statement. This results in more volatile net income as compared to the current rate method whereby the translation gain or loss is reported in shareholders equity

Joint Ventures

◦a joint venture is an entity whereby control is shared by two or more investors. ◦under IFRS, proportionate consolidation is the preferred accounting method for joint ventures although the equity method is permitted. ◦under US GAAP, the equity method is required. ◦proportionate consolidation is not allowed under US GAAP except in very limited situations

Defined-Contribution Plan

◦a retirement plan whereby the firm contributes a certain sum each period to the employee's retirement account. ◦the firm's contribution can be based on any number of factors including years of service, the employee's age, compensation, profitability, or even a percentage of the employee's contribution. ◦in any event, the firm makes no promise to the employee regarding the future value of the plan assets. ◦the investment decisions are left to the employee, who assumes all of the investment risk.

Special Purpose and Variable Interest Entities

◦a special purpose entity (SPE) is a legal structure created to isolate certain assets and liabilities of the sponsor. An SPE can take the form of a corporation, partnership, joint venture, or trust. The typical motivation is to reduce risk and thereby lower the cost of financing. ◦the FASB uses the term variable interest entity (VIE) to describe a special purpose entity that meets certain conditions. According to FIN No 46 (R) "Consolidation of Variable Interest Entities," a VIE is an entity that has one or both of the following characteristics: ‣ At-Risk equity that is insufficient to finance the entity's activities without additional financial support. ‣ Equity investors that lack any one of the following: • decision making rights. • the obligation to absorb expected losses. • the right to receive expected residual returns. ‣ if an SPE is considered a VIE, it must be consolidated by the primary beneficiary, The primary beneficiary is the entity that absorbs the majority of the risks or receives the majority of the reward.

Impairment of Financial Assets (US GAAP - Reversals)

◦a subsequent reversal of impairment losses is not allowed.

Investments in associates:

◦an ownership interest between 20% and 50% is typically a non-controlling investment; however, the investor can usually significantly influence the investee's business operations. Significant influence can be evidenced by the following: ‣ board of directors representation ‣ involvement in policy making ‣ material intercompany transactions ‣ interchange of managerial personnel ‣ dependence on technology. ‣ also possible to have significant influence with less than 20% ownership - investment is considered an investment in associates. ◦equity method is used to account for investments in associates.

Financial Assets

◦an ownership interest of less than 20% is usually considered a passive investment. In this case, the investor cannot significantly influence or control the investee. ◦IFRS: Classifies investments in financial assets as held-to-maturity, available for-sale, or fair value through profit or loss (which includes held for trading and securities designated at fair value) ◦US GAAP: Marketable financial assets are classified as held-to-maturity, available for sale, held for trading, or designated at fair value.

Business Combinations

◦an ownership interest of more than 50% is usually a controlling investment. When the investor can control the investee, the acquisition method is used. ◦it is possible to own more than 50% of an investee and not have control. then not considered controlling ‣ conversely, it is possible to control with less than a 50% ownership interest. In this case, the investment is still considered a business combination.

Current Service Cost

◦as previously discussed, current service cost is the present value of benefits earned by the employees during the current period. ◦Current service cost is the increase in the PBO that is the result of the employees working one more period. ◦Current service cost is immediately recognized in the income statement.

Impairments of Financial Assets (IFRS)

◦as under US GAAP, impairments under IFRS are recognized in the income statement ◦impairment of a debt or equity security is indicated if at least one loss event has occurred, and its effect on the security's future cash flows can be estimated reliably. ◦losses due to occurrences of future events (regardless of the probability of occurrence) are not recognized. ◦for debt securities, loss events can include default on payments of interest or principal, likely bankruptcy or recognization of the issuer, concessions from the bondholders, or other indications of financial difficulty on the part of the issuer. however, a credit rating downgrade or the lack of a liquid market for the debt are not considered to be indications of impairment in the absence of other evidence. ◦for equities, a loss event has occurred if the fair value of the security has experienced a substantial or extended decline below its carrying value or if changes in the business environment facing the equity issuer (such as economic, legal, or technological developments) have made it unlikely that the value of the equity will recover to its initial cost. ◦if a held to maturity security has become impaired its carrying value is decreased to the present value of its estimated future cash flows, using the same effective interest rate that was used when the security was purchased. This may not be equal to its fair value.

Ultimate healthcare trend rate

◦assumptions are similar for other post employment benefits except the compensation growth rate is replaced by a healthcare inflation rate. ◦Generally, the presumption is the inflation rate will taper off and eventually become constant. This constant rate is known as the ultimate healthcare trend rate. ◦all else equal, firms can reduce the post-employment benefit obligation and periodic expense by decreasing the near term healthcare inflation rate, by decreasing the ultimate healthcare trend rate, or by reducing the time needed to reach the ultimate healthcare trend rate.

Excess of Purchase Price over Book Value Acquired

◦at the acquisition date, the excess of the purchase price over the proportionate share of the investee's book value is allocated to the investee's identifiable assets and liabilities based on their fair values. any remainder is considered goodwill. ◦next years: investor recognizes expense based on the excess amounts assigned to the investee's assets and liabilities. The expense is recognized consistent with the investees recognition of the expense ◦note: the purchase price allocation to the investee's assets and liabilities is included in the investor's balance sheet, not the investee's. in addition, the additional expense that results from the assigned amounts is not recognized in the investee's income statement. ◦Under the equity method of accounting, the investor must adjust its balance sheet investment account and the proportionate share of the income reported from the investee for this additional expense.

Reporting on financial assets (available for sale)

◦available for sale securities are debt and equity securities that are neither held to maturity nor held for trading. ◦reported on balance sheet at fair value ◦however, only the realized gains or losses, and the dividend or interest income, are recognized in the income statement. ◦the unrealized gains and losses are excluded from the income statement and are reported as a separate component of stockholders' equity. ‣ GAAP: the unrealized gains and losses are reported in the "other comprehensive income" section of stockholders' equity. when the securities are sold, the unrealized gains and losses are removed from other comprehensive income as they are now realized, and recognized in the income statement. ‣ IFRS: similar as GAAP except for unrealized gains or losses that result from foreign, exchange movements. Foreign exchange gains and losses on available-for-sale securities are recognized in the income statement under IFRS. The entire unrealized gain or loss is recognized in equity under US GAAP.

Rate of compensation growth

◦average annual rate by which employee compensation is expected to increase over time. The rate of compensation growth affects both the PBO and pension expense

The IASB continues to use the term special purpose entity. ACcoridng to SIC No. 12, " consolidation - special purpose entities", the sponsoring entity must consolidate if it controls the SPE, indications of control include a sponsoring entity that:

◦benefits from the SPE's activities ◦has decision making rights to receive benefits from the SPE ◦absorbs the risks and rewards of the SPE ◦absorbs the risks and rewards of the SPE ◦has a residual interest in the SPE

Benefits paid

◦benefits paid reduce the obligation to the employees.

Changes in actuarial assumptions

◦changes in actuarial assumptions are the gains and losses that result from changes in variables such as mortality, employee turnover, retirement age, and the discount rate. ◦a actuarial gain will decrease the benefit obligation and an actuarial loss will increase the obligation.

Adjustments for comparability: differences due to classification in the income statement:

◦classification of the components of pension expense as operating/nonoperating differs under US GAAP versus IFRS ◦under US GAAP, net pension expense (including interest) is shown as an operating expense ◦under IFRS, the components of periodic pension cost can be included in various line items. ◦analysts can adjust GAAP-reported income by adding back the pension expense and subtracting only service cost in determining operating income. ◦interest cost should be added to the firm's interest expense, and the actual return on plan assets should be added to nonoperating income.

Discount Rate

◦discount rate is the interest rate used to compute the present value of the benefit obligation and the current service cost component of pension expense. ◦the discount rate is not the risk-free rate. rather, it is based on interest rates of high quality fixed income investments with a maturity profile similar to the future obligations. ◦the discount rate assumption affects the PBO as well as pension expense

Investments in Associates

◦investment ownership of between 20% and 50% is usually considered influential. ◦influential investments are accounted for using the equity method. Under the equity method, the initial investment is recorded at cost and reported on the balance sheet as a non-current asset. ◦in subsequent periods, the proportionate share of investees earnings increases the investment account on the investor's balance sheet and is recognized in the income statement. ◦dividends received from the investee are treated as a return of capital and thus, reduce the investment account. ◦unlike investments in financial assets, dividends received from the investee are not recognized in the investor's income statement. ◦if loss, share of loss brings down investment account and lowers earnings in income statement. if it reduces beyond zero, equity method discontinued. equity method is resumed once the proportionate share of the investees earnings exceed the share of losses that were not recognized during the suspension period. ◦although equity method income (proportionate share of the investees earnings, is reported in the investor's income statement, it is usually excluded from operating income.

Impairments of investments in Associates

◦equity method investments must be tested for impairment ◦if the fair value of the investment falls below the carrying value (investment account on the balance sheet) and the decline is considered permanent, the investment is written down to fair value and a loss is recognized on the income statement. IF there is a recovery in value in the future, the asset cannot be written-up.

LOS 21.b: Analyze the impact of changes in exchange rates on the translated sales of a subsidiary and the parent company

◦foreign currency denominated transactions, including sales, are measured in the presentation (reporting) currency at the spot rate on the transaction date. ◦Foreign currency risk arises when the transaction date and the payment date differ. if depreciates during payment window, then loss in income statement. ◦if the balance sheet date occurs before the transaction is settled, gains and losses on foreign currency transactions are recognized. ‣ accordingly, the balance sheet amounts are adjusted based on the exchange rate on the balance sheet date, and an unrealized gain or loss is recognized in the income statement. Once the transaction is settled, additional gain or loss is recognized if the exchange rate changes after the balance sheet date.

Reporting of financial assets (held for trading)

◦held for trading securities are debt and equity securities acquired for the purposes of profiting in the near term, usually less than three months. ◦held for trading securities are reported on the balance sheet at fair value. The changes in fair value, both realized and unrealized, are recognized in the income statement along with any dividend or interest income.

Reporting of financial assets (held to maturity)

◦held to maturity securities are debt securities acquired with the intent and ability to be held to maturity. The securities cannot be sold prior to maturity except in unusual circumstances. ◦long term held to maturity securities are reported on the balance sheet at amortized cost. Amortized cost is the original cost of the debt security plus any discount, or minus any premium, that has been amortized to date. it is the PV of the remaining cash flows. interest income (coupon cash flow adjusted for amortization of premium or discount) is recognized in the income statement but subsequent changes in fair value are ignored.

Bargain Purchase

◦if acquisition purchase price is less than the fair value of net assets acquired, IFRS and (US GAAP post December 15,2008) requires that the difference between fair value of net assets and purchase price be recognized as a gain in the income statement ◦prior to December 15, 2008, US GAAP required that the different be allocated as a pro rata reduction in the carrying value of acquired non-current assets. if any difference still remained, the excess was recognized as extraordinary gain in the income statement.

Reporting of Intercorporporate Investments (Financial Assets)

◦investment ownership of less than 20% is usually considered passive. ◦the acquisition of financial assets is recorded at cost (presumably the fair value at acquisition), and any dividend or interest income is recognized in the investor's income statement. ◦recognizing the change in the fair value of financial assets depends on their classification as either held to maturity, held for trading or available for sale. Firms can also designate financial assets and financial liabilities at fair value.

Generally, we can use the following to determine the appropriate translation method:

◦if the functional currency and the parent's presentation currency differ, the current rate method is used to translate the foreign currency financial statements. Translation usually involves self-contained, independent subsidiaries whose operating, investing, and financing activities are decentralized from the parent. see column one of figure one ◦if the functional currency is the same as the parent's presentation currency, the temporal method is used to remeasure the foreign currency financial statements. Remeasurement usually occurs when a subsidiary is well integrated with the parent (i.e., the parent makes the operating, investing and financing decisions). See column 2 of Figure 1 ◦in the case where the local currency, the functional currency, and the presentation currency all differ, both the temporal method and the current rate method are used. for example, consider a us firm that owns a german subsidiary whose functional currency is euro. if they also denominate a few transactions in swiss frances. then temporal method is used to remeasure from the local currency (swiss) to functional currency (euro). Then, the current rate method is used to translate from the functional currency (euros) to the presentation currency (dollar). See column 3 of figure 1 ◦if a subsidiary is operating in a hyperinflationary environment, the functional currency is considered to be the parent's presentation currency, and the temporal method is used under US GAAP. Under IFRS< the subsidiary's financial statements are restated for inflation and then translated using the current rate method. Hyperinflation will be discussed in more detail later in this topic review

IFRS - Reversals

◦if the held to maturity security's value recovers in a later period, and its recovery can be attributed to an event (such as a credit upgrade), the impairment loss can be reversed. Impairments of available for sale debt securities may be reversed under the same conditions as impairments of held-to-maturity securities. ◦reversals of impairments are not permitted for equity securities

Impairment of Financial Assets

◦if the value that can be recovered for a financial asset is less than its carrying value and is expected to remain so, the financial asset is impaired. ◦IFRS and GAAP require that held to maturity (HTM) and AFS securities be evaluated for impairment at each reporting period. this is not necessary for held for trading, and designated at fair value because declines in their values are recognized on the income statement as they occur.

LOS 20.f: Interpret pension plan note disclosures including cash flow related information

◦if the firm's contribution exceed its total pension cost, the difference can be viewed as a reduction in the overall pension obligation, similar to an excess principal payment on a loan. ◦conversely, if the pension expense exceeds the contributions, the difference can be viewed as a source of borrowing. ◦if the difference between cash flow and total pension expense is material, the analyst should consider reclassifying the difference from operating activities to financing activities in the cash flow statement.

Interest Cost

◦interest cost is the increase in the PBO due to the passage of time ◦It is calculated by multiplying the PBO at the beginning of the period by the discount rate. ◦interest cost is immediately recognized as a component of pension expense. ◦under IFRS, net interest expense/income is defined as the discount rate multiplied by funded status (i.e. interest cost is offset against expected plan return). ◦if the plan is reporting a liability (i.e., an underfunded plan), an expense is reported. ◦Conversely, if the plan reports an asset, interest income is reported

Interest Cost

◦interest cost is the increase in the obligation due to the passage of time. Benefit obligations are discounted obligations; thus, interest accrues on the obligation each period. Interest cost is equal to the pension obligation at the beginning of the period multiplied by the discount rate.

Defined-Benefit Plan

◦firm promises to make periodic payments to the employee after retirement. ◦the benefit is usually based on the employee's years of service and that employee's compensation at, or near, retirement. ◦since the employee's future benefit is defined, the employer assumes the investment risk.

The expected return on plan assets

◦is the assumed long-term rate of return on the plan's investments. ◦the expected return reduces pension expense and the differences between the expected return and actual return are deferred ◦also, the expected return is assumed only under GAAP. Under IFRS, it is always equal to the discount rate Firms can improve reported results by increasing the discount rate, reducing the compensation growth rate, or (under US GAAP) increasing the expected return on plan assets.

Analysis of Investments in Financial Assets

◦it is important to separate the firm's operating results from its investment results (e.g. interest, dividends, and gains and losses) ◦for comparison purposes, using market values for financial assets is generally preferred. Also, it is necessary to remove non-operating assets when calculating the return on operating assets ratio.

Definitions f the three different currencies that are involved in multinational accounting

◦local currency: the currency of the country being referred to ◦functional currency: determined by management, is the currency of the primary economic environment in which the entity operates. it is usually the currency in which the entity generates and expends cash. The functional currency can be the local currency or some other currency. ◦Presentation (reporting) currency: is the currency in which the parent company prepares its financial statements

Financial Reporting Requirements for defined-benefit plan

◦more complicated ◦employer must estimate the value of the future obligation to its employees. Requires forecasting number of variables such as future compensation levels, employee turnover, retirement age, mortality rates, and an appropriate discount rate. ◦usually fund the plan by contributing assets to a separate legal entity, usually a trust. The plan assets are managed to generate the income and principal growth necessary to pay the pension benefits as they come due.

Corridor Approach (US GAAP only)

◦once the beginning balance of actuarial gains and losses exceed 10% of the greater of the beginning PBO or plan assets, amortization is required. ◦excess amount over the "corridor" is amortized as a component of pension expense over the remaining service life of the employees. ◦the amortization of an actuarial gain reduces pension expense and the amortization of an actuarial loss increases pension expense. ◦companies can choose to amortize actuarial gains and losses more quickly than implied by the corridor method. ◦however, the application has to be consistent for gains as well as losses and over time.

Increasing the expected return on plan assets (under US GAAP) will:

◦reduce pension expense ◦not affect the benefit obligation or the funded status of the plan

Increasing the Discount rate will:

◦reduce present values; hence, PBO is lower. A lower PBO improves the funded status of the plan ◦usually result in lower pension expense because of lower current service cost. Recall that current service cost is a present value calculation; thus, an increase in the discount rate reduces the present value of a future sum. ◦usually reduce interest cost (PBO x the discount rate) unless the plan is mature.

What are the two methods used to remeasure or translate the financial statements of a foreign subsidiary to the parent's presentation (reporting) currency?

◦remeasurement: involves converting the local currency into functional currency using the temporal method. ◦translation: involves converting the functional currency into the parent's presentation (reporting) currency using the current rate method. The current rate method is also known as the all-current method

Past (Prior) service costs

◦retroactive benefits awarded to employees when a plan is initiated or amended. Under IFRS, past service costs are expensed immediately. Under US GAAP; past service costs are amortized over the average service life of employees.

LOS 20.g: Explain issues involved in accounting for share-based compensation

◦share based compensation plan can take several forms, including stock options and outright share grants. ◦recording cash compensation expense is straightforward; it is recorded as the compensation is earned. Stock options and share grants raise several issues. if the shares are not publicly traded, an estimate of value must be used for stock grants. ◦Even when a market price for the shares is available, the value of stock options must be estimated using an options valuation model. ◦shares or options may be granted with contingencies ◦in these cases, the estimated expense may be spread over a period of time. ‣ for example, if shares are granted, but cannot be sold for a period of time, the compensation expense recorded is spread over the period of time from the grant date until the date on which they can be sold by the employee. ‣ the overall principle here is that the compensation expense should be spread over the period for which they reward the employee, referred to as the service period.

Projected Benefit Obligation (PBO) AKA present value of defined benefit obligation (PVDBO) under IFRS

◦the actuarial present value (at an assumed discount rate) of all future pension benefits earned to date, based on expected future salary increases. ◦it measures the value of the obligation, assuming the firm is a going concern and that the employees will continue to work for the firm until they retire. ◦from one period to the next, the benefit obligation changes as a result of current service cost, interest cost, past (prior) service cost, actuarial assumptions, and benefits paid to employees.

The translation method, current rate or temporal, is determined by the functional currency relative to the parent's presentation currency. According to the IASB, management should consider the following factors in deciding on the functional currency:

◦the currency that influences sales prices for goods and services ◦currency of the country whose competitive forces and regulations mainly determine the sale price of goods and services. ◦the currency that influences labor, material, and other costs. ◦the currency from which funds are generated. ◦the currency in which receipts from operating activities are usually retained.

Exposure to changing Exchange Rates

◦under the current rate method, exposure is defined as the net asset position of the subsidiary. has net asset position when assets exceed liabilities. ‣ under the current rate method, all of the assets and liabilities are translated at the current rate. Thus, it is the net assets, that is, the subsidiary's equity, that are exposed to changing exchange rates. So if subsidiary has a net asset exposure and the foreign currency is appreciating, a gain is recognized. Conversely, a net asset exposure in a depreciating environment will result in a loss. ◦under the temporal method, the nonmonetary assets and liabilities are remeasured at historical rates. Thus, only the monetary assets and liabilities are exposed to changing exchange rates. Therefore, under the temporal method, exposure is defined as the subsidiary's net monetary asset or net monetary liability position. ‣ monetary is mainly cash and receivables.. so most companies have net monetary liability exposures. ‣ if the parent has a net monetary liability exposure when the foreign currency is appreciating, the result is a loss. Conversely a net monetary liability exposure coupled with a depreciating currency will result in a gain. ‣ under the temporal method, firms can eliminate their exposure to changing exchange rates by balancing monetary assets and monetary liabilities. When balanced, no gain or loss is recognized. ‣ if had a net monetary liability exposure of 1 million. A loss would occur if the euro appreciates relative to dollar. To eliminate, the exposure, the firm could sell euro denominated nonmonetary assets, such as fixed assets or inventory, and use the proceeds to reduce the monetary liabilities.

Calculating the translation/remeasurement gain or loss

◦under the current rate method, the translation gain or loss is reported in shareholder's equity as a part of the CTA. The CTA is simply a "plug" figure that forces the basic accounting equation (A= L + E) to balance.

Amortization of past (prior) service costs

◦when a firm adopts or amends its pension plan, the PBO is immediately increased. Under US GAAP, instead of expensing the cost immediately, it is reported as a part of other comprehensive income and amortized over the remaining service life of the affected employees. ◦under IFRS, the past service costs are recognized in pension expense immediately (i.e., they are expensed immediately and not amortized) ◦under US GAAP, the amortization of actuarial gains and losses and the amortization of past service costs reduces the volatility of pension expense. ◦thus, the amortization process results in pension expense that is smoothed. ◦under IFRS, there is no amortization. Actuarial gains and losses are not subject to the corridor method and hence never transferred out of OCI into income statement. As stated earlier, past service cost is immediately expensed. ◦in summary, total pension expense for a period is the employer's contributions adjusted for changes in funded status ◦IFRS and GAAP differ in recognizing this pension expense between income statement and OCI as summarized in figure 4.

Analytical issues for investments in associates

◦when an investee is profitable, and its dividend payout ratio is less than 100%, the equity method usually results in higher earnings as compared to the accounting method used for minority passive investments. ◦thus, consider if the equity method is appropriate for the investor. ◦also, the investee's individual assets and liabilities are not reported on the investor's balance sheet. ◦finally, the proportionate share of the investee's earnings are recognized in the investor's income statement, but the earnings may not be available to the investor in the form of cash flow (dividends). That is, the investees earnings may be permanently reinvested.