Quiz 5/6

article: are Valeant, Philidor, and R&O all the same company?

-Valeant has a variable interest in Philidor, which it consolidates -Since Valeant's right to buy Philidor lead it to consolidate Philidor's results, does Philidor's right to buy R&O thus lead Philidor to consolidate R&O's results? does valiant then consequently consolidate R&O's results, such that all three are the same company from the perspective of an investor reading Valeant's financial statements? the answer isn't entirely clear -this problem goes back to the murkiness of consolidation issues

inflationary currency example: Colgate Palmolive (and Energizer Holdings)

-Venezuela was designed as hyper inflationary and, therefore, the functional currency for the company's Venezuelan subsidiary became the U.S. dollar -as a result, the impact of Venezuelan currency fluctuations is reported in income -to some extent, it preserves the value on the balance sheet?

article: Zimbabwe removes 12 zeros from currency

-Zimbabwe slashed 12 zeros from its currency as hyperinflation continued to erode its value

remeasurement

-the process used to restate the foreign financial statements into US dollars when the US dollar is considered to be the functional currency

consolidation worksheet at the end of the first year

(-however, after the passage of time, both entities will have a complete set of financials that must be consolidated -all of these financials are included in the mechanical consolidation worksheet A) Step 1. debit income from the subsidiary (on the IS) to eliminate it Step 2. credit dividends declared (on the IS) of (% ownership of parent * dividends declared by subsidiary) to get rid of dividends from subsidiary to parent Step 3. credit Investment in Timid (under assets) for the income from step 1 - dividends from step 2 B) Step 1. debit shareholder's equity of subsidiary to eliminate it (beginning balance) Step 2. credit Investment in subsidiary account to completely remove it (the plug) Step 3. debit RE to eliminate the beg balance of the subsidiary Step 4. recreate (debit) the Differential for 100% of the book value of net assets of the subsidiary C) Step 1. increase assets and liabilities by 100% of the difference between the subsidiary's fair value and book value (from date of acquisition) Step 2. credit the Differential for 100% of the debited numbers from step 1 D) Step 1. credit the Differential account as the plug Step 2. debit the Goodwill as the same number from step 1 E) Step 1. credit PP&E to amortize it in the amount of 100% of the writeup / number of years remaining from the date of the acquisition -this amount would be debited for depreciation expense in the income statement F) -since the time period is post SFAS #142, there is no Goodwill Amortization G) Step 1. credit inventory to amortize it in the amount of 100% of the writeup / number of years remaining from the date of the acquisition H) Step 1. debit Income to non-controlling interest for % ownership of non-controlling interest * net income of subsidiary from year of acquisition Step 2. credit dividends declared for % ownership of non-controlling interest * dividends declared by subsidiary in year of the acquisition Step 3. credit NonControlling Interest for step 1 - step 2 I) Step 1. credit Income to NonControlling Interest for % ownership of non-controlling interest * (amortization of write-ups, which is the credits in the assets account) Step 2. debit NonControlling Interest for this same amount from step 1

quiz: is the contract a derivative?

-the option to purchase property would not be considered a derivative, as the contract does not permit net cash settlement -further, real estate contracts are required to be traded on exchanges in order to be considered derivatives

WSJ: MCI Examiner criticizes KPMG on tax strategy

-MCI is the company that emerged after WorldCom -the examiner of MCI was critical of a "highly aggressive tax strategy" that KPMG recommended -under KPMG's direction, WorldCom treated "foresight of top management" as an intangible asset (just like patents or trademarks) -WorldCom licensed its management's insights to its units, which then paid royalties to the parent, deducting such payments as normal business expenses to lower taxes -the examiner's report says that neither KPMG nor WorldCom could adequately explain why management foresight should be treated as an intangible asset -the motivation for doing this is to house all of their income in lower-tax jurisdictions: they created an asset called management foresight and housed it in a lower-tax jurisdiction -this is clearly an income shifting policy -side note: it's not just inventory that gets internally sold, but also long-lived assets, gain on sale of equipments, and interest on an intracompany loan (that should be eliminated)

WSJ article: Irish subsidiary lets Microsoft slash taxes in U.S. and Europe

-Microsoft is based in Ireland -the four year old subsidiary with few employees controls a ton of Microsoft's assets -virtually unknown in Ireland, on paper it has quickly become one of the country's biggest companies, with gross profits of nearly $9 billion in 2004 -the unit pays Ireland a lot of money in taxes -this provides a structure for Microsoft to radically reduce its corporate taxes in much of Europe, and similarly shields billions of dollars from U.S. taxation -Microsoft's effective world-wide tax rate is lowed due to the foreign earnings taxed at lower rates -the idea is to house income in a low-tax jurisdiction

change in plug if the US dollar is the functional currency

-NI

change in plug if the local currency is the functional currency

-OCI

cash flow hedge

-a cash flow hedge is a hedge of an exposure to variability in the cash flows of a planned transaction -derivatives acquired as cash flow hedges are recorded at their fair value on each balance sheet date -changes in the fair value of such derivatives are not included in net income in the period of the change in value -instead, the changes in the fair value of the derivative are reflected in net income in the period in which the hedged transaction affects net income -prior to the period in which the hedged transaction occurs, the changes in the market value of the derivates are included in "comprehensive income," and ultimately wind up in the "accumulated other comprehensive income" account in the shareholder's equity section of the balance sheet -the following example (taken from the FASB Exposure Draft) illustrates how a firm may enter into an interest rate swap to hedge cash flow exposure on a variable rate loan -for example, a financial institution receiving variable returns from the asset side of the balance sheet may want to swap fixed rate payments on its debt for variable returns so that returns on both sides of the balance sheet are variable. in this way, the financial institution may reduce potential harm resulting from fluctuations in interest rates

fair value hedges

-a fair value hedge represents the hedge of an exposure to a change in the fair value of an existing asset, liability, or firm commitment -a derivative used as a fair value hedge is recorded at its fair value on the balance sheet at the end of each period -each period, the change in the fair value of the derivative flows through net income -the economic gain/loss on the derivative offsets the economic loss/gain due to the fluctuation in the fair value of the hedged item. thus, the net impact on economic income for the period will be zero -because there is no economic gain/loss when the fair value of a hedged item fluctuates, FASB 133 dictates that there is no impact on accounting net income. this is accomplished by increasing or decreasing the carrying value of the hedged item by the fluctuation in its fair value, even if normal accounting would not require a "write-up" or a "write-down" -in order for a firm to qualify for use of a fair value hedge, the firm must indicate in advance that the derivative instrument has been acquired for hedging purposes -further, only the effective portion of the hedge can be offset by recording a gain/loss on the hedged item. any "excess" hedging flows through net income in the current period -thus, in the previous example, if Elmo entered into an oats derivative contract with a notional value of 250,000 bushels, the change in price of 150,000 bushels (which is the excess of the notional value over the asset owned) would flow through net income without an offsetting write-up/down in the value of the Inventory on hand -fair value hedging may be applied to recognized assets and liabilities (those already recorded on the balance sheet) and to firm commitments (an asset or a liability that does not yet appear on the balance sheet -per FASB 133, a firm commitment has the characteristics of an asset or liability, and must be: 1. specific as to price, quantity, and timing 2. with an unrelated party, binding on both parties, and usually legally enforceable 3. probable due to a significant disincentive for nonperformance -if fair value accounting is applied to a firm commitment, a firm commitment account is used to aggregate the fluctuation in value of the hedged item -the firm commitment account is closed to the actual asset liability when the expected transaction occurs

foreign currency transaction example

-a letter in parenthesis means what the currency in which the transaction was settled is (a P in parenthesis means that the payment was received/settled in non-U.S. dollars) -we want to get everything in US dollars -the dollar weakens and the peseta strengthens if it costs more dollars to get the same number of pesatas (rate increased: 1 peseta=$.0068 to .0078) -the dollar strengths and the peseta weakens if it costs less dollars to get the same number of pesatas (rate decreased) 1. record the sale of equipment to Spain on that date: debit Accounts Receivable (P) and credit Sales Revenue for 5,000,000 pesetas * exchange rate on that date of .0068 -this gets it into dollars 2. spot rate in effect as of the balance sheet date: .0078 (US dollar weakened) -do: (the amount of the sale * the new spot rate as of the balance sheet date) - (the answer from #1: the amount of the sale * the spot rate from #1) -b/c A/R is more now, you have a gain -debit Accounts Receivable (P) and credit Foreign Currency Transaction Gain for that number 3. the date the payment is due: -same process from #2 of revaluing foreign receivable to current US dollar equivalent -do: (the amount of the sale * the new spot rate as of the date the payment is due) - (the answer from #2/the last change: the amount of the sale * the spot rate from #2) -b/c A/R is worth less now, you have a loss -debit Foreign Currency Transaction Loss and credit Accounts Receivable (P) for this amount -now, record the final settlement: debit Foreign Currency Units (P) and credit Accounts Receivable (P) for the amount collected: the amount of the sale * the spot rate on the day the payment is due -Q: did they have an overall gain or loss? -do gains - losses to see what it is overall -another way to do it is the amount of the sale * (spot rate on the day it is settled - spot rate on the day of the sale)

consolidation at the end of the first year of ownership - SFAS #141R

-at the end of the first year of ownership, the financial statements of the parent and subsidiary companies are obtained -these financial statements are then input into the worksheet and a number of eliminations are made into the consolidation process -the consolidation process is performed as follows: 1. eliminate the "Investment Account" that appears on the balance sheet of the parent company -by the end of the first year, the account balance will reflect the original acquisition as well as increases/decreases related to the subsidiary's income and dividends -the components are eliminated as follows: 1A) -undo the impact of the subsidiary's income and dividends on the parent's Investment account -subsidiary income increases the parent's Investment account and dividends decrease the parent's Investment -therefore, to undo this transaction on the consolidated financials, the Investment account should be decreased (credited) by the amount by which income exceeds dividends, or increased if dividends exceed income -to balance the entry described above, eliminate the Income from Subsidiary account, and decrease consolidated Dividends by the amount of dividends paid from the subsidiary to the parent corporation 1B) -second, undo the original acquisition by crediting the Investment account for the amount of the original acquisition -eliminate the shareholders' equity of the subsidiary -the appropriate location to eliminate the retained earnings of the subsidiary is in the RE section of the worksheet, as the balances from this section will be carried down to the balance sheet section of the worksheet -the appropriate amount of RE to eliminate is the subsidiary's RE at the beginning of the period (at the end of the first year, this will be the time of the acquisition of the subsidiary by the parent) -if the original acquisition was less than 100%, part of the original shareholders' equity is allocated to the non-controlling interest on the balance sheet (re-establish non-controlling interest) -the difference between the amount paid and the book value of equity of the subsidiary is recorded in the Differential 2. -eliminate the Differential account by writing up/writing down the assets and liabilities acquired by the % acquired multiplied by the difference between book value and fair value at the time of acquisition (recall that this was also a step that was performed at the time of the acquisition) -any remaining Differential is allocated to Goodwill (if a debit is needed to close the Differential, the credit is to an income statement account in the period in which the business combination occurs, and to RE in a subsequent period) 3. -amortize the components of the Differential (write-ups need to be amortized) -the offset to the amortization of a component of the Differential is to an income statement account (Depreciation Expense, COGS, etc) 4. -if applicable, assign a portion of the subsidiary's income and dividends to the NonControlling Interest -the NonControlling Interest (balance sheet) account is increased by the excess of the NonControlling Interest's share of the income of the subsidiary over the NonControlling Interest's share of the dividends of the subsidiary -to balance the allocation to the NonControlling Interest balance sheet account, Dividends is credited for the NonControlling Interest's share of the Dividends (thereby zeroing out the dividends paid by the subsidiary) and the NonControlling Interest's share of the income of the subsidiary is allocated to its own line item on the consolidated IS -note that the NonControlling Interest should also be assigned a proportionate share of the amortization of the various asset write-ups 5. -bring the subtotals from the Income Statement section of the consolidated worksheet down to the Net Income line in the Retained Earnings section (this step may be thought of as closing the consolidated income statement accounts) 6. -determine ending balances for Retained Earnings -these balances are included on the Consolidated Balance sheet 7. -eliminate any intracompany receivables/payables, if applicable

foreign currency transactions

-most large U.S. corporations operate on an international basis -accordingly, those firms frequently engage in transactions in a currency other than the doller -while certain transactions may be denominated in currencies other than the dollar, U.S. financial statements are expressed entirely in dollars (dollars are the reporting currency) -therefore, it is necessary to record such transactions in dollar terms -foreign exchange rates are used to "convert" transactions denominated in currencies other than dollars into transactions recorded in dollars

review: consolidation worksheet at the time of the acquisition

-at the time of the acquisition, only the balance sheets of the two entities are considered -the Investment account is reflected at the price paid for the subsidiary a) Step 1. credit the Investment account to get rid of it Step 2. non-controlling interest: % of non-controlling interest * implied value of non-controlling interest (which is consideration paid/% of controlling interest) Step 3. debit all of the shareholder's equity of the subsidiary to eliminate it Step 4. debit the Differential for 100% of the book value of net assets of the subsidiary b) Step 1. increase assets and liabilities by 100% of the difference between the subsidiary's fair value and book value Step 2. credit the Differential for 100% of the debited numbers from step 1 c) Step 1. credit the Differential account as the plug Step 2. debit the Goodwill as the same number from step 1 d) -entry to eliminate intracompany receivable/payable

summary of changes

-bottom line NI is the same whether they use the equity method for Aggressive or consolidated -consolidated assets will be higher

consolidation in subsequent years

-consolidation in years after the year of the combination is quite similar to the consolidation in the year of the acquisition -the entire "Investment in Subsidiary" account, and the entire "Income from Subsidiary" account are eliminated -one difference relates to the treatment of the Differential account -unlike the year of acquisition, in subsequent years only the unamortized component is recorded in the entry in which the Investment account is eliminated (previous years' amortization has already reduced the Investment and NonControlling Interest accounts) -then, the unamortized differential is allocated to the various components, and those components are amortized as applicable A) Step 1. debit income from the subsidiary (on the IS) to eliminate it Step 2. credit dividends declared (on the IS) of (% ownership of parent * dividends declared by subsidiary) to get rid of dividends from subsidiary to parent Step 3. credit Investment in Timid (under assets on the BS) for the income from step 1 - dividends from step 2 B) Step 1. debit shareholder's equity of subsidiary to eliminate it (beginning balance) Step 2. credit Investment in subsidiary account to completely remove it (the plug) -note: RE of the subsidiary should be eliminated as of beg of year 2: see worksheet Step 3. credit non-controlling interest for the consolidated number from the prior year (to re-establish it) Step 4: debit Differential for the unamortized component of the original differential (original differential gotten from the elimination debit in the consolidation worksheet at time of acquisition - amortization of write-ups in the consolidation worksheet at the end of the first year, which is the credits in the assets account) C) Step 1. increase assets and liabilities by 100% of the difference between the subsidiary's fair value and book value (from date of acquisition), be careful w/ PP&E and acc dep. Step 2. credit depreciation expense to record amortization in the prior period in the amount of 100% of the writeup / number of years remaining from the date of the acquisition Step 3. credit differential to remove the amount (plug it) -see notes to make sure you are doing this step right D) Step 1. credit depreciation expense to record amortization in the current year in the amount of 100% of the writeup / number of years remaining from the date of the acquisition E) Step 1. debit Income to non-controlling interest (IS) for % ownership of non-controlling interest * net income of subsidiary from that current year Step 2. credit dividends declared for % ownership of non-controlling interest * dividends declared by subsidiary from that current year Step 3. credit NonControlling Interest for step 1 - step 2 F) Step 1. credit Income to NonControlling Interest for % ownership of non-controlling interest * (amortization of write-ups, which is the credits in the assets account, but be careful on this one) Step 2. debit NonControlling Interest for this same amount from step 1 -side note: PP&E totals at the end of the first and second year are calculated under the assumption that the acc dec of the subsidiary at the time of the acquisition is not carried over to the consolidated balance sheet. thus, the totals for PP&E and acc dep. are $2,000 less than the amounts that would be obtained by adding up the lines. the PP&E totals are consistent with the interpretation that a new (undepreciated) PP&E asset was acquired at the time of the acquisition

hedging

-corporations may not wish to expose themselves to losses due to currency fluctuations -in order to prevent such losses, a corporation may acquire a forward exchange contract, which enables the firm to buy/sell a foreign currency at a future date at a specified exchange rate -by locking in a specific rate, the corporation eliminates their exposure to future exchange rate fluctuations, and is said to have hedged their exposure

setup for the consolidation worksheet problem

-debit Investment in... for the number of shares issued by the parent * the parent's stock price, credit common stock for number of shares * par value, and credit Add. PIC as the plug -income from the subsidiary on the parent's IS 2017: (% ownership * net income reported by subsidiary) - ((% ownership * PP&E writeup of subsidiary over the year) / number of years PP&E will last) - ((% ownership * inventory writeup of subsidiary over the year) / number of years inventory will last) -income from the subsidiary on the parent's IS 2018: (% ownership * net income reported by subsidiary) - ((% ownership * PP&E writeup of subsidiary over the year) / number of years PP&E will last) -under the Equity Method, the balance in the Investment account that will appear on the BS of the parent''s corp is: -in 2017: initial investment + total adjusted NI - (% ownership * dividends) -in 2018: balance at the end of 2017 + adjusted NI - (% ownership * dividends)

derivatives intro

-derivative markets have grown: an examination of both the volume and types of derivative contracts traded at the Chicago Board of Trade inmates that the level of activity in the derivatives market has exploded over the last few decades

hedge accounting

-derivatives acquired for "hedging" purposes, like all other derivatives, are also reported at fair value on the balance sheet -however, changes in the value of such derivatives may or may not flow through NET income in the period of the change in value -FASB 133 addresses three types of hedges: fair value hedges, cash flow hedges, and foreign currency hedges -foreign currency hedges are of three types: fair value hedges, cash flow hedges, and hedges of a net investment in a foreign operation

strengthened vs. weakened

-exchange rates may fluctuate on a day-to-day basis 1. strengthened -when the relative value of one currency increases, that currency is said to have strengthened -this is, the "strengthened" currency will purchase more units of another currency than it did previously -ex. a U.S. dollar strengthens if $1 dollar buys more of another currency than it did before 2. weakened -when the relative value of one currency decreases, the currency is said to have weakened -a weakened currency will purchase fewer units of another currency than it did previously -note: strengthened and weakened should not necessarily be interpreted as "better" or "worse" -for example, if the US dollar strengthens, foreign customers may purchase fewer goods from US suppliers since the relative price of those goods will have increased if the selling price is fixed in dollars

article: deteriorating Euro could hurt US bottom lines

-foreign currency exchange rates can have a big impact on the reported results of U.S. firms -exchange rates may hurt earnings/bottom-line -ex. a Euro converts into fewer US dollars, which would mean less U.S. revenue, which affects the income statement -you can gauge what exposure a company has based on their percentage of sales in certain regions

current US GAAP on foreign currency transactions

-from an accounting perspective, we are primarily concerned with converting transactions involving foreign currencies into U.S. dollars, aka direct exchange rates -US GAAP steps for foreign currency transactions 1. on the transaction date, the purchase or sale is recorded using the spot rate on that date 2. on a balance sheet date, any payables or receivables which are denominated in foreign currencies are translated into U.S. dollars using the spot rate in effect as of the balance sheet date (update based on exchange rate as of the balance sheet date). any gain or loss due to fluctuations in the exchange rate is included in net income in the period of the exchange rate fluctuation 3. when a foreign currency receivable/payable is settled, any additional fluctuations in the value of the receivable/payable from the last balance sheet is recorded as an exchange gain or loss. the receivable/payable is adjusted accordingly. the actual settlement is then recorded.

example: Send It Scam

-had a lot of products sold on a subscription basis -they fraudulently increased their revenue on the consolidated level -ex. a subsidiary reported $55 mil, but internally $45 mil was the real number and they inflated it by $10 mil (you had to look into the numbers to see the truth) -reporting an extra $10 mil goes through the IS and increases NI

fair value hedge example

-hedging the value of oats against future price fluctuations -SP=selling price -counter party: person on the other side of the contract -you have effectively hedges your exposure to fluctuations in the fair value if: no matter what happens to the market price, you have effectively locked in the current fair value of the oats -2018 Journal entry 1: record derivative at its fair value at the end of the year: debit Derivative Asset and credit Gain on Derivative for the decrease in the price per bushel (you receive money if price decreases): (100,000 bushels)*(market price at the time of the derivative - market price at the end of the year) -2018 Journal entry 2: record the decrease in the fair value of the "hedged item," aka the asset which is the oats: debit Loss on Inventory and credit Oats Inventory for the same number -note that the gain and loss in the above journal entries flow through net income, and thus the net impact on 2018 net income is zero -also, note that the second journal entry would not be made had the inventory not been hedged (market is still above cost so no write-down would be required) -2019 Journal entry 1: record derivative at its fair value at the end of the year: debit Derivative Asset and credit Gain on Derivative for the decrease in the price per bushel (you receive money if price decreases): (100,000 bushels)*(market price at the end of last year - market price at the end of this year) -2019 Journal entry 2: record the decrease in the fair value of the "hedged item," aka the asset which is the oats: debit Loss on Inventory and credit Oats Inventory for the same number -2019 journal entry 3: to record settlement of derivative contract: debit Cash and credit Derivative Asset for the gross profit you would receive (plug the current market price into the appropriate derivative equation) -if Elmo sold the oats at the prevailing market price at the end of 2019, he would receive $325,000 from the sale. COGS would be $250,000, and he would record a gross profit of $75,000 - which is the same gross profit that he would have recorded had he sold the Oats at the prevailing market price on the date he entered into the derivative contract

foreign currency translation: if the functional currency of a foreign subsidiary is the U.S. dollar

-if the functional currency of a foreign subsidiary is the U.S. dollar, the financial statements of the subsidiary are translated into U.S. dollars using a process known as remeasurement (via a method known as the temporal method) -when the functional currency is the U.S. dollar, the foreign entity may be thought of as an extension of the U.S. corporation -accordingly, the foreign entity financial statements are restated into U.S. dollars in a manner such that the restated financial statements approximate how the financial statements would appear if the transactions had originally been recorded in U.S. dollars -the specific procedures for translating foreign financial statements when the U.S. dollar is the functional currency are as follows: 1. assets and liabilities are classified as either monetary or nonmonetary. monetary assets and liabilities are those that represent a claim on a fixed amount of currency (cash, accounts receivable, bonds payable). nonmontary assets and liabilities would be everything else (ex. inventory b/c it depends on the market price) -monetary assets and liabilities are reported on the balance sheet at current value, fair value, present value, or as a function of future value. for purposes of translating these accounts to U.S. dollars, the exchange rate as of the balance sheet date is used -nonmonetary assets and liabilities are reported on the balance sheet at historical cost. for purposes of translating these accounts to U.S. dollars, the historical exchange rate is used. the exchange rate at the time of the parent's investment is used for the foreign entity's assets and liabilities existing on that date 2. revenues and expenses are translated at either the current rate at the time of the transaction or a historical rate (it depends on the related asset or liability) -historical rates are used if the related asset or liability is translated using a historical rate (typically revenues are more likely to be at current rate and expenses are more likely to be at a historical rate) -if transactions to which the current rate is applied are numerous, a weighted-average rate may be used in translating those revenues and expenses -ex: since PP&E will be translated using a historical rate, depreciation will be translated using a historical rate -ex: since inventory is translated using a historical rate, Cost of Goods Sold will be translated using a historical rate -ex: sales would be translated using the current rate at the time of the transaction 3. with the exception of retained earnings, shareholders' equity accounts are translated using the historical exchange rates at the time of the respective transaction. but for transactions occurring prior to the parent's investment in the subsidiary, the exchange rate at the time of the parent's investment is used (this is the same as before) -the translated balance for Retained Earnings at any point in time is equal to the balance at the beginning of the period plus the current period net income (as measured after the translations described above), less the current period dividends (which are translated using the exchange rate in effect on the date of declaration) -as before, after translating the foreign entity financial statements into U.S. dollars via the procedures described above, the accounts are likely to be out of balance -in order to keep the books in balance, a remeasurement gain or loss is recorded (this will flow through the income statement) -a remeasurement gain will be necessary when a credit must be recorded to keep the books in balance, while a remeasurement loss will be necessary when a debit must be recorded -the remeasurement gain/loss is considered part of the income of the foreign entity. accordingly, it should flow into the RE account of the foreign entity. however, the foreign entity will not include this amount in their retained earnings balance. therefore, before calculating the current period remeasurement gain or loss, it is necessary to adjust the translated financial statements for the cumulative remeasurement gains/losses through the beginning of the current period -the remeasurement method is used when the U.S. dollar is the functional currency, but it should also be used when the functional currency is the local currency, but the local currency is "inflationary" -an inflationary currency is one in which inflation over a three year period exceeds 100% -remeasurement is required in such instances b/c use of the exchange rate on the balance sheet would result in inappropriately low translated values

accounting for derivatives

-in response to the increased use of and variety of derivates, as well as a number of accounting related incidents, the FASB has published an extensive amount of derivates related literature, suggesting that the accounting for this area is quite complicated (the various documents are now integrated into the Accounting Standards Codification as part of "broad transactions 0derivatives and hedging - ASV 815) -definition: derivatives are contracts/instruments whose value is "derived" from the price of some other security/commodity (like a bet) -derivatives often require little or no "up front" investment. thus, there is often little or no historical cost associated with such instruments. nevertheless, derivates may potentially expose the firm to great risk, which would not be readily apparent on a "historical cost based" balance sheet -the FASB has said that the following are important attributes of accounting for derivatives: 1. derivatives are contracts that create rights and obligations that meet the definitions of assets and liabilities 2. fair value is the only relevant measure for derivatives 3. only items that are assets and liabilities should be reported as such on the balance sheet 4. special hedge accounting should be provided, but should be limited to transactions involving offsetting changes in fair values or cash flows for the risk being hedged -consistent with these principles, in June 1998, FASB issued the controversial SFAS #133

article: Venezuela, Argentina currency devaluations hit P&G expected sales and earings

-incurred a one-time charge resulting from revaluing its Venezuelan balance sheet in the wake of a change in the way its currency is valued -local Venezuela rules prevented P&G from paying dividends -b/c of this, they concluded that they don't have control over the subsidiary due to regulations and de-consolidated -NI statement: Venezuela deconsolidation charge

intracompany inventory transfers: upstream vs. downstream inventory sale

-intercompany inventory sales may be upstream or downstream -an upstream sale is one in which the subsidiary sells to the parent, while a downstream sale is one in which the parent sells to the subsidiary -in an upstream intracompany inventory sale, a percentage of the unrealized gross profit will be allocated to the minority interest -therefore, in periods, in which unrealized gross profit is included in the beginning balance in the NonControlling Interest account, the eliminating entries must back out this amount

the consolidation process after acquisition: intracompany inventory transfers

-like non-current assets, inventory is also often sold between entities -with respect to consolidated financial statements, consolidated Sales should include only sales to external parties and consolidated Inventory should be based upon the external acquisition price -thus, eliminating entries are required whenever adding up the financial statements of entities to be consolidated would result in a violation of the described rules -the flow of inventory into and out of the consolidated entity: external acquisition to intracompany/internal sale (from the original owner of the inventory to the second owner) to an external sale -a total of 4 possible scares requiring eliminating entries: A. internal sale in current period, external sale has not yet occurred B. internal sale in current period, external sale in current period C. internal sale in previous period, external sale has not yet occurred D. internal sale in previous period, external sale in current period -in each case, the intracompany inventory selling price is assumed to be greater than the external acquisition price, resulting in positive gross profit appearing on the seller's income statement in the year of the sale -also, the eliminating entries provided in the table are the entries necessary when using a perpetual inventory system (a perpetual inventory system is an inventory system in which COGS is increased and inventory is decreased at the time inventory is sold) -if the consolidated entity uses a periodic inventory system, the nature of the eliminating entries does not change. however, different accounts, reflecting the fact that COGS is calculated as beg inv + purchases - ending inv (rather than COGS being an account in which entries are entered directly), will be used

article: Valeant's accounting error a warning sign of bigger problems

-possible spring-loading: after its bought Bausch & Lomb, Valiant posted large increases in sales from products sold by Bausch & Lomb (Bausch & Lomb started to do better) -this was possible b/c they were spring-loading earnings: recognizing expenses sooner or deferring revenue or both -"a heavy acquisitions strategy can also generate concerns about a practice known as spring-loading. when one company acquires another, there is usually a period of several weeks between the announcement of the deal and the actual date at which the acquired company becomes part of the acquirer. in that interim, the acquirer may find a way to book a higher level of costs and lower revenue at the company being acquired. this process, which takes place before the acquired company's financial statements merge with those of the acquirer, is intended to suppress the profitability of the firm being bought, solely for the interim period. once part of the acquirer, the costs and revenue of the acquired firm return to more normal levels, enabling its profit to surge once it can benefit the bottom line of the acquirer"

translation of foreign financial statements

-previously, we examined the accounting rules related to U.S. corporations entering into transactions denominated in foreign currencies -on a broader level, many U.S. corporations have entire subsidiaries that operate in foreign countries -US GAAP requires controlled subsidiaries to be consolidated, regardless of the location of those subsidiaries -when the subsidiaries prepare their financial statements in a currency other than the US dollar, GAAP prescribes a set of rules related to the manner in which those financial statements are to be converted into dollars (this is a step in the consolidation process) -before the financial statements of a foreign division or subsidiary can be translated into U.S. dollars, the functional currency of the foreign entity must be determined

adjusting entries for foreign currency balances example

-some transactions are denominate din US dollars and others in foreign currencies -we only need to make adjustments for those that are not in our currency 1. adjusting entry #1 -adjust receivable denominated in foreign currency to current US dollar equivalent -(amount of A/R in French currency * spot rate as of the balance sheet date where FF 1 = $.176) - (pre-adjusted value) -b/c A/R is worth more now, debit Accounts Receivable (FF) and credit Foreign Currency Translation Gain 2. adjusting entry #2 -adjust payable denominated in foreign currency to current US dollar equivalent -(preadjusted value) - (amount of A/P in yen * spot rate as of the balance sheet date where 1 yen = .0081 dollars) -b/c it is worth less now, you have a gain (lower liability is better) -debit Accounts Payable (yen) and credit Foreign Currency Transaction Gain 3. adjusting entry for the collection of the A/R a) first, adjust receivable to spot rate on settlement date: (amount of A/R in French currency * spot rate as of the settlement date) - (amount of A/R in French currency * spot rate as of the last balance sheet date) -debit Accounts Receivable and credit Foreign Currency Transaction Gain since its worth more now b) collect all accounts receivable (including the ones that were in US dollars) -debit Cash and credit Accounts Receivable ($) for the amount of the sale in US dollars, and in the same journal entry, debit Foreign Currency Units (FF) and credit Accounts Receivable (FF) for the adjusted amount as of the collection date 4. adjusting entry for the collection of the A/P a) first, adjust payable to spot rate on settlement date: (amount of A/P in yen * spot rate as of the settlement date) - (amount of A/P in yen * spot rate as of the previous date), record a gain since this is a negative number/it is worth less now: debit Accounts Payable (yen) and credit Foreign Currency Transaction Gain b) debit Accounts Payable ($) and credit Cash for the amount of the purchase in US dollars, and in the same journal entry, debit Accounts Payable (yen) and credit Foreign Currency Units (yen) for the amount as of the collection gain 4. overall foreign currency transactions gain: all gains - all losses

functional currency

-the currency of the primary economic environment in which the entity operates, which may be thought of as the currency of the environment in which the entity primarily generates and expends cash (the primary currency in which they do business) -this assessment has an impact on what the financial statements look like -there are generally two possible functional currencies: one possibility is the U.S. dollar, while the other possibility is the local currency of the country in which the subsidiary operates -since the manner in which the foreign subsidiary financial statements are translated varies according to the functional currency, the identification of the functional currency can be quite important -accordingly, the FASB has indicated a number of factors that should be considered in determining the functional currency -the following factors would indicate that the local currency is the functional currency: 1. cash flows of the subsidiary are primarily received and distributed in the local currency, and do not affect the parent's cash flows (they buy and sell in the local market and are autonomous) 2. selling prices tend to respond to local competition or regulation and are not generally responsive to changes in exchange rates 3. the selling markets are the local markets and not the parent country 4. expenses (labor and materials) are primarily incurred in the local country (hiring local talent, buying resources locally) 5. financing is primarily obtained form local sources and is denominated in the local currency (getting money locally rather than from the global market) 6. intracompany transactions between the parent and subsidiary are infrequent -this list is not exhaustive and is not a checklist -if, after considering the items described above, the local currency is determined to be the functional currency, the foreign currency financial statements are restated into U.S. dollars in a process known as translation, suing what is referred to as the current rate method -note that the term translation is often used to describe the general process of converting foreign financial statements into US GAAP, as well as one specific manner in which to do so -thus, it is important to be able to differentiate between the generic use of the term and the very specific use of the term -if the US dollar is considered to be the functional currency, the foreign financial statements are restated into US dollars via a process known as remeasurement -it is also important to note that if the foreign subsidiary financial statements are already expressed in U.S. dollars, no restatement of those financial statements is necessary, although it may be necessary to verify that the statements have been prepared in accordance with GAAP

spot rate

-the current exchange rate

example where local currency is the functional currency

-the date of investment is after the company was organized -financial statements prepared in the local currency -Step 1. convert all assets and liabilities on the balance sheet at the direct exchange rate at the end of the fiscal year by multiplying the New Zealand amount by that translation rate to get it into US dollars -Step 2. in this example, for revenues and expenses, make an assumption that you will use the average exchange rate for the year: multiply the New Zealand amount by that translation rate to get it into US dollars (note: this isn't the case for RE) -Step 3: (beg RE is the date of the original investment since it is later than the start of the company * translation rate on the day of investment) + (NI*average exchange rate for the year) - (dividend 1 declared * exchange rate on date it was declared) - (dividend 2 declared * exchange rate on date it was declared) = end RE -Step 4. convert shareholder equity accounts using the exchange rate on the day you made the investment (if the underlying equity transactions occurred prior to the investment by the U.S. parent, the exchange rate in effect at the time of the investment by the U.S. parent is used) Step 5. change in the plug, aka "translation amount:" you want the left side of the balance sheet (assets) to match up with the right side of the balance sheet (liabilities and SE): in this example, the right side is deflated by the proper amount

WASJ example

-the exchange rates for major currencies are published on a daily basis in the WSJ -ex. how many Brazilian Real would one US dollar purchase at the close of business? look at the rate for "per US$" (NOT in US$)

direct exchange rate

-the number of US dollars that one unit of a foreign currency will buy

indirect exchange rate

-the number of units of a foreign currency that a U.S. dollar will purchase

translation/current rate method

-the process used to restate the foreign financial statements into US dollars when the local currency is the functional currency -when the local currency is designated as the functional currency, the process of translating foreign financial statements into U.S. dollars is performed via the following steps 1. all assets and liabilities are translated using the current exchange rate on the balance sheet date 2. revenues and expenses are translated by using the exchange rate on the dates in which the underlying transactions occurred. since these transactions will often occur continuously throughout the year, revenues and expenses are often translated using an average exchange rate for the year 3. Shareholders' Equity accounts other than Retained Earnings (contributed capital accounts) are translated using the historical exchange rates that were in effect when the underlying transactions occurred. if the underlying equity transactions occurred prior to the investment by the U.S. parent, the exchange rate in effect at the time of the investment by the U.S. parent is used -the translated RE balance is calculated as the translated RE balance at the beginning of the period + the (translated) current period income - the (translated) dividends -the amount to deduct for dividends is determined by the exchange rate in effect on the date on which the dividends were declared (there is usually a discrete date) -notes: -after translating the accounts as described above, the financial statements of the subsidiary, expressed in US dollars, are not likely to be in balance -as a result, a balancing item is used so that the books remain in balance, known as a translation adjustment (kind of like a plug) -the change in the translation adjustment is an element of Other Comprehensive Income, and thus flows through Comprehensive Income in the period of the change -the cumulative total ends up in "Accumulated OCI, which is included in the Shareholder's Equity section on the balance sheet -once the subsidiary financial statements have been expressed in US dollars, the consolidation process is completed, using the procedures described earlier (the shareholder's equity of the subsidiary is eliminated, etc)

SFAS #133: Accounting for Derivative Instruments and Hedging Activities

-their initial attempt to improve the financial reporting related to derivatives -they pushed back the initial adoption date: while the original effective date of this standard was fiscal years beginning after June 15, 1999, SFAS #137 was issued solely to defer the effective date of SFAS #133 to fiscal years beginning after June 15, 2000. accordingly, 2001 was the first year in which most firms were required to adopt the new derivative reporting rules -per FASB 133, ALL derivatives are to be reported on the balance sheet at their fair value as of the balance sheet date -with the exception of derivatives that qualify as hedges, changes in the fair value of the derivates flow through net income in the period of the change in fair value -in order to be considered a derivative, a financial instrument or contract much process EACH of the following characteristics 1. it has (1) one or more underlying AND (2) one or more notional amounts or payment provisions or both -definition of underlying: what you are betting on, which determines the value of the contract (ex. a specified interest rate, security price, commodity price, foreign-exchange rate, measure of creditworthiness) -definition of notional amount: the size of the contract/the settlement amount (ex: a number of currency units, shares, bushels, pounds, or other units specified in a contract) -definition of payment provision: tells you who has to pay under what circumstances: a specification of a fixed or determinable settlement based on the underlying (ex. payment of $500,000 will be made if LIBOR > 8% on a June 30 or payment of 50,000 bushels * (spot price of corn on June 30 - $3) 2. it does not require an initial net investment, or it can include an initial net investment less than would be required for other types of contracts expected to result in similar response to changes in market factors -minimal (less than it would be to buy the asset) or no initial investment -ex. the purchase of stock options, a type of derivative, may require an initial net investment. however, the cost of the options, relative to the value of the underlying shares, is often small, while the change in value of the options will be similar to the change in the value of the underlying stock 3. the terms require or permit cash settlement, it can be easily settled by a means outside of the contract (either by selling the contract on an exchange or by purchasing an offsetting contract), or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement -it is not a derivative in the accounting sense if there is not a cash settlement -examples of contracts that are considered "derivatives" under the FASB's definition include swaps, futures, forwards, and options

FASB 133: exclusions

-there are a number of types of transactions that are excluded from covered by FASB 133, even though the definitions described above cover them -for example, most traditional insurance contracts are not considered derivates (even though it has an underlying (a death certificate, a national, and a payment provision, it is hard to report a life insurance contract at fair value) -another group of transactions excluded from classification as derivatives include non-exchange traded contracts in which payment is based on climatic conditions (average temperate exceeds 80 degrees, etc) (note: it is not a derivative b/c the side bet is non-exchange traded) -further, instruments indexed to an entity's own stock, stock based compensation, and contingent consideration in a business combination (from the perspective of the issuer) are (usually) not considered derivates for purposes of the application of the rules -in other words, you can't consider a derivative if the underlying is your own share price -page 6 and 7 for April 15th: examples of derivatives vs. not derivatives

quizzes: miscelaneous

-when the US dollar is the reporting currency, accounts receivable related to sales denominated in a currency other than the US dollar should be reported on the BS using the BS date spot exchange rate b/w the US dollar and the foreign currency (since it's a monetary asset) -when the US dollar is the reporting currency, subsequent fluctuations in the value of the US dollar equivalent of the amount owed are NOT reported as an adjustment to inventory -all derivatives not designed as hedges are reported at fair value on the balance sheet, with changes in fair value being included in net income -the fluctuation in value of a derivative designed as a fair value hedge is recorded in Net Income, rather than Other Comprehensive Income -during the period in which inventory has been fair value hedged, the change in the value of the inventory is included in net income, regardless of whether such a change would have been included in net income if the inventory item had not been fair value hedged

example: U.S. dollar is the functional currency of the foreign subsidiary

1. balance sheet assets and liabilities translated based on whether they are monetary (current exchange rate as of the end of the year) or non-monetary -monetary: cash and receivables -non-monetary: inventory (used average for the last four months of the year), land (used date of investment), buildings (used date of investment), equipment (used date of investment for one, and a later date for another b/c remember that it depends on when they were bought) -monetary: short-term payables -monetary: long-term payables 2. -revenues uses the average exchange rate for the year -create a schedule for COGS: (beg inv * exchange rate on date of investment, rather than the rate in effect when the inventory was purchased) + (purchase * rate in effect when the inventory was purchased) - (ending inventory * average for the last 4 months of the year) -create a schedule for depreciation expense: (buildings*exchange rate on date of investment) + (equipment on hand * exchange rate on date of investment) + (equipment purchased * date it was purchased) -other expenses reported at average exchange rate for the year 3. -translation loss (gain) ???????? 4. -RE: (beg RE * date of original investment) + NI (already in $$) - (dividend 1 declared * exchange rate on date it was declared) - (dividend 2 declared * exchange rate on date it was declared) = end RE

eliminating entries related to intracompany inventory transfers

1. internal sale current period; external sale current period (it is the same for both downstream or upstream sale) -eliminate "double counting" of intracompany sales and COGS -debit sales and credit COGS for the internal selling price 2. internal sale current period; external sale future period (it is the same for both downstream or upstream sale) -reduce inventory carrying value; eliminate current period sale -debit Sales for the internal selling price, credit COGS for the external acquisition price, and credit Inventory as the plug/the difference 3. internal sale previous period; external sale future period; downstream: -reduce carrying value; eliminate unrealized gross profit from beginning RE balance -debit RE and credit Inventory for internal sales price - external acquisition price 4. internal sale previous period; external sale future period; upstream -reduce carrying value; eliminate unrealized gross profit from beginning RE and minority interest balances -debit RE for (% ownership)(internal sales price - external acquisition price), debit NonControlling Interest for (% of non-controlling ownership)(internal sales price - external acquisition price), and credit Inventory for internal sales price - external acquisition price 5. internal sale previous period; external sale current period; downstream: -transfer unrealized gross profit from RE into current period gross profit -debit RE and credit COGS for internal sales price-external acquisition price 6. internal sale previous period; external sale current period; upstream -transfer unrealized gross profit from RE and minority interest into current period gross profit -debit RE for (% ownership)(internal sales price - external acquisition price), debit NonControlling Interest for (% of non-controlling ownership)(internal sales price - external acquisition price), and credit COGS for internal sales price - external acquisition price

example of intracompany inventory transfers

1. internal sale previous period, external sale current period. downstream: -debit RE and credit COGS for (% of sale that happened this year)(internal sale-external acquisition price) 2. -credit COGS for (% of sale that happened this year)(internal sale-external acquisition price), debit RE for (% of controlling interest)(COGS credit), debit NonControlling Minority Interest for (% of non-controlling interest)(COGS credit) 3. -credit Inventory for (% left to sold: 100%-previous % sold))(internal sale-external acquisition price), debit RE for (% of controlling interest)(% left to sold)(internal sale-external acquisition price), and debit Noncontrolling interest as the plug

Coca-Cola example

OCI: current period and accumulated OCI shows up in shareholders equity -accumulated other comprehensive income is where the number shows up on the balance sheet -consolidated statements of comprehensive income: "net foreign currency translation adjustment" is a big part of OCI

quizzes: transaction occurring in a different currency

SPRING 2018 1. gain/loss for a quarter: -(amount in the other currency * exchange rate at the end of the current period) - (amount in the other currency * exchange rate at the time of the transaction) -in this case, A/P went up, so a loss is reported 2. at what amount would 400 gallons of maple syrup be reported at on the balance sheet on a certain day? -(total amount of original purchase in the other currency / number of gallons originally purchased) * (400 gallons left) * (exchange rate at the time of the transaction) -a check on this: the inventory would originally be recorded using the exchange rate on the date of delivery ((amount in the other currency * exchange rate at the time of the transaction). the reported amount would NOT change as a result of subsequent changes in exchange rates. accordingly, the inventory would be reported at (# of gallons remaining / total # of gallons originally purchased) * (number of US dollars inventory was originally purchased at) SPRING 2017 1. what amount will the acquired inventory be reported at on the BS at the end of the year? -amount in other current / exchange rate at the time of the transaction -it is not adjusted as a result of fluctuations of exchange rates when the US dollar is the reporting currency 2. exchange rate gain/loss related to the A/P inventory purchase -(amount of transaction in other currency / exchange rate at the end of the quarter) * (amount of transaction in other currency / exchange rate at the time of the transaction or the last quarter) -if A/P went up, it is a loss

quizzes: what is the functional currency?

SPRING 2019 3C: -if the parent corporation plans on purchasing all of the product made by the subsidiary, then the subsidiary is not really an autonomous entity -thus, the cash flows of the subsidiary are essentially the cash flows of the parent -this would seemingly outweigh the fact that production inputs (labor and raw materials) are purchased in the local market -as a result, the US$ is likely to be considered the functional currency SPRING 2017 #2: A) "all products are shipped to the US for sale after manufacturing is completed:" since the primary selling market is the US and intracompany transactions are frequent, the U.S. dollar would be the functional currency B) "when the price of labor in Brazil increases, the Brazilian subsidiary charges the US parent a higher price for ties, and sells to other buyers if the parent is not willing to pay the higher prices:" since the labor market is outside of the US and the selling price changes in response to changes in the cost of Brazilian labor, the Brazilian Real would be the functional currency

quizzes: consolidation after acquisition

Spring 2018 #1: -if you consolidate an investment (ex. owning 80% of the common stock), the account "Investment in Seller" does NOT appear on the consolidated balance sheet -asset on the BS one year after consolidation: (fair value on the date of the acquisition) - (one year of amortization) -note: amortize it over the shorter of its remaining economic or legal life -Noncontrolling interest: (initial value: % non-controlling ownership * implied fair value of the firm) + (% non-controlling ownership * NI of subsidiary) - (% non-controlling ownership * amortization recorded in that year) - (% non-controlling ownership * dividends of subsidiary) Spring 2019 #1: A. asset on the BS one year after consolidation: (fair value on the date of the acquisition) - (one year of amortization) B. Noncontrolling interest: (initial value: % non-controlling ownership * implied fair value of the firm) + (% non-controlling ownership * NI of subsidiary) - (% non-controlling ownership * amortization recorded in that year) - (% non-controlling ownership * dividends of subsidiary) C. Net income on the consolidated IS before allocation to non-controlling interest: -NI to non-controlling interest: ???

quizzes: intracompany transactions

Spring 2018 #2: Step 1. 70% of the intracompany transaction: internal sale current period, external sale current period, upstream -debit sales and credit COGS for (% that was sold in the current period)*(total internal selling price) Step 2. 30% of the intracompany transaction remained in inventory at the end of the year: internal sale current period, external sale future period: -debit sales for (% that will be sold in a future period)*(total internal selling price) , credit COGS for (% that will be sold in a future period)*(the external acquisition price), and credit Inventory as the plug/the difference Step 3. -add up the parent and subsidiary numbers for each category, and then subtract based on the journal entries SPRING 2019 #2 Step 1. 80% of the intracompany transaction: internal sale current period, external sale current period: -debit sales and credit COGS for (% that was sold in the current period)*(total internal selling price) Step 2. 20% of the intracompany transaction remained in inventory at the end of the year: internal sale current period, external sale future period: -debit sales for (% that will be sold in a future period)*(total internal selling price) , credit COGS for (% that will be sold in a future period)*(the external acquisition price), and credit Inventory as the plug/the difference -note: external acquisition price is the first price that the first party bought the inventory at or manufactured it at Step 3. -add up the parent and subsidiary numbers for each category, and then subtract based on the journal entries

quizzes: acquiring a foreign subsidiary when the local currency is the functional currency

Spring 2018 #3: 1. Net income: NI reported by the subsidiary on the Income statement * average rate for the year 2. Other comprehensive income from investment: the plug, which will be negative if the right side is greater than the left side -all assets and liabilities: use the rate at the end of the reporting period -shareholders equity accounts (common stock): use the rate at the time of the investment (usually) -RE: (RE at the beg of the year * rate at the beg of the year) + (NI at the end of the year * average rate for the year) - dividends if applicable -add up the assets, and add up the liabilities and SE -the plug is the right side - the left side -this is b/c since a "debit" is needed to balance the financials, and this is the first year after the acquisition, OCI related to the translation adjustment is negative 3. Comprehensive income = NI + OCI SPRING 2017 #3: -the amount of OCI is the amount of the plug -all assets and liabilities: use the rate at the end of the reporting period -shareholders equity accounts (common stock): use the rate at the time of the investment (usually) -RE: (RE at the beg of the year * rate at the beg of the year) + (NI at the end of the year * average rate for the year) - (dividend paid during the year * rate on the day the dividend was paid) -add up the assets, and add up the liabilities and SE -the plug is the right side - the left side -since a "debit" is needed to balance the financials, and this is the first year after the acquisition, OCI related to the translation adjustment is negative