CFA® Level II – Financial Reporting and Analysis Intercorpor Inter corporate ate Inves Investments tments www.irfanullah.co Graphs, charts, tables, examples, and figures are copyright 2012, CFA Institute. Reproduced and republished with permission from CFA Institute. Institute. All rights reserved.
Contents and Introduction 1. Introduction 2. Bas Basic ic Corp Corpor orat ate e Inv Inves estmen tmentt Cat Catego egorie riess 3. In Inve vestm stment entss in in Fin Financ ancial ial Ass Assets ets (IAS 39) 4. In Inves vestme tment nt in Fin Financ ancial ial Ass Assets ets (IF (IFRS RS 9) 5. In Inve vestm stment entss in Assoc Associat iates es and and Joint Joint Ven Ventur tures es 6. Bu Busi sine ness ss Co Comb mbin ina ati tion onss
2. Basic Corporate Investment Categories
3. Investment Investment in Financial Assets: IAS 39 Investor can not exert significant influence or control over the operations of the investees Four categories: 1. Hel eldd-tto-matu turi rity ty 2. Fa Fair ir valu value e thro through ugh pr profi ofitt or or loss loss 3. Avai aila labl blee-ffor or-s -sal ale e 4. Lo Loan anss and and rec recei eiv vab able less Reclassification of Investments Impairments
Financial Assets: Four Categories Held-to-Maturity
Fair Value through Profit or Loss
Available-for-Sale
Investments in financial assets with fixed or determinable payments; positive intent and ability to hold to maturity
Two sub-categories: Held for trading: intent to sell in the near term Designated at fair value
Investments not categorized as HTM or FVPL
Initially report at fair value and subsequently at amortized cost
Shown at fair value on balance sheet
Shown at fair value on balance sheet
Interest income and realized gains/losses shown on Income Statement
Interest income, realized gains/losses and unrealized gains/losses shown on Income Statement
Interest income and realized gains/losses shown on Income Statement
Unrealized gain/loss is ignored
•
•
Unrealized gain/loss shown as part of OCI
Loans and receivables are broadly defined as non-derivative financial assets with fixed or determinable payments.
Reclassifications and Impairments •
•
Reclassification of Investments
Allowed but with restrictions
Example: HTM AFS if there is a change in intent or change in ability to hold to maturity
Impairments
Financial asset is impaired whenever its carrying amount is expected to permanently exceed its recoverable amount
IFRS: at the end of each reporting period, financial assets not carried at fair value need to be reviewed for any objective evidence that the assets are impaired; for HTM securities, loss = difference between carrying value and PV of cash flows
U.S. GAAP: For AFS or HTM securities, determine whether decrease in value is temporary. If not temporary, the cost base is written down and loss recognized in the income statement
Example 1 How would this investment be reported on the balance sheet, income statement, and statement of shareholders’ equity at 31 December 2011, under either IFRS or U.S. GAAP (accounting is essentially the same in this case), if Baxter designated the investment as 1) held-to-maturity, 2) held for trading, 3) available-for-sale, or 4) designated at fair value? How would the gain be recognized if the debt securities were sold on 1 January 2012 for £352,000? How would this investment appear on the balance sheet at 31 December 2012? How would the classification and reporting differ if Baxter had invested in Cartel’s equity securities instead of its debt securities?
Working for Example 1
4. Investments in Financial Assets: IFRS 9 •
IFRS 9 will take effect by 2015 and will replace IAS 39
•
Significant convergence between IFRS and U.S. GAAP.
•
New approach considers the contractual characteristic of cash flows as well as the management of the financial assets. The portfolio approach of the current standard (i.e., designation of held for trading, available-for-sale, and held-to-maturity) is no longer appropriate and the terms available-for-sale and held- to-maturity no longer appear in IFRS 9.
Financial Assets Classification and Measurement Model Reclassification of equity instruments is not permitted because the initial classification of FVPL and FVOCI is irrevocable. Reclassification of debt instruments from FVPL to amortized cost (or vice versa) is only permitted if the business model for the financial assets (objective for holding the financial assets) has changed in a way that significantly affects operations. Changes to the business model will require judgment and are expected to be very infrequent.
5. Investments in Associates and Joint Ventures An investment is considered an “Associate Company” when the investor has (or can exercise) significant influence, but not control, over the investee’s business activities. Significant influence may be evidenced by: •
representation on the board of directors
•
participation in the policy-making process
•
material transactions between the investor and the investee
•
interchange of managerial personnel
•
technological dependency
Characteristics of joint ventures: 1) A contractual arrangement exists between two or more venturers, and 2) the contractual arrangement establishes joint control Equity method of accounting is required for investment in associates and joint venture
5.1 Equity Method of Accounting: Basic Principles •
Investment is initially recorded at cost
•
Share of income (not dividends) recorded in investor’s I/S
•
Investment account reflected as single line item on B/S
•
Value of investment = beginning value + share of profit – share of dividends
•
Investment classified as noncurrent asset on B/S
•
One line consolidation
Example 2 – Equity Method: Balance in Investment Account
5.2 Investment Costs That Exceed the Book Value of the Investee Value of investment (in proportion to investor’s stake) consists of:
Reported net asset value of investee (on investee’s B/S)
Fair value surplus/deficit relating to investee’s identifiable assets/liabilities Surplus is amortized over time
Goodwill = difference between purchase price and acquirer’s share of fair value of investee’s net assets
Example 3 – Equity Method Investment in Excess of Book Value
5.3 Amortization of Excess Purchase Price Excess amounts allocated to identifiable assets/liabilities of investee must be amortized on investor’s I/S Example 4 The plant and equipment are depreciated on a straight-line basis and have 10 years of remaining life. Prince reports net income for 2011 of €100,000 and pays dividends of €50,000. Calculate the following: 1. Goodwill included in the purchase price. 2. Investment in associate (Prince) at the end of 2011.
Working for Example 4
5.4 Fair Value Option & 5.5 Impairment •
•
Both IFRS and U.S. GAAP give the investor the option to account for their equity method investment at fair value. Under U.S. GAAP, this option is available to all entities; however, under IFRS, its use is restricted to venture capital organizations, mutual funds, unit trusts, and similar entities, including investment-linked insurance funds.
Both IFRS and U.S. GAAP require periodic reviews of equity method investments for impairment. If the fair value of the investment is below its carrying value and this decline is deemed to be other than temporary, an impairment loss must be recognized.
5.6 Transactions with Associates •
•
•
Because an investor company can influence the terms and timings of transactions with associates, profits from such transactions cannot be realized until confirmed through use of third party sale. Investor company’s share of any unrealized profit must be deferred by reducing the amount recorded under the equity method. This deferred profit is added back to the equity income when confirmed. Transactions may be upstream or downstream
Upstream (associate to investor) profit recorded in investee’s I/S.
Downstream (investor to associate) profit included in investor’s I/S.
Example 5
Example 6
5.7 Disclosure & 5.8 Issues for Analysts •
•
Companies must disclose assets, liabilities and results of equity method investments Is the equity method appropriate?
Investor may hold < 20% of investee but exercise significant influence
Investor may hold > 25 of investee but may not have significant influence
•
Equity method is effectively one-line consolidation
•
Net margin may be overstated but debt ratios understated
Quality of equity method earnings
Assumes that a dollar earned by investee is a dollar received by the investor company
6. Business Combinations •
Involve the combination of two or more organizations into a larger economic entity
•
IFRS: No distinction among business combinations; one party identified as acquirer
•
US GAAP: Four types of business combinations
Merger
Acquisition
Consolidation
Variable interest (special purpose) entity
Accounting for Business Combinations •
•
•
Historically, two methods have been used:
Pooling of Interest
Purchase Method
Pooling of interest method has been discontinued:
US GAAP discontinued it in June 2001
IFRS discontinued it in 2004
Both U.S. GAAP and IFRS require use of acquisition method (replaces the purchase method)
6.1 Pooling of Interests and Purchase Methods •
•
Pooling of Interests
Combined companies portrayed as if they had always existed as one
Assets and liabilities of combined companies recorded at book values and pre-combination retained earnings are included in the balance sheet of the combined companies
Purchase Method
Net assets were recorded at fair values
For the same level of revenue, the purchase method results in lower reported income than the pooling of interests method
6.2 Acquisition Method •
Recognition and measurement of identifiable assets and liabilities
•
Recognition and measurement of contingent liabilities
•
Recognition and measurement of indemnification assets
•
Recognition and measurement of financial assets and liabilities
•
Recognition and measurement of goodwill
•
Recognition and measurement acquisition price is less than fair value
Example 7 – Recognition and Measurement of Goodwill
6.3 Impact of the Acquisition on Financial Statements and Post-Acquisition Example 8 Jefferson has no identifiable intangible assets. Show the balances in the postcombination balance sheet using the acquisition method.
Working for Example 8
6.4 The Consolidation Process •
Combine assets, liabilities, revenues and expenses of subsidiary with parent
•
Intercompany transactions are eliminated
•
•
For business combination with less than 100% acquisition show non-controlling (minority) interests on balance sheet Difference between IFRS and U.S. GAAP in terms of how minority interest is measured
U.S. GAAP says use Full Goodwill method
IFRS says either Full Goodwill or Partial Goodwill methods can be used
Example 9 – Non-controlling Asset Valuation 1. Calculate the value of PP&E (net) on the consolidated balance sheet under both IFRS and U.S. GAAP. 2. Calculate the value of goodwill and the value of the non-controlling interest at the acquisition date under the full goodwill method. 3. Calculate the value of goodwill and the value of the non-controlling interest at the acquisition date under the partial goodwill method.
Example 9 - Working
Income Statement Impact Non-controlling (minority) interests are presented as a line item reflecting the allocation of profit or loss for the period. Intercompany transactions, if any, are eliminated in full.
Goodwill Impairment Goodwill is not amortized, it must be tested for impairment at least annually. Once written down, goodwill cannot be restored. IFRS Goodwill is allocated to acquirer’s cash generating units Goodwill impairment testing is done using a one-step approach Impairment loss is based on difference between carrying value and recoverable amount U.S. GAAP Goodwill is allocated to acquirer’s reporting units Goodwill impairment testing is done using a two-step approach 1.
Identify impairment possibility by comparing carrying value and fair value
2.
Determine implied fair value of goodwill: fair value of reporting unit – fair value of net assets
Examples 10 and 11 – Goodwill Impairment
6.5 Financial Statement Presentation Subsequent to the Business Combination
IFRS and U.S. GAAP have similar formats for consolidated income statements. Each line item (e.g., turnover [sales], cost of sales, etc.) includes 100% of the parent and the subsidiary transactions after eliminating any upstream (subsidiary sells to parent) or downstream (parent sells to subsidiary) intercompany transactions. The portion of income accruing to non-controlling shareholders is presented as a separate line item on the consolidated income statement.
6.6 Variable Interest and Special Purpose Entities Special purpose entities (SPEs) are created to accommodate specific needs of the sponsoring entity. The sponsoring entity frequently transfers assets to the SPE, obtains the right to use assets held by the SPE, or performs services for the SPE, while other parties provide funding to the SPE. SPEs can be a legitimate financing mechanism for a company to segregate certain activities and thereby reduce risk. SPEs may take the form of a limited liability company (corporation), trust, partnership, or unincorporated entity.
Variable Interest Entity VIE is a U.S. GAAP concept and refers to an entity that is financially controlled by one or more parties that do not hold a majority voting interest. A SPE is a VIE if: 1.
Total equity at risk is insufficient to finance activities without financial support from other parties
2.
Equity investors lack any one of the following: a.
the ability to make decisions
b.
the obligation to absorb losses
c.
the right to receive returns
The primary beneficiary of a VIE must consolidate it as its subsidiary regardless of how much of an equity investment it has in the VIE.
Example 12 – Receivables Securitization
Example 12 - Working
6.7 Additional Issues in Business Combinations That Impair Comparability •
Contingent Assets and Liabilities
•
Contingent Considerations
•
In-Process R&D
•
Restructuring Costs
Summary Investments in Financial Assets
Investment in Associates
Joint Ventures
Business Combinations
Description
No significant influence
Significant influence
Shared control
Control
Accounting
HTM, FVPL, AFS
Equity
Equity
Acquisition Method
Assets Liabilities Equity Revenue Net Income Leverage NPM ROE ROA
