Intercorporate Investments

Degree of Influence
Category
(OVERRIDING FACTOR)

Minority Passive No significant influence

Minority Active Significant Influence

Joint Venture Joint Control

Controlling Interest Control

Control(IFRS)/Primary
Special Purpose Entities(SPE's)
Beneficiary(US GAAP)

Pooling of Interest Method

No goodwill recognized
Lower Assets
Higher income due to lower depreciation
Intercorporate Investments

Accounting
Ownership Level
Method

INVESTMENTS
IN FINANCIAL
ASSETS
Held for Trading,
< 20%
Available for Sale,
Held to Maturity,
Designated At
Fair Value

20 - 50 % Equity Method

Equity Method(US
GAAP requires)
Proportionate
Equal amounts of control
Consolidation(IFR
S preferred, but
accepts Equity)
> 50% Full Consolidation

Varies Full Consolidation

 Notes

- Dividends are NOT included in

income, but are in cash flow
- Under the equity method, the
investor recognizes its pro-rata share
of the affiliate's income on IS

"Control" means
- benefits from SPE
- has decision making powers

"Primary Beneficiary" means

- absorbs majority of losses
- receives majority of returns
NO MORE QUALIFIED SPE's
- absords majority of risks OR
receives majority of rewards
- has residual interest
* A lease residual guarantee and
subordinated debt are both
examples of variable interests.

Examples of VIE's
* Debt Guarantees
* Subordinated debt instruments
* Lease residual value guarantee
 Category BS Treatment

Held to Maturity(ONLY Reported at amortized

DEBT) cost

Fair Value, UNREALIZED

Available for Sale
G/L goes to OCI
Held for
Trading/Designated at Fair Fair Value
Value

* No change in Interest Income when reclassification occurs between any cat

* Changes in FV for AFS and HFT get marked to market on B/S with different treatment fo

Reclassification
FROM TO
Held for Trading Any Other Category
Any Other Category Held for Trading
Held to Maturity Available For Sale

Available For Sale Held to Maturity

* Under IFRS reclassifications to/from HFT category are extremely restricted. Market Turmoil
must exist
 IS Treatment Notes
When bought at discount(Cost
< Par) interest income is
Interest Income(Coupon Receipts) +/- higher
REALIZED Gains/Losses When bought at
premium(Cost>Par) interest
income is lower
Dividends + Interest Income +
Realized G/L
Dividends + Interest Income +
REALIZED&UNREALIZED G/L

Income when reclassification occurs between any category

t marked to market on B/S with different treatment for Unrealized G/L's

ssification
Unrealized Gains/Losses
Recognize in IS
Recognize in IS
Recognize in OCI
Available-for-sale securities transferred
to held-to-maturity are transferred at
fair market value, and any unrealized
gains or losses remain in equity but are
subsequently amortized over the
remaining life of the security.

ategory are extremely restricted. Market Turmoil

st exist
 Proportionate
Equity Method Consolidation(IFRS
ONLY!!!!)
Net Income Same Same
Equity Same Same
Assets and Liabilities Lowest In Between
Sales Lowest In Between
Highest due to same NI
Incorporates some of
Profit Margin and ROA but lower Sales &
sub's assets and sales
Assets

ROE Same Same

Lowest since only Higher as some of subs

Debt to Equity
parents debt is included debt is included

* Generally Equity Method produces the most favorable results with the Acquisition Method
results
* Be careful with SPE's. If required to consolidate, no impact on financial statements. If not requi
usually goes up with AR going down.
* Proportionate consolidations and acquisitions are the same except for the exclusion of minority i
proportionate consolidations.
 Acquisition
Method/Consolidation
Same
Same
Highest
Highest
Lowest due to same NI but
highest denominator for
Same if 100% ownership. Lower
if less than 100% since have to
include noncontrolling interest
in Equity(higher denominator)
Highest as consolidated
statements reflect all debt but
can get skewed if less than
100% ownership -> D/E gets
lowered due to additional E b/c
of Non-Controlling Interest
added to E

with the Acquisition Method the worst

nancial statements. If not required, cash

own.
t for the exclusion of minority interests in
s.
Presentation Currency - currency financial statements are reported in. Same as Parent Currency
Local Currency - currency foreign subsidiary carries out transactions
Functional Currency(defines translation method) - currency of primary environment in which sub

Criteria Method

Temporal
If FC = PC
(Remeasurement)

If LC=FC(i.e FC NOT Current

EQUAL PC) (Translation)
 Hyperinflationary(3
years of >= 26% US GAAP - Temporal
inflation) IFRS - restate for inflation, then
Can use (1+INFR)^3 -1 use Current
>= 100%

Ratio Analysis

* All pure balance sheet and

income statement ratios will stay
the same
* If foreign currency
Current Method depreciating, mixed ratios will be
larger
* If foreign currency
appreciating, mixed ratios will be
smaller.
Temporal Method More complicated
 tements are reported in. Same as Parent Currency.
rries out transactions
od) - currency of primary environment in which subsidiary operates

Translation Method Rules

Translation/Remeasurement
Reason
Steps
1) Start with Balance Sheet
2) Current rates apply to Monetary
Items such as: Cash, AR, pre-paids,
DTA's and ALL DEBT
3) Historical Rates apply to:
Nonmonetary Assets/Liabilities, PIC,
* Subsidiary is highly integrated B/S Related expenses. ONLY
with parent/acts as sales EXCEPTION - HFT/AFS securities
outlet(US GAAP) use Current Rates
* Parent company influences 4)Move to Income Statement
sales prices(IFRS) 5) Sales and most expenses use
* Parent makes operating, weighted average exchange rate.
investing, and financing ONLY EXCEPTION is COGS, Depr
decisions and Amortization which use
historical rates(same as B/S
items)
6) Net Income is derived using:
NI = RE(end) - RE(beg) +
Dividends

1) Start with Income Statement.

2) ALL items translated at weighted
average exchange rate
3) Move to Balance Sheet. ALL items
translated using current exchange
rates.
* Self-contained, independent
4) Paid in capital(contributed
and operating, investing, and
capital) uses HISTORICAL rates.
financing decisions are
Only exception.
decentralized from parent
5) Retatined Earnings derived using
formula:
RE(end) = RE(Beg) + NI-
Dividends(use rate when paid)
 1. Nonmonetary assets and liabilities
are restated by multiplying the
historical cost of the asset or liability
by the change in the general price
index from the date of acquisition to
the balance sheet date. Monetary
Ever weakening currency due to assets and liabilities do not need
hyperinflation reduces value of to be restated.
PPE and leads to "vanishing 2. Equity is restated by multiplying
plant" syndrome. Using the component of equity by the
temporal method under US change in price index from the
GAAP brings back older beginning of the period (or date of
historical rate used when asset contribution if later) to the balance
was acquired/built and solves sheet date.
problem 3. Income statement items are
restated by applying the change in
price index from the date the items
were recorded to the balance sheet
date. Generally, the average
price index for the period is
used.
slation Method Rules
Inventory Treatment

FIFO - use current rates as more

recently purchased units remain in
inventory.
LIFO - use historical ratesas older units
purchased at historical rates remain in
inventory

Irrelevant
Based on method see above
 Balance Sheet Exposure

First determine if there is a Net Monetary Asset(NMA) or

Liability(NML).
If NMA - Direct relationship with foreign currency.
GAINS when Foreign Currency STRENGTHENS, Loses
when Foreign Currency Weakens.
If NML - Inverse Relationship with foreign currency.

Net Monetary Asset(Assets always > Liabilities) - b/c all

B/S items are revalued using current rate. Direct
relationship with foerign currency. GAINS when Foreign
Currency STRENGTHENS, Loses when Foreign Currency
Weakens
Based on method see above
 Gains/Losses

On Income Statement

Direct to Equity
Under IFRS, purchasing power
gains and losses are
reported on the income
statement when a foreign
subsidiary operates in a
hyperinflationary environment.
Three Measures of Defined Benefit Pension Plan under US GAAP
1) Projected Benefit Obligation (PBO) aka (DBO) under IFRS – Defined Benefit
Obligation
- Actuarial PV of vested and non-vested benefits earned including projected salary
increases.
2) Accumulated Benefit Obligation (ABO)
- Actuarial PV of vested and non-vested benefits based on current salaries but
Ignores any assumptions of future salary increases. For non-pay plans ABO
= PBO
3) Vested Benefit Obligation (VBO)
- Amount of ABO that is not contingent on future service

Components of Pension Expense

* Current Service Cost - PV of benefits earned by employees during current period

+ Interest Cost - increase in DBO during current period due to passage of time
- Expected Return on Plan Assets - assets in plan invested in trust used to satsify
pension requirements in future.
+/- Amortization of Past Service Cost(Benefit) add costs and subtract benefits
+/- Amortization of Actuarial Losses(Gains) add costs and subtract benefits
= Current Period Pension Expense

ECONOMIC Pension Expense - eliminates smoothing effects. Leads to more

volatile measure
* Current Service Cost
+ Interest Cost
- ACTUAL Return on Plan Assets
+/- Past Service Cost(Benefit) from CURRENT PERIOD Amendments add costs and
subtract benefits
+/- CURRENT PERIOD(NOT AMORTIZED) Actuarial Losses(Gains) add costs and
subtract benefits
= ECONOMIC Pension Expense

Can also use Change in Funded Status - Employer(not Employee) Contributions.

Should = # from above formula.

* Pension expense typically does not = actual cash flow.

* Cash flows are operating expenses.
* However, when firm's contributions > economic pension expense, acts like principal
reduction on a loan. When contribtions < economic pension expense, acts like source
of borrowing.----> Should be reclassified as a financing CF
 Impact of Assumptions on DBO and Pension
Expense
Higher
Higher Discount Comp Higher Exp
Rate Growth Return on Assets
DBO LOWER Rate
HIGHER NO EFFECT
Pension
LOWER HIGHER LOWER
Expense
Earnings HIGHER LOWER HIGHER
* Reported pension expense is a net (smaller) amount and
therefore, is generally quite sensitive to relatively minor changes in
actuarial assumptions. Changing an assumption may have a small
effect on the projected benefit obligation (PBO) but may have a
much larger effect on the funded status (which is a net pension
amount).
 Relationship between Stock Option Value,
Compensation Expense, and NI
Longer Expected
Higher
Term, Volatility,
Dividends
and RFR
Option
Compensatio Option worth more,
worth less,
n Expense HIGHER
LOWER
Earnings LOWER Higher
 IFRS
Funded Status
± Unrecognized Past Service Cost (Benefit)
± Unrecognized actuarial losses (Gains)
= Prepaid (Accrued) Pension Cost <----
Difference between pension expense and
B/S Reporting cash contributed

Unrealized past service cost and/or

actuarial gains/losses disclosed in
footnotes ONLY

Companies allowed to disclose individual

I/S Reporting
components on line items
 `

US GAAP

* Net Funded Status reflected as asset

or liability without adjustment for
unrecognized items. Reflects
economic reality.
* Unrealized past service costs and
actuarial gains/losses are in
OCI(equity) until they get amortized.
Then they hit I/S

Requires various components to

be reported as a Net Amount
Six phases of FSA
1) Determine objectives and context
2) Collect input data
3) Process input data
4) Analyze and interpret data
5) Develop and communicate
conclusions and recommendations
6) Update analysis periodically
same as Profit Margin x ROA
Capitalizing an Operating Lease
Why is data being collected,
communicate with client or supervisor
Economic, Financials, Interviews with
suppliers, customers, executives, etc
Adjustments, Common size statements,
Forecasts
Address concerns from prior analysis,
trends, etc.
Securitizing Receivables
1)To get amount to add to asset and
liability base(no change in equity),
calculate PV of remaining lease
payments given the capitalization rate
2) to adjust EBIT, add lease expense,
and subtract new depreciation(PV of 1) If receivables securitized, add equal
Operating Lease Commitments/Lease amounts back to Assets and Liabilities
Term) then calculate any ratios. Equity NOT
3) To adjust Interest Expense, take AFFECTED
amount from step 1 and X rate of LT 2) If company has investment in another
bonds then add to existing interest company that contributes to earnings,
expense. take % of ownership
Adjustments to Improve Quality

Manipulation Technique Categories

Revenue Recognition

Expense Recognition

Balance Sheet

Balance Sheet Adjustments

* VIE's brought back on B/S. Increases
Assets and Liabilities in same amounts.
* Capitalize operating leases. See
section below
* Securitization of AR - increase AR and
liabilities in same amount.
* LIFO inventory value - increase
inventory by amount of reserve and
equity in same amounts
 Warning Signs Adjustments
* Look for large changes in AR and
unearned revenue
* Increasing DSO
* Compare to actual cash collected
* Disproportionate Revenue in most
recent 1/4
* Large changes in fixed assets or
inventory
* Change in depreciation
assumptions(Salvage value, Average
life, etc)
* LIFO liquidation
* Calculate Core Operating
Margin([Sales-COGS-SG&A]/Sales)
* VIE's brought back on B/S. Increases
Assets and Liabilities in same amounts.
Raises leverage ratios.
* Capitalize operating leases. See
section below
* Securitization of AR - increase AR and
liabilities in same amount. Raises
leverage ratios
* LIFO inventory value - increase
* Check for operating leases and inventory by amount of reserve and
capitalize them equity in same amounts
* Check for goodwill impairment charge

Effects
Raises leverage ratios. Receivable
turnover decreases, ROA decreases

Raises leverage ratios.

Raises leverage ratios

Effects