Financial

Statement
Analysis
K R Subramanyam
John J Wild

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

5-2

Analyzing Investing Activities:

Intercorporate Investments

05

CHAPTER

5-3

Investment Securities
Composition
Investment
Investment (marketable)
(marketable) securities:
securities:
Debt
Debt Securities
Securities
Government
Government or
or corporate
corporate debt
debtobligations
obligations
Equity
Equity Securities
Securities
Corporate
Corporatestock
stockthat
thatis
isreadily
readilymarketable
marketable

5-4

Investment Securities
Accounting for Investment Securities

SFAS 115.
Departure from the traditional lower-of-cost-ormarket principle.
Prescribes that investment securities be reported on
the balance sheet at cost or fair (market) value,
depending on the type of security and the degree of
influence or control that the investor company has
over the investee company.
Accounting is determined by its classification.

5-5

Investment Securities
Accounting for Debt Securities

5-6

Investment Securities
Accounting for Transfers between Security Classes

5-7

Investment Securities
Classification and Accounting for Equity Securities

5-8

Investment Securities
Analyzing Investment Securities
Two main objectives:
To separate operating performance from investing (and
financing) performance
Remove all gains (losses) relating to investing activities
Separate operating and nonoperating assets when
determining RNOA

To analyze accounting distortions from securities

Opportunities for gains trading

Liabilities recognized at cost
Inconsistent definition of equity securities
Classification based on intent

5-9

Equity Method Accounting

Required for intercorporate investments in which
the investor company can exert significant
influence over, but does not control, the investee.
Reports the parents investment in the subsidiary, and
the parents share of the subsidiarys results, as line
items in the parents financial statements (one-line
consolidation)
Note: Generally used for investments representing
20 to 50 percent of the voting stock of a companys
equity securities--main difference between
consolidation and equity method accounting rests in
the level of detail reported in financial statements

5-10

Equity Method Accounting

Equity Method Accounting

Investment account:
Initially recorded at acquisition cost
Increased by % share of investee earnings
Decreased by dividends received

Income:
Investor reports % share of investee company earnings
as equity earnings in its income statement
Dividends are reported as a reduction of the investment
account, not as income

5-11

Equity Method Accounting

Equity Method Mechanics

Assume that Global Corp.

acquires for cash a 25%
interest in Synergy, Inc. for
$500,000, representing onefourth of Synergys
stockholders equity as of the
acquisition date.
Acquisition entry:

Investment
Cash

500,000
500,000

Synergy, Inc.
Current assets
PP&E
Total assets

700,000
5,600,000
6,300,000

Current liabilities
300,000
Long-term debt
4,000,000
Stockholders Equity 2,000,000
Total liabs and equity 6,300,000

Equity Method Accounting

5-12

Equity Method Mechanics

Subsequent to the
acquisition date, Synergy
reports net income of
$100,000 and pays
dividends of $20,000.
Global records its
proportionate share of
Synergys earnings and
the receipt of dividends
as follows:

Investment 25,000
Equity earnings 25,000
(to record proportionate share of
investee company earnings)

Cash 5,000
Investment

5,000

(to record receipt of dividends)

5-13

Equity Method Accounting

Important points:
Investment account reported at an amount equal to the proportionate
share of the stockholders equity of the investee company. Substantial
assets and liabilities may not be recorded on balance sheet unless the
investee is consolidated.
Investment earnings should be distinguished from core operating
earnings (unless strategic).
Investments are reported at adjusted cost, not at market value.
Should discontinue equity method when investment is reduced to zero
and should not provide for additional losses unless the investor has
guaranteed the obligations of the investee or is otherwise committed to
providing further financial support to the investee.
Resumes once all cumulative deficits have been recovered via investee
earnings.

Excess of initial investment over the proportionate share of the book

value is allocated to identifiable tangible and intangible assets that are
depreciated/amortized over their respective useful lives. Investment
income is reduced by this additional expense. The excess not allocated in
this manner is treated as goodwill and is no longer amortized.

5-14

Business Combinations
The merger, acquisition, reorganization, or restructuring of two or more
businesses to form another business entity
Motivations
enhance company image and growth potential
acquiring valuable materials and facilities
acquiring technology and marketing channels
securing financial resources
strengthening management
enhancing operating efficiency
encouraging diversification
rapidity in market entry
achieving economies of scale
acquiring tax advantages
management prestige and perquisites
management compensation

5-15

Business Combinations
Accounting for Business Combinations

Purchase method of accounting

Companies are required to recognize on their balance sheets
the fair market value of the (tangible and intangible) assets
acquired together with the fair market value of any liabilities
assumed.
Tangible assets are depreciated and the identifiable intangible
assets amortized over their estimated useful lives.

Nonamortization of goodwill

5-16

Business Combinations
Consolidated Financial Statements
Consolidated
Consolidated financial
financial statements
statements report
reportthe
theresults
resultsof
ofoperations
operations
and
andfinancial
financialcondition
conditionof
ofaaparent
parentcorporation
corporationand
andits
itssubsidiaries
subsidiariesin
inone
one
set
setof
ofstatements
statements

Basic Technique of Consolidation

Consolidation
Consolidationinvolves
involvestwo
twosteps:
steps:aggregation
aggregationand
andelimination
elimination
Aggregation
Aggregationof
ofassets,
assets,liabilities,
liabilities,revenues,
revenues,and
and
expenses
of
subsidiaries
with
the
parent
expenses of subsidiaries with the parent
Elimination
Eliminationof
ofintercompany
intercompanytransactions
transactions
(and
(andaccounts)
accounts)between
betweensubsidiaries
subsidiariesand
andthe
theparent
parent
Note:
Note:Minority
Minority interest
interestrepresents
representsthe
theportion
portionof
ofaasubsidiarys
subsidiarysequity
equity
securities
securitiesowned
ownedby
byother
otherthan
thanthe
theparent
parentcompany
company

5-17

Business Combinations
Consolidation Illustration
On
OnDecember
December 31,
31,Year
Year 1,
1, Synergy
SynergyCorp.
Corp. purchases
purchases100%
100%of
of
Micron
MicronCompany
Companyby
by exchanging
exchanging10,000
10,000shares
shares of
of its
its common
common
stock
stock($5
($5par
par value,
value, $77
$77market
marketvalue)
value)for
forall
allof
of the
thecommon
common
stock
stockof
ofMicron.
Micron.
On
Onthe
thedate
dateof
ofthe
theacquisition,
acquisition, the
the book
bookvalue
valueof
of Micron
Micronisis
$620,000.
$620,000.Synergy
Synergyisiswilling
willingto
topay
paythe
themarket
market price
priceof
of
$770,000
$770,000because
becauseititfeels
feelsthat
that Microns
Micronsproperty,
property,plant,
plant, and
and
equipment
equipment(PP&E)
(PP&E) isisundervalued
undervaluedby
by$20,000,
$20,000, itithas
hasan
an
unrecorded
unrecorded trademark
trademarkworth
worth $30,000
$30,000and
andintangible
intangiblebenefits
benefits
of
of the
thebusiness
businesscombination
combination(corporate
(corporatesynergies,
synergies,market
market
position,
position,and
andthe
thelike)
like)are
arevalued
valued at
at $100,000.
$100,000.

Business Combinations
Consolidation Illustration
The
Thepurchase
purchaseprice
priceis,
is,therefore,
therefore,allocated
allocatedas
asfollows:
follows:
Purchase
770,000
Purchaseprice
price
770,000
Book
620,000
Bookvalue
valueof
ofMicron
Micron
620,000
Excess
150,000
Excess
150,000
Excess
useful
Excessallocated
allocatedto
to
usefullife
life
Undervalued
UndervaluedPP&E
PP&E
Trademark
Trademark
Goodwill
Goodwill

20,000
10
20,000
10
30,000
55
30,000
100,000
100,000 indefinite
indefinite
150,000
150,000

annual
annual
deprec/amort.
deprec/amort.
2,000
2,000
6,000
6,000
-0-0-

5-18

5-19

Business Combinations
Synergy Corp and Micron Company
Consolidated Income Statement Steps

The four consolidation entries are

1. Replace $620,000 of the investment account with the book
value of the assets acquired. If less than 100% of the
subsidiary is owned, the credit to the investment account is
equal to the percentage of the book value owned and the
remaining credit is to a liability account, minority interest.
2. Replace $150,000 of the investment account with the fair value
adjustments required to fully record Microns assets at fair
market value.
3. Eliminate the investment income recorded by Synergy and
replace that account with the income statement of Micron. If
less than 100% of the subsidiary is owned, the investment
income reported by the Synergy is equal to its proportionate
share, and an additional expense for the balance is reported
for the minority interest in Microns earnings.
4. Record the depreciation of the fair value adjustment for
Microns PP&E and the amortization of the trademark. Note,
there is no amortization of goodwill under current GAAP.

5-20

Business Combinations
Synergy Corp and Micron Company
Consolidated Income Statement Steps

Income statement of Synergy is combined with that of Micron.

Depreciation / amortization of excess of purchase price over the
book value of Microns assets is recorded as an additional
expense in the consolidated income statement.
Any intercompany profits on sales of inventories held by the
consolidated entity at year-end, along with any intercompany
profits on other asset transactions, are eliminated.
Equity investment account on Synergys balance sheet is
replaced with the Micron assets / liabilities to which it relates.
Consolidated assets / liabilities reflect the book value of Synergy
plus the book value of Micron, plus the remaining undepreciated
excess of purchase price over the book value of Micron assets.
Goodwill, which was previously included in the investment
account balance, is now broken out as a separately identifiable
asset on the consolidated balance sheet.

5-21

5-22

Business Combinations
Impairment of Goodwill

Goodwill recorded in the consolidation process is subject to

annual review for impairment.
The fair market value of Micron is compared with the book
value of its associated investment account on Synergys books.
If the current market value is less than the investment balance,
goodwill is deemed to be impaired and an impairment loss
must be recorded in the consolidated income statement.
Impairment loss reported as a separate line item in the
operating section of Synergys consolidated income statement.
A portion of the goodwill contained in Synergys investment
account is written off, and the balance of goodwill in the
consolidated balance sheet is reduced accordingly.

5-23

Business Combinations
Issues in Business Combinations
Contingent
ContingentConsideration
Consideration--aacompany
companyusually
usuallyrecords
recordsthe
theamount
amountof
of
any
anycontingent
contingentconsideration
considerationpayable
payablein
inaccordance
accordancewith
withaapurchase
purchase
agreement
agreementwhen
whenthe
thecontingency
contingencyis
isresolved
resolvedand
andthe
theconsideration
considerationisis
issued
issuedor
orissuable.
issuable.
Allocating
AllocatingTotal
TotalCost
Cost--once
onceaacompany
companydetermines
determinesthe
thetotal
totalcost
costof
ofan
an
acquired
acquiredentity,
entity,ititis
isnecessary
necessaryto
toallocate
allocatethis
thiscost
costto
toindividual
individualassets
assets
received;
received;the
theexcess
excessof
oftotal
totalcost
costover
overthe
theamounts
amountsassigned
assignedto
toidentifiable
identifiable
tangible
tangibleand
andintangible
intangibleassets
assetsacquired,
acquired,less
lessliabilities
liabilitiesassumed,
assumed,is
isrecorded
recorded
as
asgoodwill.
goodwill.
In-Process
In-ProcessResearch
Research&
&Development
Development(IPR&D)
(IPR&D)-- some
somecompanies
companiesare
are
writing
writingoff
offaalarge
largeportion
portionof
ofan
anacquisitions
acquisitionscosts
costsas
aspurchased
purchasedresearch
research
and
anddevelopment.
development.Pending
Pendingaccounting
accountingstandard
standardwill
willrequire
requirecapitalization
capitalizationof
of
IRR&D
IRR&Dand
andannual
annualtesting
testingfor
forimpairment.
impairment.
Debt
Debtin
inConsolidated
ConsolidatedFinancial
FinancialStetements
Stetements--Liabilities
Liabilitiesin
inconsolidated
consolidated
financial
statements
do
not
operate
as
a
lien
upon
a
common
financial statements do not operate as a lien upon a common
pool
poolof
ofassets.
assets.

5-24

Business Combinations
Issues in Business Combinations
Gain
Gainon
onsubsidiary
subsidiary stock
stocksales
sales --The
Theequity
equityinvestment
investmentaccount
accountis
is
increased
increasedvia
viasubsidiary
subsidiarystock
stocksales.
sales.Companies
Companiescan
canrecord
recordthe
thegain
gaineither
either
to
toincome
incomeor
orto
toAPIC
APIC
Consequences
Consequencesof
of Accounting
Accountingfor
forGoodwill
Goodwill--goodwill
goodwillisisnot
notpermanent
permanent
and
andthe
thepresent
presentvalue
valueof
ofsuper
superearnings
earningsdeclines
declinesas
asthey
theyextend
extendfurther
furtherinto
into
the
thefuture
futurefuture
futureimpairment
impairmentlosses
lossesare
arelikely
likely
Push
PushDown
DownAccounting
Accounting --aacontroversial
controversialissue
issueis
ishow
how the
theacquired
acquired
company
company(from
(fromaapurchase)
purchase)reports
reportsassets
assetsand
andliabilities
liabilitiesin
inits
itsseparate
separate
financial
financialstatements
statements(if
(ifthat
thatcompany
companysurvives
survivesas
asaaseparate
separateentity)
entity)

5-25

Business Combinations
Additional Limitations of Consolidated Financial Statements

Financial statements of the individual companies composing the

larger entity are not always prepared on a comparable basis.
Consolidated financial statements do not reveal restrictions on use
of cash for individual companies. Nor do they reveal intercompany
cash flows or restrictions placed on those flows.
Companies in poor financial condition sometimes combine with
financially strong companies, thus obscuring analysis.
Extent of intercompany transactions is unknown unless the
procedures underlying the consolidation process are reported.
Accounting for the consolidation of finance and insurance
subsidiaries can pose several problems for analysis. Aggregation
of dissimilar subsidiaries can distort ratios and other relations.

5-26

Business Combinations
Additional Limitations of Consolidated Financial Statements

Financial statements of the individual companies composing the

larger entity are not always prepared on a comparable basis.
Consolidated financial statements do not reveal restrictions on use
of cash for individual companies. Nor do they reveal intercompany
cash flows or restrictions placed on those flows.
Companies in poor financial condition sometimes combine with
financially strong companies, thus obscuring analysis.
Extent of intercompany transactions is unknown unless the
procedures underlying the consolidation process are reported.
Accounting for the consolidation of finance and insurance
subsidiaries can pose several problems for analysis. Aggregation
of dissimilar subsidiaries can distort ratios and other relations.

5-27

Business Combinations
Consequences of Accounting for Goodwill
Superior competitive position is subject to change.
Goodwill is not permanent.

Residual goodwill - measurement problems.

Timing of goodwill write-off seldom reflects prompt
recognition of this loss in value.
In many cases goodwill is nothing more than mechanical
application of accounting rules giving little consideration to
value received in return.
Goodwill on corporate balance sheets typically fails to reflect
a companys entire intangible earning power

5-28

Business Combinations
Pooling Accounting
Used prior to the passage of the current business
combination accounting standards.
Disallowed for combinations initiated post June 30, 2001.
Companies may continue its use for acquisitions accounted for
under that method prior to the effective date of the standard.
Under the purchase method, the investment account is debited for the
purchase price. Under the pooling method, this debit is in the amount of
the book value of the acquired company. Assets are not written up from
the historical cost balances reported on the investee company balance
sheet, no new intangible assets are created in the acquisition, and no
goodwill is reported. The avoidance of goodwill was the principle attraction
of this method.

5-29

Business Combinations
Pooling method Illustration
On
OnDecember
December 31,
31,Year
Year 1,
1, Synergy
SynergyCorp.
Corp. purchases
purchases100%
100%of
of
Micron
MicronCompany
Companyby
by exchanging
exchanging10,000
10,000shares
shares of
of its
its common
common
stock
stock($5
($5par
par value,
value, $77
$77market
marketvalue)
value)for
forall
allof
of the
thecommon
common
stock
stockof
ofMicron.
Micron.
On
Onthe
thedate
dateof
ofthe
theacquisition,
acquisition, the
the book
bookvalue
valueof
of Micron
Micronisis
$620,000.
$620,000.Synergy
Synergyisiswilling
willingto
topay
paythe
themarket
market price
priceof
of
$770,000
$770,000because
becauseititfeels
feelsthat
that Microns
Micronsproperty,
property,plant,
plant, and
and
equipment
equipment(PP&E)
(PP&E) isisundervalued
undervaluedby
by$20,000,
$20,000, itithas
hasan
an
unrecorded
unrecorded trademark
trademarkworth
worth $30,000
$30,000and
andintangible
intangiblebenefits
benefits
of
of the
thebusiness
businesscombination
combination(corporate
(corporatesynergies,
synergies,market
market
position,
position,and
andthe
thelike)
like)are
arevalued
valued at
at $100,000.
$100,000.

5-30

Business Combinations
Pooling method Illustration

Pooling method Illustration

5-31

5-32

Derivative Securities
Background
Hedges
Hedgesare
arecontracts
contractsthat
thatseek
seekto
toinsulate
insulatecompanies
companiesfrom
from
market
marketriskssecurities
riskssecuritiessuch
suchas
asfutures,
futures,options,
options,and
andswaps
swapsare
are
commonly
commonlyused
usedas
ashedges
hedges
Derivative
Derivative securities,
securities, or
or simply
simply derivatives
derivatives are
arecontracts
contracts

whose
whosevalue
valueis
isderived
derivedfrom
fromthe
thevalue
valueof
ofanother
anotherasset
assetor
or
economic
economicitem
itemsuch
suchas
asaastock,
stock,bond,
bond,commodity
commodityprice,
price,
interest
interestrate,
rate,or
orcurrency
currencyexchange
exchangerate
rate

they
theycan
canexpose
exposecompanies
companiesto
toconsiderable
considerable
risk
riskbecause
becauseititcan
canbe
bedifficult
difficultto
tofind
findaa
derivative
derivativethat
thatentirely
entirelyhedges
hedgesthe
therisks
risksor
or
because
becausethe
theparties
partiesto
tothe
thederivative
derivativecontract
contract
fail
failto
tounderstand
understandthe
therisk
riskexposures
exposures

5-33

Derivative Securities
Definitions
Futures
Futurescontractan
contractanagreement
agreementbetween
betweentwo
twoor
ormore
moreparties
partiesto
to
purchase
purchaseor
orsell
sellaacertain
certaincommodity
commodityor
orfinancial
financialasset
assetat
ataafuture
futuredate
date
(called
(calledsettlement
settlementdate)
date)and
andat
ataadefinite
definiteprice.
price.
Swap
Swapcontractan
contractanagreement
agreementbetween
betweentwo
twoor
ormore
moreparties
partiesto
to
exchange
exchangefuture
futurecash
cashflows.
flows.ItItisiscommon
commonfor
forhedging
hedgingrisks,
risks,especially
especially
interest
interestrate
rateand
andforeign
foreigncurrency
currencyrisks.
risks.
Option
Optioncontractgrants
contractgrantsaaparty
partythe
theright,
right,not
notthe
theobligation,
obligation,to
toexecute
execute
aatransaction.
transaction.AAcall
calloption
optionisisaaright
rightto
tobuy
buyaasecurity
security(or
(orcommodity)
commodity)at
at
aaspecific
specificprice
priceon
onor
orbefore
beforethe
thesettlement
settlementdate.
date.AAput
putoption
optionisisan
an
option
optionto
tosell
sellaasecurity
security(or
(orcommodity)
commodity)at
ataaspecific
specificprice
priceon
onor
orbefore
before
the
thesettlement
settlementdate.
date.

5-34

Derivative Securities

5-35

Derivative Securities

Derivative Securities

Qualitative Disclosures
Disclosures generally outline the
types of hedging activities
conducted by the company
and the accounting methods
employed.
Quantitative Disclosures
Campbell Soup provides
quantitative information relating to
its interest rate and foreign
exchange hedging activities in the
MD&A section of the annual report.
These disclosures are provided in
Exhibit 5.8.

5-36

5-37

Derivative Securities
Analysis of Derivatives

Identify Objectives for Using Derivatives

Risk Exposure and Effectiveness of Hedging
Strategies
Transaction Specific versus Companywide Risk
Exposure
Inclusion in Operating or Nonoperating Income

5-38

The Fair Value Option

Fair Value Reporting Requirements
Eligible assets and liabilities investments in debt and equity
securities, financial instruments,
derivatives, and various financial
obligations.
Not allowed: investment in
subsidiaries that need to be
consolidated, postretirement benefit
assets and obligations, lease assets/
obligations, certain types of insurance
contracts, loan commitments; equity
method investments under certain
conditions.

Selective Application
Substantial flexibility exists to selectively
apply the fair value option to individual
assets or liabilities.

Reporting Requirements
1. Carrying amount of the asset (or
liability) in the balance sheet will
always be at its fair value on the
measurement date.
2. All changes in the fair value of the
asset (or liability), including unrealized
gain and losses, will be included in net
income.
3. Can choose to report the unrealized
gain/loss portion differently from cash
flow components or together.

5-39

The Fair Value Option

Analysis Implications

Reliability of fair value measurements

Opportunistic adoption of SFAS 159
SFAS 159 allows considerable discretion to companies in
choosing the specific assets or liabilities for which they
exercise the fair value option.
An analyst needs to verify whether the fair value election has
been opportunistic with an aim to window dressing the financial
statements.