Analyzing Investing Activities: Intercorporate Investments

5
CHAPTER

Investment Securities
Composition Investment securities (also called marketable securities) are of two types: Debt Securities Government or corporate debt obligations Equity Securities Corporate stock that is readily marketable.

Investment Securities
Classification
Investment Securities Debt Securities Equity Securities No Influence (below 20% holding) - Trading - Available-for-Sale Significant Influence (between 20% and 50% holding) Controlling Interest (above 50% holding)

Trading

Held-to-Maturity

Available-for-Sale

Investment Securities
Accounting for Debt Securities
Accounting Balance Sheet Income Statement Unrealized Gains/Losses Not recognized in either net income or comprehensive income Recognize in net income Other Recognize realized gains/losses and interest income in net income Recognize realized gains/losses and interest income in net income Recognize realized gains/losses and interest income in net income

Category Held-to-Maturity

Description Securities acquired with both the intent and ability to hold to maturity Securities acquired mainly for short-term or trading gains (usually less than three months) Securities neither held for trading nor heldto-maturity

Amortized Cost

Trading

Fair Value

Available-forSale

Fair Value

Not recognized in net income, but recognized in comprehensive income

Investment Securities
Accounting for Transfers between Security Classes
Transfer From Held-to-Maturity To Available-forSale Accounting Effect on Asset Value in Balance Sheet Asset reported at fair value instead of (amortized) cost Effect on Income Statement Unrealized gain or loss on date of transfer included in comprehensive income

Trading

Available-forSale
Trading

No effect

Unrealized gain or loss on date of transfer included in net income

Unrealized gain or loss on date of transfer included in net income Unrealized gain or loss on date of transfer included in comprehensive income

Available-forSale Available-forSale

No effect

Held-to-Maturity

No effect at transfer; however, asset reported at (amortized) cost instead of fair value at future dates

Investment Securities
Classification and Accounting for Equity Securities
Category Ownership Purpose No Influence Available-for-Sale Less than 20% Long- or intermediateterm investment Fair value Fair value Trading Less than 20% Short-term investment or trading Fair value Fair value Between 20% and 50% Degree of business control Equity method Acquisition cost adjusted for proportionate share of investees retained earnings and appropriate amortization Not recognized Significant Influence Controlling Interest About 50% Full business control Consolidation Consolidated balance sheet

Valuation Basis Balance Sheet Asset Value

Income Statement: Unrealized Gains Income Statement: Other Income Effects

In comprehensive income Recognize dividends and realized gains and losses in income

In income

Not recognized

Recognize dividends and realized gains and losses in income

Recognize proportionate share of investees net income less appropriate amortization in income

Consolidated income statement

Investment Securities
Analyzing Investment Securities At least three main objectives: (1) to separate operating from investing (and financing) performance (2) to evaluate investment performance and risk (3) to analyze accounting distortions due to accounting rules and /or earnings management involving investment securities

Investment Securities
Separating Operating from Investing Assets and Performance

Determine whether investment securities (and related income streams) are investing or operating in naturebased on an assessment of whether each investment is strategic or made purely for the purpose of investment Remove all gains (losses) relating to investing activities including dividends, interest income, and realized and unrealized gains and losseswhen evaluating the operating performance of a company Separate operating and non-operating assets when determining operating return on investment

Investment Securities
Analyzing Accounting Distortions from Investment Securities Potential accounting distortions an analyst must be alert to:

Classification based on intent Opportunities for gains trading Liabilities recognized at cost Auditors Inconsistent definition of equity securities

Intercorporate Investments
Equity Method Accounting
Equity method accountingreports the parents

investment in the subsidiary, and the parents share of the subsidiarys results, as line items in the parents financial statements (referred to as 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

Intercorporate Investments
Equity Method Accounting
Investment account: Initially recorded at acquisition cost Increased by % share of investee earnings Decreased by dividends received

Intercorporate Investments
Equity Method Accounting

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

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. Synergy, Inc. Current assets PP&E Total assets 700,000 5,600,000 6,300,000

Acquisition entry:
Investment Cash 500,000 500,000

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

Equity Method 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)

Investment balance = % Share of Investee Equity

Global Corp. Investment Account Beg. 500,000 Inc. 25,000 5,000 Div. Div. Synergy, Inc. Stockholders equity 2,000,000 Beg. 20,000 100,000 Inc.

End 520,000

2,080,000 End.

Equity Investments
Important Points in Equity Method Accounting

The investment account represents the proportionate share of the stockholders equity of the investee company. Substantial assets and liabilities may, therefore, not be recorded on balance sheet unless the investee is consolidated. This can have important implications for the analysis of the investor company. Investment earnings (the proportionate share of the earnings of the investee company) should be distinguished from core operating earnings in the analysis of the earnings of the investor company. Investments accounted for under the equity method are reported at adjusted cost, not at market value. Substantial unrealized gains may, therefore, not be reflected in assets or stockholders equity.

Equity Investments
Important Points in Equity Method Accounting

An investor should discontinue equity method accounting when the investment is reduced to zero (such as due to investee losses), 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. Equity method accounting only resumes once all cumulative deficits have been recovered via investee earnings. If the amount of the initial investment exceeds the proportionate share of the book value of the investee company, the excess 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.

Intercorporate Investments
Consolidation
Intercorporate investments investments by one

corporation in the equity securities of another corporation

Parent corporation who controls,

generally through ownership of equity securities, the activities of another separate legal entity known as a subsidiary
Parent-subsidiary relation when one corporation

owns all or a majority of the voting equity securities of another corporation

Business Combinations
Definitions
Business combinationsrefer to 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

Business Combinations

Source:Accounting Trends & Techniques

Business Combinations
Accounting
GAAP only allows one method of accounting for business combinations: Purchase accountingreflects acquisition of one or more

companies by another company; acquiror continues operating, while the acquired company disappears; acquiror records the acquired assets (including goodwill) and liabilities at fair values at date of acquisition Previously, the Pooling-of-interest method was allowed. Although prior acquisitions accounted for as poolings are allowed to continue, acquisitions after 6/30/01 must use Purchase Method.

Debt

Debt

Debt

Debt

Intercorporate Investments
Consolidated Financial Statements
Consolidated financial statements report the results of operations and financial condition of a parent corporation and its subsidiaries in one set of statements

Basic Technique of Consolidation

Consolidation involves two steps: aggregation and elimination

Aggregation of assets, liabilities, revenues, and expenses of subsidiaries with the parent
Elimination of intercompany transactions (and accounts) between subsidiaries and the parent Note: Minority interest represents the portion of a subsidiarys equity securities owned by other than the parent company

Intercorporate Investments
Consolidation Illustration
On December 31, Year 1, Synergy Corp. purchases 100% of Micron Company by exchanging 10,000 shares of its common stock ($5 par value, $77 market value) for all of the common stock of Micron.
On the date of the acquisition, the book value of Micron is $620,000. Synergy is willing to pay the market price of $770,000 because it feels that Microns property, plant, and equipment (PP&E) is undervalued by $20,000, it has an unrecorded trademark worth $30,000 and intangible benefits of the business combination (corporate synergies, market position, and the like) are valued at $100,000.

Intercorporate Investments
Consolidation Illustration

The purchase price is, therefore, allocated as follows: Purchase price 770,000 Book value of Micron 620,000 Excess 150,000 Excess allocated to Undervalued PP&E Trademark Goodwill useful life 20,000 10 30,000 5 100,000 indefinite 150,000 annual deprec/amort. 2,000 6,000 -0-

Intercorporate Investments
Synergy Corp. and subsidiary trial balances and consolidated financial statements for year-ended December 31, Year 2. Prepared under the purchase accounting method

Synergy Revenues Oper. expenses Deprec. Expense Amort. Expense Investment income Net Income Retained Earn.,1/1 Net Income Dividends Paid Ret.Earn.,12/31 Cash Receivables Inventory Invest. in Micron 610,000 (270,000) (115,000) 142,000 367,000 680,000 367,000 (90,000) 957,000 105,000 380,000 560,000 912,000

Micron 370,000 (140,000) (80,000) [4] [4] [3] 150,000 490,000 [1] 150,000 640,000 20,000 220,000 280,000 -

Debits

Credits

Consolidated 980,000 (410,000) (197,000) (6,000) 367,000 680,000 367,000 (90,000) 957,000 125,000 600,000 840,000 -

2,000 6,000 142,000 490,000

PP&E ( net) Trademark Goodwill Total assets Liabilities Common Stock Add'l. Pd-In Cap. Retained Earnings Tot. Liab & Eq.

1,880,000 3,837,000 780,000 800,000 1,300,000 957,000 3,837,000

720,000 [2] [2] [2] 1,240,000 470,000 100,000 [1] 30,000 [1] 640,000 1,240,000

20,000 30,000 100,000

[1] [2] [3] [4] [4]

620,000 150,000 142,000 2,000 6,000

2,618,000 24,000 100,000 4,307,000 1,250,000 800,000 1,300,000 957,000 4,307,000

100,000 30,000 920,000 920,000

Intercorporate Investments
Synergy Corp and Micron Company Consolidated Income Statement Steps

Income statement of Synergy Supplies is combined

with that of Micron Corp. 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

Intercorporate Investments
Synergy Corp and Micron Company Consolidated Balance Sheet Steps

The 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

Intercorporate Investments
Synergy Corp and Micron Company Consolidated Balance Sheet Steps - Summary
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. Replace $150,000 of the investment account with the fair value adjustments required to fully record Microns assets at fair market value, and 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 is reported for the minority interest in Microns earnings.

Intercorporate Investments
Concept of Control Presumption of control if an entity: Has a majority voting interest in or a right to appoint a majority of an entitys governing body Has a large minority voting interest and no other party or organized group of parties has a significant voting interest No other partner or organized group of partners has the current ability to dissolve the limited partnership or otherwise remove the general partner and
FASB

Intercorporate Investments
Concept of Control (cont.)
Presumption of control if an entity: Has a unilateral ability to (1) obtain a majority voting interest in or (2) obtain a right to appoint a majority of the corporations governing body through the present ownership of convertible securities or other rights that are currently exercisable at the option of the holder and the expected benefit from converting those securities or exercising that right exceeds its expected cost

FASB

Business Combinations
Purchase Accounting Concerns
Contingent Considerationa company usually records the amount of
any contingent consideration payable in accordance with a purchase agreement when the contingency is resolved and the consideration is issued or issuable

Allocating Total Costonce a company determines the total cost of an

acquired entity, it is necessary to allocate this cost to individual assets received; the excess of total cost over the amounts assigned to identifiable tangible and intangible assets acquired, less liabilities assumed, is recorded as goodwill

In-Process Research & Development (IPR&D)some companies are

writing off a large portion of an acquisitions costs as purchased research and development. Pending accounting standard will require capitalization of IRR&D and annual testing for impairment

Debt in Consolidated Financial Stetements - Liabilities in consolidated

financial statements do not operate as a lien upon a common pool of assets.

Business Combinations
Analysis Implications
Gain on subsidiary stock sales The equity investment account is increased via subsidiary stock sales. Companies can record the gain either to income or to APIC Consequences of Accounting for Goodwillgoodwill is not permanent and the present value of super earnings declines as they extend further into the future future impairment losses are likely Push-Down Accountinga controversial issue is how the acquired company (from a purchase) reports assets and liabilities in its separate financial statements (if that company survives as a separate entity)

Preparers

Business Combinations
Analysis Implications
Validity of Taking Up Earningsdollar-for-dollar equivalence of earnings cannot be taken for granted because:

A regulatory authority can sometimes intervene in a subsidiarys dividend policy A subsidiary can operate in a country where restrictions exist on remittance of earnings or where the value of currency can deteriorate rapidly Dividend restrictions in loan agreements can limit earnings accessibility Presence of a stable or powerful minority interest can reduce a parents discretion in setting dividend or other policies

Business Combinations
Analysis Implications
Provision for Taxes on Undistributed Subsidiary Earnings
Current practice assumes all undistributed earnings transfer to the parent and that a provision for taxes is made by the parent in the current period The decision on whether taxes are provided on undistributed earnings is that of management Management must report the amount of earnings for which no income taxes are provided by the parent

Business Combinations
Analysis Implications
Debt in Consolidated Financial Statements
Liabilities in consolidated financial statements do not operate as a lien upon a common pool of assets Creditors, whether secured or unsecured, have recourse in the event of default only to assets owned by the specific corporation that incurred the liability If a parent company guarantees a liability of a subsidiary, then the creditor has the guarantee as additional security with potential recourse provisions To assess the security of liabilities, analysis must examine the individual financial statements of each subsidiary

Business Combinations
Analysis Implications
Additional Limitations of Consolidated Financial Statements
Consolidated retained earnings actually available for payment of dividends are difficult to establish unless reported Composition of minority interest (e.g., between common and preferred) cannot be determined from a combined minority interest amount in the consolidated balance sheet Aggregation of dissimilar enterprises can distort ratios and other relationsfor example, current assets of finance subsidiaries are not generally available to satisfy current liabilities of the parent; assets and liabilities of separate entities are not interchangeable

Business Combinations
Analysis Implications
Additional Limitations of Consolidated Financial Statements
Financial statements of the individual companies comprising the larger entity are not always prepared on a comparable basisthese differences can inhibit homogeneity and impair the validity of ratios, trends, and other analyses Consolidated financial statements do not reveal restrictions on use of cash for individual companies--these factors obscure analysis of liquidity 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

Business Combinations
Analysis Implications of Pooling vs. Purchase
Assets are acquired and carried at book value and not market value as reflected in consideration givento the extent goodwill is purchased, the acquiring company does not report it on its balance sheet Understatement of assets yields understatement in combined company equity Understatement of assets (including inventory, property, plant, equipment, goodwill, and intangibles) yields understatement of expenses (such as cost of goods sold, depreciation, amortization) and overstatement of income Understatement of assets yields not only understatement of expenses but potential overstatement of gains on asset disposition; the combined company reports in its income any gains on sales of assets, yet these gains potentially arise at time of acquisition and are carried forward at unrealistically low amounts only to be recognized at disposition

Business Combinations
Analysis Implications of Pooling vs. Purchase
Understatement of invested equity or overstatement of income yields overstatement in return on investment Retained earnings of the acquired entity are carried forward to the combined company Income statements and balance sheets of the combined entity are restated for all periods reported; under purchase accounting they are combined and reported post acquisitionalthough pro forma
statements showing pre-acquisition combined results are typically furnished

Derivative Securities Background

Market risks

commodity price risk

interest rate risk

foreign currency risk

Derivative Securities
Background
Hedges are contracts that seek to insulate companies from market riskssecurities such as futures, options, and swaps are commonly used as hedges
Derivative securities, or simply derivatives, are contracts whose

value is derived from the value of another asset or economic item such as a stock, bond, commodity price, interest rate, or currency exchange rate they can expose companies to considerable risk because it can be difficult to find a derivative that entirely hedges the risks or because the parties to the derivative contract fail to understand the risk exposures

Derivative Securities
Definitions
Derivative is a contract possessing each of the following characteristics: One or more underlying indexes and one or more notional amounts (and/or payments)the underlying indexes and the notional amounts determine the settlement amount, if any. No initial net investment or an initial net investment less than that required for a normal transaction yielding similar responses to market risk changes. Permits a net settlement. Underlying index, or simply underlying (also called a primitive), is the main driver of derivative value--it can be any economic variable such as a commodity price, security price, index, interest rate, or exchange rate Notional amount is the number of unitsexpressed in figures, weight, volume, dollars, or other unit measureas specified in the contract Net settlement is a cash resolution for the contracting parties in lieu of settling up in full amounts (or quantities)

Derivative Securities
Classification of Derivatives
Derivatives

Hedge

Speculative

Fair Value Hedge

Cash Flow Hedge

Foreign Currency Hedge Cash Flow Hedge Hedge of Net Investment in Foreign Operation

Fair Value Hedge

Derivative Securities
Accounting for Derivatives
Derivative Speculative Fair value hedge Balance Sheet Derivative recorded at fair value Both derivative and hedged asset and/or liability recorded at fair value Derivative recorded at fair value (offset by accumulated comprehensive income) Income Statement Unrealized gains and losses included in income Unrealized gains and losses on both derivative and hedged asset and/or liability included in income Unrealized gains and losses on effective portion of derivative are recorded in other comprehensive income until settlement date, after which transferred to income; unrealized gains and losses on the ineffective portion of derivative are included in income Same as fair value hedge Same as cash flow hedge Unrealized gains and losses reported in other comprehensive income as part of translation adjustment

Cash flow hedge

Foreign currency fair value hedge Foreign currency cash flow hedge Foreign currency hedge of net investment in foreign operation

Same as fair value hedge Same as cash flow hedge Derivative (and cumulative unrealized gain or loss) recorded at fair value (part of cumulative translation adjustment in accumulated comprehensive income)

Derivative Securities
Analysis of Derivatives
Identify Objectives for Using Derivativesrisk associated with derivatives is much higher for speculation than for hedging; many companies implicitly speculate with derivatives Risk Exposure and Effectiveness of Hedging Strategiesevaluate the underlying risks, the risk management strategy, the activities to hedge its risks, and the effectiveness of hedging operations; also consider counterparty risk

Transaction Specific versus Companywide Risk Exposureevaluate companywide effects of derivatives; hedging specific risk exposures to transactions, commitments, assets, and/or liabilities does not necessarily ensure hedging of companywide risk
Inclusion in Operating or Nonoperating Incometo the extent derivatives are hedges, then unrealized and realized gains and losses should be excluded from operating income and their fair values should be excluded from operating assets

International Activities
Analysis obstacles with companies that operate in more than one country subdivide into two categories:

(Appendix 5A)

Obstacles due to differences in accounting practices peculiar to a country where operations exist Obstacles arising from translation of assets, liabilities, and equities into the home-country measuring unit

International Activities
Translation of Foreign Currencies
Current rate methodtranslates all assets and liabilities at current rates

Temporal methodtranslates cash, receivables, payables, and other assets and liabilities measured at present or future prices at current rates, and assets and liabilities measured at past prices (historical costs) at historical rates

International Activities
Accounting using the Current Rate Method
Major provisions of accounting for foreign currency translation using a the Current Rate Method are:
Translation requires identifying the functional currency of the entity generally the currency of the country in which the subsidiary is located; all financial statement elements of the foreign entity are measured using the functional currency, but in conformity with the parents accounting practices Translation from the functional currency into the reporting currency is required, if they are differentthis translation occurs at the current exchange rate, except for revenues and expenses that are translated at the average current exchange rate during the period Translation adjustments are not included in incomethey are reported and accumulated as a separate component of equity until such time the parent sells or completely or substantially liquidates the net investment in the foreign entity; translation adjustments are removed from equity and included as gains or losses in determining income for the period when such sale or liquidation occurs Exchange gains and losses attributable to intercompany foreign currency transactions, and balances that are of a trading nature, are included in income; but those attributable to long-term financing or capital transactions, where settlement is not expected for the foreseeable future, are reported as a separate component of equity

International Activities
Illustration of Foreign Currency Translation
Facts
BritCo, a wholly owned U.K. subsidiary of DollarCo, incorporates when exchange rate is 1 = US$1.10; Other exchange rates are: January 1, Year 6 1 = US$1.20 December 31, Year 6 1 = US$1.40 Average for Year 6 1 = US$1.30 Receivables, payables, and noncurrent liability amounts are denominated in local currency Dollar balance of Retained Earnings at December 31, Year 5, is $60,000 Cumulative Foreign Exchange Translation Adjustment at December 31, Year 5, is $30,000 (Cr.) BritCos December 31, Year 6, trial balance conforms to DollarCos accounting principles; the pound () is the functional currency of BritCo:
Cash Accounts receivable Inventories, at cost Prepaid expenses Property, plant, and equipment (net) Long-term note receivable Accounts payable Current portion of long-term debt Long-term debt Capital stock Retained earnings, January 1, Year 6 Sales Cost of sales Depreciation Other expenses Debit 0,100,000 300,000 500,000 25,000 1,000,000 75,000 Credit

0,500,000 100,000 900,000 300,000 50,000 5,000,000 4,000,000 300,000 550,000 6,850,000

Sales, purchases, and all operating expenses occur evenly throughout the yearaccordingly, cost of sales is convertible by use of the average rate Income tax consequences, if any, are ignored

6,850,000

International Activities
BritCo Translated Balance Sheet and Income Statement
Balance Sheet Exchange Rate Explanation* Code or US $

Illustration of Foreign Currency Translation

Cash Accounts receivable Inventories, at cost Prepaid expenses Property, plant, and equipment (net) Long-term note receivable Total assets Accounts payable Current portion of long-term debt Long-term debt Total liabilities Capital stock Retained earnings: Balance, 1/1/Year 6 Current year net income Balance, 12/31/Year 6 Cumulative foreign exchange translation adjustment: Balance, 1/1/Year 6 Current year translation adjustment Balance, 12/31/ Year 6 Total stockholders equity Total liabilities and equity Income Statement Sales Cost of sales Depreciation Other expenses Net income

100,000 300,000 500,000 25,000 1,000,000 75,000 2,000,000 500,000 100,000 900,000 1,500,000 300,000

1.4 1.4 1.4 1.4 1.4 1.4 1.4 1.4 1.4 1.1

C C C C C C C C C H

140,000 420,000 700,000 35,000 1,400,000 105,000 2,800,000 700,000 140,000 1,260,000 2,100,000 330,000

50,000 150,000 200,000

B F

60,000 195,000 255,000

30,000 85,000 115,000 700,000 2,800,000 6,500,000 (5,200,000) (390,000) (715,000) 195,000

B G 500,000 2,000,000 5,000,000 (4,000,000) (300,000) (550,000) 150,000 1.3 1.3 1.3 1.3 A A A A

*Translation code or explanation: C = Current rate. H = Historical rate. A = Average rate. B = Balance in U.S. dollars at the beginning of the period. F = Per income statement. G = Amount needed to balance the financial statements.

International Activities
Analysis Implications of Foreign Currency Translation
Current Rate Methodthis is current practice; selectively introduces current
value accounting and allows gains and losses to bypass the income statement

Translation exposure is measured by size of the net investment Translation adjustment is determined from net investment multiplied by change in exchange rates Currency translation affects equity (not income) Translated income varies directly with changes in exchange rates Income includes results of completed foreign exchange transactions Any gain or loss on translation of a current payable by subsidiary to parent flows through consolidated income Decline in the dollar relative to other currencies increases income of consolidated foreign subsidiaries It is managements decision whether the functional currency is the local currency Yields substantial changes in equity because of changes in the cumulative translation adjustment (CTA)

International Activities
Analysis Implications of Foreign Currency Translation
Temporal methodmost faithful to and consistent with historical cost

accounting; current practice does not follow the temporal method except in two cases:

When a foreign entity is

merely an extension of the parent and, thus, the functional currency is that of the parent

When hyperinflation causes

translation of nonmonetary assets to unrealistically low reported values because of using the current rate

International Activities
Summary of Translation Methods
Functional Currency Translation method Account Cash & securities Local Currency Current Rate Method $US Temporal method Exchange Rated used for Translation current current

Inventory
PP&E & Intangibles Current Liabilities Long-Term Liabilities

current
current current current

historical
historical current current

Capital stock Retained earnings Dividends Revenues Expenses COGS Depreciation/ amortization Translation adjustment Remeasurement gains (losses)

historical derived specific average average average average Other Comprehensive Income

historical derived specific average average historical historical

Income statement

Investment Securities
Evaluating Investment Performance and Risk
ROI
= Investment income (Beginning fair value of investment + Ending fair value of investment)/2

(Appendix 5B)

Investment income consists of three parts: Interest (and dividend) income + Realized gains and losses + Unrealized gains and losses

Investment Securities
Evaluating Investment Performance and RiskCoca-Cola Case
Held-to-Maturity Investment income (1998): Interest and dividend Realized gains and losses Unrealized gains and losses Total before tax Tax adjustment (33%) Total after tax 219 Available-for-Sale 219 (70) (70) 23 (47) (70) 149 (49) 100 Total

(Appendix 5B)

219 (72) 147

Average investment base (1998): 1997 Fair value 1,591 1998 Fair value 1,431 Average 1,511 Return on investment (ROI) Before tax After tax

526 422 474

2,117 1,853 1,985

14.5% 9.7%

-14.8% -9.9%

7.5% 5.0%