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1
Hedging
• Types of Risks Hedge
• Types of Hedges
• Hedging Instruments
•
2
Characteristics of
Derivatives
• Underlying
• Notional Amount
• Settlement Terms
3
Accounting for Derivatives
• Derivative Not Designated as a
hedge
– Derivative carried at fair market
value
– Unrealized gains/losses flow to
earnings
• Derivative Designated as a Hedge
– Accounting depends upon nature
of hedge.
• Fair value hedge
• Cash flow hedge
• Foreign currency hedge
4
Fair Value Hedge
• A fair value hedge is a hedge designed to
hedge changes in the fair value of an
existing asset, liability, or firm commitment
(e.g., unexecuted contract).
•
5
Fair Value Hedges -
Accounting for derivative and the hedged item
• The Derivative Position
– All changes in the fair value flow through to
earnings.
– The fair value is reflected on the balance
sheet.
•
• The Hedged Item
– The change in the value of the hedged item
attributable to the riskbeing hedged flows
to earnings.
– This change is reflected as a change in the
carrying value of the hedged item.
• Note - the derivative may only hedge a particular type of 6
Cash-Flow Hedges
• A derivative instrument designed to
hedge the exposure to the
variability in cash flows that is
attributable to a particular risk
• That exposure may be associated
with
– an existing recognized asset or liability
(such as all or certain future interest
payments on variable-rate debt) or
– a forecasted transaction (such as a
forecasted purchase or sale). 7
Cash Flow Hedges - Accounting
for derivative and the hedged
item
• All changes in the fair value of the derivative
position flows through to comprehensive
earnings. The fair value is reflected on the
balance sheet.
•
• The accumulated comprehensive income will flow
to net income in the same period(s) as the
hedged asset, liability, or forecasted
transaction affects net income.
•
• The idea is for the two types of cash flows to
offset each other and to recognize them in
earnings in the same period 8
Forward Contract
• Contract to purchase or sell
– A specific quantity
– For a specific price
– At a specific date
– Often settled on a cash basis
– Usually no cash payments at
intermediate dates
–
– Note: regular purchases of raw materials or supplies,
or regular sales of a product don’t qualify
9
Futures Contract
• Very similar to a Forward Contract,
except
– Futures are more standardized
– Futures are more liquid
– Futures get “closed out” at the end of
each day
10
Example – Use of Forward Contract
to Hedge Foreign Exchange Rate
Risk
• Global Candy Co. forecasts the sale of 100,000
boxes of its top-quality chocolates to a British
distributor for a price of 1,000,000 British
pounds (£1,000,000).
– The sale has not been firmly committed to, but the
Company believes that the transaction is probable
and expects the sale to occur in five months, on
December 31, 20X0.
• Global Candy Co. is exposed to foreign currency
exchange risk because the Company’s
functional currency is the U.S. dollar and the
sale will be consummated in British pounds.
11
To Hedge Its Exposure
• Global enters into a foreign-currency-
exchange forward contract with
BigBenBank on August 1, 20X0 to
sell £1,000,000 for $1,586,500 on
December 31, 20X0
• What risks has Global hedged?
• What risks has Global NOT hedged?
12
Global Candy must give BigBenBank
£1,000,000 on December 31 and will
receive $1,586,500 in return
$2,000,000
$1,500,000
$1,000,000
Revenue from Chocolate Sale
Profit (Loss)
$500,000
$-
0 0.5 1 1.5 2 2.5 3
$(500,000)
$(1,000,000)
Profit or Loss from the Foreign Exchange
Forward Contract
$(1,500,000)
$(2,000,000)
D
D
The fair value of the forward contract can be estimated by
( 1 ) multiplying the change in the forward rate since inception of the
Inception of h
contract by the notional amount of the contract and
( 2 ) discounting that amount at an appropriate rate for the remaining
term of the forward .
At September 30 , 20X0 , $ ( 25 , 025 ) = ( $1 . 5865 $1 . 6119 ) 1 , 000 , 000
British pounds , discounted at 6 % ( assumed to be an appropriate
rate ) for 3 months .
15
Interest Rate Swaps
• A contract to exchange cash flows over a pre-
specified period of time
• The payments are based on an agreed upon
notional amount, but principal amounts rarely
change hands
• Could convert from variable to fixed, or vice
versa, or from one index to another, etc.
16
Hedge of Fixed Rate Debt
with Interest Rate Swap
• Global has three year, $5 million non-prepayable
8% fixed rate note payable with semiannual
payments
• How is Global subject to interest rate risk?
• Suppose Global enters into a three year interest
rate swap contract
– With a notional amount of $5 million
– Global receives interest at fixed 7%
– Global pays interest at LIBOR
– The contract calls for semi-annual payments
based on the market rate on the first day
of each semi-annual period
17
Why would Global Swap
Fixed rate debt for variable?
• Doesn’t this INCREASE their exposure
to risk?
18
If the LIBOR rate falls from 6% to 5%
21
Payoff of Call vs Put Option
(Strike price = 10)
12 12
10 10
8 8
6 6
4 4
2 2
0 0
0 5 10 15 20 25 0 5 10 15 20 25
22
Example – Use of Options to Hedge
Investment in Available For Sale
Securities
• GCC purchased 10,000 shares of UYB
@ $30
• These securities are classified as
Available for Sale
• The price is now $50
23
Example – Use of Options to Hedge
Investment in Available For Sale
Securities
• GCC purchased 10,000 shares of UYB
@ $30
• These securities are classified as
Available for Sale
• The price is now $50
• GCC constructs a “costless collar”
– GCC purchases put options with an exercise
price of $45
– To finance the puts, GCC writes call options
with an exercise price of $55
24
Subsequent Price
Changes
D ec
25
Example - EDS
• EDS wants to hedge the cost of their employee
stock options
– They purchase forward contracts to buy
539,000 of their own shares in the
future at a pre-set price of $70.14. The
contracts include a limit as to how
much money EDS will receive in the
event the stock price increases.
– They sell put options on 821,000 shares
of their own stock with a strike price of
$70.73. EDS received $0.75 per
option.
• How do these transactions help hedge EDS’s
cost of stock options?
26
Not a Very Good Hedge!
• Very limited protection if stock price
rises
• Large Exposure if stock price drops
•
• EDS ended up having to pay $340
million when stock prices fell
27
Accounting Statement Recognition
28
Accounting Statement Recognition
31
Interest Rate Swaps
32
Hedge of Fixed Rate Debt
with Interest Rate Swap
• Global has three year, $5 million non-prepayable
8% fixed rate note payable with semiannual
payments
• How is Global subject to interest rate risk?
• Suppose Global enters into a three year interest
rate swap contract
– With a notional amount of $5 million
– Global receives interest at fixed 7%
– Global pays interest at LIBOR
– The contract calls for semi-annual payments
based on the market rate on the first day
of each semi-annual period
33
Why would Global Swap
Fixed rate debt for variable?
• Doesn’t this INCREASE their exposure to
risk?
34
If the LIBOR rate falls from 6% to 5%
37
Payoff of Call vs Put Option
(Strike price = 10)
12 12
10 10
8 8
6 6
4 4
2 2
0 0
0 5 10 15 20 25 0 5 10 15 20 25
38
Revenue from Sale of Chocolate (in Dollars)
$2,000,000
$1,500,000
$1,000,000
Revenue from Chocolate Sale
Profit (Loss)
$500,000
$-
0 0.5 1 1.5 2 2.5 3
$(500,000)
$(1,000,000)
$(1,500,000)
$(2,000,000)
$2,000,000
$1,500,000
$1,000,000
Revenue from Chocolate Sale
Profit (Loss)
$500,000
$-
0 0.5 1 1.5 2 2.5 3
$(500,000)
$(1,000,000)
Payoff from Put Option
$(1,500,000)
$(2,000,000)
$2,000,000
$1,500,000
$1,000,000
Revenue from Chocolate Sale
Profit (Loss)
$500,000
$-
0 0.5 1 1.5 2 2.5 3
$(500,000)
$(1,000,000)
$(1,500,000)
$(2,000,000)
42
Example – Use of Options to Hedge
Investment in Available For Sale
Securities
• GCC purchased 10,000 shares of UYB
@ $30
• These securities are classified as
Available for Sale
• The price is now $50
• GCC constructs a “costless collar”
– GCC purchases put options with an exercise
price of $45
– To finance the puts, GCC writes call options
with an exercise price of $55
43
Subsequent Price Changes
D ec
44
Example - EDS
46
Accounting Statement Recognition
• Sensitivity Analysis
– Impact of Percentage Change
– Is it linear?
– How are the Individual Changes
correlated?
49
Value At Risk
• Can be used to reflect multiple risks that are
correlated
• Calculates the change in value of your current
contracts given a set of changes in values of
interest rates, exchange rates, commodity
prices, etc.
• Generates a probability distribution of changes
in value
– Discloses a point (or a few points) on the lower tail of a
probability distribution
• E.g. There is a 95% chance that the loss won’t
be more than $5 million in one day
– Can you really get out of your position quickly?
• What data is being used to calibrate it? (often
only “normal days are used”
• Doesn’t tell you what factors (or directions of
changes) lead to the losses 50
What is Your Exposure to
Losses?
• It is Common to disclose how much
your financial instruments change
in value
– But this isn’t risk if it’s offset by
changes in value of the thing it’s a
hedge against
– What you’d really like to know is how
large your Exposure (or unhedged
position) is
51
Guidance for Assessing
Hedge Effectiveness is Vague
• To be considered an Effective hedge, the
derivative should offset between 80 and
120 percent of the hedged item’s
change in value or cash flow (due to the
risk being hedged)
• The change in the value of the derivative
that is considered to be effective is kept
in AOCI
• The remainder is sent thru Net Income
• Critics complain that this introduced
unnecessary volatility
52
Reasons for Hedge
Ineffectiveness
• Differential sensitivity to time value
• Differential sensitivity to default risk
• Different basis – using corn futures to
hedge prices of corn syrup
• Different terms (expiration date, payment
dates, etc).
53
Hedge effectiveness is often
judged
• By comparing changes in the value of your
real derivative contracts to
HYPOTHETICAL ones
• Can also use regression (or correlation)
analysis on past time series of prices on
real contracts
54
Example
55
Journal Entries
56
Session 17
Leases, Repos, and
Leverage
• Leases
– Most leases will be capital leases
–
• Repos
– End of period transactions
– Sales or Borrowings?
57
Leases
• Lease: a contract calling for the lessee (user) to pay the
lessor (owner) for the use of the asset
• The lease versus buy decision is an important one that
is based on economic factors (flexibility), taxes (who
gets the depreciation tax shield) , and ACCOUNTING
TREATMENT
• Accounting Rules currently require leases to be
classified into two types
– The accounting treatment is very different
– An industry has sprung up to help firms design
lease contracts to get the “favorable”
accounting treatment
– Lease accounting is a prime example of “off-
balance sheet” financing
• The FASB and IASB are in the process of changing lease
accounting 58
Capital Lease vs.
Operating Lease
• Which accounting treatment would
you choose?
Operating Capital
– Balance sheet No asset or liab. Asset and
Liab.
– Earnings Higher at start Higher at end
– Cash flow All CFO Interest: CFO
Principal: CFF
60
Capital Lease vs.
Operating Lease
• FASB Rules: Firms must use capital
lease accounting if one of the
following applies:
– Ownership is transferred at end of
lease
– A “bargain purchase” option exists
(right to buy asset at lease end for
less than market value)
– Lease period covers more than 75%
of asset’s life
– Present value of contractual future
lease payments exceeds 90% of the
current market value of the asset
• IRS Tax rules are different and are 61
Converting Operating
Leases
to Capital Leases
Adjust Balance Sheet
1. Calculate the PV of minimum future operating lease
payments disclosed in footnotes
2. Capitalize these leases by adding the PV to Long-term
Assets and to Long-term Debt (Balance sheet done)
62
Converting Operating
Leases
to Capital Leases
Adjust Statement of Cash Flows
5. Determine the principal portion of the lease payment
(i.e. lease payment – interest expense)
6. Add the principal portion to CFO (so only interest portion
is still included) and subtract principal portion from
CFF (Statement of cash flows done)
67
New Accounting -- Assets
• Asset
– Classify it according to the substance
of the asset being leased (not an
intangible “right to use” asset)
– Value it initially at cost (the same PV
as above)
– Depreciate it over the shorter of its
economic life and the lease term
68
Lease Accounting -
Lessors
• Right now, the rules are similar as for
lessees, except to be a capital lease
you must also satisfy both of the
following:
– Collectability of lease payments is
reasonably predictable
– There are no important uncertainties
surrounding amount of costs yet to be
incurred by lessor
73
• However, arrangements to repurchase or lend
readily obtainable securities, typically
with as much as 98 percent
collateralization (for entities agreeing to
repurchase) or as little as 102 percent
overcollateralization (for securities
lenders), valued daily and adjusted up or
down frequently for changes in the market
price of the security transferred and with
clear powers to use that collateral
quickly in the event of default, typically
fall clearly within that guideline. The
Board believes that other collateral
arrangements
• typically fall well outside that
guideline 74
Three Banks Practice
Problem
• Four step transaction
– Use the repo to “give up” the security
for cash
– Use the proceeds to retire debt
– “Reacquire “ the securities by using
cash
– Borrow money to finance the
reacquisition
–
• Contrary to many initial reports, It’s
not step 1 that lowers your
leverage
• The assets sold were not “toxic” 75
Is there any Business
Purpose to structuring the
transaction this way?
• Lehman did a little of these
throughout the quarter to make it
look like there was a business
purpose
– Having them all at quarter-end would
look more suspicious
76
New Rules (Fall 2010)
• At its September 17, 2010, meeting, the SEC
voted unanimously to issue Release No. 33-
9143, which proposed rules that would
require public companies to disclose
additional information about their short-
term-borrowing arrangements, regardless of
how such arrangements are accounted for
• The new disclosure requirements would enable
users of a reporting entity's financial
statements to compare average and maximum
levels of short-term debt during each
quarterly reporting period to quarter-end
levels
• 77
FASB Exposure Draft –
Nov 2010
• The exchange of collateral is no
longer a factor in whether or not an
entity has maintained effective
control of an asset. The draft said
that assessments of the
transferor’s effective control should
focus on the transferor’s rights and
obligations with respect to the
transferred assets, not on whether
the transferor has a practical ability
to exercise those rights. 78
Session 18
Convertibles
79
Agenda
• Accounting for “Straight Bonds”
– Issuance
– Historical Cost vs Market Value
– Retirement
• Convertible Debt
– Issuance – Balance Sheet Classification
– Effective Interest Rate and Interest Expense
• MGM
• Royal Bank of Scotland
80
Accounting for Bonds
Under Historical Cost
• At Issuance, Book Value of bonds =
Market Value
•
• If the coupon rate is not high enough, the bond sells
at a discount: Book Value = Face Value -
Unamortized Bond Discount
•
• If the coupon rate is “more than enough”, the bond
sells at a premium
Book Value = Face Value + Unamortized Bond Premium
• Accrual of Interest
• Interest Expense = Beg Bal of Liab x (Effective
Interest rate that existed when the bonds were
81
issued)
Accounting for Bonds
(continued)
• Coupon Payment
•
– If the Coupon payment > Interest Expense, the excess
goes to reduce the liability (e.g., amortize the bond
premium)
–
– If the Coupon payment < Interest Expense, the
“deficiency” adds to the liability (e.g. amortizes the
bond discount)
–
• Important Feature of Bonds
•
• If interest rates rise, the market value
of the debt will fall below its book
value
– this is an unrealized gain for shareholders
• Balance Sheet
– Historical costs get out of date
– Fair values may contain measurement
error that is accidentally or
intentionally induced
• Income Statement
– Historical cost income can be
manipulated by strategic timing of
sales
– Fair Value income is recognized when
the change in value occurs, not when it
is realized
– Fair value income can be manipulated by
misstating the fair value 86
Over the Life of the Bond
…
• The total impact on income is the
same regardless of what
accounting method is used
– Interest Expense (including
amortization of bond premium or
discount) under historical cost
– Interest Expense plus unrealized
gains and losses under mark to
market
• The income numbers are more
volatile under mark to market – IS 87
Does it make a
difference…
• If the firm intends to hold the bond till
maturity?
• If the firm has the ability/intent to use
derivatives to manage interest rate
exposure?
• If the Market Value of a Liability goes
down, this would be a gain
– Does it make a difference if this occurs
because
• Interest rates went up
• Default risk went up
– Should the latter be a gain for the
company? 88
Convertible Debt
90
Convertible Debt at
Conversion -
Firms can choose between
• Book Value2Method
methods
(usually chosen)
– transfer the existing book value of the
debt over to the shareholders’
equity side
– no gain or loss is recognized on
conversion
–
• Market Value Method (rarely chosen)
– Remove the debt at its book value
– Record the new equity at its market
value
91
– Recognize the difference as a loss (or
But if the company has the
option to pay in cash
• They separate the convertible bond
in a “straight debt” and an “equity
conversion option” feature (see
next slide)
•
• This is likely to be extended to other
types of convertible debt as well
92
Convertible Debt –
Separation Into
Components
• Decompose the convertible debt into its
straight debt and its conversion
features (and value each component)
• Record the straight debt component as a
liability
• Record the option component as a part of
shareholders’ equity
• Account for the debt in the usual fashion
- accrue interest and record payments
• Record a gain or loss on conversion
• The FASB is struggling with how to do this
•
• Note: this decomposition process is already being done for 93
complex financial instruments like derivatives
Session 19 - Pensions
• Importance
• Simplified Accounting
• Smoothing and Deferring Features
• Footnote Disclosure
– American Airlines
• Other Post Employment Benefits
94
Why Is It Important?
• Pension assets and liabilities can be
huge
• Pensions are sometimes significantly
under-funded
• Pension values can be volatile
– Small changes in rates of return, interest
rates, etc, can have a large financial
impact on the firm
– These changes do not flow thru to the
income statement (even under new
proposed rules)
• Many firms are using “optimistic”
assumptions
– To understate what they owe 95
Defined Benefit Plans are
waning in popularity, but ….
• They are very large in the public
sector
– Many of the same issues arise for
local, state and federal
govtemployees
– e.g. San Diego’s pension problems
• The same reporting issues arise
for
– Other Post-Retirement Employment
Benefits – like health care
96
– Social Security
Accounting Issues
• What is the funded status of the pension plan
– What do we owe?
– What have we put aside?
– If we are underfunded, we’ll have to make this up
later
– If we are overfunded, …. ?
• How is the liability estimated?
• Accounting for pensions explicitly allows/
requires firms to smooth gains and losses on
the income statement – THIS IS BEING
RECONSIDERED!!
•
• THE FOOTNOTES will disclose important
information about the economic value and
performance of the firm’s pension assets 97
and liabilities
What is a Pension?
• Part of a compensation/benefit package
– in exchange for labor services today, the
firm promises to make payments to the
worker after he retires
• Ideally, the balance sheet would show
the present value of these promised
payments (and any assets put aside
to cover them)
• Ideally, the income statement would
match the cost of providing these
benefits over the working life of the
employee 98
Defined Contribution
Plans
• Common for white collar employees (401K plans)
• Employer pays a pre-specified amount each year
into the worker’s pension account (usually
operated by a trust fund, insurance company,
or investment company)
• Worker often has some influence as to how the
pension assets are invested
• Worker bears the risk of uncertain rate of return
the assets will earn
• Accounting is easy -- once the firm puts the
money into the account, their liability is over
99
Defined Benefit Plans
• The plan defines the benefits the worker will
receive (they could be paid in a lump sum or be
a pre-specified amount per year)
• The magnitude of the benefits will often depend
on
– years of service
– level of compensation
• Employer bears the risk if the pension assets
don’t earn enough to cover the promised
payments
– if a plan is underfunded, the employer will
(eventually) have to put in more money
100
Pension Fund
Contributions
• The minimum contribution the firm can make is
specified by ERISA and the PBGC (to ensure
that the govt does not have to bail out the
pension fund)
• Congress has recently passed legislation
speeding up how rate that under-fundedness
must be corrected
• The maximum contribution the firm can make is
implicitly determined by the IRS limit on how
much pension contributions are tax deductible
in a year
101
Pension Plan Accounting –
Analogous To an Unconsolidated
Subsidiary
• Pension assets are netted against pension
liabilities on the balance sheet
• Pension asset returns are netted against pension
expense on the income statement
• The difference between the new funding of the
plan and the pension income results in an
adjusting entry on the statement of cash flows
• Deferred taxes will arise because
– the funding is what it tax deductible
– usually we see deferred tax ASSETS resulting from
pension plans and other post retirement
employment benefits
102
Pension Economics -
the Asset Side
• The balance sheet amount is the fair value
of the plan assets
• The pension plan’s assets change due to
• new funding makes the assets go up
• benefits paid out to workers makes the
assets go down
• the return on the existing assets could go
either way
•
• The income statement is affected by the
return earned on the plan assets (which
can be volatile) 103
Pension Liability
• The liability is the PV of the benefits
expected to be paid out due to services
rendered to date
– note that this may involve estimating
employee turnover, future wage rates,
mortality rates, discount rates, etc
–
• This liability measure is called the
Projected Benefit Obligation (PBO)
104
Simplified Pension Economics -
105
Factors that will inject
volatility into the numbers
• Uncertain rate of return on plan assets
• Changes in assumptions (interest rates,
mortality rates, etc) used to calculate PV
of pension benefits
• Changes in the terms of the plan
(especially if they are applied retro-
actively)
• Pension plan terminations
• Acquisitions and divestitures
106
Smoothing Out
The Impact of These Factors
• The numbers are so large and so volatile
that it was felt that running them
through the income statement might
– Overwhelm “regular operating income”
– Have a significant non-recurring element,
thereby diminishing the quality of
earnings
• Smoothing used to occur on both the
balance sheet and the income
statement
• Now the balance sheet is marked to
market, but the income statement is
smoothed 107
Smoothing - On the Return
Side
• The EXPECTED return, not the realized
return is what goes thru the income
statement
•
• The difference between the realized return
and the expected return is deferred (and
hopefully will get offset by future
differences)
•
• The disclosed asset value in the footnotes
is now measured at the end of the fiscal
year 108
Smoothing - on the
Cost Side
• The interest expense and service costs are
based upon actuarial assumptions made at
the beginning of the year
•
112
Important Points to
check
• Funded Status
• How was the Benefit Obligation
calculated
• Income - economic vs smoothed
• Cash Flow
• Expected Contributions in the near
future
• Expected Benefit payouts in the near
future
• Deferred Taxes
113
Pension Income
• Economic
• Actual Return minus Service costs minus
Interest cost +/- Gains and Losses
•
• Accounting
• Expected Return minus Service Cost minus
Interest Cost +/- Amortization of gains and
losses, prior service costs, and transition
amt
•
• Note: these are Pre-tax income numbers
• Note: might also have to worry about
gains/losses on plan curtailments/ 114
How Reasonable are the
Assumptions?
• Expected Rate of return
• Discount Rate
• Rate of future compensation
increases
• How do they compare
– across firms
– over time
115
Other Post Employment
Benefits (usually Health
• Care)that they ever
Companies are denying
promised to pay these
• Requires an estimate of inflationary trend
in health care costs
•
• Companies must disclose the sensitivity of
the liability measure and the pension
cost measure to the underlying
assumptions (discount rate and health
care inflation)
116
Session 20
Long-Lived Assets:
International
117
Long-Lived Asset Issues
• Should an asset be recognized in the
financial statements?
– Capitalization vs. expensing
• What costs are included in the
acquisition cost of the asset?
– Set-up costs, transportation costs, capitalized
interest
• How is the asset’s book value reduced
over time?
– Depreciation and amortization
• What future costs are added to the
asset?
– Repairs and maintenance vs. capital
improvements
118
• How do you remove the asset when sold
Capitalization vs.
Expensing
Capitalization and
Expensing
• Future entries (yr 2 – yr 11)
• Future entries (yr 2 – yr 11) No entry
Dr. Expense 10
Cr. Asset 10
119
Determining Acquisition
Cost
• Acquisition cost of an asset should include all
costs necessary to get the asset ready to
use, including:
– Purchase price
– Transportation costs
– Installation/customization costs
– Borrowing costs (capitalized interest) if self-
constructed asset
–
• If acquisition costs include multiple classes of
assets (e.g. land, building, and machinery),
the cost must be allocated into separate
assets classes
120
Depreciation and
Amortization
• Terminology
– Tangible assets (Buildings and equipment)
Dr. Depreciation expense (or WIP
Inventory) xxx
Cr. Accumulated depreciation
xxx
– Intangible assets (Patents, Software)
Dr. Amortization expense
xxx
Cr. Asset (or Acm. Amort.)
xxx
• Elements of depreciation calculations
– Depreciable basis (cost – salvage value) 121
Sales or Impairments of
Assets
Dr. Cash (sale amount or 0 if impairment)
Dr. Accumulated Depreciation (full
balance)
Dr. Loss (plug)
Cr. Gain (plug)
Cr. Equipment (original cost or
amount of
impairment)
122
Impairment Tests (US
GAAP)
• Under US GAAP, fixed assets must be written
down if they fail the impairment test (all
must be answered “yes”)
124
International Financial
Reporting Standards
• IFRS are determined by the IASB,
which operated out of London
• The European Union required all
companies in member states that
are listed on exchanges to adopt
IFRS in 2005 (or by 2007 in some
cases)
• Many small non-EU countries also
require IFRS instead of having their
own local GAAP’s 125
International Differences for
LT Assets
• US GAAP requires the cost method
for fixed assets
– Net PPE is carried at lower of cost or market and
depreciation expense is recorded each period
128
Session 22
Intangible Assets
• R&D
• Goodwill
– Impairment
• Other Intangibles
• Customer Satisfaction
129
R&D
Asset or Expense?
• Expense it all
• Expense up to a certain point in the
development
• Capitalize it all and write off the
amounts associated with projects
deemed unsuccessful
• Capitalize it all
– Are the costs of “failed projects” part
of the cost of the identifying the
“good projects”
– Oil and Gas – Full cost vs Successful
Efforts 130
R&D – SFAS #2 - (1974)
Rationale for Expensing
• There is normally a high degree of
uncertainty about the future benefits of
individual research and development projects
– The element of uncertainty may diminish as a
project progresses.
–
134
Do R&D Expenditures
improve your ability to
predict future profits?
• Lagged regression of Operating Income on on
Prior R&D expenditures (all scaled by sales)
135
Is the “Constructed" R&D Asset
Priced?
Price = a + b Reported + c Adjustment + d
Adjustment
Earnings To Earnings to
Balance Sheet
for R&D for R&D
136
In Process R&D
137
In Process R&D - continued
138
In Process R&D Disclosures
139
In Process R&D
FASB Exposure Draft
144
Disposals and Discontinuations
145
Amortization of Intangibles
Other Than Goodwill
• Intangible assets with Finite Lives
– amortized the asset over its life (use your
best guess as to what the life will be)
– also review it for impairment
• Intangible assets with Indefinite Lives (a
trademark is renewable every 10 years)
•
– do not amortize until its life is determined to
be finite
– Review it (at least annually) for impairment
146
INTANGIBLE ASSETS :
Brand Names
• How Big Are They?
•
• Do They Appear to Be Priced?
•
• How are they Estimated?
– Interbrand method
147
Regression of Market Value of
Equity (MVE)
Variable
Coefficient T-stat
149
Customer Satisfaction
• Is It Related to Customer
Retention?
•
• Is It Related to Future Revenue?
•
• Does It Appear to Be Priced?
•
• What Could (Should) Companies
Disclose about Customer
Satisfaction?
150
Is Customer Satisfaction
Valued By the Market?
Market Book Book
Customer
Value = a + b1 Value + b2 Value + b3
Satisfaction
Equity Assets Liabilities
Index
Adjusted R2 = .77
151
Pressure to Begin Putting Non-
Financial Measures into
Financial Statements
• How will these be “standardized” so
they are comparable across firms,
yet still meaningful?
152
Session 23
Business Combinations
and Consolidations
153
Agenda
• Business Combinations (Acquisitions)
– 100% Ownership
– Less Than 100% Ownership
• FASB Exposure Draft – Minority Interest is to be
included in the Equity Section of the Balance
Sheet and called NONCONTROLLING
INTEREST
• FAIR VALUE OPTION – Firms have the option to
carry Investments accounted for using the
Equity Method at FAIR VALUE
• Consolidation
– FASB is still working on new rules for determining
when an entity must be consolidated (voting
ownership vs financial interest)
• Impact on Financial Statements of Avoiding
Consolidation
– Keep “subsidiary” debt off the balance sheet
– Related Party Transactions 154
Consolidation Example
P buys 100% of S for $3000
• Assume S’s BV is $1,000
– Consists of $2000 of recorded assets less $1000 of
recorded liabilities
• Equity Method (would be hard to justify in this case)
– Record ONE ASSET of $3000
– NO DEBT would show up on the balance sheet of the
“parent”
• Consolidation – record all assets and liabilities at their
market value
– Assume the extra $2000 is due to
• $800 of unrecorded PPE
• $1,200 of Goodwill (plug)
•
Dr Various Assets $2000
PPE 800
Goodwill 1200
Cr Various Liabilities $1000
Cash 3000 155
Consolidation Example
P Buys 50% of S for $500
• S’s BV is $1,000 ($2000 of assets less $1000 of
liabilities)
• The FMV of S’s Net Assets is (implicitly)
$1,000
•
• Equity Method – Record a Single Asset of $500
• Consolidation - Record S’s assets at Market
value
• Recognize their ENTIRE assets and Liabilities
• Recognize NONCONTROLLING INTEREST of $500
• NEW Exposure Draft – this goes in the
equity session
•
Dr Various Assets 2000
156
Cr Various Liabilities 1000
Consolidation Example
P Buys 50% of S for $1500
• S’s BV is $1,000 (2,000 of assets less 1000 of
liabilities)
• The FMV of S’s is implicitly $3000
• Investigation reveals S has $800 of
understated assets (PPE) and $1,200 of
Unrecorded Goodwill
•
• Equity Method – record a single asset of $1500
(and no liabilities)
• Consolidation - Record their assets at Market
value
Investments = $650-(80 -
40) = $610
• The components are not
disclosed separately
• Dividends received of $100
increases our cash and
decreases our investment
account -- NO INCOME EFFECT160
Net Income Presentation
Consolidated Method
• P reports ALL of S’s Revenues and expenses
LINE BY LINE
Revenues: P’s Revenues + $1900
Expenses: P’s Expenses + 600
• P Increases its Depreciation Expense by $80
• P subtracts the Noncontrolling Interests in the
Income of S of .5 (1900 – 600 – 80) = 610
• The overall impact on P’s Income Statements is
1900 – 600 – 80 – 610 = $610
167
Session 24 - Joint Ventures and
SPE’s
• Real Benefits
• Financial Statement Benefits
– Keep Losses and/or Debt off the
books
• How?
– Reduce Ownership (Coke)
– Hold Options (Alza, Dura, Boston
Chicken)
– Give power to Minority Holders
(Whole Foods avoided
consolidation of a new internet
startup even though they owned
168
Joint Ventures
• Small and Medium Sized Companies
Often Enter into Joint Ventures with
Much Bigger Companies to Pursue
Research and Development
Partnerships
•
• Pluses and Minuses To Each Party?
•
• How much of the investment the
smaller company receives is
“investment” versus revenue?
• 169
Model of R&D Partnership
ALZA/TDC Business
Arrangement
INVESTORS R&D
Corporation
Alza Shareholders Base Alza
Technology
$$ Risk License/Purchase
Leverage Option
170
Alza - TDC
• Alza starts new venture TDC with $250
million investment
• TDC’s corporate charter requires them to
use the money to hire Alza to do R&D
for them
• Alza spins off the shares of TDC to Alza
shareholders as a separate company
• But Alza retains an option to repurchase
all the shares for $100 million
• No other parties contribute any capital to
Alza
•
• After the $250 is exhausted, Alza 171
Dura and Spiros I
• 1995
– $28 million private placement (each
unit is one share of Spiros calleable
common and a warrant to purchase
2.4 shares of Dura)
– $13 million cash contribution from
Dura
– HAD TO RECOGNIZE AN EXPENSE
FOR THE CASH CONTRIBUTION
• 1995-1997 Contract Revenues of
$38.415 million
• 1997 - exercised purchase option
172
Dura and Spiros II
• 1997 - $101 million PUBLIC offering
(each unit is one share of Spiros
Corp II calleable common and a
warrant to purchase 1/4 share of
Dura)
$75 million contribution from Dura
Had to record an Expense of 75
million
• Terms of Exercise
• Purchase price = $24.01 through 12-
31-99, then increasing
173
Dura - Subsequent Events
• November 1998 FDA does not
approve Dura’s Spiros Inhaler
– Stock price falls 21%
• November 2000 - acquired by Elan
(Irish pharmaceutical and drug
delivery company)
174
Are TDC, Crescendo, and Spiros SPE’s?
Are they VIE’s
Should they be consolidate by Alza and
Dura?
175
Citi
• What constitutes a “reconsideration”
event?
176
Special Purpose Entities (now being
called Variable Interest Entities)
• These are not necessarily “evil” or
sham transactions
• There Can be legitimate Business
reasons for setting up an entity as
an SPE
– To allow project specific financing
– To shield investors from company
risks other than those pertaining the
specific “project”
– To prevent the sponsoring company
from “stealing” the assets of the
“special project” 177
Qualifying Special Purpose Entities
(QSPE’s) are exempted from the new
SPE rules (so far)
• SPE is demonstrably distinct from transferor SPE is
demonstrably distinct from transferor
• SPE must operate on “Autopilot” – i.e., be “brain dead”
– permitted activities are limited, entirely specified at
inception, and only changed by third-party
beneficial interests (BI) holders
• SPE may only hold
– Passive financial assets Passive financial assets
– Passive derivatives
– Guarantees
– Servicing right
– Nonfinancial assets from collections (temporarily)
– Collected cash and investments pending distribution
•
178
Consolidating Variable Interest Entities
Multinationals and
Foreign Currency
Exchange
Rate Changes
183
Issues With Foreign
Operations
• Accounting for operations and
transactions conducted in
currencies other than the dollar
• Consolidating operations from other
countries and currencies
• Impact of changes in foreign
exchange rates on financial
statements
• Economic Exposure to exchange rate
fluctuations versus Accounting 184
Exchange Rate Impacts
• When a firm has foreign operations,
the parent firm’s financial
statements (growth in revenues,
etc) are affected by
– The “Real” growth in the foreign
operations
– The Change in the Exchange Rate
185
SFAS 52 - Consolidating
Foreign Operations
• The accounting treatment depends
on the "functional currency” of the
foreign operation
• For foreign operations that are
“significantly integrated” with the
parent
– The functional currency is the parent
currency
– Translate using the "Temporal" Method
• For foreign operations that are
“stand-alone” 186
Under the Temporal
Method
• All monetary assets and liabilities are
translated using the exchange rates existing
on the balance sheet date
• Foreign currency gains and losses on monetary
items are included as part of income
• All nonmonetary items are translated using the
historical exchange rate
– These are not updated over time
– Unrealized gains and losses stay off the
balance sheet till they are realized
• Income statement line items are translated at
average exchange rates, except COGS and
Depreciation, which are translated at the
historical exchange rates
187
Under the Current Method
• All assets and liabilities are translated using
the exchange rate existing on the balance
sheet date
• All income statement line items are translated
using the average exchange rate during the
year
• The Common Stock account is left alone
• A new stockholders equity account called
Cumulative Translation Adjustment is
created to reconcile the beginning and
ending balances
– this bypasses the Income Statement until
the foreign sub is liquidated or sold 188
Analysis of the Temporal
Method
• Accounting exposure is the Net Monetary
Assets position (Monetary Assets minus
Monetary Liabilities) -- virtually all Liabilities
are monetary
• Foreign Currency Gain or Loss =
Beg. Net Monetary Assets x Change in
exchange rate during the year
Plus
Increase in Net Monetary Assets during year x
Change in exchange rate over second half of
year
189
Analysis of the Temporal
Method
• Foreign Currency Gain or Loss (due to
exchange rate changes on net monetary
assets) goes thru the income statement as a
separate line item
•
• Realized gains and loses due to exchange rate
changes on nonmonetary assets are buried
in the income statement - they are not
segregated into the foreign exchange
gain/loss line item
•
• Unrealized gains and losses on nonmonetary
items are NOT reflected in the financial 190
statements
Analysis of Temporal Method
• Revenues and COGS are not matched
very well
– Revenues are translated at the avg.
rate during the year,
– COGS is translated using the
historical rate that existed when the
inventory was acquired
– COGS lags the revenue number in
reflecting exchange rate changes
(analogous to FIFO COGS lagging
the revenue number) 191
Analysis of the Current
Method
• All gains and losses due to changes
in exchange rates (recognized and
unrecognized) impact the balance
sheet
• But more of them "bypass" the
income statement than under the
temporal method
• Accounting Exposure is the Net
Assets of the Foreign Subsidiary
(monetary and nonmonetary) 192
Cumulative Translation
Adjustment
• If the Subsidiary’s books balance but
– each balance sheet is translated at
the exchange rates on the balance
sheet date
– the income statement is translated at
the average exchange rate during
the year
• The parent’s books won’t balance
unless we make an adjustment
193
Interpretation of Cumulative
Translation Adjustment (CTA)
• The annual change in the CTA is equal to:
196
An Alternative Solution in
Hyperinflationary economies
(not allowed under US GAAP)
• Use current cost accounting on the
foreign sub’s books
– This will scale up the assets by the
inflation rate
• The foreign currency translation
would then scale the asset values
back down using the foreign
exchange rate
197
Foreign Exchange Rate
Changes and the Cash Flow
Statement
• An Additional reason why the
adjustments in the cash flow
statement will not correspond the
change in the corresponding
balance sheet account
•
• The cash flow statement of the
parent should replicate the cash
flow effects on the subsidiaries’
books (translated at the average
exchange rate) 198
Cash Flow Example -
Hold Cash During the Year
Balance Sheet Foreign Sub Exch Rate
US Parent
Beg Bal FC 250 1.00 $250.00
End Bal FC 250 1.50 $166.67
Change in Cash FC 0.00 $( 83.33)
201
Segmental Disclosures
• Advantages to disclosing information
about segments?
•
•
•
•
• Costs?
202
Segmental Disclosures
• Advantages to disclosing information
about segments?
– Different operating segments of a
company may be very different in
terms of level of profitability, growth
and risk
• Costs?
– Release of proprietary information to
competitors (or unions)
– Accounting classification/allocation
problems 203
SFAS 131 --What is a
segment?
• A distinct revenue-producing
component of an enterprise
• Use the “management approach” to
define segments
– Use the same definition that management uses
internally to make operating decision and assess
performance (but even if you don’t do this
internally, you still have to define segments for
external reports)
• Segments can be defined based on
– type of product or service,
– geographic area,
– by legal entity, or
– by type of customer
204
Ten Percent Tests - A segment
must be reported separately
if it meets one of these 3
tests
• 10 % of combined revenues (include
intersegmental sales)
• 10 % of combined profits (of segments reporting
profits) or 10% of combined losses (of segments
reporting losses)
• 10% of combined assets
•
• try to preserve comparability and consistency in
the definition of segments over time
205
Assuming the 10% test is
met
• Add up the total unaffiliated revenue
of the reportable segments
– If this is not at least 75% of total
unaffiliated revenues, go back and
define more segments
–
• Room for Discretion
–
206
Mandated Disclosure about
Segments
• General Descriptive Information
• Information about profit or loss
• Information about identifiable assets
– why not also liabilities?
• Reconcile segment information with the
enterprise numbers
• Restate previously reported segmental
data if the definition of segments has
changed
• Information about Major Customers
207
“Information about Profits”
• Companies do NOT have to disclose
segmental earnings in accordance
with GAAP
• They can pick any “profit-like”
performance measure they want
• In principle, they are suppose to
disclose the performance measure
they most pay attention to
internally
• Obviously, consistency over time and
across firms is a big problem here
208
Dividend Discount models can also be
expressed in term of Accounting numbers
∞
(E t − rBt −1 )
P0 = B0 + ∑
t =1 (1 + re ) t
• Firm’s Equity value is equal to its
Book Value plus
Present Value of the expected future Abnormal
Earnings
Another term for the abnormal earnings is Economic
Value Added
∞
(E t − rBt −1 )
Market Value Added = P0 − B0 = ∑
t =1 (1 + re ) t
The Market Value Added (MVA) by the Firm (the excess of what
209
Another way to express equity
value
∞
(ROE t − r)Bt −1 ∞
(ROE t − r)G t −1
P0 = B0 + ∑ = B0 {1 + ∑
}
t =1 (1 + re ) t
t =1 (1 + re ) t
210
Abnormal Earnings
Et - r Bt-1 = Net Incomet - re Book
Value of Share Equityt-1
•
• Interpretations
• Earnings minus “normal earnings”
• Earnings minus charge for equity capital (note
that the charge for debt capital is already
included in the earnings number)
•
• Other names for it
• Residual Income
211
• Economic Value Added (EVA)
EVA as a Performance
Measure
• "EVA is easily today's leading idea in
corporate finance and one of the most
talked about in business. Simply stated,
EVA is just a way of measuring an
operations' real profitability. It allows you
to look at almost any business operation
and see immediately whether it was
becoming more valuable or less. What
makes it so revealing is that it takes into
account a factor no conventional measure
includes: the total cost of the operations'
capital. Managers who run their business
according to the precepts of EVA have
hugely increased the value of their
companies (CSX, Briggs and Stratton,
Coca-Cola, etc.)" S. Tully, "The Real Key to
Creating Wealth," Fortune, September 20, 212
1993
What is EVA?
• EVA is net operating profit minus an
appropriate charge for the opportunity
cost of all capital invested in an
enterprise.
•
• As such, EVA is an estimate of true
"economic" profit, or the amount by
which earnings exceed or fall short of
the required minimum rate of return
that shareholders and lenders could get
by investing in other securities of
comparable risk.
•
Stern, Stewart 213
Why a Charge for Capital?
• The capital charge is the most distinctive and
important aspect of EVA. Under conventional
accounting, most companies appear profitable
but many in fact are not.
•
• "Until a business returns a profit that is greater
than its cost of capital, it operates at a loss.
Never mind that it pays taxes as if it had a
genuine profit. The enterprise still returns less to
the economy than it devours in resources… Until
then it does not create wealth; it destroys it."
Peter Drucker, Harvard Business Review article
• Equity capital (new investments or retained
earnings) is not free
214
There are Many Equivalent
Ways of Calculating EVA
• All start with some measure of
profitability and then subtract a
charge for capital
•
• It is important that the profitability
measure, the measure of capital, and
the charge for capital be consistent
with each other
•
• The profit number is usually some
variant of accounting net income (I.e.,
215
Three equivalent versions of
EVA
218
Pepsi - Subsequent Events
1996
– New CEO - stated they had been
“trying too hard sometimes,
overreached, got in front of their
headlights in their quest for growth”
– Began to sell back restaurants to
franchisees
1997
– Left the restaurant business entirely
– Spun off KFC, Pizza Hut, Taco Bell into
a separate company called Tricon
Global restaurants and gave to
shareholders
– Sold the smaller businesses to outside 219
Pepsi’s Current Segments
(2002 AR)
• By Product type
– Beverages - Pepsi Cola (NA and Intl);
Gatorade
– Snacks -- Frito-Lay (NA and Intl)
– Foods – Quaker Oats
–
• By Geographic Area
– North America (US and Canada)
– International
• Merger with Quaker Oats – this was
added as a segment
220
Desirable Features of EVA
• The present value of EVA is equal to the
present value of cash flows
•
– This holds for any accounting method!!!! (as long as it satisfies
clean surplus this means that The Change in Book Value of
the Firm = Net Investment + Net Income
•
• The market value of an asset (or the firm) is
equal to the book value plus the present
value of the remaining EVA - this also
holds for any accounting method!!!
•
• What makes a good accounting method 221
The Accounting Methods Used to
Calculate the Profit and Capital
Measures Matter if…...
• In a valuation context, you can only
forecast over a finite horizon
–
• In a Performance Measurement
Perspective Always