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Financial Reporting & AnalysisLevel II – 2016Topic Weight 15-20% (3 to 4 case studies)Ankur Kulshrestha, CFAChartered Accountant, Certified ValuerM. Com, B. Com (H) 91 9711 066 000ankur.k@finstudyclub.com
Overview of FRA: 6 hoursThree new topics5.5 hours Inter-corporate Investments 2.0 hr Pensions2.5 hr Multinationals1 hr Level 1 concepts: Inventory, LLA Quality of Earnings / Analysis20.5 hours.com
Inter-Corporate Investments-What would be the impact on your security if the company makesan investment into any other corporate?-How would standalone results be different from the consolidatedones?-Whether to purchase shares of the group’s holding company (likeTata Sons) or invest in any of its subsidiary (Tata Steel)?3.com
Scope of discussion Different levels of equity acquisition Accounting Treatment of inter-corporate Investments Equity MethodProportionate ConsolidationFull ConsolidationImportant points Passive investments (Marketable Securities)Active investmentsGoodwill Creation and ImpairmentInter-company transfer adjustmentMinority Interest valuationVariable Interest Entities4.com
Categories of Inter Corporate Investments Type of method of accounting is dependent on the level of involvement investor company is able tohave in the investee. To make this criteria objective, % holding has been used a guideline to classify and differentiatebetween different types of investmentsOwnership %Degree of influenceMethod of accounting under theUS GAAPMethod of accounting under IFRS1Less than 20%No influenceAmortized cost/ Fair valueAmortized cost/ Fair value220% - 50%Significant influenceEquity methodEquity methodMore than 50%ControlFull ConsolidationFull ConsolidationJoint VentureJoint ControlEquity methodProportionate consolidation isallowed only selectivelyEquity Method is preferred/Proportionate consolidation isallowed only selectively34Substance over form:1.If the holding % is more than 50% but there is no control due to barriers like bankruptcy,government interventions, etc – No Consolidation is done2.If % holding is 20% to 50% but the investor is not able to exercise any influence – Equitymethod is not used3.If % holding is less than 20% but the investor is able to exercise any influence – UseEquity Method5.com
Practice Question – Equity SecurityA company purchased a share at beginning of the year for 90,000. During the year,dividend of 8,000 was distributed. Fair value of share at the end of the year is 98,500.Find out the Balance Sheet value, Income statement impact if you classify the securityinto:1. Held to Maturity2. Available for Sale3. TradingWhat would be the impact on financial statements if this security was sold for 100,000next year?Next yearB/S ValueIncome StOCIIncome St.OCIHTMAFSTrading6.com
Calculation of Amortized CostA company purchased a five year 9% bond with FV of 100,000 at beginning of the year.The bond was issued for 96,209 to yield 10%. The coupon payments are made annually atyear end.YearOpening InvestInterest IncomeCoupon RecDeltaClosing Invest1237.com
Practice Question – Debt SecurityA company purchased a five year 9% bond with FV of 100,000 at beginning of the year.The bond was issued for 96,209 to yield 10%. The coupon payments are made annually atyear end. Fair value of bond at the end of the year is 98,500.Find out the Balance Sheet value, Income statement impact if you classify the security into:1. Held to Maturity2. Available for Sale3. TradingWhat would be the impact on financial statements if this security was sold for 100,000 nextyear?Next yearB/S ValueIncome StOCIIncome St.OCIHTMAFSTrading8.com
Valuation of Passive Investments – Marketable SecuritiesOR financial AssetsIFRS has come up with the new IFRS 9 on passive investments. We focus on Old rules Securities in which the objective of investment is not to participate in the management ofthe investee but earn interest / dividend and Capital gain. There are two broad options of valuation :1. Fair Value options: All securities are valued at fair value and the changes invalues are taken to income statement. The investor need to make this choice upfront and state the same in thefootnotes2. Classifying the security into the following three categories:US GAAP (new & Old) IFRS OldValuationHeld Till MaturityHistorical cost /Amortized costAvailable for SaleFair valueHeld for TradingFair valueIncome(Dividend /Interest)Realizedgain / LossUnrealized gain /lossNot recognizedIncome StatementEquityIncomeStatement.com
Valuation of Passive Investments – Marketable SecuritiesOR financial Assets Only Debt securities can be classified as HTM Amortized cost is equal to face value less any unamortized discount or plus anyunamortized premium. It is the present value of the remaining cash flows (coupon and fv)discounted at YTM (also the market rate of interest at issuance) In case of debt security: Amortized cost replaces Historical cost for all practical purpose Under IFRS: Only ON DEBT security - If the unrealized gain / loss for AFS security iscaused due to forex fluctuation, then it is taken to income statement rather than to the OCI.E.g. US investor purchased a Debt Security in the UK at GBP 100 when the spot rate was1GBP 1.2 USD. At the close of the year, the exchange rate was 1GBP 1.5 USD. Findout the balance sheet value of the security if it was classified as AFS.10.com
Reclassification from one category to another Sometimes its prospective and sometimes it retrospectiveNext yearB/S ValueIncome StHTM96,8309,621AFS98,5009,621Trading98,5009,621 e St.OCI3,1701,6703,170-1,6701,500Treatment11.com
Reclassification of marketable securities –Under US GAAPChange in classification possible if there is change in intention of holding the he Fair value becomes the new carrying value for the HTMsecurity. The Unrealized gain previously recognized in OCIis amortized over life of the securityHTMAFSThe security is valued at the Fair value and the Unrealizedgain / loss is recognized in OCIUnrealized gain / Loss previously recognized in Incomestatement to not transferred to OCIUnrealized gain / loss previously recognized in OCI istransferred to Income StatementNotes:(1) Standard allows transfer from HTM to Trading directly but not vice versa(2) Above treatment for Trading category is applicable for Fair Value Option also(3) Once classified out of HTM, a firm may no longer be able to classify that particular security orsimilar securities into HTM in future12.com
Reclassification of marketable securities –Under IFRSChange in classification possible if there is change in intention of holding the securityFromToTreatmentAFSHTMThe Fair value becomes the new carrying value for the HTMsecurity. The Unrealized gain previously recognized in OCIis amortized over life of the securityHTMAFSThe security is valued at the Fair value and the Unrealizedgain / loss is recognized in OCINotes:(1) Once classified out of HTM, a firm may no longer be able to classify that particular security orsimilar securities into HTM in future(2) IFRS restricts any movement from / to Trading category and Fair Value option.13.com
Impairment of Marketable Securities Impairment is required if any event which warrants impairment has occurred. Check for impairment at the endof every reporting period Since Under fair Value option and for Trading securities, valuation has already been done on fair Value anddifference taken to Income statement, there is no need to impair these Criteria of impairment1.For debt: When atleast one loss event has occurred and the impact of such event can be measured onthe cash flows from that security Likely bankruptcy, default on interest / principle payment, Does not include any delisting, credit downgrade, lack of liquidity in the security2.For Equity: If its fair value has experienced substantial or extended decline below its carrying value Treatment under impairment1.Debt: Revised fair value is calculated by discounting revised cash flows using YTM at the time ofpurchase. Impairment loss (T/F Income Statement) Carrying value – Revised fair value2.Equity: Impairment loss (T/F Income Statement) Carrying value (which would also be at FV) –Revised fair value Reversal of Impairment Loss US GAAP: Impairment loss can be reversed on HTM but not AFS IFRS: Impairment loss can be reversed on all Debt securities but not on Equity security14.com
Equity Method of Accounting for Inter-corporateInvestmentsOwnership %Degree of influenceMethod of accounting under theUS GAAPMethod of accounting under IFRS1Less than 20%No influenceAmortized cost/ Fair valueAmortized cost/ Fair value220% - 50%Significant influenceEquity methodEquity methodMore than 50%ControlFull ConsolidationFull ConsolidationJoint VentureJoint ControlEquity methodProportionate consolidation isallowed only selectivelyEquity Method is preferred/Proportionate consolidation isallowed only selectively34Substance over form:Some examples of significant influence:1.If the holding % is more than 50% but there is no control dueto barriers like bankruptcy, government interventions, etc –No Consolidation is done1.Board representation2.Involvement in policy makingIf % holding is 20% to 50% but the investor is not able toexercise any influence – Equity method is not used3.Material inter company transaction4.Interchange of managerial personnelIf % holding is less than 20% but the investor is able toexercise any influence – Use Equity Method5.Dependence on technology2.3.15.com
Investment into Associates – 20% to 50% holdingQues: Company A invests in the shares of company B and acquire 40% of B’s equity for 10,000. During the year, B earns a net income of 1,000 and out of this pays a dividendof 800. You are required to find the following: What is the value at which the initial investment be recorded in A’s Balance sheet?What is the impact on Income statement (Equity Income) of A during the year?What is the final balance sheet at the year end?16.com
Investment into Associates – 20% to 50% holdingQues: Company P acquire 30% of Q‟s equity for 1,000 in 2011. During the year, Qearns a net loss of 3,000. During 2012, Q incurred a further loss of 1,000. There weregood sales in 2016 when the company Q makes a profit of 1,200. You are required tofind the following: What is the value at which the initial investment be recorded in P‟s Balance sheet?What is the impact on Income statement of P during 2011 and the value in 2011balance sheet?What is the impact on the financial statement of P during2012 and 2016?17.com
Investment into Associates – 20% to 50% holding-Record initial investment at costWhen the investor is able toexercise significant influenceover investee-Follow Equity Method-Report on B/Sheet as NonCurrent Asset1.Pro rata share of investee‟s earnings/loss: Take it to P&L A/c (non-operating item) andincrease the balance sheet asset with the same amount2.Dividend received is not recorded in the income statement. It simply reduces theinvestments balance since the net worth of the investee reduces on payment of dividend3.If the investee reports losses, value of investment goes down4.If investee‟s continuous losses reduce the balance sheet asset a/c to zero, then we usuallydiscontinue the use of equity method5.Resumption is done only when the pro rate share of profits exceed the pro-rate share oflosses not recognized during the suspension period6.Investor can make irrevocable election to report it at Fair Value (unrealized gains to be takento P&L a/c)18.com
Special case - Purchase consideration in excess of theproportionate book value of investee Ques: Sahara company purchased 40% of KF for 60,000. On the acquisition datethe BV of KF‟s identifiable Net Assets was 100,000. Fair value of KF‟s PPE wasmore than its book value by 30,000. The remaining life of the PPE is 10 years usingSLM method. During the year, KF reported its Net income as 80,000 and paid adividend of 60,000. Calculate goodwill created on the acquisitionCalculate the impact on Income statement of SaharaWhat is the closing value of the investment a/c in the books of Sahara?19.com
Special case - Purchase consideration in excess of theproportionate book value of investee In a theoretically correct scenario, the amount invested by the investor should be equal tothe proportionate book value of the investee. (This is rarely true practically) When the amount paid proportionate book value of the investee, the excess amount is allocated to the identifiable net assets based on their fair values.Any remaining excess is considered as goodwill. In subsequent period, investor recognizes (additional) expense on the basis of the aboveallocation. E.g. if excess of 100 has been allocated to the fixed assets (since their FV must be more than the BV)and these FA have a remaining life of 2 years, then the investor will also allocate 50 as depreciation byreducing its value of investment in the balance sheet and reducing its Equity IncomeA L 50Value ofinvestment a/c C 50Lower equity Income due to greaterdepreciation lower profits lower equityIt is to be noted that the asset in the balance will continue to appear as „ Investment‟a/c (even goodwill is not shown separately)20.com
Upstream / Downstream transactions1. Goods worth 8,000 were sold by investor to the investee at 10,000. All the goodswere lying with the investee by the end of the year. What is the adjustment for profitrequired due to this inter-company transaction if ownership % is 30%?2. Goods worth 8,000 were sold by investor to the investee at 10,000. 50% of thosegoods sold during the year. What is the adjustment for profit required due to this intercompany transaction if ownership % is 30%?21.com
Other important points1. Impairment US GAAP: If the fair value of the investment falls below the value
Financial Reporting & Analysis Level II – 2016 Topic Weight 15-20% (3 to 4 case studies) Ankur Kulshrestha, CFA Chartered Accountant, Certified Valuer M. Com, B. Com (H) 91 9711 066 000 ankur.k@finstudyclub.com . 2 .com Overview of FRA: 6 hours Three new topics 5.5 hours Inter-corporate Investments 2.0 hr Pensions 2.5 hr Multinationals 1 hr Level 1 concepts: Inventory, LLA 0.5 hours
