Capitalized interest Intercorporate investments Employee compensation: post-employee and share based Multinational operations

When a firm constructs an asset for its own use or, in limited circumstances, for resale, the interest that accrues during the construction period is capitalized as a part of the assets cost. The objective of capitalizing interest is to accurately measure the cost of the asset & to better match the cost with the revenues generated by the constructed asset. The treatment of capitalizing interest is similar under US GAAP & IFRS. The interest rate used to capitalize interest is based on debt specifically related to the construction of the asset. IF no construction debt is outstanding, the interest rate is based on existing unrelated borrowing. Interest costs on general corporate debt is excess of project construction costs are expensed. Capitalized interest is not respond in the income statement as interest expense. Once construction interest is capitalized, the interest cost is allocated to the income statement through depreciation expense (if the asset is held for use), or COGS (if the asset is held for sale). Generally, capitalized interest is reported in the cash flow statement as an outflow from investing activities, while interest expense is reported as an outflow from operating activities.

Securities that are purchased by corporations rather than individual investors. Intercorporate investments allow a company to achieve higher growth rates compared to keeping all of its funds in cash. These investments can also be used for strategic purposes like forming a joint ventures or making acquisitions. Companies purchase securities from other companies, banks and governments in order to take advantage of the returns from these securities. Marketable securities that can readily be exchanged for cash, such as notes and stocks, are usually preferred for this type of investment. Intercorporate investments are accounted for differently than other funds held by a company. Short-term investments that are expected to be turned into cash are considered current assets, while other investments are considered non-current assets. When companies buy intercorporate investments, dividend and interest revenue is reported on the income statement.

Financial assets - an ownership interest of less than 20% is considered as passive investment . There 3 types of financial assets under IFRS & US GAAP

1. 2. 3.

Held to maturity - are debt securities acquired with the intent & ability to be held to maturity . Held for trading are debt & equity securities for the purpose of profiting in the near term . Available for sale are debt & equity securities that neither held to maturity nor held for trading .

Investments in associates ownership interest between 20% & 50% is typically a non controlling investment . The investor can usually significantly influence the investees business operations .

Business combinations ownership interest of more than 50% is usually a controlling investment .
Joint ventures is a entity where control is shared by 2 or more investors.

Under US GAAP , a security is considered impaired if its decline in value is determined to be other than temporary. Under IFRS impairment of a debt security is indicated if at least one loss event has occurred and its effect on the securitys future cash flow can be estimated . An equity security can be considered impaired if its fair value has experienced a substantial or extended decline below its carrying value . Held to maturity become impaired when its carrying value is decreased to the present value of its estimated future cash flows. Under IFRS , impairments of available for sale debt securities may be reversed under the sane conditions as impairments of held to maturity securities . Reversals of impairments are not permitted for equity securities . Under US GAAP , impairments on available for sale may not be reversed for either debt or equity. Impairment of held for trading securities are not allowed under US GAAP & IFRS

Ownership

Degree of Influence

Accounting Treatment

Less than 20% (Investments in financial assets)

No Significant Influence

Held-to-maturity, availablefor-sale, held-for-trading, or designated at fair value (through P/L) Equity method

20%-50% (Investment in associates) More than 50% (Business combinations) 50%/50% (Joint Venture)

Significant influence

Control

Acquisition Method

Shared Control

IFRS: Proportionate consolidated preferred; US GAAP: Equity Method

Held-to-Maturity

Held-for-Trading

Available-forsale

Balance Sheet

Amortized cost

Fair value

Fair Value with unrealized G/L recognized in equity Interest Dividends Realized G/L

Income Statement Interest (including amortization) Realized G/L

Interest Dividends Realized G/L Unrealized G/L

Investment ownership of between 20% & 50% is considered investment in associates . Equity method is used for reporting

Equity method
Income statement treatment Proportionate share of investee earnings is recognized Additional, depreciation from excess of purchase price allocated to investee assets & liabilities Balance sheet treatment Proportionate share of investee earnings increases investment account Dividends decreases investment account Equity income from income statement increases investment account

At the acquisition date, the excess of the purchase price over the proportionate share of the investees book value is allocated to the investees identifiable assets & liabilities based on their fair values . Any remainder is considered as goodwill . Impairment of investment of associates If the fair value of the investment fall below the carrying value . The investment is written down to fair value & loss is recognized in the income statement

Under IFRS, business combinations are not differentiated based on the structure of the surviving entity. Under US GAAP, business combinations are categorized as: Merger - The combining of two or more companies, generally by offering the stockholders of one company securities in the acquiring company in exchange for the surrender of their stock. Acquisition - A corporate action in which a company buys most, if not all, of the target company's ownership stakes in order to assume control of the target firm. Acquisitions are often made as part of a company's growth strategy whereby it is more beneficial to take over an existing firm's operations and niche compared to expanding on its own. Acquisitions are often paid in cash, the acquiring company's stock or a combination of both. Consolidation - A stage in the life of a company or an industry in which components in the company or industry start to merge to form fewer components. These components can include product lines at the company level or companies themselves at the industry level. The consolidation of companies differs from mergers in that consolidations create new entities while mergers do not. Special Purpose Entities It is a legal entity created to fulfill narrow, specific or temporary objectives. SPEs are typically used by companies to isolate the firm from financial risk.

There are 2 approaches for accounting

Pooling of interest method (or uniting of interest under IFRS)

Purchase method (acquisition method) acquisition method three major accounting issues . 1. Recognition and measurement of assets and liabilities of the combined entities 2. Goodwill : initial recognition & subsequent treatment 3. Minority interest : recognition and measurement of non controlling interest

Identifiable assets and liabilities To be measured at the fair value on the date of acquisition Contingent liabilities The parent must recognize any contingent liabilities which can create an obligation due to past action of the subsidiary . Financial assets Reclassification can be done by the parent at the time of acquisition Goodwill is equal to the excess of purchase consideration paid over the fair value of identifiable net assets acquired

Add each asset and liability of the subsidiary (100%) with the parent company Dont add equity accounts Remove the investments in shares of subsidiary from parents B/sheet Remove all inter company balances Equity of subsidiary doesnt figure into parents balance sheet

Owns 100%

SBI

SBH

SBH is a wholly owned subsidiary of SBI

There are two methods of recognizing goodwill at the time of acquisition Full goodwill method (compulsory under US GAAP) Partial goodwill method ( preferred under IFRS)

1.

1.

Full goodwill method goodwill = fair value of the subsidiary fair value of total identifiable net assets. Partial goodwill method goodwill = acquisition price fair value proportionate identifiable net assets .

Add each line item of subsidiary (100%) with the parent company . Dont add equity accounts Remove the investments in shares of subsidiary from parents B/sheet Remove all inter company balances Equity of subsidiary does not figure into parents balance sheet Minority interest is share of the other investors in the net assets of the subsidiary and shown in equity
Owns 60%

SBI

SBH SBH
Owns 40%

HDFC will be called as minority Interest in the books of SBI when it consolidates the books of SBH

 Value

of minority interest depends upon the method of recognizing goodwill Full goodwill method MI = shareholding% x fair value of subsidiary Partial goodwill method MI = share holdings x fair value of net assets of subsidiary

1.

1.

Steps

Add each line of subsidiary (100%) with the parent company Remove all; inter company transactions Arrive at the consolidated profit before minority interest Subtract minority interest after calculating PAT Notes

If the subsidiary has incurred profits >>the value of its equity goes up>> value of minority interest will also go up Value of consolidated income is not dependent of the method of goodwill valuation

Important points Goodwill to be recognized only when purchased Goodwill is neither depreciated nor amortized Goodwill is tested for impairment at least annually Impairment (US GAAP) 1. 2. Recoverability test whether to impair? Goodwill to be impaired when net book value of reporting unit > FV of reporting unit Loss impairment how much to impair? Impairment loss = Book value of goodwill (less)Implied fair value of goodwill

Under IFRS
Impairment loss = Book value of cash generating unit fair value of cash generating unit

SPE is an legal structure created tom isolate certain liabilities from the main company . It is created by the primary sponsor and finances its activities . It can take following forms : corporation, joint venture or trust VIE is a category of SPE that meets any or both of the following conditions : 1. Risk-equity is insufficient to finance the entities activities without additional financial support . 2. Equity investors that lack anyone of the following . Decision making right Obligation to absorb expected loss Right to receive residual return

Equity Method Leverage Lower Liabilities are lower & equity is the same

Proportionate Consolidation In-between

Acquisition Method Higher

Net profit margin

Higher-sales are lower & net income is the same

Higher-equity is lower & net income is the same Higher-net income is the same & assets are lower

In-between

Lower

ROE

Same as Equity Method

Lower

ROA

In-between

Lower

Present value calculation need to be understood in detail Rule of pension accounting for income statement and balance sheet Rules of adjustment in US GAAP and IFRS need to be differentiated

 Different

types of pension plans Rules of pension accounting under US GAAP Rules of pension accounting under IFRS Shared based compensation


1. 2. 3. 4. 5. 6. 7.

Defined contribution plan

Firm make a periodic contribution to the retirement fund Based on factors like no of years service , last drawn salary , employee age , profits etc No assurance by the firm for the final placement of the liability Fund managed by the employees No assurance by the firm for the future value plan assets Pension expense = contribution made each year No liability recognized on the balance sheet

1. 2. 3. 4. 5.

Defined benefit plan

Firm makes a periodic contribution to the retirement fund Fund managed by the firm through an independent trust Payment to be made to each employee after the retirement till his / her death Approximation of several factors involved to estimate the total pension obligation Investment risk of fund assets lies with firm which has responsibility for the discharge of the retirement obligation

Balance sheet impact

Assets fair value of plan assets in pension fund Liability present value of amount owed to employee for their services till date ( define benefit obligation) Fund assets are compared against fund liabilities In case the status is overvalued ( assets more than liabilities)- difference is shown on assets side In case the status is undervalued ( liability more than assets)- difference is shown on liability side

Income statement impact : pension expense include the following

Service cost PV of benefits earned by employee due to their service in the current period Interest cost closing PV of obligation estimated at beginning of year (less) opening PV of obligation estimated at beginning of the year Actuarial gain or loss PV of any change in future obligation caused because of changes in assumptions used by actuarial Prior service cost retroactive benefits awarded to employees when a plan is initiated or amended Expected return on fund assets it reduced the pension expense . Expected return is used in price of actual return to reduce the volatility

Under US GAAP

Projected Benefit Obligation (PBO)

Accumulated Benefit Obligation (ABO)

Vested Benefit Obligation (VBO)

Funded Status

IT is the actuarial present value (at an assumed discount rate) of all future pension benefits earned to date, based on expected future salary increases. The assumptions here are of going concern and that the employees will work until retirement . It is the actuarial present value (at an assumed discount rate) of all future pension benefit earned to date, based on current salary levels, ignoring future salary increases. It is on current basis and shows the liability that will be payable if the firm expects to liquidate and settle pension obligation. This is the amt of ABO that is not contingent on future service. For example, the minimum tenure of the employee for being eligible to receive pension benefits. Present value of Cash outflow required to satisfy the pension obligation (Less) Fair Value of Pension Plan assets.

Opening Obligation

Current Service Cost

Interest Cost

Plan Amendments

Actuarial gains and losses Benefit Paid Closing Obligation

Current Service Cost

It is the PV of benefits earned by the employees during the current. It is the increase in the PBO that is the result of the employees working one more period. For PBO, it includes an estimate of compensation growth It is immediately recognized as a component of pension expense . Increase in the obligation due to passage of time It is equal to beg. Pension obligation x discount rate It is immediately recognized as a component of pension expense.

Interest Cost

Past (prior) Service Costs

It is the change in PBO as a result of the firm adopting or amending its pension plan. Charged immediately in Income Statement; or Report in OCI and amortize over remaining average service life Gains and losses arising as a result of changes in variables such as mortality, employee turnover, retirement age and the discount rate. This also includes any difference between actual and estimated return on plan assets. Charged immediately in Income Statement; or Report in OCI and follow Corridor method for recognition Pension paid to employees during the current year. It reduces the pension obligation (treat it like a liability that has been paid)

Change in Actuarial Assumptions

Benefits Paid

Discount (Settlement) Rate

It is the interest rate used to calculate the PV of benefit obligation It affects all measures of benefit viz., ABO, PBO & VBO and Pension expense. It is not risk free rate. It is based on interest rates of high quality fixed income investments with maturity profile similar to the future obligation It is the expected average annual rate of compensation increase. It affects PBO and Pension expense but has no impact on ABO and VBO It is the assumed long term rate of return on the investments in the plan Its treatment is similar to any other actuarial assumptions Expected return on plan assets is recognized as part of pension expense (-ve) Treatment of difference between Expected and Actual Return is same as that of actuarial gains/losses. Such amount is clubbed with Actuarial gains/losses and treated accordingly

Rate of Compensation growth Expected Return on plan Assets

Current Service Cost Interest Cost Expected Return on Assets

Amortization of Deferred (gains) and Losses

Amortization of past service cost

Pension Expenses

When It is Used ?

Used to recognized AGL that were taken to OCI (and not to income statement) Take the opening balance of PBO and FV of plan assets Take the one which is higher Take 10% of it This is the corridor (max range available to the company ) If the unrecognized AGL exceed this range , then this excess needs to be amortized The amortized will be over expected average remaining service lives of the employees

Treatment under CORRIDOR METHOD

Firms are required to disclose reconciliation of PBO and plan assets in the financial footnotes

PBO

PBO at beginning of period Current service cost Interest cost Plan amendments Actuarial (gains)/losses Benefits paid PBO at end of period
Fair value of plan assets at the Beg Actual return on assets Employer contributions Benefits paid FV of plan assets at the end

Plan Assets

Effect of changing plan assumptions on Benefit Obligation

Effect on

Increase Discount Rate

Decrease Decrease

Decrease Rate of compensation Increase

Decrease No Effect

Increase Expected Rate of Return

No Effect No Effect

PBO ABO

VBO

Decrease

No Effect

No Effect

Effect of changing plan assumptions on Pension Expenses

Effect on

Increase Discount Rate

Decrease Decrease* No Effect

Decrease Rate of compensation Increase

Decrease Decrease No Effect

Increase Expected Rate of Return

No Effect No Effect Increase

Service Cost Interest Cost Expected Return

Pension Expenses

Decrease*

Decrease

Decrease

For mature plans, a higher discount rate might increase interest cost. In rate cases, interest cost will increase by enough to offset the decrease in the service cost, and pension expenses will increase.

Economic Pension Expenses

Economic Expense = Current Service Cost + Interest Cost Actual Return on Assets It can also be calculated by summing all changes in PBO for the period except for the benefits paid and then subtracting the actual return on assets Or it is equal to change in funded status excluding the firms contributions (US GAAP) For analytical purposes, only current service cost should be treated as operating Operating Vs. Non Operating Expenses expenses. Interest cost should be added to interest expense and the actual return on plan assets should be added to non operating income. If contribution to pension fund is more than the economic expense, it is deemed as Impact on cash flows (Analysts adjustment) extra payment for the principal of the loan. Hence the incremental cash outflow should be classified as financing rather than Operating. To make adjustment, Operating CF to be increased and Financing CF to be reduced by this incremental cash flow Opposite adjustment will be made by the analyst when the contribution to pension fund is less than the economic expense.

All the actuarial gains or loss AND prior period costs needs to be recognized as pension liability under the US GAAP irrespective of the fact whether it has been expensed in income statement or taken to OCI That is, Under US GAAP the net pension asset or liability reported on the balance sheet equals to the funded Pension Accounting under US GAAP does not reduce the volatility of the FUNDED STATUS (by not eliminating past service cost and deferred gains and losses that have not yet been recognized in the income statement). On the positive side: The net pension asset/liability reported on the balance sheet represents the economic reality. Reported Expense, however is still smoothed number that may not represent economic reality and thus will require adjustment for analytical purposes

Adjustments required when transaction takes place involving currency of two different countries When assets and liabilities are in a currency other than the reporting currency?

Meaning: when a company make any operational transaction involving currency of other country Example: (1) A firm in the US has sold goods to a customer in Europe (2) A firm in the US has purchased goods from a supplier in Japan There is no legal entity in FC which need to be consolidated into HC Since there is no equity investment involved, there is no need to consolidate any FS
Rules of inter-corporate investments do not come into picture

Impact on financial statement Sales / purchase is initially recognized at the spot rate on the transaction date. Balance sheet values (Debtors / Creditors) are re-stated at the closing rate any realized gain / loss is T/F Income Statement At the time of payment, Debtors / Creditors are settled at the rate on the date of cash flow and any gain / loss (from the previous balance sheet value) is recognized in income statement

This is the main concept and the rules / standards learnt will be used to convert a foreign currency FS into Home Currency

Local currency
Functional Currency

Currency of the investees country being referred to

Currency of the primary economic environment in which the entity operates. Usually the currency of cash generation and spending Determined by the Management As per IASB, the management should consider the following factors while determining the functional currency:

Reporting (Presentation currency)

The currency that influences sale prices for goods and services Currency of the country whose competitive forces and regulations mainly determine the sale price of goods and services The currency that influences labor, material and other costs The currency from which funds are generated The currency in which receipts from operating activities are usually Currency in which the parent company prepares its financial retained

statements

The consolidation of the foreign subsidiary is similar to the consolidation of a local subsidiary There are two steps in converting foreign subsidiarys financial statements:

Conversion from local currency to functional currency This is also called re-measurement Temporal method is used Re-measurement usually occurs when a subsidiary is well integrated with the parent (i.e.; parent takes O,I&F decisions)

Conversion from functional currency to reporting currency This is also called translation Current rate method is used Translation usually involves self contained , independent, subsidiaries whose operating , investing and financing activities are decentralized from parent

The current rate is the exchange rate on the balance sheet date . The average rate is the average exchange rate over the reporting period The historical rate is the actual rate that wads in effect when the original transaction occurred. For example , if a firm bought machinery on January 2, 2008, the historical rate for that transaction at every balance sheet date in the future would be the exchange rate on January 2, 2008 Remeasurement involves converting the local currency into functional currency using the temporal method . Translation involves converting the functional currency into the parents presentation (reporting) currency using the current rate method. The current rate method is also known as the all- current method Monetary assets and liabilities are fixed in amount of currency to be received or paid and includes cash , receivables , payables and short term and long term debt All other assets and liabilities such as inventory , fixed assets unearned revenue etc. are examples of non monetary assets Clean surplus : taking any unrealized gain/loss into income statement Dirty surplus : taking any unrealized gain/loss into OCI > equity

Remeasurement
Local currency Local currency Local = Functional currency Functional Currency

Translation
Reporting currency

Functional = Reporting currency Reporting currency

1. 2.

3.

Income statement is translated first at the average rate to calculate the translated profit The translated profit is then taken to the translated balance sheet which has different assets and liabilities being translated as per table below The balancing difference in the balance sheet is the currency translation gain or loss which is part of OCI (and thus part of Equity)
Parameter
All income statement A/cs All Balance sheet A/cs (except common stock) Common Stock Dividends Translation Gains / Losses

Conversion Rate
Average Rate Current Rate Historical Rate (Date of issue of stock) Rate at the time of payment (i.e., Historical Rate) Report under shareholders equity as CTA

1. 2.

3. 4.

Balance sheet is remeasured first as per table below The net difference in the equity (closing less opening) is the remeasured PAT during the year Income statement is remeasured as per table below to calculate the PAT Difference in PAT as per step 2 (from Balance sheet) and step 3 (from Income statement) is the remeasurement gain / loss which has automatically become part of the Income statement Parameter
Balance Sheet A/cs
Monetary Assets & Liabilities All other assets and liabilities i.e., Non Monetary assets and liabilities Current Rate Historical Rate

Conversion Rate

Income statement A/cs

Expenses related to non monetary assets (Eg. COGS, D&A) Revenues and all other expenses Remeasurement gains / losses Historical Rate Average Rate Recognise in the income statement

Current method Exposure is equal to net assets position of the subsidiary Generally net assets position is positive

Temporal method Exposure is equal to net monetary assets or liability position Generally firms have net monetary liability position as only few assets are considered monetary

If subsidiary has net assets exposure If subsidiary has net monetary assets and foreign currency is appreciating , exposure and foreign currency is a gain is recognized appreciating , a gain is recognized Difficult to eliminate exposure by managing the net assets as it would result into elimination of share holders equity Firms can eliminate the exposure by managing assets and liabilities

 Since

inventory is a non monetary asset, it should be re measured using the historic rate FIFO ending inventory and LIFO COGS are re measured based on most exchange rates FIFO COGS and LIFO ending inventory are re measured using older exchange rates Under the weighted average method , ending inventory and COGS are re measured at the weighted average exchange rate for the period

Temporal method Monetary A&L

Non monetary A&L Common stock Equity (full) Revenue and SG&A COGS D&A Net income Exposure Forex gain or loss

All current method Current rate

Current rate historical Current rate Average rate Average rate Average rate Average rate Net assets Equity (in oci)

Current rate
Historical Historical mixed Average rate Historical Historical mixed Net monetary assets Income statement

This is the comparison between the original FS in local currency and finally converted FS in reporting this conversion would have involved either translated or remeasured or both

Current method
pure ratios will not be affected If foreign currency is depreciating , translated mixed ratio will be greater than the

original and vice versa .(assuming mixed ratio has income statement item in the numerator and b/sheet item in denominator)

Temporal method
depends on which item has been converted at what rate and what is the trend in

exchange rates

Pure ratios : both Nr and Dr from the same FA either from income statement
or from the balance sheet E.g. current ratio, debt to equity , proprietary ratio(from BS), GP/NP margin ,(from Inc St.)

Mixed ratio : both Nr and Dr are from different FA one from income statement
AND one . From the balance sheet E.g. ROCE, ROE , Turnover ratios

Hyperinflation = cumulative inflation exceeds 100% over 3 years , defined by FASB

(CAGR of over 26%)

Value of local currency would have been severely depreciated (PP Theory) thus converting the values into reporting currency without adjusting for inflation will reduce their weight significantly in the reporting currency

IFRS : FS are restated for inflation and then translated using rules of current method
non monetary A&L to be restated using price index change since acquisition Not necessary to restate Monetary A&L Components of equity (change in PI during the year or post contribution , if that is later ) Income statement items (change in PI from the date of transaction ) Net purchasing power gain/loss is recognized in the income statement (NOT OCI) Balance sheet is closed first and the difference takes place in income statement

US GAAP : adjusting non monetary assets and liabilities for inflation is not allowed under
US GAAP We assume that since LC has been severely depreciated , functional currency = reporting currency Remeasurement is done temporal method is used