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Chapter 7

Investing
Activities

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Investing Activities
Includes acquisition of long-term

tangible & intangible assets and


disposition of assets.
Investment categories:
Investments in long-lived operating assets
Long-lived tangible fixed assets
Amortizable intangible assets
Non-amortizable intangible assets
Investments in the securities of other firms
Chapter: 07

Accounting for Acquisition of


Property, Plant and Equipment
Costs incurred to yield future benefits

imply asset.
Asset is recorded at Fair Value.
Fair Value includes cash paid, fair value of
debt incurred, fair value of lease payments .

Chapter: 07

Cash-Flows from Acquisition of


Property, Plant and Equipment
When cash is paid
It is a Cash outflow
Reported in the investing activities section of

the statement of cash flows.

When debt is incurred or equity is issued


It is a non-cash, investing & financing activity.
Reported in a separate schedule,

accompanying the statement of cash flows.


Chapter: 07

Accounting for Research and


Development Costs
U.S. GAAP
Internally incurred R&D costs are expensed.
Externally acquired R&D are capitalized.
For

Industries with high R&D expenditures, U.S. GAAP


requirement to expense is troublesome because a
major asset never appears on the balance sheet.

IFRS
Research costs are expensed.
Product development costs are capitalized.
Chapter: 07

Reporting for Research and


Development Costs
Reported in the statement of cash flows

as operating activity.
Reduces current period net income.

Chapter: 07

Analysts Approach to R&D costs


Modify financial statements
If the R&D costs have a future service

potential, capitalize & subsequently amortize


expenditures on R&D; else, expense.
When R&D costs are expensed
Effect

on ROA should be examined


Look for volatility & growth

Consolidate firms share of R&D project for

joint ventures & partnerships.


Chapter: 07

Software Development Costs


Accounting:
Until technological feasibility is achieved, all

costs incurred internally are expensed.


On achieving technological feasibility
Capitalized
Additional

costs are subsequently amortized

Area of caution for Analyst: Computer

software development costs.


Chapter: 07

Subsequent Expenditures for


Enhancement or Improvements
Involves additional expenditure to add or

improve long-lived operating assets.


Capitalize expenditures that increase
service life beyond the original life of the
asset.
Expense repairs & maintenance to maintain
expected service potential.
Management judgment in this area creates
opportunity for earnings management.
Chapter: 07

Costs of Self-Construction
Cost of self-constructed asset = Fair Value

of all costs incurred to produce asset.


Fair value includes materials, labor and
overhead (variable & fixed).
If internal expenditure > Cost of acquiring
externally
Amount = cost of external purchase
Excess costs incurred are recorded as loss.
Chapter: 07

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Interest Incurred to Self-Construct


Assets
Avoidable interest :
Nil if a company has no debt
Capitalized amount of annual interest
Cannot exceed actual interest
A component of Acquisition Cost

Interest Expense = Actual interest

Capitalized interest
Chapter: 07

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Computation of Avoidable Interest


Compute time weighted average

accumulated expenditures
Interest computation
Interest

on accumulated expenditure to the extent of specific


borrowing is calculated using specific borrowings interest
rate (a)
Interest on excess of accumulated expenditure over and
above the specific borrowing is calculated using the
weighted average interest rate on other borrowings (b)

Avoidable interest = (a) + (b)


Chapter: 07

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Cost of Acquiring Natural Resources


Types of Costs
Acquisition
Costs
Costs of

acquiring natural
resources
Reclamation

cost or
restoration costs

Exploration
Costs
Costs incurred to
discover the
existence &
location of natural
resource

Chapter: 07

Development
Costs
Tangible costs
(capitalized)
Intangible costs
(expensed)

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Accounting for Exploration Costs


Successful Efforts Method
Cost of successful wells are capitalized as

assets; unsuccessful wells are expensed.


Used by larger producers.

Full Costing Method


Costs of successful and unsuccessful wells

are capitalized.
Used by smaller producers.
Chapter: 07

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Cost of Acquiring Natural Resources


for Analysts
Analyst should consider the differential

treatment of exploration costs.


Firms disclose the method in accounting
policies note to financial statements.

Chapter: 07

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Costs of Acquiring Intangible Assets


U.S.GAAP & IFRS: Cost of internally

developing intangibles is expensed.


Intangibles acquired in a business
combination have Fair values and are
capitalized.
Most analysts prefer immediate expensing
of all intangible assets.
Chapter: 07

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Goodwill in Corporate Acquisition


Acquiring firms allocate purchase price to
Step 1

The fair value of identifiable tangible


assets & liabilities

Step 2

Identifiable intangible assets

Step 3

Remainder is allocated to goodwill

Chapter: 07

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Managers Choice of Acquisition


Costs Allocation
Investing-like activities such as R&D,

pretechnological feasibility software costs


etc. are expensed.
Managers make three primary choices:
Choose an allocation method
Estimated useful life and
Estimated salvage value

Chapter: 07

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Managers Choice of Acquisition


Costs Allocation (Contd.)
Throughout the life of the asset, book

value is tested for


Impairment under U.S.GAAP & IFRS (for

intangible assets with indefinite life).


Appreciation only under IFRS.

Managers estimate bias reported earnings


To report higher earnings, useful lives or

salvage value of assets are revised upward.


Chapter: 07

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Cost Allocation Methods


Differences in Methods
US Firms (Statement No.109)

Other countries

Use accelerated methods


for tax purpose than for
financial reporting purposes

Accelerated method for


both tax and financial
reporting

Analyst must restate the amounts.


An addition to net income in the operating

section of cash flows.


Chapter: 07

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Cost Allocation Methods (Contd.)


Depreciation
Tangible assets

Straight-line method or
accelerated method
Straight-line method

Amortization
Intangible assets

Depletion
Natural resources
Chapter: 07

Straight-line method or
proportionate to
consumption
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Market Value Vs. Book Value:


Impairment of Long-Lived Assets
U.S.GAAP

IFRS

Record impairment if: Impairment charge =


Carrying amount >
Book value [Higher
Undiscounted cash
of (Fair Value less
flows from the asset
estimated costs to
Impairment charge =
sell) or (Present value
Carrying Value Fair
of estimated future
value
cash flows)]
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Market Value Vs. Book Value:


Impairment of Goodwill
U.S.GAAP
Record impairment if:
Carrying amount > Fair
value of reporting unit
Implied goodwill = Fair
value of reporting unit
Fair value of identifiable
assets

Chapter: 07

IFRS
Record impairment if:
Carrying amount >
Recoverable amount
(Higher of fair value or
sale)
Implied goodwill = Fair
value of reporting unit
Fair value of identifiable
assets
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Long-Lived Assets
Upward revaluation
U.S.GAAP does

not permit upward


revaluations
IFRS allows
revaluation of both
tangible &
intangible longlived assets

Chapter: 07

Replacement
Gain/loss on disposal or

sale or trade-ins is reported


in operating income
Cash inflow from sale of
assets is reported in
investing section of cash
flow statement
New assets must be
recorded at fair Value

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Investment in Securities

Chapter: 07

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Accounting for Minority Passive


Investments
Initially record investments at acquisition

cost.
Interest & Dividend received/receivable
each year are recorded as revenue.

Chapter: 07

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Accounting for Minority Passive


Investments (Contd.)
Classification of Securities
Debt
securities

Debt & Equity


securities Trading securities

Debt & Equity


securities Available for sale

Firm actively buys &


sells securities to take
advantage of shortterm differences in
market value.

Firms classify
securities that do not
fall into one of the
other two categories
as Available-for-sale.

Held-tomaturity
Firm has a
positive intent
& ability to
hold to
maturity.

Chapter: 07

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Accounting for Minority Passive


Investments (Contd.)
Debt securities held-to-maturity
At amortized cost.
Difference between acquisition cost and

maturity value is an adjustment to interest


revenue (Effective Interest rate method).
Fair values are disclosed in notes.

Trading security
Marked-to-market.
Unrealized gain or loss: As a part of Net

Income.

Chapter: 07

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Accounting for Minority Passive


Investments (Contd.)
Sale of security: Gain or loss (Selling Price

less Book Value) in Net Income.

Available-for-sale
Marked to market.
Unrealized gain or loss: As a part of other

comprehensive income (OCI).


Sale of security:
Realized

Gain or loss (Selling Price less Acquisition


Cost) on Income Statement.
Chapter: 07

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Accounting for Minority Passive


Investments (Contd.)
Unrealized

holding gain or loss is recognized in


current period OCI.

Other than temporarily impaired

securities
Tested whether securities that experienced

unrealized losses are other than temporarily


impaired.
Written down to fair value.
Unrealized loss reported in net income.
Chapter: 07

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Reporting Values of Minority, Active


Investments
U.S.GAAP & IFRS- Equity method
Balance Sheet at
Acquisition

cost +/- investors share of the net


income /loss share of dividends.

Income Statement at
Pro

rata share of investee income minus any


allocation cost of extra investment.

Cash Flow Statement:


Subtract share of earnings from net income and add
cash dividends.
Chapter: 07

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Accounting for Minority, Active


Investments (Contd.)
Implied Goodwill
Related Party Transactions
Sales, purchases, receivables & payables must

be disclosed in notes to financial statements.


Profits arising from intercompany transactions
should be eliminated.

Reported at acquisition cost in non-IFRS

statements.
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Accounting for Majority, Active


Investments
Accounting for corporate acquisitions -

SFAS 141,141R, 160 (FASB codification


topics 805 and 810) and IFRS 3.
Consolidated financial statements are
prepared.
Business combinations can be statutory
mergers and acquisitions- acquisition
method.
Chapter: 07

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Accounting for Majority, Active


Investments (Contd.)
Goodwill
Measure the fair value of the consideration

transferred to acquire the company and the fair


values of the identifiable assets acquired,
liabilities assumed and noncontrolling interests
(if any).
Assign any excess consideration to goodwill
or record a gain from a bargain purchase.

Chapter: 07

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Consolidated Financial Statements at


the Date of Acquisition
Investment in subsidiary.
Subsidiarys equity accounts.
Individual assets & liabilities of subsidiary.
Goodwill.
Acquisition Reserves
Management has some latitude in managing

earnings, given the estimates required to


establish reserves.
Chapter: 07

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Consolidated Financial Statements


Subsequent to the Date of Acquisition
Investment in subsidiary
Subsidiarys equity accounts
Individual assets & liabilities of subsidiary
Goodwill component to consolidated totals
Related-party transactions eliminations

Chapter: 07

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Noncontrolling Interests
Arises if an investing firm acquires less

than 100% of another firm.


Also termed as minority interest.
Disclosure
Income Statement: Is deducted from the net

income of the parent.


Balance Sheet: A component of shareholders
equity of the parent.
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Noncontrolling Interests (Contd.)


Subsidiarys fair value less book value at

the date of acquisition is allocated to


identifiable assets and to goodwill.
Fair value amortization must be reflected
in consolidated net income each year.
Tax effect adjustment is not necessary for
noncontrolling interest as it is an after-tax
net income.
Chapter: 07

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Corporate Acquisitions and Income


Taxes
The acquired company does not restate

its assets & liabilities for tax purpose.


The tax basis of assets & liabilities of the
acquired company before acquisition
carries over after the acquisition called
nontaxable reorganization.
Deferred taxes would be recognized, as a
difference between fair and book values.
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Consolidation of Unconsolidated
Subsidiaries and Affiliates
Companies do not consolidate the

financial statements of joint ventures or


minority-owned affiliates.
Under U.S.GAAP firms use the equity
method to account for joint ventures.
IFRS permits use of proportionate
consolidation for joint ventures.
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Special-Purpose or Variable-Interest
Entity (VIE)
Can be a corporation, partnership, trust or

any other legal structures for business


purpose.
May be passive or active.
The sponsoring firm would not consolidate
a VIE under the percentage of ownership
criterion.
Also called a bankruptcy remote entity.
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Consolidating VIE
Firm must consolidate if it is the primary

beneficiary of the VIE.


FIN 46R- Firm is primary beneficiary if it has
The direct or indirect ability to make decisions about
the entitys activities.
The obligation to absorb the entitys expected losses
if they occur.
The right to receive the entitys expected residual
returns if they occur.
Chapter: 07

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Income Tax Consequences of


Investment in Securities
For income tax purposes, investments fall

into two categories.


Investments in debt securities, preferred stock,

and in less than 80% of the common stock.


Interest

or dividends, gains or losses- taxable

income.
Investments in 80% or more of the common

stock.
Consolidated

tax returns are prepared.

Chapter: 07

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Foreign Currency Translation


Types of Foreign Entities
A foreign entity operates as a self-contained &

integrated unit (All current method)


The operations of a foreign entity are a direct &
integral extension of the parent companys
operations (Monetary/Non-monetary methods).

Exception to these guidelines U.S.GAAP


If the foreign entity operates in a highly

inflationary country (FASB Statement No.52).


Chapter: 07

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Translation Methodology-Foreign
Currency is the Functional Currency
Income
Revenues & expenses are translated
Statement at average exchange rate.
Income includes realized translation
gains & losses on sale of foreign unit
Balance
Sheet

Assets & liabilities are translated at


end-of-period exchange rate.
Unrealized translation adjustment is
included in other comprehensive
income
Chapter: 07

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Translation Methodology-Foreign
Currency is the Functional Currency
Translation adjustment is a component
of other comprehensive income &
includes:
Effect of exchange rate changes on the

parents equity investment in subsidiaries.


Change in fair value of a derivative (Firms
hedge their foreign operations).

Chapter: 07

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Translation Methodology-U.S. Dollar


is the Functional Currency
Firms must use the Monetary or Non-

monetary translation method.


Monetary items include cash, marketable
securities, receivables, accounts payable,
short-term & long-term debt.
Nonmonetary items include inventories,
fixed assets, common stock, revenues and
expenses.
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Translation Methodology-U.S. Dollar


is the Functional Currency
Income
Statement

Revenues & Expenses are translated


at average exchange rate.
Cost of goods sold & depreciation are
translated using historical exchange
rate.

Balance
Sheet

Monetary assets & liabilities are


translated at end-of-period exchange
rate. Non-monetary assets & equities
using historical exchange rate.
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Foreign Currency Translation and


Income Taxes
Branch of US parent
Use all-current or monetary/non-monetary

translation method as appropriate.

Subsidiary of US parent
Dividends received are translated at exchange

rate on date of remittance.

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Analyst Adjustments
Whether to include change in the foreign

currency translation account in earnings or


in other comprehensive income?
Analyst should consider how changes in
exchange rates affect changes in sales
levels, sales mix, and net income.

Chapter: 07

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Analyst Adjustments (Contd.)


To swing the balance of factors towards

use of foreign currency, management may:


Decentralize decision making to foreign unit.
Minimize remittances or dividends.

Chapter: 07

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