©Cambridge Business Publishers, 2013 FINANCIAL STATEMENT ANALYSIS & VALUATION Third Edition Peter D. Mary LeaGregory A.Xiao-Jun EastonMcAnallySommersZhang

©Cambridge Business Publishers, 2013 Module 9: Intercorporate Entities

©Cambridge Business Publishers, 2013 Intercorporate Investments

©Cambridge Business Publishers, 2013 Accounting Treatment and Financial Statement Effects

©Cambridge Business Publishers, 2013 Passive Investments: Market Method Initially record at purchase price (fair market value on purchase date) Initially record at purchase price (fair market value on purchase date)

©Cambridge Business Publishers, 2013 Are Changes in Asset Value During the Holding Period Income? During holding period, investment is recorded at current market value (“marked-to-market”). During holding period, investment is recorded at current market value (“marked-to-market”). Changes in the carrying amount of the investment (asset) has a corresponding effect on equity: Changes in the carrying amount of the investment (asset) has a corresponding effect on equity: Is the change in equity is income? Is the change in equity is income? The answer depends on the investment classification. The answer depends on the investment classification.

©Cambridge Business Publishers, 2013 Financial Statement Effects

©Cambridge Business Publishers, 2013 Fair Value Adjustments During Holding Period

©Cambridge Business Publishers, 2013 Google’s Footnote

©Cambridge Business Publishers, 2013 Google’s Disclosure of Fair Value Gains and Losses

©Cambridge Business Publishers, 2013 Cisco’s Disclosure of Fair Value Gains and Losses Investments are reported on Cisco’s balance sheet at $21,345 million.

©Cambridge Business Publishers, 2013 Bond Investment Classifications Available-for-sale Available-for-sale Trading Trading Held-to-maturity Held-to-maturity

©Cambridge Business Publishers, 2013 Google’s Investments Reported at Cost Google uses historical cost to account for investments in non- marketable securities. Google uses historical cost to account for investments in non- marketable securities. Google monitors the value of these investments and writes them down to market value if they suffer a permanent decline in value. Google monitors the value of these investments and writes them down to market value if they suffer a permanent decline in value. If such an investee company ever goes public, Google will change its accounting method. If such an investee company ever goes public, Google will change its accounting method.

©Cambridge Business Publishers, 2013 Equity Method Investments Investments are recorded at their purchase cost. Investments are recorded at their purchase cost. Dividends received are treated as a recovery of the investment and, thus, reduce the investment balance (dividends are not reported as income). Dividends received are treated as a recovery of the investment and, thus, reduce the investment balance (dividends are not reported as income). The investor reports income equal to its percentage share of the investee’s reported net income; The investor reports income equal to its percentage share of the investee’s reported net income; the investment account is increased by the percentage share of the investee’s income or is decreased by the percentage share of any loss. the investment account is increased by the percentage share of the investee’s income or is decreased by the percentage share of any loss. Changes in fair value do not affect the investment’s carrying value. Changes in fair value do not affect the investment’s carrying value.

©Cambridge Business Publishers, 2013 Equity Method Accounting Mechanics

©Cambridge Business Publishers, 2013 Equity Method Accounting Mechanics

©Cambridge Business Publishers, 2013 Effects of Equity Method Investments on ROE Net operating profit margin (NOPM = NOPAT/Sales). Most analysts include equity income (sales less expenses) in NOPAT since it relates to operating investments. However, investee’s sales are not included in the NOPM denominator. The reported NOPM is, thus, overstated. Net operating profit margin (NOPM = NOPAT/Sales). Most analysts include equity income (sales less expenses) in NOPAT since it relates to operating investments. However, investee’s sales are not included in the NOPM denominator. The reported NOPM is, thus, overstated. Net operating asset turnover (NOAT = Sales/Average NOA). Investee’s sales are excluded from the NOAT numerator, and net operating assets in excess of the investment balance are excluded from the denominator. This means the impact on NOAT is indeterminate. Net operating asset turnover (NOAT = Sales/Average NOA). Investee’s sales are excluded from the NOAT numerator, and net operating assets in excess of the investment balance are excluded from the denominator. This means the impact on NOAT is indeterminate. Financial leverage (FLEV = Net nonoperating obligations/Average equity). Financial leverage is understated due to the absence of investee liabilities in the numerator. Financial leverage (FLEV = Net nonoperating obligations/Average equity). Financial leverage is understated due to the absence of investee liabilities in the numerator.

©Cambridge Business Publishers, 2013 Investments with Control: Consolidation Google’s footnote on consolidated entities: Google’s footnote on consolidated entities: Consolidation replaces … Consolidation replaces … the investment balance with the assets and liabilities to which it relates, and the investment balance with the assets and liabilities to which it relates, and the equity income reported by the investor company with the sales and expenses of the investee company to which it relates. the equity income reported by the investor company with the sales and expenses of the investee company to which it relates.

©Cambridge Business Publishers, 2013 Consolidation

Consolidation of Less than Wholly-Owned Subsidiaries

©Cambridge Business Publishers, 2013 Consolidation When Purchase Price Exceeds Book Value of Stockholders’ Equity

©Cambridge Business Publishers, 2013 CAT’s Consolidating Balance Sheet

©Cambridge Business Publishers, 2013 Acquired Intangible Assets The purchase price is allocated to acquired identifiable intangible assets, which include the following: The purchase price is allocated to acquired identifiable intangible assets, which include the following: Marketing-related assets like trademarks and internet domain names Marketing-related assets like trademarks and internet domain names Customer-related assets like customer lists, production backlog, and customer contracts Customer-related assets like customer lists, production backlog, and customer contracts Artistic-related assets like plays, books, and video Artistic-related assets like plays, books, and video Contract-based assets like licensing and royalty agreements, lease agreements, franchise agreements, and servicing contracts Contract-based assets like licensing and royalty agreements, lease agreements, franchise agreements, and servicing contracts Technology-based assets like patents, computer software, databases and trade secrets Technology-based assets like patents, computer software, databases and trade secrets

©Cambridge Business Publishers, 2013 P&G’s Allocation of Gillette Purchase

©Cambridge Business Publishers, 2013 Oracle’s Acquisition of Siebel Systems, Inc.

©Cambridge Business Publishers, 2013 Impairment of Goodwill The impairment test is a two-step process. The impairment test is a two-step process. First First, if the market value of the investee company is less than the investment balance, the investment is deemed impaired. Second Second, the investor estimates the goodwill value as if the subsidiary were acquired at current market value, and the imputed balance for goodwill becomes the balance in the goodwill account.

©Cambridge Business Publishers, 2013 Goodwill Impairment Example Assume that an investment currently reported on the investor's balance sheet in the amount of $1 million has a current fair market value of $900,000. Assume that an investment currently reported on the investor's balance sheet in the amount of $1 million has a current fair market value of $900,000. Further assume that the fair market value of the net assets of the investee company is $700,000 and the current value of goodwill on the consolidated balance sheet is 300,000. Further assume that the fair market value of the net assets of the investee company is $700,000 and the current value of goodwill on the consolidated balance sheet is 300,000. This indicates an impairment loss of $100,000, which is computed as follows: This indicates an impairment loss of $100,000, which is computed as follows:

©Cambridge Business Publishers, 2013 FedEx’s Goodwill Write-Off

©Cambridge Business Publishers, 2013 Mead Johnson Nutrition IPO Bristol-Myers Squibb (BMY) equity method investment account increased by $782 million. Bristol-Myers Squibb (BMY) equity method investment account increased by $782 million. BMY recognized a corresponding $782 million increase in stockholders’ equity, allocated between the parent’s additional paid-in capital and an increase in noncontrolling interests equity. BMY recognized a corresponding $782 million increase in stockholders’ equity, allocated between the parent’s additional paid-in capital and an increase in noncontrolling interests equity.

©Cambridge Business Publishers, 2013 Sales of Subsidiaries – Discontinued Operations

©Cambridge Business Publishers, 2013 Kraft’s Divestiture of its NA Pizza Business to Nestlé

©Cambridge Business Publishers, 2013 Limitations of Consolidated Financial Statements Consolidation income does not imply that cash is received by the parent company. Consolidation income does not imply that cash is received by the parent company. Comparisons across companies are often complicated by the mix of subsidiaries included in the financial statements. Comparisons across companies are often complicated by the mix of subsidiaries included in the financial statements. Segment profitability can be affected by intercorporate transfer pricing and allocation of overhead. Segment profitability can be affected by intercorporate transfer pricing and allocation of overhead.

©Cambridge Business Publishers, 2013 Global Accounting: Passive Investments Under both U.S. GAAP and IFRS, companies classify financial (passive) instruments as trading, available-for-sale, or held-to-maturity. Under both U.S. GAAP and IFRS, companies classify financial (passive) instruments as trading, available-for-sale, or held-to-maturity. Under IFRS the definition of financial instrument is much broader. Under IFRS the definition of financial instrument is much broader. Under IFRS, unlisted securities can be valued at fair value. Under IFRS, unlisted securities can be valued at fair value. Under IFRS, reclassifications to and from the trading portfolio is prohibited. Under IFRS, reclassifications to and from the trading portfolio is prohibited.

©Cambridge Business Publishers, 2013 Global Accounting: Consolidation Consolidation accounting standards were developed jointly by the FASB and the IASB. Consolidation accounting standards were developed jointly by the FASB and the IASB. Yes, a few differences remain: Yes, a few differences remain: Under IFRS, companies can measure noncontrolling interests either at fair value (full goodwill approach) or at the proportionate share of the identifiable net assets acquired (purchased goodwill approach). U.S. GAAP permits fair value only. Under IFRS, companies can measure noncontrolling interests either at fair value (full goodwill approach) or at the proportionate share of the identifiable net assets acquired (purchased goodwill approach). U.S. GAAP permits fair value only. Contrary to US GAAP, under IFRS, parent and subsidiaries’ accounting policies must conform. Contrary to US GAAP, under IFRS, parent and subsidiaries’ accounting policies must conform. Contrary to US GAAP, under IFRS, fair-value impairments for intangible assets, excluding goodwill, can be later reversed (that is, written back up after being written down). Contrary to US GAAP, under IFRS, fair-value impairments for intangible assets, excluding goodwill, can be later reversed (that is, written back up after being written down).

©Cambridge Business Publishers, 2013 End Module 9