Accounting & Financial Reporting

1. Accounting & Financial Reporting BUSG 503Michael Dimond

2. Let’s review… • Exercises E7-27, 28, 29, 32, 33 & 37

3. E7-27 • a. DuPont reports its equity method investments at adjusted cost, not fair value. Adjusted cost is the purchase price of the investment, plus DuPont’s proportionate share of the investees’ profits or losses, and less dividends received from the equity-method investees. • b. The equity of the affiliated companies is $1,884 million (assets of $3,369 million – liabilities of $1,485 million = $1,884 million). DuPont’s investment balance of $1,041 million is 55%, on average, of the $1,884 million net equity of the investee companies. DuPont does not control these investments (or they would be consolidated) and thus, must own less than 50% of the voting common shares. Some of the excess relates to advances Dupont has made to equity investee companies and some may result from DuPont paying more than book value for some of the investments. • c. Once the stockholders’ equity of the investee company reaches zero, the investor must discontinue accounting for the investment by the equity method. Instead, it accounts for the investment at cost with a zero balance and no further recognition of its proportionate share of the investee company losses. In this case, the investor’s income statement no longer includes the losses of the investee company and its balance sheet no longer reports the troubled investee company. • The cessation will create a number of analysis problems. Unreported liabilities may be particularly problematic in this case. As the investee continues to report losses, DuPont will not report this. As well, continued losses may compel DuPont to advance more cash to the investee. This will be reported on the balance sheet as an investment in the equity-method company, which may be misleading.

4. E7-28 • Cummins reports these equity method investments on its balance sheet at $734 million. Consequently, Cummins’ balance sheet reports net assets of only $734 million and, importantly, none of the liabilities of the investee companies. The lack of full reporting of the investees’ assets and liabilities fails to present a clear picture of the capital investment required to conduct Cummins’ business or the financial leverage inherent in its operations, even though its accounting is in conformity with GAAP. • Although Cummins is not directly obligated for the debts of these unconsolidated affiliates (unless it has legally guaranteed those debts), if the affiliates were to fail, would Cummins have to invest additional capital to support it? Probably not, from a strictly legal standpoint. Yet, if this investment is necessary for Cummins’ strategic plan, it might find it difficult to arrange future ventures of this type if it does not support the failing investee. This means that there can be an effective liability even when no legal liability exists. Analysts can, of course, replace the equity investment with the assets and liabilities to which it relates (pro forma consolidation for analysis purposes) if they feel consolidated numbers better represent the company’s balance sheet and income statement. •  The equity method reports only Cummins’ proportion of the affiliated companies’ equity and Cummins’ proportion of the affiliated companies’ earnings. As a result, the equity method, arguably, omits assets and liabilities from the face of Cummins’ balance sheet, and omits sales and expenses from the income statement (compared with the assets, liabilities, sales and expenses that would be recorded with consolidation). Net income and stockholders’ equity are the same whether the equity method or consolidation is used so ROE is the same. But, net operating profit margin and net operating asset turnover are likely biased upward and biased downward, respectively (due to the omission of assets and sales).

5. E7-29 • a. The trading investments will be reported at $225,300. This is computed from year-end fair values: $65,300 + $160,000= $225,300. • b. The available for sale investments will be reported at $346,700. This is computed using year-end fair values: $192,000 + $154,700= $346,700. • c. The equity method investments will be reported at $236,000. This is computed using the year-end equity method values (since no information is available on any dividends or income for those companies): $100,000 + $136,000= $236,000. • d. Unrealized holding losses of $5,200 will appear in the current year’s income statement. These losses relate to the trading securities; specifically— Barth: $68,000 - $65,300 = $2,700; Foster: $162,500 - $160,000 = $2,500; total of $2,700 + $2,500 = $5,200 in unrealized losses reported in income. • e. (i) Unrealized holding losses of $7,300 will appear in the stockholders' equity section of the December 31 balance sheet as Accumulated Other Comprehensive Income (AOCI). These losses relate to the available for sale securities; specifically— McNichols: $197,000 - $192,000 = $5,000; Patell: $157,000 - $154,700 = $2,300; total of $5,000 + $2,300 = $7,300 in unrealized losses reported in stockholders' equity. (cont’d)

6. E7-29, cont’d • e. (ii) Unrealized holding losses of $5,200 will be included in retained earnings on the December 31 balance sheet. These losses relate to the trading securities; specifically— Barth: $68,000 - $65,300 = $2,700; Foster: $162,500 - $160,000 = $2,500; total of $2,700 + $2,500 = $5,200. • (iii) Total unrealized holding losses in equity of $12,500—totals of (i) & (ii) • f. (i) A fair-value adjustment to available-for-sale investments of $7,300 will appear in the December 31 balance sheet. See part (e) for the supporting computations. The fair-value adjustment decreases the book value of the available for sale securities to their year end fair value. • (ii) A fair-value adjustment to trading investments of $5,200 will appear in the December 31 balance sheet. See part (e) for supporting computations. The fair-value adjustment decreases the book value of the trading securities to their year end fair value. • (iii) Total fair-value adjustment on the balance sheet is $12,500—totals of (i) & (ii).

7. E7-32

8. E7-33

9. E7-37 c. The fair-value adjustment to fixed assets will be depreciated over the assets’ estimated useful lives. The patent will be amortized over its useful life. Finally, intangible assets with an indeterminate useful life (such as goodwill) are not amortized, but are tested annually for impairment or more often if circumstances require.

10. Current liabilities • Operating • Accounts payable - Obligations to others for amounts owed on purchases of goods and services; these are usually non-interest-bearing. • Accrued liabilities - Obligations with no related external transaction in the current period (e.g. accruals for employee wages and taxes, accruals for other liabilities such as rent, utilities, and insurance. • Non-operating • Short-term interest-bearing loans - Short-term bank borrowings and notes expected to mature in whole or in part during the upcoming year; this item can include any accrued interest payable. • Current maturities of long-term debt - Long-term liabilities that are scheduled to mature in whole or in part during the upcoming year.

11. Verizon’s current liabilities

12. Useful ratios for managing accounts payable • How do these relate to the inventory & receivables ratios we computed previously?

13. Warranties and other contingent liabilities • A contingent liability is a potential liability whose occurrence and/or ultimate amount is dependent upon a future event. • If the obligation is probable and the amount estimable, then a company will recognize this obligation. • If only one of the criteria is met, the contingent liability is disclosed in the footnotes.

14. Current non-operating liabilities • Short-term bank loans (including the accrual of interest) • Current maturities of long-term debt – long-term liabilities that are scheduled to mature on whole or in part during the upcoming 12 months are reported as a current liability. • Companies generally finance seasonal swings in working capital with a bank line of credit.

15. Example: Notes payable

16. Bonds • Bonds are long-term debt contracts used to raise capital • Bonds are denominated in a set amount (most U.S. corporate bonds are $1,000) and can be bought and sold in a secondary market • The bond indenture specifies the terms of the bond, including the rights and duties, the amounts and dates involved, standard debt provisions and restrictive covenants.

17. Bonds: Linking terminology to TVM functions • PV = Price • FV = Face Value (also called “Par Value.” Usually $1,000) • n = Periods (usually semiannual) • i = Yield • PMT = Coupon Payment • The Coupon Rate is only used to determine the coupon payment. For example, a 10% coupon rate on a $1,000 bond would give a $100 annual payment, which would be $50 semiannually. • NOTE: If you do not have a financial calculator, there are tables in the appendix to compute PV & FV

18. Bond pricing, yields, etc. • Bond terminology is what gives most students problems. Sometimes you need to make assumptions based on how the question is worded. • Here’s a typical sort of a bond question: • XYZ Company has a 10% bond with semiannual payments which matures in 12 years. The market rate for bonds of this risk is currently 8%. What is the price of this bond? • The key to solving a question like this is to identify the relevant information and organize it: • PV = Price = Unknown. This is what we are solving for. • FV = Face Value = Not stated, so we assume $1,000. • n = Periods = Semiannual for 12 years. 12 x 2 = 24, :. n = 24. • i = Yield = Return demanded ÷ Periods per year = 8% ÷ 2 = 4% semiannual • PMT = Coupon Payment = FV x Coupon Rate ÷ Periods per year = 1,000 x 10% ÷ 2 = 50, :. PMT = 50. The expression “10% bond” means a bond with a 10% coupon annual rate.

19. Bond pricing, yields, etc. • Entering this information in a financial calculator lets us find an answer. • PV = Price = Unknown. This is what we are solving for. • FV = $1,000. • n = 24 semiannual • i = 4% semiannual • PMT = 50 semiannual • Solve for PV = -1,152.4696 • Notice n, i and PMT are all semiannual values. These must all be in the same scale: Annual, semiannual, etc. • The answer appears negative because it is a cash outflow. The price will be $1,152.47 • Here’s another bond question: • XYZ Company has a 10% semiannual bond which matures in 12 years and is selling for $1,050. What is the yield of this bond?

20. Bond pricing, yields, etc. • Let’s try another. Entering this information in a financial calculator lets us find an answer, but it will be a semiannual answer. • PV = -1,050 (remember, the price is a cash outflow, so it has a minus sign) • FV = 1,000 • n = 24 semiannual • i = Unknown. This is what we are solving for. • PMT = 50 semiannual • Solve for i = 4.6499% • Remember, n, i and PMT are all semiannual values. The result the calculator gives is the semiannual interest rate. To annualize it, multiply it by 2: • Yield = 2 x semiannual i = 2 x 4.6499% = 9.2998%

21. Bond pricing, yields, etc. • Here’s one more: • XYZ Company has a 10% bond with semiannual payments which matures in 12 years and is selling for $1,000. What is the yield of this bond? • In this case, the price and the face value are both 1,000. This means the bond is selling at par, which means the yield will equal the coupon rate (10%). To test this: • PV = -1,000 • FV = 1,000 • n = 24 semiannual • PMT = 50 semiannual • Solve for i = 5.0000% semiannual • Yield = 2 x semiannual i = 2 x 5.0000% = 10%

22. More about bonds • Provisions of bonds • Convertability: A conversion feature allows bondholders to exchange the bond for a certain number of shares of stock. • Callability: A call feature allows the bond issuer to repurchase the bonds before they mature (for a premium above the face value) • Warrants: A “sweetener” which allows the bondholders to purchase a certain number of shares of stock at a specific price & time. • Current Yield vs Yield to Maturity vs Yield to Call • Current Yield: Annual Payment ÷ Price • YTM: Solve for i using the number of periods until the bond matures (remember to annualize if appropriate) • YTC: Solve for i using the number of periods until the bond can be called (remember to annualize if appropriate)

23. Bond ratings are driven by financial indicators

24. Which drivers matter the most for bond ratings?

25. For next week… • Ch 8 Exercises 8-31, 32 • Prepare for Exam #2 • The following week we will begin chapter 9 and also start some minicases to prepare you for the final case in week 15