Financial Reporting Requirements and Analytical Implications

1. REPORTING REQUIREMENTS Chapter 7

2. CHAPTER 7 OBJECTIVES • Identify the basic reporting requirements for business acquisitions, security investments, foreign investments, risk management, deferred compensation arrangements, and deferred taxes. • Understand the primary analytical implications for each of the six topics addressed in this chapter.

3. CHAPTER 7 OBJECTIVES (CONT.) • Indicate how certain standards deviate from historical cost reporting and the all-inclusive concept of net income. • Relate this chapter’s topics to the financial statements of Apple Computer, Inc. and other PC firms.

4. CHAPTER 7 OBJECTIVES (CONT.) • Articulate how business maturation, industry factors, and the transition to the new economy influence reporting requirements and analytical considerations.

5. BUSINESS ACQUISITIONS • One company (the acquirer) obtains control of another entity (the target) • Rationale—enhance shareholder wealth through • Larger market share • Increased productivity • Shared technologies • Cost reductions

6. BUSINESS ACQUISITIONS (CONT.) • Types of business acquisitions • Parent-subsidiary relationship—one company purchases a majority of another entity’s voting stock • Merger—acquired company is dissolved and its assets are merged with those of the acquirer • Business consolidation—newly formed entity is formed to incorporate assets of combining companies and the previously existing firms are dissolved

7. BUSINESS ACQUISITIONS (CONT.) • Financial reporting requirements • Purchase method of accounting—GAAP for business acquisitions • Target’s accounts are revalued to fair value • Goodwill is reported when the purchase price exceeds fair value of the acquired assets • Goodwill is amortized over its productive life • The FASB recently eliminated the pooling of interest method as an acceptable alternative to goodwill • The FASB may eliminate goodwill amortization, unless the intangible asset is impaired

8. BUSINESS ACQUISITIONS (CONT.) • Analytical implications • Consolidated financial statements • based on the economic entity assumption • legally separate but economically combined entities report one set of financial statements

9. BUSINESS ACQUISITIONS (CONT.) • Analytical implications • Goodwill—complicates analysis because the account • Lacks a distinct, separate economic entity • Represents a residual value (purchase price less fair net asset values) • Is amortized over time but that amortization does not affect cash flows

10. BUSINESS ACQUISITIONS (CONT.) • Reporting examples and observations of business acquisitions • Firms tended to consolidate in the PC industry as it matured in the 1990s • Despite consolidation, industry remained fragmented by 1998

11. BUSINESS ACQUISITIONS (CONT.) • Apple Computer acquired NeXT Software for $427 million in 1997 • Apple co-founder Steven Jobs was CEO of NeXT • $375 million of the purchase price was allocated to in-process research and development costs • In-process R&D was written off in the year of acquisition • Apple reported $52 million of goodwill in acquiring NeXT

12. SECURITIES INVESTMENTS • Instruments that demonstrate an economic interest in other entities • Equity security—ownership position in another company • Debt security—creditor relationship with a firm or government agency

13. SECURITIES INVESTMENTS (CONT.) • Financial reporting requirements • Investment revenues—reported on the income statement • debt investments earn interest revenue (income) • equity investments earn dividend revenue (income)

14. SECURITIES INVESTMENTS (CONT.) • Financial reporting requirements • Realized gains and losses • Reported on the income statement • Arise when security investments are sold for more or less than their reported value • Securities held at the end of a reporting period (Exhibit 7-1) • Balance sheet classifications depend on • Type of security (debt or equity) • Management’s intent (length of expected ownership)

15. SECURITIES INVESTMENTS (CONT.) • Financial reporting requirements • Unrealized gains and losses • The difference between fair value and cost or previously reported fair value • Applies to trading and available-for-sale securities • Disclosed on income statement for trading securities • Disclosed as part of shareholders’ equity for available-for-sale securities

16. SECURITIES INVESTMENTS (CONT.) • Investments are either passive or active • Passive investments—investor does not significantly influence investee’s operations • Passive investments consist of all debt and trading and available-for-sale equity investments • Active investments—investor significantly influences investee’s operations • Active investments consist of active minority and majority equity investments

17. SECURITIES INVESTMENTS (CONT.) • Analytical implications • Investment revenues and realized gains and losses reported after operating income • Unrealized gain and loss treatment depend on classification of security • If reported on the income statement, unrealized gains and losses increase volatility of net income

18. SECURITIES INVESTMENTS (CONT.) • Reporting examples and observations of security investments • Apple Computer reported only available-for-trading securities • Changes in investments’ fair value reported as part of shareholders’ equity • No significant affect on income as a result of securities investments

19. FOREIGN INVESTMENTS • Multinational enterprises • Source material, manufacture goods, and sell products throughout the world • GAAP requires multinational parent firms to consolidate majority ownership positions in foreign subsidiaries

20. FOREIGN INVESTMENTS (CONT.) • Financial reporting requirements • Two methods of consolidating majority-owned foreign investments • Current rate method—translates foreign financial statements on the basis of current exchange rates • Temporal method—remeasures foreign financial statements on the basis of both historical and current exchange rates

21. FOREIGN INVESTMENTS (CONT.) • Functional currency—a foreign subsidiaries’ primary currency in conducting economic activities • Functional currency determines which reporting method is used • Current rate method is used if the foreign currency is the functional currency • Temporal rate method is used if the dollar is the functional currency

22. FOREIGN INVESTMENTS (CONT.) • Analytical considerations • Translation method affects disclosures • Remeasurement gains and losses (temporal method) are reported on the income statement • The temporal method reports gains and losses on a cumulative basis as part of shareholders’ equity

23. FOREIGN INVESTMENTS (CONT.) • Reporting examples and observations of foreign investments • Apple, Compaq, Dell, and Gateway • U. S. firms with international business operations • Global presence increased during the period of analysis • Increased globalization required greater organizational structure and asset control

24. FOREIGN INVESTMENTS (CONT.) • Apple Computer reported four foreign subsidiaries in 1998 • Subsidiaries’ domestic currencies were their functional currencies • The temporal method of conversion was used • Apple reported cumulative adjustments to shareholders’ equity

25. RISK MANAGEMENT • Strategies and tactics • Used to reduce financial exposure inherent in certain transactions • Often complex, creative, and risky transactions

26. RISK MANAGEMENT (CONT.) • Financial Reporting Requirements • Derivatives are financial tools that help companies manage risk • A derivative’s value is based on another resource’s worth (e.g., forward contracts on inventory)

27. RISK MANAGEMENT (CONT.) • Traditional GAAP • Derivative transactions went unreported (off-balance sheet) • They were based on mutual promises (as opposed to arms length transactions) • Current GAAP • Derivatives have economic value • Reported at fair value on the balance sheet

28. RISK MANAGEMENT (CONT.) • Analytical Implications • Fair value adjustments reported on either the income statement (gains and losses) or the balance sheet (shareholders’ equity adjustments) • Market value adjustments increase the volatility of earnings and shareholders’ equity • Credit risk—corporate exposure if the counter party to a risk management transaction fails to fulfill agreement

29. RISK MANAGEMENT (CONT.) • Reporting examples and observations of risk management • New FASB was not in place until after 1998 • Apple Computer engaged in transactions with an exposure to risk • Notes payable were issued at fixed interest rates • Short-term security investments earned variable interest rates • The company swapped fixed-rate debt for floating-rate debt

30. DEFERRED COMPENSATION ARRANGEMENTS • Provides employees with future benefits for services rendered in current period, consisting of • pension plans • other post-retirement benefits • corporate contributions to employee’s saving plans

31. DEFERRED COMPENSATION ARRANGEMENTS (CONT.) • Defined contribution arrangements • Corporate contributions based on predetermined formula (e.g., percentage of employee earnings) • The pension expense is relatively stable over time (it equals an entity’s required contributions) • Employee benefits vary depending on the earnings of defined contributions

32. DEFERRED COMPENSATION ARRANGEMENTS (CONT.) • Defined benefit arrangements • Provide employees with set level of benefits (e.g., based on years of service) • The pension expense can vary from year to year (actuarial assumptions affect it)

33. DEFERRED COMPENSATION ARRANGEMENTS (CONT.) • Analytical implications • Defined benefit plans require detailed analysis • Various components of retirement plans affect disclosures, including • Service costs • Pension liability • Pension plan assets

34. DEFERRED COMPENSATION ARRANGEMENTS (CONT.) • The rate of return on pension plan assets does not always equal growth in the pension liability; pension expense deviates from normal service cost in such instances • Plan funding • Over funded—the extent to which plan assets exceed plan liabilities • Under funded—the extent to which plan liabilities exceed plan assets

35. DEFERRED COMPENSATION ARRANGEMENTS (CONT.) • Reporting examples and observations of defined contribution arrangements • The PC industry reflects the new economy • contribute to employees savings’ plans • does not have defined benefit or contribution plans

36. DEFERRED COMPENSATION ARRANGEMENTS (CONT.) • Apple Computer • Section 401(k) employee savings plan • Matched employee contributions up to six percent • Stock options were another means of providing compensation to employees

37. DEFERRED TAXES (CONT.) • Financial reporting requirements • Temporary differences--result because GAAP and tax laws recognize revenues and expenses in different reporting periods • A deferred tax account is the disparity between the book value of an asset or liability (per GAAP) and its tax basis • Deferred tax liability—future tax obligation resulting from a temporary difference • Deferred tax asset—future tax savings resulting from a temporary difference

38. DEFERRED TAXES (CONT.) • Analytical implications • The balance sheet reports one net current deferred tax account (asset or liability) • The balance sheet reports one net noncurrent deferred tax account (asset or liability) • Classification of a deferred tax account as current or noncurrent is based on the asset (or liability) that created it

39. DEFERRED TAXES (CONT.) • Analytical implications • Unique feature of deferred tax accounts • No predetermined life or finite payment date (unlike most assets and liabilities) • Current deferrals can more than offset reversals of previous ones

40. DEFERRED TAXES (CONT.) • Reporting examples and observations of deferred taxes • Apple Computer reported deferred tax current assets and deferred tax noncurrent liabilities for the years analyzed • Deferred tax current assets were stable over time • Deferred tax noncurrent liabilities decreased in the later years of the study • Net operating losses in 1996 and 1997 created deferred tax assets that offset deferred tax noncurrent assets