Compilation of useful notes on advanced accounting [For B.Com and CA IPCC]!
Notes on Advanced Accounting [For B.Com and CA IPCC]
Note # 1. Criteria for Utilizing the Equity Method:
An understanding of the equity method is best gained by initially examining the APB’s treatment of two questions:
1. What parameters identify the area of ownership for which the equity method is applicable?
2. How should the investor report this investment and the income generated by it to reflect the relationship between the two companies?
In sanctioning the equity method, the APB reasoned that an investor begins to gain the ability to influence the decision-making process of an investee as the level of ownership rises. According to APB Opinion 18, achieving this “ability to exercise significant influence over operating and financial policies of an investee even though the investor holds 50 percent or less of the voting stock” is the sole criterion for requiring application of the equity method.
Clearly, a term such as the ability to exercise significant influence is nebulous and subject to a variety of judgments and interpretations in practice. At what point does the acquisition of one additional share of stock give an owner the ability to exercise significant influence? This decision becomes even more difficult in that only the ability to exercise significant influence need be present. The pronouncement does not specify that any actual influence must have ever been applied.
APB Opinion 18 provides guidance to the accountant by listing several conditions that indicate the presence of this degree of influence:
i. Investor representation on the board of directors of the investee.
ii. Investor participation in the policy-making process of the investee.
iii. Material intercompany transactions.
iv. Interchange of managerial personnel.
v. Technological dependency.
vi. Extent of ownership by the investor in relation to the size and concentration of other ownership interests in the investee.
No single one of these guides should be used exclusively in assessing the applicability of the equity method. Instead, all are evaluated together to determine the presence or absence of the sole criterion: the ability to exercise significant influence over the investee.
These guidelines alone do not eliminate the leeway available to each investor when deciding whether the use of the equity method is appropriate. To provide a degree of consistency in applying this standard, the APB established a general ownership test. If an investor holds between 20 and 50 percent of the voting stock of the investee, significant influence is normally assumed and the equity method applied.
Limitations of Equity Method Applicability:
At first, the 20 to 50 percent rule may appear to be an arbitrarily chosen boundary range established merely to provide a consistent method of reporting for investments. However, the essential criterion is still the ability to significantly influence (but not control) the investee, rather than 20 to 50 percent ownership. If the absence of this ability is proven (or control exists), the equity method should not be applied regardless of the percentage of shares held.
For example, the equity method is not appropriate for investments that demonstrate any of the following characteristics regardless of the investor’s degree of ownership:
i. An agreement exists between investor and investee by which the investor surrenders significant rights as a shareholder.
ii. A concentration of ownership operates the investee without regard for the views of the investor.
iii. The investor attempts but fails to obtain representation on the investee’s board of directors.
In each of these situations, because the investor is unable to exercise significant influence over its investee, the equity method is not applied.
Alternatively, if an entity can exercise control over its investee, regardless of its ownership level, consolidation (rather than the equity method) is appropriate. FASB Interpretation No. 46R, “Consolidation of Variable Interest Entities,” limits the use of the equity method by expanding the definition of a controlling financial interest. FIN 46R addresses situations in which financial control exists absent majority ownership interest. In these situations, control is achieved through contractual and other arrangements called variable interests.
To illustrate, one firm may create a separate legal entity in which it holds less than 50 percent of the voting interests, but nonetheless controls that entity through governance document provisions and/or contracts that specify decision making power and the distribution of profits and losses.
Entities controlled in this fashion are typically designated as variable interest entities, and their sponsoring firm may be required to include them in consolidated reports despite the fact that ownership is less than 50 percent. Many firms (e.g., The Walt Disney Company and Mills Corporation) reclassified former equity method investees as variable interest entities and now consolidate these investments.
Extensions of Equity Method Applicability:
For some investments that either fall short or exceed 20 to 50 percent ownership, the equity method is nonetheless appropriately used for financial reporting. As an example, International Paper Company disclosed that it accounts for its investment in Scitex Corporation using the equity method despite holding only a 13 percent interest. In its annual report, International Paper cited its ability to exercise significant influence “because the Company is party to a shareowners’ agreement with two other entities which together with the Company own just over 39% of Scitex.”
Conditions can also exist where the equity method is appropriate despite a majority ownership interest. In some instances approval or veto rights granted to minority shareholders restrict the powers of the majority shareholder. Such minority rights may include approval over compensation, hiring, termination, and other critical operating and capital spending decisions of an entity. If the minority rights are so restrictive as to call into question whether control rests with the majority owner, the equity method is employed for financial reporting rather than consolidation.
For example, in its 2005 annual report, AT&T, Inc., stated “we account for our 60 percent economic investment in Cingular under the equity method of accounting because we share control equally with our 40 percent partner BellSouth.”
To summarize, the following table indicates the method of accounting that is typically applicable to various stock investments:
Note # 2. The Consolidation Process:
The consolidation of financial information into a single set of statements becomes necessary when the business combination of two or more companies creates a single economic entity. “There is a presumption that consolidated statements are more meaningful than separate statements and that they are usually necessary for a fair presentation when one of the companies in the group directly or indirectly has a controlling financial interest in the other companies.”
This sentiment was reiterated nearly 30 years later in Financial Accounting Standards Board Statement No. 94, “Consolidation of All Majority-Owned Subsidiaries,” October 1987 “Consolidated financial statements became common once it was recognized that boundaries between separate corporate entities must be ignored to report the business carried on by a group of affiliated corporations as the economic and financial whole that it actually is.”
Most recently, in December 2007, the FASB again confirmed the importance of consolidated financial statements. In SFAS 160, “Non-controlling Interests and Consolidated Financial Statements”—a replacement of ARB 51—the FASB carried forward, without reconsideration, the provisions of ARB 51, as amended, related to consolidation purpose and policy and left unchanged the requirement that all companies in which the parent has a controlling financial interest be consolidated.
Thus, in producing financial statements for external distribution, the reporting entity transcends the boundaries of incorporation to encompass all companies for which control is present. Even though the various companies may retain their legal identities as separate corporations, the resulting information is more meaningful to outside parties when consolidated into a single set of financial statements.
To explain the process of preparing consolidated financial statements for a business combination, we address three questions:
i. How is a business combination formed?
ii. What constitutes a controlling financial interest?
Business Combinations—Creating a Single Economic Entity:
A business combination refers to any set of conditions in which two or more organizations are joined together through common control.
Business combinations are formed by a wide variety of transactions or events with various formats. For example, each of the following is identified as a business combination although it differs widely in legal form. In every case, two or more enterprises are being united into a single economic entity so that consolidated financial statements are required.
1. One company obtains the assets, and often the liabilities, of another company in exchange for cash, other assets, liabilities, stock, or a combination of these. The second organization normally dissolves itself as a legal corporation. Thus, only the acquiring company remains in existence, having absorbed the acquired net assets directly into its own operations. Any business combination in which only one of the original companies continues to exist is referred to in legal terms as a statutory merger.
2. One company obtains the capital stock of another in exchange for cash, other assets, liabilities, stock, or a combination of these. After gaining control, the acquiring company can decide to transfer all assets and liabilities to its own financial records with the second company being dissolved as a separate corporation. The business combination is, once again, a statutory merger because only one of the companies maintains legal existence. This statutory merger, however, is achieved by obtaining equity securities rather than by buying the target company’s assets. Because stock is obtained, the acquiring company must gain 100 percent control of all shares before legally dissolving the subsidiary.
3. Two or more companies transfer either their assets or their capital stock to a newly formed corporation. Both original companies are dissolved, leaving only the new organization in existence. A business combination effected in this manner is a statutory consolidation. The use here of the term consolidation should not be confused with the accounting meaning of that same word.
In accounting, consolidation refers to the mechanical process of bringing together the financial records of two or more organizations to form a single set of statements. A statutory consolidation denotes a specific type of business combination that united two or more existing companies under the ownership of a newly created company.
4. One company achieves legal control over another by acquiring a majority of voting stock. Although control is present, no dissolution takes place; each company remains in existence as an incorporated operation. The National Broadcasting Company (NBC), as an example, continued to retain its legal status as a corporation after being acquired by General Electric Company. Separate incorporation is frequently preferred to take full advantage of any intangible benefits accruing to the acquired company as a going concern.
Better utilization of such factors as licenses, trade names, employee loyalty, and the company’s reputation can be possible when the subsidiary maintains its own legal identity. Moreover, maintaining an independent information system for a subsidiary often enhances its market value for an eventual sale or initial public offering as a standalone entity.
One important aspect of this final type of business combination should be noted. Because the asset and liability account balances are not physically combined as in statutory mergers and consolidations, each company continues to maintain an independent accounting system.
To reflect the combination, the acquiring company enters the takeover transaction into its own records by establishing a single investment asset account. However, the newly acquired subsidiary omits any recording of this event; its stock is simply transferred to the parent from the subsidiary’s shareholders. Thus, the subsidiary’s financial records are not directly affected by a takeover.
As you can see, business combinations are created in many distinct forms. Because the specific format is a critical factor in the subsequent consolidation of financial information, Exhibit 2.2 provides an overview of the various combinations.
Control Exercised through Voting Interests:
ARB 51, as quoted previously, states that consolidated financial statements are usually necessary when one company has a controlling financial interest over another. However, nowhere in the official accounting pronouncements is a “controlling financial interest” actually defined. Traditionally in the United States, control is considered to exist if one company holds more than 50 percent of another company’s voting stock.
Thus, control has been tied directly to ownership. Control through ownership of a majority of voting shares continues to define the vast majority of “controlling financial interests.” However, in the decades since ARB 51 was issued, the complexity of business combinations has increased significantly so that control is not always that easy to define.
Control Exercised through Variable Interests:
The difficulty in defining control is exemplified in FASB Interpretation 46R, “Consolidation of Variable Interest Entities,” December 2003 (FIN 46R). One popular type of variable interest entities has become widely known as a special purpose entity (SPE). SPEs typically take the form of a trust, partnership, joint venture, or corporation. For example, a business may create an SPE to finance its acquisition of a large asset.
The SPE purchases the asset using debt and equity financing and then leases the asset back to the sponsoring firm. If their activities are strictly limited and the asset is pledged as collateral, lenders often view SPEs as less risky than their sponsoring firms. As a result, such arrangements can allow financing at lower interest rates than would otherwise be available to the sponsor.
Control of an SPE by design often does not rest with its equity holders. Instead, control is exercised through contractual arrangements with the sponsoring firm who may become the “primary beneficiary” of the entity. These contracts can take the form of leases, participation rights, guarantees, or other residual interests.
Through contracting, the primary beneficiary bears a majority of the entity’s risks and receives a majority of its rewards often without owning any voting shares. Consequently, an exclusive examination of voting interests can fail to identify the firm with the controlling financial interest in an SPE or similar entity.
Throughout the 1990s and 2000s, SPEs and other variable interest entities became very popular. The increasing use of SPEs was criticized in part because these structures allowed off-balance- sheet financing for the sponsoring firm. Other critics observed that sponsors recorded questionable profits on sales to their SPEs. Many SPEs were often characterized simply as vehicles to hide debt and manipulate earnings. Prior to FIN 46R, many sponsoring entities of SPEs did not technically meet the definition of a controlling financial interest and thus did not consolidate their SPEs.
To prevent future financial reporting abuses, FIN 46R expands the definition of control beyond simply holding a majority of another entity’s voting shares. An entity (e.g., an SPE) whose control rests with a primary beneficiary is referred to as a variable interest entity. The primary beneficiary bears the risks and receives the rewards of a variable interest entity and is considered to have a controlling financial interest.
The fact that the primary beneficiary could own no voting shares whatsoever becomes inconsequential because such shares do not effectively allow the equity holders to exercise control. FIN 46R reasons in its summary that if a “business enterprise has a controlling financial interest in a variable interest entity, assets, liabilities, and results of the activities of the variable interest entity should be included with those of the business enterprise.”
Currently, SFAS 160 carries forward the guidance in ARB 51 that a controlling financial interest is ownership of a majority (more than 50 percent) of the outstanding voting shares of another company. However, both the FASB and the International Accounting Standards Board (IASB) have on their agendas a long-term project to develop comprehensive guidance on accounting for affiliations between entities. The two boards have agreed to work toward a common standard on consolidation policy which may include a new definition of financial control.
Note that this tentative definition does not rely on majority ownership of voting shares as a criterion for determining control. As the complexity of arrangements between companies increases, defining when one firm controls another firm remains a continuing challenge for financial reporting standard setters.
In this text, we first examine control relationships established through voting interests. Owning a majority of voting interests continues to be the primary mechanism through which one firm controls another. However, we expand our coverage to include the consolidation of firms where control is exercised through variable interests.
When one company gains control over another, a business combination is established. Financial data gathered from the individual companies are then brought together to form a single set of consolidated statements. Although this process can be complicated, the objectives of a consolidation are straightforward. The asset, liability, equity, revenue, and expense accounts of the companies simply are combined. As a part of this process, reciprocal accounts and intercompany transactions must be adjusted or eliminated to ensure that all reported balances truly represent the single entity.
Applicable consolidation procedures vary significantly depending on the legal format employed in creating a business combination. For a statutory merger or a statutory consolidation, when the acquired company (or companies) is (are) legally dissolved, only one accounting consolidation ever occurs. On the date of the combination, the surviving company simply records the various account balances from each of the dissolving companies.
Because all accounts are brought together permanently in this manner, no further consolidation procedures are necessary. After all of the balances have been transferred to the survivor, the financial records of the acquired companies are closed out as part of the dissolution.
Conversely, in a combination when all companies retain incorporation, a different set of consolidation procedures is appropriate. Because the companies preserve their legal identities, each continues to maintain its own independent accounting records. Thus, no permanent consolidation of the account balances is ever made. Rather, the consolidation process must be carried out anew each time that the reporting entity prepares financial statements for external reporting purposes.
When separate record-keeping is maintained, the accountant faces a unique problem: The financial information must be brought together periodically without disturbing the accounting systems of the individual companies. Because these consolidations are produced outside the financial records, worksheets traditionally are used to expedite the process. Worksheets are a part of neither company’s accounting records nor the resulting financial statements. Instead, they are an efficient structure for organizing and adjusting the information used to prepare externally reported consolidated statements.
Consequently, the legal characteristics of a business combination have a significant impact on the approach taken to the consolidation process:
i. If dissolution takes place, all account balances are physically consolidated in the surviving company’s financial records.
ii. If separate incorporation is maintained, only the financial statement information (not the actual records) is consolidated.
i. If dissolution takes place, a permanent consolidation occurs at the date of the combination.
ii. If separate incorporation is maintained the consolidation process is carried out at regular intervals whenever financial statements are to be prepared.
i. If dissolution takes place, the surviving company’s accounts are adjusted to include all balances of the dissolved company. The dissolved company’s records are closed out.
ii. If separate incorporation is maintained each company continues to retain its own records. Using worksheets facilitates the periodic consolidation process without disturbing the individual accounting systems.
The fundamental characteristic of any asset acquisition—whether a single piece of property or a multibillion dollar corporation—is a change in ownership. Following a business combination, accounting and financial reporting require that the new owner (the acquirer) record appropriate values for the items received in the transaction. As presented below, in a business combination, fair values for both the items exchanged and received can enter into the determination of the acquirer’s accounting valuation of the acquired firm.
SFAS 141R requires the acquisition method to account for business combinations replacing the SFAS 141 purchase method.
Applying the acquisition method typically involves recognizing and measuring:
i. The consideration transferred for the acquired business.
ii. The separately identified assets acquired liabilities assumed and any non-controlling interest.
iii. Goodwill or a gain from a bargain purchase.
SFAS 141R’s emphasis on fair value as a measurement attribute for an acquired firm represents a distinct departure from the cost-based provisions of SFAS 141. Therefore, prior to examining specific applications of the procedures required by the new standards, we present a brief discussion of the fair-value concept as applied to business combinations.
The fair value of the consideration transferred to acquire a business from its former owners is the starting point in valuing and recording a business combination.
The acquisition method thus embraces the fair value of the consideration transferred in measuring the acquirer’s interest in the acquired business. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (SFAS 157).
Thus, market values are often the best source of evidence of the fair value of consideration transferred in a business combination. Items of consideration transferred can include cash, securities (either stocks or debt), and other property or obligations.
Contingent consideration can also serve as an additional element of consideration transferred.” Combination agreements often contain provisions to compensate former owners upon achievement of specified future performance measures.
The acquisition method treats contingent consideration obligations as a negotiated component of the fair value of the consideration transferred, consistent with the fair value measurement attribute. Determining the fair value of any contingent future payments typically involves probability assessments based on circumstances existing on the acquisition date.
A fundamental principle of the acquisition method is that an acquirer must recognize the identifiable assets acquired and the liabilities assumed in the business combination. Further, once recognized, the acquirer measures the identifiable assets acquired and the liabilities assumed at their acquisition-date fair values, with only a few exceptions. As demonstrated in subsequent examples, the principle of recognizing and measuring assets acquired and liabilities assumed at fair value applies across all business combinations.
We focus exclusively on combinations that result in complete ownership by the acquirer (i.e., no non-controlling interest in the acquired firm). In a less-than-100-percent acquisition, the non-controlling interest also is measured initially at its fair value. Then, the combined fair values of the parent’s consideration transferred and the non-controlling interest comprises the valuation basis for the acquired firm in consolidated financial reports.
The parent records both the consideration transferred and the individual amounts of the assets acquired and liabilities assumed at their acquisition-date fair values. However, in many cases the respective collective amounts of these two values will differ. SFAS 141R requires an asymmetrical accounting for the difference—in one situation the acquirer recognizes an asset, in the other a gain.
For combinations resulting in complete ownership by the acquirer, the acquirer recognizes the asset goodwill as the excess of the consideration transferred over the collective fair values of the net identifiable assets acquired and liabilities assumed. Goodwill is defined as an asset representing the future economic benefits arising in a business combination that are not individually identified and separately recognized. Essentially, goodwill embodies the expected synergies that the acquirer expects to achieve through control of the acquired firm’s assets.
Conversely, if the collective fair values of the net identifiable assets acquired and liabilities assumed exceeds the consideration transferred, the acquirer recognizes a “gain on bargain purchase.” In such cases, the fair value of the net assets acquired replaces the consideration transferred as the valuation basis for the acquired firm. Bargain purchases can result from business divestitures forced by regulatory agencies or other types of distress sales. Before recognizing a gain on bargain purchase, however, the acquirer must reassess whether it has correctly identified and measured all of the acquired assets and liabilities.
Note # 4. Internal Reporting Methods:
Internal Investment Accounting Alternatives the Equity Method, Partial Equity Method, and Initial Value Method:
The internal reporting philosophy of the acquiring company often determines the accounting method choice for its subsidiary investment.
Depending on the measures a company uses to assess the ongoing performances of its subsidiaries, parent companies may choose any of the following three internal reporting methods:
The equity method embraces full accrual accounting in maintaining the investment account and related income over time. Under the equity method, the acquiring company accrues income when the subsidiary earns it. To match the additional fair value recorded in the combination against income, amortization expense stemming from the original excess fair-value allocations is recognized through periodic adjusting entries.
Unrealized gains on intercompany transactions are deferred; dividends paid by the subsidiary serve to reduce the investment balance. The equity method creates a parallel between the parent’s investment accounts and changes in the underlying equity of the acquired company.
When the parent has complete ownership equity method earnings from the subsidiary, combined with the parent’s other income sources, creates a total income figure reflective of the entire combined business entity. Consequently, the equity method often is referred to as a single-line consolidation. The equity method is especially popular in companies where management periodically (e.g., monthly or quarterly) measures each subsidiary’s profitability using accrual-based income figures.
The initial value method might be selected because the parent does not require an accrual-based income measure of subsidiary performance. Subsequent to acquisition, the initial value method uses the cash basis for income recognition. Dividends received by the parent from the subsidiary are recognized as income. No recognition is given to the income earned by the subsidiary. The investment balance remains permanently on the parent’s financial records at the initial fair value assigned at the acquisition date.
The initial value method can be appropriate if the parent assesses subsidiary performance its ability to generate cash flows, on revenues generated or some other non-income basis. Also, some firms may find attractive the initial value method’s ease of application. Because the investment account goes to zero in consolidation and the actual subsidiary revenues and expenses are eventually combined, firms may avoid the complexity of the equity method unless they need the specific information provided by the equity income measure.
A third method available to the acquiring company is a partial application of the equity method. Under this approach, the parent recognizes the reported income accruing from the subsidiary. Dividends that are collected reduce the investment balance. However, no other equity adjustments (amortization or deferral of unrealized gains) are recorded. Thus, in many cases, earnings figures on the parent’s books approximate consolidated totals but without the effort associated with a full application of the equity method.
Each acquiring company must decide for itself the appropriate approach in recording the operations of its subsidiaries. For example, Alliant Food Service, Inc., applies the equity method. According to Joe Tomczak, vice president and controller of Alliant Food Service, Inc., “We maintain the parent holding company books on an equity basis. This approach provides the best method of providing information for our operational decisions.”
In contrast, Reynolds Metals Corporation has chosen to utilize the partial equity method approach. Allen Earehart, director of corporate accounting for Reynolds, states, “We do adjust the carrying value of our investments annually to reflect the earnings of each subsidiary. We want to be able to evaluate the parent company on a stand-alone basis and a regular equity accrual is, therefore, necessary. However, we do separate certain adjustments such as the elimination of intercompany gains and losses and record them solely within the development of consolidated financial statements.”
Exhibit 3.1 provides a summary of these three reporting techniques. The method adopted affects only the acquiring company’s separate financial records. No changes are created in either the subsidiary’s accounts or the consolidated totals.
Because specific worksheet procedures differ based on the investment method being utilized by the parent, the consolidation process subsequent to the date of combination will be introduced twice. First, we review consolidations in which the acquiring company uses the equity method. Then we redevelop all procedures when the investment is recorded by one of the alternative methods. \
Note # 5. How are Consolidated Values Determined for Variable Interest Entities?
Starting in the late 1970s, many firms began establishing separate business structures to help finance their operations at favorable rates. These structures became commonly known as special purpose entities (SPEs), special purpose vehicles, or off-balance sheet structures. Here we refer to all such entities collectively as variable interest entities or VIEs. Many firms have routinely included their VIEs in their consolidated financial reports. However, others sought to avoid consolidation.
VIEs can help accomplish legitimate business purposes. Nonetheless, their use was widely criticized in the aftermath of Enron Corporation’s 2001 collapse. Because many firms avoided consolidation and used VIEs for off-balance sheet financing, such entities were often characterized as vehicles to hide debt and mislead investors. Other critics observed that firms with variable interests recorded questionable profits on sales to their VIEs that were not arms- length transactions.’ FASB Interpretation 46R, “Consolidation of Variable Interest Entities,” December 2003 (FIN 46R), issued in response to such abuses, addresses financial reporting for enterprises involved with VIEs.
A VIE can take the form of a trust, partnership, joint venture, or corporation although sometimes it has neither independent management nor employees. Most are established for valid business purposes, and transactions involving VIEs have become widespread(dot)Common examples of VIE activities include transfers of financial assets, leasing, hedging financial instruments, research and development, and other transactions. An enterprise often sponsors a VIE to accomplish a well-defined and limited business activity and to provide low-cost financing.
Low-cost financing of asset purchases is frequently a main benefit available through VIEs. Rather than engaging in the transaction directly, the business may sponsor a VIE to purchase and finance an asset acquisition. The VIE then leases the asset to the sponsor. This strategy saves the business money because the VIE is often eligible for a lower interest rate. This advantage is achieved for several reasons. First, the VIE typically operates with a very limited set of assets—in many cases just one asset.
By isolating an asset in a VIE, the asset’s risk is isolated from the sponsoring firm’s overall risk. Thus the VIE creditors remain protected by the specific collateral in the asset. Second, the governing documents can strictly limit the business activities of a VIE. These limits further protect lenders by preventing the VIE from engaging in any activities not specified in its agreements.
Because governing agreements limit activities and decision making in most VIEs, there is often little need for voting stock. In fact, a sponsoring enterprise may own very little, if any, of its VIE’s voting stock. Prior to FIN 46R because these businesses were technically not majority owners of their VIEs, they often left such entities unconsolidated in their financial reports. In utilizing the VIE as a conduit to provide financing, the related assets and debt were effectively removed from the enterprise’s balance sheet.
Like all business entities, VIEs generally have assets, liabilities, and investors with equity interests. Unlike most businesses, because a VIE’s activities can be strictly limited the role of the equity investors can be fairly minor. The VIE may have been created specifically to benefit its sponsoring firm with low-cost financing. Thus, the equity investors may serve simply as a technical requirement to allow the VIE to function as a legal entity. Because they bear relatively low economic risk, equity investors are typically provided only a small rate of return.
The small equity investments normally are insufficient to induce lenders to provide a low-risk interest rate for the VIE. As a result, another party (often the sponsoring firm that benefits from the VIE’s activities) must contribute substantial resources—often loans and/or guarantees—to enable the VIE to secure additional financing needed to accomplish its purpose. For example, the sponsoring firm may guarantee the VIE’s debt, thus assuming the risk of default.
Other contractual arrangements may limit returns to equity holders while participation rights provide increased profit potential and risks to the sponsoring firm. Risks and rewards such as these cause the sponsor’s economic interest to vary depending on the created entity’s success—hence the term variable interest entity. In contrast to a traditional entity, a VIE’s risks and rewards are distributed not according to stock ownership but according to other variable interests. Exhibit 6.1 describes variable interests further and provides several examples presented in FIN 46R.
A firm with variable interests in a VIE increases its risk with the level (or potential level in the case of a guarantee) of resources provided. With increased risks come increased incentives to exert greater influence over the VIE’s decision making. In fact, a firm with variable interests will regularly limit the equity investors’ decision-making power through the governance documents that establish the VIE.
Although the equity investors are technically the owners of the VIE, in reality they may retain little of the traditional responsibilities, risks, and benefits of ownership. In fact, the equity investors often cede financial control of the VIE to those with variable interest in exchange for a guaranteed rate of return.
Prior to FASB Interpretation No. 46R, “Consolidation of Variable Interest Entities,” December 2003 (FIN46R), the assets, liabilities, and results of operations for VIEs and other entities frequently were not consolidated with those of the firm that controlled the entity. These firms invoked ARB 51’s reliance on voting interests, as opposed to variable interests, to indicate a lack of a controlling financial interest.
FIN 46R first describes how to identify a VIE that is not subject to control through voting ownership interests but is nonetheless controlled by another enterprise and therefore subject to consolidation. Each enterprise involved with a VIE must then determine whether the financial support it provides makes it the primary beneficiary of the VIE’s activities. The VIE’s primary beneficiary is then required to include the assets, liabilities, and results of the activities of the VIE in its consolidated financial statements.
According to FIN 46R, an entity qualifies as a VIE if either of the following conditions exists:
i. The total equity at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders. In most cases, if equity at risk is less than 10 percent of total assets, the risk is deemed insufficient.
ii. The equity investors in the VIE lack any one of the following three characteristics of a controlling financial interest:
1. The direct or indirect ability to make decisions about an entity’s activities through voting rights or similar rights.
2. The obligation to absorb the expected losses of the entity if they occur (e.g., another firm may guarantee a return to the equity investors).
3. The right to receive the expected residual returns of the entity (e.g., the investors’ return may be capped by the entity’s governing documents or other arrangements with variable interest holders).
Once it is established that a firm has a relationship with a VIE, FIN 46R requires the firm to determine whether it qualifies as the VIE’s primary beneficiary. The primary beneficiary then must consolidate the VIE’s assets, liabilities, revenues, expenses, and non-controlling interest.
The following characteristics indicate an enterprise qualifying as a primary beneficiary with a controlling financial interest in a VIE:
i. The direct or indirect ability to make decisions about the entity’s activities.
ii. The obligation to absorb the entity’s expected losses if they occur.
iii. The right to receive the entity’s expected residual returns if they occur.
Note that these characteristics mirror those that the equity investors lack in a VIE. Instead the primary beneficiary is subject to the majority of risks of losses or entitled to receive a majority of the entity’s residual returns or both. The fact that the primary beneficiary may own no voting shares whatsoever becomes inconsequential because such shares do not effectively allow the equity investors to exercise control.
Thus, in assessing control, a careful examination of the VIE’s governing documents and the contractual arrangements among the parties involved is necessary to determine who bears the majority risk.
The magnitude of the effect of consolidating an enterprise’s VIEs can be large. For example, Walt Disney Company disclosed that two of its major investments qualified as VIEs and that it now will consolidate them.
As a result of the consolidation of these two VIEs, Disney’s total assets increased by $3.9 billion while its total debt increased by $3.6 billion. FIN 46R emphasizes that its objective is to improve financial reporting by companies involved with VIEs, not to restrict the use of VIEs. FIN 46R reasons that if a “business enterprise has a controlling financial interest in a variable interest entity, assets, liabilities, and results of the activities of the variable interest entity should be included with those of the business enterprise.”
Example of a Primary Beneficiary and Consolidated Variable Interest Entity:
Assume that Twin Peaks Power Company seeks to acquire a generating plant for a negotiated price of $400 million from Ace Electric Company. Twin Peaks wishes to expand its market share and expects to be able to sell the electricity generated by the plant acquisition at a profit to its owners.
In reviewing financing alternatives, Twin Peaks observed that its general credit rating allowed for a 4 percent annual interest rate on a debt issue. Twin Peaks also explored the establishment of a separate legal entity whose sole purpose would be to own the electric generating plant and lease it back to Twin Peaks. Because the separate entity would isolate the electric generating plant from Twin Peaks’s other risky assets and liabilities and provide specific collateral, an interest rate of 3 percent on the debt is available producing before tax savings of $4 million per year.
To obtain the lower interest rate, however, Twin Peaks must guarantee the separate entity’s debt. Twin Peaks must also maintain certain of its own predefined financial ratios and restrict the amount of additional debt it can assume.
To take advantage of the lower interest rate, on January 1, 2009, Twin Peaks establishes Power Finance Co., an entity designed solely to own, finance, and lease the electric generating plant to Twin Peaks.
The documents governing the new entity specify the following:
i. The sole purpose of Power Finance is to purchase the Ace electric generating plant, provide equity and debt financing, and lease the plant to Twin Peaks.
ii. An outside investor will provide $16 million in exchange for a 100 percent nonvoting equity interest in Power Finance.
iii. Power Finance will issue debt in exchange for $384 million. Because the $16 million equity investment by itself is insufficient to attract low-interest debt financing, Twin Peaks will guarantee the debt.
iv. Twin Peaks will lease the electric generating plant from Power Finance in exchange for payments of $12 million per year based on a 3 percent fixed interest rate for both the debt and equity investors for an initial lease term of five years.
v. At the end of the five-year lease term (or any extension).
Twin Peaks must do one of the following:
a. Renew the lease for five years subject to the approval of the equity investor.
b. Purchase the electric generating plant for $400 million.
c. Sell the electric generating plant to an independent third party. If the proceeds of the sale are insufficient to repay the equity investor, Twin Peaks is required to make a payment of $16 million to the equity investor.
Once the purchase of the electric generating plant is complete and the equity and debt are issued, Power Finance Company reports the following balance sheet:
Exhibit 6.2 shows the relationships between Twin Peaks, Power Finance, the electric generating plant, and the parties financing the asset purchase.
In evaluating whether Twin Peaks Electric Company must consolidate Power Finance Company, two conditions must be met. First, Power Finance must qualify as a VIE by either- (1) an inability to secure financing without additional subordinated support or (2) a lack of either the risk of losses or entitlement to residual returns (or both). Second, Twin Peaks must qualify as the primary beneficiary of Power Finance.
In assessing the first condition, several factors point to VIE status for Power Finance. Its owner’s equity comprises only 4 percent of total assets, far short of the 10 percent benchmark provided by FIN 46R. Moreover, Twin Peaks guarantees Power Finance’s debt, suggesting insufficient equity to finance its operations without additional support. Finally, the equity investor appears to bear almost no risk with respect to the operations of the Ace electric plant. These characteristics indicate that Power Finance qualifies as a VIE.
In evaluating the second condition for consolidation, an assessment is made to determine whether Twin Peaks qualifies as Power Finance’s primary beneficiary. According to FIN46R, an enterprise must consolidate a VIE if that enterprise has a variable interest that will absorb a majority of the entity’s expected losses if they occur, receive a majority of the entity’s expected residual returns if they occur, or both. But what possible losses or returns would accrue to Twin Peaks? What are Twin Peaks’s variable interests that rise and fall with the fortunes of Power Finance?
As stated in the VIE agreement, Twin Peaks will pay a fixed fee to lease the electric generating plant. It will then operate the plant and sell the electric power in its markets. If the business plan is successful, Twin Peaks will enjoy residual profits from operating while Power Finance’s equity investors receive the fixed fee. On the other hand if prices for electricity fall, Twin Peaks may generate revenues insufficient to cover its lease payments while Power Finance’s equity investors are protected from this risk.
Moreover, if the plant’s fair value increases significantly, Twin Peaks can exercise its option to purchase the plant at a fixed price and either resell it or keep it for its own future use. Alternatively, if Twin Peaks were to sell the plant at a loss, it must pay the equity investors all of their initial investment, furthering the loss to Twin Peaks. Each of these elements points to Twin Peaks as the primary beneficiary of its VIE through variable interests. As the primary beneficiary, Twin Peaks must consolidate the assets, liabilities, and results of operations of Power Finance with its own.
Mutual Ownership and Consolidated Financial Statements:
One specific corporate structure that requires further analysis is a mutual ownership. This type of configuration exists when two companies within a business combination hold an equity interest in each other. This ownership pattern is sometimes created as a result of financial battles that occur during takeover attempts.
A defensive strategy (often called the Pac-Man Defense) is occasionally adopted whereby the target company attempts to avoid takeover by reversing roles and acquiring shares of its investor. Consequently, the two parties hold shares of each other, and one usually gains control.
Two typical mutual ownership patterns follow. In situation A, the parent and the subsidiary possess a percentage of each other’s voting shares; in situation B, the mutual ownership exists between two subsidiary companies-
Accounting for mutual ownership raises unique conceptual issues. These concerns center on handling any parent company stock owned by a subsidiary.
This approach has theoretical merit because the ownership of parent shares by the subsidiary does not involve outside parties. By requiring a treasury stock treatment for shares of the parent held by a subsidiary, the FASB in SFAS 160 takes the perspective that financial reporting should not vary based on the purchasing agent’s specific identity. For consolidation purposes, no legitimate accounting distinction is drawn between an acquisition by the parent and the same transaction made by a subsidiary. The acquisition of treasury shares by either a parent or its controlled subsidiary represents an identical economic event that should have identical financial reporting implications.
Treasury Stock Approach:
The treasury stock approach to mutual ownership focuses on the parent’s control over the subsidiary. Although the companies maintain separate legal incorporation, only a single economic entity exists, and the parent dominates it. Hence, either company can purchase stock or other items, but all reporting for the business combination must be from the parent’s perspective. The focus on the parent’s perspective is underscored by the fundamental purpose of consolidated financial statements.
Therefore, as a single economic entity, the purchase of the parent’s shares by any of the affiliated members is reported as treasury stock in the consolidated financial statements.
Even prior to SFAS 160, the treasury stock approach was predominate in practice, although this popularity was undoubtedly based as much on the ease of application as on theoretical merit. The cost of parent shares held by the subsidiary is merely reclassified on the worksheet into a treasury stock account. Any dividend payments on this stock are considered intercompany cash transfers that must be eliminated. This reporting technique is simple, and the shares are indeed no longer accounted for as if they were outstanding.
Mutual Ownership Illustrated:
To illustrate the treasury stock approach, assume that on January 1, 2009, Sun Company purchased 10 percent of Pop Company. Sun paid $120,000 for these shares, an amount that exactly equaled Pop’s proportionate book value. Many possible reasons exist for this transaction.
The acquisition could be simply an investment or an attempt to forestall a takeover move by Pop. Regardless, Sun subsequently accounts for these shares according to SFAS 115. To simplify the illustration, it is assumed that Pop’s shares are not traded actively and therefore continuous market values are unavailable. Under these circumstances, Sun’s books appropriately carry the investment in Pop at the $120,000 initial value.
On January 1, 2010, Pop manages to gain control over Sun by acquiring a 70 percent ownership interest, thus creating a business combination.
Details of the acquisition are as follows:
Treasury Stock Approach Illustrated:
Exhibit 7.2 presents the consolidation of Pop and Sun for 2011. This worksheet has been developed under the treasury stock approach to mutual ownerships so that Pop’s investment in Sun is consolidated along routine lines.
Following the calculation of the franchise value and amortization, regular worksheet entries are developed for Pop’s investment. Because the initial value method is applied, the $7,000 dividend income recognized in the prior years of ownership (only 2010, in this case) is converted to an equity accrual in Entry *C.
The parent should recognize 70 percent of the subsidiary’s $35,000 income for 2010, or $24,500. However, inclusion of the $2,100 amortization expense (the parent’s 70% share) dictates that $22,400 is the appropriate equity accrual. Because the parent has already recognized $7,000 in dividend income, Entry *C records the necessary increase as $15,400 ($22,400 – $7,000).
The remaining entries relating to Pop’s investment are standard. The subsidiary’s stockholders’ equity accounts are eliminated (Entry S), the franchises’ allocation is recognized (Entry A), and so on. The existence of the mutual ownership actually affects only two facets of Exhibit 7.2. First, Sun’s $120,000 payment made for the parent’s shares is reclassified into a treasury stock account (through Entry TS).
Second, the $8,000 intercompany dividend flowing from Pop to Sun during the current year of 2011 is eliminated within Entry I (used because the collection was recorded as income). The simplicity of applying the treasury stock approach should be apparent from this one example.
Before leaving the treasury stock approach, a final comment is needed regarding the computation of the non-controlling interest’s share of Sun’s income. In Exhibit 7.2, this balance is recorded as $13,500, or 30 percent of the subsidiary’s $48,000 net income figure less $3,000 excess fair-value amortization. A question can be raised as to the validity of including the $8,000 dividend within this income total because that payment is eliminated within the consolidation.
These dividends, although intercompany in nature, increase the subsidiary company’s book value. Therefore, the increment must be reflected in some manner to indicate the change in the amount attributed to the outside owners. For example, the increase could be recognized as a direct adjustment of $2,400 (30 percent of $8,000) in the non-controlling interest balance being reported. More often, as shown here, such cash transfers are considered to be income when viewed from the perspective of these other unrelated parties.
Note # 6. Expanded Financial Reporting:
The SEC has long advocated inclusion of a verbal explanation of a for-profit company’s operations and financial position to accompany its financial statements. This memorandum, known generally as the management’s discussion and analysis (MD&A), provides a wealth of vital information for the reader of the financial statements.
Thus, in evaluating for-profit organizations, outside decision makers are accustomed to having a “plain English” explanation of the figures and other critical information disclosed within the statements. For example General Electric Company’s 2005 financial statements contained a Management’s Discussion and Analysis of Financial Condition and Results of Operation. Consequently, this provides a stockholder, creditor, potential investor, or other interested party with extensive details to describe and supplement the facts and figures presented within the company’s financial statements.
One of the most important recent changes in governmental accounting was the requirement that state and local governments provide a similar MD&A.
This divides the general purpose external financial statements of a state or local government into three distinct sections:
1. Management’s discussion and analysis.
2. Financial statements-
a. Government-wide financial statements.
b. Fund-based financial statements.
c. Notes to the financial statements.
3. Required supplementary information (other than the MD&A). For example, the City of Saint Paul, Minnesota, uses this section to compare budgetary figures with actual results for each major fund although a separate statement within the fund-based financial statements could also have been used.
The GASB explains its justification for requiring officials to provide readers of the government’s financial statements with an MD&A:
The basic financial statements should be preceded by MD&A, which is required supplementary information (RSI). MD&A should provide an objective and easily readable analysis of the government’s financial activities based on currently known facts, decisions, or conditions. The financial managers of governments are knowledgeable about the transactions, events, and conditions that are reflected in the government’s financial report and of the fiscal policies that govern its operations.
MD&A provides financial managers with the opportunity to present both a short- and a long-term analysis of the government’s activities. MD&A should discuss current-year results in comparison with the prior year, with emphasis on the current year. This fact-based analysis should discuss the positive and negative aspects of the comparison with the prior year. The use of charts, graphs, and tables is encouraged to enhance the understandability of the information.
As an illustration, the 2006 financial statements for the City of Greensboro, North Carolina, begin with a management’s discussion and analysis that present information such as this:
The governmental activities program revenue decreased by $1.7 million, down 2.9% from last year, largely due to the decrease in contributions generated in the prior year from the sale of property along with a decrease in grant revenues. General revenues for property taxes increased by $.1 million which is consistent with the prior year due to a stabilized tax rate.
The general purpose external financial statements are presented to the public as part of a comprehensive annual financial report (often referred to as a CAFR). The CAFR also includes other extensive information about the reporting government. For example, the 2006 CAFR for the City of Salt Lake City, Utah, with total revenues of about $500 million, was 192 pages long. In comparison, the 2006 annual report for Wal-Mart, with more than $312 billion in revenues, was only 56 pages.
The CAFR of a state or local government must include three broad sections:
1. Introductory Section:
Includes a letter of transmittal from appropriate government officials, an organization chart, and a list of principal officers.
2. Financial Section:
Presents the general purpose external financial statement and reproduces the auditor’s report. The government also usually prepares additional supplementary information such as combining statements to present financial information for funds that do not qualify as major.
3. Statistical Section:
An important element of acquisition accounting is the acquirer’s recognition and measurement of the assets acquired and liabilities assumed in the combination. In particular, the advent of the information age brings new measurement challenges for a host of intangible assets that provide value in generating future cash flows.
Intangible assets often comprise the largest proportion of an acquired firm. For example, when AT&T acquired AT&T Broadband, it allocated approximately $19 billion of the $52 billion purchase price to franchise costs. These franchise costs form an intangible asset representing the value attributed to agreements with local authorities that allow access to homes.
In addressing the importance of proper asset recognition, the FASB in SFAS 141R observed that intangible assets include both current and noncurrent assets (not including financial instruments) that lack physical substance. Furthermore, in determining whether to recognize an intangible asset in a business combination. SFAS 141R relies on two essential attributes. First, does the intangible asset arise from contractual or other legal rights? Second, is the asset capable of being sold or otherwise separated from the acquired enterprise?
Exhibit 2.7 lists intangible assets with indications of whether they typically meet the legal/ contractual or separability criteria.
Undoubtedly, as our knowledge economy continues its rapid growth, asset allocations to items such as those identified in Exhibit 2.7 are expected to be frequent.
In our examples of business combinations so far, the assets acquired and liabilities assumed have all been specifically identifiable (e.g., current assets, capitalized software, computers and equipment, customer contracts, and notes payable). However, in many cases, an acquired firm has an unidentifiable asset (i.e., goodwill recorded on its books in connection with a previous business combination of its own). A question arises as to the parent’s treatment of this preexisting goodwill on the newly acquired subsidiary’s books.
By its very nature, such preexisting goodwill is not considered identifiable by the parent. Therefore, the new owner simply ignores it in allocating the acquisition-date fair value. The logic is that the total business fair value is first allocated to the identifiable assets and liabilities. Only if an excess amount remains after recognizing the fair values of the net identifiable assets is any goodwill recognized. Thus, in all business combinations, only goodwill reflected in the current acquisition is brought forward in the consolidated entity’s financial reports.
The accounting for a business combination begins with the identification of the tangible and intangible assets acquired and liabilities assumed by the acquirer. The fair values of the individual assets and liabilities then provide the basis for financial statement valuations. Recently, many firms—especially those in high-tech industries—have allocated significant portions of acquired businesses to in-process research and development (IPR&D).
An example is seen in the Yahoo! acquisition of Log-Me-On(dot)com. As noted in a Yahoo! 10-Q SEC filing, Log-Me-On’s efforts were focused solely on developing an Internet browser technology that at the time was approximately 30 percent complete. This IPR&D was considered not to have reached technological feasibility and had no alternative future use as of the acquisition date.
Of the $9.9 million paid for Log-Me-On(dot)com, $9.8 million was allocated to IPR&D, which at the time was immediately and appropriately allocated to an expense. Many critics, however, questioned whether firms such as Yahoo! would pay such amounts for intangibles with such low expectations of future value to justify an immediate write-off.
In a marked departure from past practice, SFAS 141R now requires that acquired IPR&D be measured at acquisition-date fair value and recognized in consolidated financial statements as an asset.
Recognizing acquired IPR&D as an asset is clearly consistent with the FASB’s fair-value approach to acquisition accounting. Similar to costs that result in goodwill and other internally generated intangibles (e.g., customer lists, trade names, etc.). IPR&D costs are expensed as incurred in ongoing business activities.
However, a business combination is considered a significant recognition event for which all fair values transferred in the transaction should be fully accounted for, including any values assigned to IPR&D. Moreover, because the acquirer paid for the IPR&D. an expectation of future economic benefit is assumed and. therefore, the amount is recognized as an asset.
As an example, assume that ClearTone Company pays $2.300.000 in cash for all assets and liabilities of Newave. Inc., in a merger transaction. ClearTone manufactures components for cell phones. The primary motivation for the acquisition is a particularly attractive research and development project under way at Newave that will extend a cell phone’s battery life by up to 50 percent. ClearTone hopes to combine the new technology with its manufacturing process and projects a resulting substantial revenue increase. ClearTone is optimistic that Newave will finish the project in the next two years.
At the acquisition date, ClearTone prepares the following schedule that recognizes the items of value it expects to receive from the Newave acquisition:
Future research and development expenditures incurred subsequent to the date of acquisition will continue to be subject to the guidance of FASB SFAS 2 (i.e., expensed). Subsequent to the acquisition date, acquired IPR&D assets should be considered initially indefinite-lived until the project is completed or abandoned. In accordance with paragraph 16 of SFAS 142, an indefinite-lived intangible asset is tested for impairment but is not amortized until its useful life is determined to be no longer indefinite.
In most business combinations resulting in complete ownership, the fair value of the consideration transferred by the acquiring firm will serve as the starting point for measuring and reporting the acquisition. Goodwill is measured as the excess of the consideration transferred over the net recognized amount of the acquisition-date identifiable assets acquired and liabilities assumed. Conversely, if the consideration transferred is less than the net amount of assets acquired and liabilities assumed, the acquirer recognizes a gain on bargain purchase.
The consideration transferred in a business combination can include cash, other property, debt or equity securities, and contingent consideration. Typically, the fair values of these items are readily measureable and recording goodwill (or an infrequent bargain purchase gain) from the combination is fairly straightforward. However, in some cases, the fair value of the consideration transferred is not readily available and accountants turn to other valuation measures.
For example, if the acquirer and acquire exchange only equity shares, a question may arise regarding whose shares provide the most reliable measurement for the combination.
Alternatively, there may be no consideration transferred in a combination. Such a situation can arise if the acquire repurchases enough of its own shares to give an existing owner a controlling percentage of the acquirer’s outstanding shares. With no consideration transferred, other valuation techniques must be relied upon to determine the acquisition-date fair value of the acquirer’s interest.
Valuation techniques used in combinations that lack consideration transferred include discounted cash flow analysis, market comparable, and other future income estimation models. It should be noted that the fair value of the consideration transferred will serve as the basis for recording one-hundred percent combinations in most cases. Nonetheless, in certain situations where the fair value of the consideration transferred is uncertain or unavailable, other measurements of the acquired firm’s acquisition-date fair value may be needed.
Note # 8. Derivatives Accounting:
SFAS 133, “Accounting for Derivative Instruments and Hedging Activities,” which went into effect in 2001, governs the accounting for all derivatives, including those used to hedge foreign exchange risk. In response to concerns expressed by many companies, SFAS 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities,” amends SFAS 133 with respect to the accounting for hedges of recognized foreign currency denominated assets and liabilities.
SFAS 133 (as amended by SFAS 138) provides guidance for hedges of the following sources of foreign exchange risk:
1. Recognized foreign currency denominated assets and liabilities.
2. Unrecognized foreign currency firm commitments.
3. Forecasted foreign currency denominated transactions.
4. Net investments in foreign operations.
Different accounting applies to each type of foreign currency hedge.
Fundamental Requirement of Derivatives Accounting:
The fundamental requirement of SFAS 133 (and SFAS 138) is that companies carry all derivatives on the balance sheet at their fair value. Derivatives are reported on the balance sheet as assets when they have a positive fair value and as liabilities when they have a negative fair value. The first issue in accounting for derivatives is the determination of fair value.
The fair value of derivatives can change over time, causing adjustments to be made to the carrying values of the assets and liabilities. The second issue in accounting for derivatives is the treatment of the gains and losses that arise from these adjustments.
Determination of Fair Value of Derivatives:
The fair value of a foreign currency forward contract is determined by reference to changes in the forward rate over the life of the contract, discounted to the present value.
Three pieces of information are needed to determine the fair value of a forward contract at any point in time:
1. The forward rate when the forward contract was entered into.
2. The current forward rate for a contract that matures on the same date as the forward contract entered into.
3. A discount rate—typically, the company’s incremental borrowing rate.
Assume that Exim Company enters into a forward contract on December 1 to sell 1 million Mexican pesos on March 1 at a forward rate of $0,085 per peso, or a total of $85,000. Exim incurs no cost to enter into the forward contract, which has no value on December 1. On December 31, when Exim closes its books to prepare financial statements, the forward rate to sell Mexican pesos on March 1 has changed to $0,082.
On that date, a forward contract for the delivery of 1 million pesos could be negotiated, resulting in a cash inflow of only $82,000 on March 1. This represents a favorable change in the value of Exim’s forward contract of $3,000 ($85,000 – $82,000). The undiscounted fair value of the forward contract on December 31 is $3,000.
Assuming that the company’s incremental borrowing rate is 12 percent per annum, the undiscounted fair value of the forward contract must be discounted at the rate of 1 percent per month for two months (from the current date of December 31 to the settlement date of March 1). The fair value of the forward contract at December 31 is $2,940.90 ($3,000 × 0.9803).
The manner in which the fair value of a foreign currency option is determined depends on whether the option is traded on an exchange or has been acquired in the over-the-counter market. The fair value of an exchange-traded foreign currency option is its current market price quoted on the exchange. For over-the-counter options, fair value can be determined by obtaining a price quote from an option dealer (such as a bank).
If dealer price quotes are unavailable, the company can estimate the value of an option using the modified Black-Scholes option pricing model. Regardless of who does the calculation, principles similar to those of the Black-Scholes pricing model can be used to determine the fair value of the option.
Accounting for Changes in the Fair Value of Derivatives:
Changes in the fair value of derivatives must be included in comprehensive income, which is defined as all changes in equity from non-owner sources. It consists of two components: net income and other comprehensive income. Other comprehensive income consists of income items that previous FASB statements required to be deferred in stockholders’ equity such as gains and losses on available-for-sale marketable securities.
Other comprehensive income is accumulated and reported as a separate line in the stockholders’ equity section of the balance sheet. This book uses the account title Accumulated Other Comprehensive Income to describe this stockholders’ equity line item.
In accordance with SFAS 133 (as amended by SFAS 138), gains and losses arising from changes in the fair value of derivatives are recognized initially either- (1) on the income statement as a part of net income or (2) on the balance sheet as a component of other comprehensive income.
Recognition treatment depends partly on whether the company uses derivatives for hedging purposes or for speculation. For speculative derivatives, the company recognizes the change in the fair value of the derivative (the gain or loss) immediately in net income. The accounting for changes in the fair value of derivatives used for hedging depends on the nature of the foreign exchange risk being hedged and on whether the derivative qualifies for hedge accounting.
Note # 9. Hedge Accounting:
Companies enter into hedging relationships to minimize the adverse effect that changes in exchange rates have on cash flows and net income. As such, companies would like to account for hedges in such a way to recognize the gain or loss from the hedge in net income in the same period as the loss or gain on the risk being hedged. This approach is known as hedge accounting.
SFAS 133 and SFAS 138 allow hedge accounting for foreign currency derivatives only if three conditions are satisfied:
1. The derivative is used to hedge either a fair-value exposure or cash flow exposure to foreign exchange risk.
2. The derivative is highly effective in offsetting changes in the fair value or cash flows related to the hedged item.
3. The derivative is properly documented as a hedge.
Each of these conditions is discussed in turn.
Nature of the Hedged Risk:
A fair-value exposure exists if changes in exchange rates can affect the fair value of an asset or liability reported on the balance sheet. To qualify for hedge accounting, the fair-value risk must have the potential to affect net income if it is not hedged. For example, a fair-value risk is associated with a foreign currency account receivable. If the foreign currency depreciates, the receivable must be written down with an offsetting loss recognized in net income. The FASB has determined that a fair-value exposure also exists for foreign currency firm commitments.
A cash flow exposure exists if changes in exchange rates can affect the amount of cash flow to be realized from a transaction with changes in cash flow reflected in net income. A foreign currency account receivable, for example, has both a fair-value exposure and a cash flow exposure. A cash flow exposure exists for- (1) recognized foreign currency assets and liabilities, (2) foreign currency firm commitments, and (3) forecasted foreign currency transactions.
Derivatives for which companies wish to use hedge accounting must be designated as either a fair value hedge or a cashflow hedge. For hedges of recognized foreign currency assets and liabilities and hedges of foreign currency firm commitments, companies must choose between the two types of designation.
Hedges of forecasted foreign currency transactions can qualify only as cash flow hedges. Accounting procedures differ for the two types of hedges. In general, gains and losses on fair value hedges are recognized immediately in net income, and gains and losses on cash flow hedges are included in other comprehensive income.
For hedge accounting to be used initially, the hedge must be expected to be highly effective in generating gains and losses that offset losses and gains on the item being hedged. The hedge actually must be effective in generating offsetting gains and losses for hedge accounting to continue to be applied.
At inception, a foreign currency derivative can be considered an effective hedge if the critical terms of the hedging instrument match those of the hedged item. Critical terms include the currency type, currency amount, and settlement date. For example, a forward contract to purchase 100,000 Canadian dollars in 30 days would be an effective hedge of a 100,000 Canadian dollar liability that is payable in 30 days. Assessing hedge effectiveness on an ongoing basis can be accomplished using a cumulative dollar offset method.
For hedge accounting to be applied, SFAS 133 requires formal documentation of the hedging relationship at the inception of the hedge (i.e., on the date a foreign currency forward contract is entered into or a foreign currency option is acquired). The hedging company must prepare a document that identifies the hedged item, the hedging instrument, the nature of the risk being hedged, how the hedging instrument’s effectiveness will be assessed, and the risk management objective and strategy for undertaking the hedge.