Chapter 7
Investing
Activities
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Investing Activities
 Includes acquisition of long-term – tangible
& intangible assets and disposition of
assets.
 Investment categories:
 Investments in long-lived operating assets
 Long-lived tangible fixed assets
 Amortizable intangible assets
 Non-amortizable intangible assets
 Investments in the securities of other firms
Chapter: 07
2
Accounting for Acquisition of
Property, Plant and Equipment
 Costs incurred to yield future benefits imply
asset.
 Asset is recorded at Fair Value.
 Fair Value includes cash paid, fair value of
debt incurred, fair value of lease payments.
Chapter: 07
3
Cash-Flows from Acquisition of
Property, Plant and Equipment
 When cash is paid
 It is a Cash outflow
 Reported in the investing activities section of
the statement of cash flows.
 When debt is incurred or equity is issued
 It is a non-cash, investing & financing activity.
 Reported in a separate schedule,
accompanying the statement of cash flows.
Chapter: 07
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Accounting for Research and
Development Costs
 U.S. GAAP
 Internally incurred R&D costs are expensed.
 Externally acquired R&D are capitalized.
 For Industries with high R&D expenditures, U.S.
GAAP requirement to expense is troublesome –
because a major asset never appears on the
balance sheet.
 IFRS
 Research costs are expensed.
 Product development costs are capitalized.
Chapter: 07
5
Reporting for Research and
Development Costs
 Reported in the statement of cash flows as
operating activity.
 Reduces current period net income.
Chapter: 07
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Analysts Approach to R&D costs
 Modify financial statements
 If the R&D costs have a future service
potential, capitalize & subsequently amortize
expenditures on R&D; else, expense.
 When R&D costs are expensed


Effect on ROA should be examined
Look for volatility & growth
 Consolidate firms share of R&D project for
joint ventures & partnerships.
Chapter: 07
7
Software Development Costs
 Accounting:
 Until “technological feasibility” is achieved, all
costs incurred internally are expensed.
 On achieving “technological feasibility”


Capitalized
Additional costs are subsequently amortized
 Area of caution for Analyst: Computer
software development costs.
Chapter: 07
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Subsequent Expenditures for
Enhancement or Improvements
 Involves additional expenditure to add or
improve long-lived operating assets.
 Capitalize expenditures that increase
service life beyond the original life of the
asset.
 Expense repairs & maintenance to
maintain expected service potential.
 Management judgment in this area creates
opportunity for earnings management.
Chapter: 07
9
Costs of Self-Construction
 Cost of self-constructed asset = Fair Value
of all costs incurred to produce asset.
 Fair value includes materials, labor and
overhead (variable & fixed).
 If internal expenditure > Cost of acquiring
externally
 Amount = cost of external purchase
 Excess costs incurred are recorded as loss.
Chapter: 07
10
Interest Incurred to Self-Construct
Assets
 Avoidable interest :
 ‘Nil’ if a company has no debt
 Capitalized amount of annual interest
 Cannot exceed actual interest
 A component of Acquisition Cost
 Interest Expense = Actual interest –
Capitalized interest
Chapter: 07
11
Computation of Avoidable Interest
 Compute time weighted average
accumulated expenditures
 Interest computation


Interest on ‘accumulated expenditure to the extent of specific
borrowing’ is calculated using ‘specific borrowing’s interest
rate’ (a)
Interest on ‘excess of accumulated expenditure over and
above the specific borrowing’ is calculated using the
‘weighted average interest rate on other borrowings’ (b)
 Avoidable interest = (a) + (b)
Chapter: 07
12
Cost of Acquiring Natural Resources
Types of Costs
Acquisition
Costs
• Costs of
acquiring natural
resources
• Reclamation
cost or
restoration costs
Chapter: 07
Exploration
Costs
• Costs incurred to
discover the
existence &
location of natural
resource
Development
Costs
• Tangible costs
(capitalized)
• Intangible costs
(expensed)
13
Accounting for Exploration Costs
 Successful Efforts Method
 Cost of successful wells are capitalized as
assets; unsuccessful wells are expensed.
 Used by larger producers.
 Full Costing Method
 Costs of successful and unsuccessful wells
are capitalized.
 Used by smaller producers.
Chapter: 07
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Cost of Acquiring Natural Resources
for Analysts
 Analyst should consider the differential
treatment of exploration costs.
 Firms disclose the method in accounting
policies note to financial statements.
Chapter: 07
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Costs of Acquiring Intangible Assets
 U.S.GAAP & IFRS: Cost of internally
developing intangibles is expensed.
 Intangibles acquired in a business
combination have Fair values and are
capitalized.
 Most analysts prefer immediate expensing
of all intangible assets.
Chapter: 07
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Goodwill in Corporate Acquisition
 Acquiring firms allocate purchase price to
Step 1
The fair value of identifiable tangible
assets & liabilities
Step 2
Identifiable intangible assets
Step 3
Remainder is allocated to goodwill
Chapter: 07
17
Managers’ Choice of Acquisition
Costs Allocation
 Investing-like activities such as R&D,
pretechnological feasibility software costs
etc. are expensed.
 Managers make three primary choices:
 Choose an allocation method
 Estimated useful life and
 Estimated salvage value
Chapter: 07
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Managers’ Choice of Acquisition
Costs Allocation (Contd.)
 Throughout the life of the asset, book
value is tested for
 Impairment under U.S.GAAP & IFRS (for
intangible assets with indefinite life).
 Appreciation only under IFRS.
 Managers estimate bias reported earnings
 To report higher earnings, useful lives or
salvage value of assets are revised upward.
Chapter: 07
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Cost Allocation Methods
 Differences in Methods
US Firms (Statement No.109)
Other countries
Use accelerated methods
for tax purpose than for
financial reporting purposes
Accelerated method for
both tax and financial
reporting
 Analyst must restate the amounts.
 An addition to net income in the operating
section of cash flows.
Chapter: 07
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Cost Allocation Methods (Contd.)
Depreciation
Straight-line method or
accelerated method
Tangible assets
Amortization
Straight-line method
Intangible assets
Depletion
Natural resources
Chapter: 07
Straight-line method or
proportionate to
consumption
21
Market Value Vs. Book Value:
Impairment of Long-Lived Assets
U.S.GAAP
IFRS
• Record impairment if: • Impairment charge =
Carrying amount >
Book value – [Higher
Undiscounted cash
of (Fair Value less
flows from the asset
estimated costs to
• Impairment charge =
sell) or (Present value
Carrying Value – Fair
of estimated future
value
cash flows)]
Chapter: 07
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Market Value Vs. Book Value:
Impairment of Goodwill
U.S.GAAP
• Record impairment if:
Carrying amount > Fair
value of reporting unit
• Implied goodwill = Fair
value of reporting unit –
Fair value of identifiable
assets
Chapter: 07
IFRS
• Record impairment if:
Carrying amount >
Recoverable amount
(Higher of fair value or
sale)
• Implied goodwill = Fair
value of reporting unit –
Fair value of identifiable
assets
23
Long-Lived Assets
Upward revaluation
 U.S.GAAP does
not permit upward
revaluations
 IFRS allows
revaluation of both
tangible &
intangible longlived assets
Chapter: 07
Replacement
 Gain/loss on disposal or
sale or trade-ins is reported
in operating income
 Cash inflow from sale of
assets is reported in
investing section of cash
flow statement
 New assets must be
recorded at fair Value
24
Investment in Securities
Chapter: 07
25
Accounting for Minority Passive
Investments
 Initially record investments at acquisition
cost.
 Interest & Dividend received/receivable
each year are recorded as revenue.
Chapter: 07
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Accounting for Minority Passive
Investments (Contd.)
Classification of Securities
Debt
securities
Held-tomaturity
Debt & Equity
securities Trading securities
Debt & Equity
securities Available for sale
Firm has a
positive intent
& ability to
hold to
maturity.
Firm actively buys &
sells securities to take
advantage of shortterm differences in
market value.
Firms classify
securities that do not
fall into one of the
other two categories
as Available-for-sale.
Chapter: 07
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Accounting for Minority Passive
Investments (Contd.)
 Debt securities held-to-maturity
 At amortized cost.
 Difference between acquisition cost and
maturity value is an adjustment to interest
revenue (Effective Interest rate method).
 Fair values are disclosed in notes.
 Trading security
 Marked-to-market.
 Unrealized gain or loss: As a part of Net
Income.
Chapter: 07
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Accounting for Minority Passive
Investments (Contd.)
 Sale of security: Gain or loss (Selling Price
less Book Value) in Net Income.
 Available-for-sale
 Marked to market.
 Unrealized gain or loss: As a part of ‘other
comprehensive income’ (OCI).
 Sale of security:

Chapter: 07
Realized Gain or loss (Selling Price less Acquisition
Cost) on Income Statement.
29
Accounting for Minority Passive
Investments (Contd.)

Unrealized holding gain or loss is recognized in
current period OCI.
 “Other than temporarily impaired” securities
 Tested whether securities that experienced
unrealized losses are “other than temporarily
impaired”.
 Written down to fair value.
 Unrealized loss reported in net income.
Chapter: 07
30
Reporting Values of Minority, Active
Investments
 U.S.GAAP & IFRS- Equity method
 Balance Sheet at
 Acquisition cost +/- investor’s share of the net
income /loss – share of dividends.
 Income Statement at
 Pro rata share of investee income minus any
allocation cost of extra investment.
 Cash Flow Statement:
 Subtract share of earnings from net income and add
cash dividends.
Chapter: 07
31
Accounting for Minority, Active
Investments (Contd.)
 Implied Goodwill
 Related Party Transactions
 Sales, purchases, receivables & payables must
be disclosed in notes to financial statements.
 Profits arising from intercompany transactions
should be eliminated.
 Reported at acquisition cost in non-IFRS
statements.
Chapter: 07
32
Accounting for Majority, Active
Investments
 Accounting for corporate acquisitions -
SFAS 141,141R, 160 (FASB codification
topics 805 and 810) and IFRS 3.
 Consolidated financial statements are
prepared.
 Business combinations can be statutory
mergers and acquisitions- acquisition
method.
Chapter: 07
33
Accounting for Majority, Active
Investments (Contd.)
 Goodwill
 Measure the fair value of the consideration
transferred to acquire the company and the
fair values of the identifiable assets acquired,
liabilities assumed and noncontrolling interests
(if any).
 Assign any excess consideration to goodwill or
record a gain from a bargain purchase.
Chapter: 07
34
Consolidated Financial Statements at
the Date of Acquisition
 Investment in subsidiary.
 Subsidiary’s equity accounts.
 Individual assets & liabilities of subsidiary.
 Goodwill.
 Acquisition “Reserves”
 Management has some latitude in managing
earnings, given the estimates required to
establish reserves.
Chapter: 07
35
Consolidated Financial Statements
Subsequent to the Date of Acquisition
 Investment in subsidiary
 Subsidiary’s equity accounts
 Individual assets & liabilities of subsidiary
 Goodwill component to consolidated totals
 Related-party transactions eliminations
Chapter: 07
36
Noncontrolling Interests
 Arises if an investing firm acquires less
than 100% of another firm.
 Also termed as minority interest.
 Disclosure
 Income Statement: Is deducted from the net
income of the parent.
 Balance Sheet: A component of shareholders’
equity of the parent.
Chapter: 07
37
Noncontrolling Interests (Contd.)
 Subsidiary’s fair value less book value at
the date of acquisition is allocated to
identifiable assets and to goodwill.
 Fair value amortization must be reflected in
consolidated net income each year.
 Tax effect adjustment is not necessary for
noncontrolling interest as it is an after-tax
net income.
Chapter: 07
38
Corporate Acquisitions and Income
Taxes
 The acquired company does not restate its
assets & liabilities for tax purpose.
 The tax basis of assets & liabilities of the
acquired company before acquisition
carries over after the acquisition called
nontaxable reorganization.
 Deferred taxes would be recognized, as a
difference between fair and book values.
Chapter: 07
39
Consolidation of Unconsolidated
Subsidiaries and Affiliates
 Companies do not consolidate the financial
statements of joint ventures or minorityowned affiliates.
 Under U.S.GAAP firms use the equity
method to account for joint ventures.
 IFRS permits use of proportionate
consolidation for joint ventures.
Chapter: 07
40
Special-Purpose or Variable-Interest
Entity (VIE)
 Can be a corporation, partnership, trust or
any other legal structures for business
purpose.
 May be passive or active.
 The sponsoring firm would not consolidate
a VIE under the percentage of ownership
criterion.
 Also called a bankruptcy remote entity.
Chapter: 07
41
Consolidating VIE
 Firm must consolidate if it is the primary
beneficiary of the VIE.
 FIN 46R- Firm is primary beneficiary if it has
 The direct or indirect ability to make decisions about
the entity’s activities.
 The obligation to absorb the entity’s expected losses
if they occur.
 The right to receive the entity’s expected residual
returns if they occur.
Chapter: 07
42
Income Tax Consequences of
Investment in Securities
 For income tax purposes, investments fall
into two categories.
 Investments in debt securities, preferred stock,
and in less than 80% of the common stock.

Interest or dividends, gains or losses- taxable
income.
 Investments in 80% or more of the common
stock.

Chapter: 07
Consolidated tax returns are prepared.
43
Foreign Currency Translation
 Types of Foreign Entities
 A foreign entity operates as a self-contained &
integrated unit (All current method)
 The operations of a foreign entity are a direct
& integral extension of the parent company’s
operations (Monetary/Non-monetary
methods).
 Exception to these guidelines – U.S.GAAP
 If the foreign entity operates in a highly
inflationary country (FASB Statement No.52).
Chapter: 07
44
Translation Methodology-Foreign
Currency is the Functional Currency
Income
Revenues & expenses are translated
Statement at average exchange rate.
Income includes realized translation
gains & losses on sale of foreign unit
Balance
Assets & liabilities are translated at
Sheet
end-of-period exchange rate.
Unrealized translation adjustment is
included in other comprehensive
income
Chapter: 07
45
Translation Methodology-Foreign
Currency is the Functional Currency
 “Translation adjustment” is a component of
other comprehensive income & includes:
 Effect of exchange rate changes on the
parent’s equity investment in subsidiaries.
 Change in fair value of a derivative (Firms
hedge their foreign operations).
Chapter: 07
46
Translation Methodology-U.S. Dollar
is the Functional Currency
 Firms must use the Monetary or Non-
monetary translation method.
 Monetary items include cash, marketable
securities, receivables, accounts payable,
short-term & long-term debt.
 Nonmonetary items include inventories,
fixed assets, common stock, revenues and
expenses.
Chapter: 07
47
Translation Methodology-U.S. Dollar
is the Functional Currency
Income
Statement
Balance
Sheet
Chapter: 07
Revenues & Expenses are translated
at average exchange rate.
Cost of goods sold & depreciation are
translated using historical exchange
rate.
Monetary assets & liabilities are
translated at end-of-period exchange
rate. Non-monetary assets & equities
using historical exchange rate.
48
Foreign Currency Translation and
Income Taxes
 Branch of US parent
 Use all-current or monetary/non-monetary
translation method as appropriate.
 Subsidiary of US parent
 Dividends received are translated at exchange
rate on date of remittance.
Chapter: 07
49
Analyst Adjustments
 Whether to include change in the foreign
currency translation account in earnings or
in other comprehensive income?
 Analyst should consider how changes in
exchange rates affect changes in sales
levels, sales mix, and net income.
Chapter: 07
50
Analyst Adjustments (Contd.)
 To swing the balance of factors towards
use of foreign currency, management may:
 Decentralize decision making to foreign unit.
 Minimize remittances or dividends.
Chapter: 07
51