Accounting & Financial Reporting
BUSG 503
Michael Dimond
Let’s review…
• Exercises E7-27, 28, 29, 32, 33 & 37
Michael Dimond
School of Business Administration
E7-27
•
•
•
•
a.
DuPont reports its equity method investments at adjusted cost, not fair value.
Adjusted cost is the purchase price of the investment, plus DuPont’s proportionate share of
the investees’ profits or losses, and less dividends received from the equity-method
investees.
b.
The equity of the affiliated companies is $1,884 million (assets of $3,369 million –
liabilities of $1,485 million = $1,884 million). DuPont’s investment balance of $1,041 million
is 55%, on average, of the $1,884 million net equity of the investee companies. DuPont
does not control these investments (or they would be consolidated) and thus, must own less
than 50% of the voting common shares. Some of the excess relates to advances Dupont
has made to equity investee companies and some may result from DuPont paying more
than book value for some of the investments.
c.
Once the stockholders’ equity of the investee company reaches zero, the investor
must discontinue accounting for the investment by the equity method. Instead, it accounts
for the investment at cost with a zero balance and no further recognition of its proportionate
share of the investee company losses. In this case, the investor’s income statement no
longer includes the losses of the investee company and its balance sheet no longer reports
the troubled investee company.
The cessation will create a number of analysis problems. Unreported liabilities may be
particularly problematic in this case. As the investee continues to report losses, DuPont will
not report this. As well, continued losses may compel DuPont to advance more cash to the
investee. This will be reported on the balance sheet as an investment in the equity-method
company, which may be misleading.
Michael Dimond
School of Business Administration
E7-28
•
•
•
Cummins reports these equity method investments on its balance sheet at $734 million.
Consequently, Cummins’ balance sheet reports net assets of only $734 million and, importantly,
none of the liabilities of the investee companies. The lack of full reporting of the investees’ assets
and liabilities fails to present a clear picture of the capital investment required to conduct
Cummins’ business or the financial leverage inherent in its operations, even though its accounting
is in conformity with GAAP.
Although Cummins is not directly obligated for the debts of these unconsolidated affiliates (unless
it has legally guaranteed those debts), if the affiliates were to fail, would Cummins have to invest
additional capital to support it? Probably not, from a strictly legal standpoint. Yet, if this
investment is necessary for Cummins’ strategic plan, it might find it difficult to arrange future
ventures of this type if it does not support the failing investee. This means that there can be an
effective liability even when no legal liability exists. Analysts can, of course, replace the equity
investment with the assets and liabilities to which it relates (pro forma consolidation for analysis
purposes) if they feel consolidated numbers better represent the company’s balance sheet and
income statement.
The equity method reports only Cummins’ proportion of the affiliated companies’ equity and
Cummins’ proportion of the affiliated companies’ earnings. As a result, the equity method,
arguably, omits assets and liabilities from the face of Cummins’ balance sheet, and omits sales
and expenses from the income statement (compared with the assets, liabilities, sales and
expenses that would be recorded with consolidation). Net income and stockholders’ equity are the
same whether the equity method or consolidation is used so ROE is the same. But, net operating
profit margin and net operating asset turnover are likely biased upward and biased downward,
respectively (due to the omission of assets and sales).
Michael Dimond
School of Business Administration
E7-29
•
a.
The trading investments will be reported at $225,300. This is computed from
year-end fair values: $65,300 + $160,000= $225,300.
• b.
The available for sale investments will be reported at $346,700. This is
computed using year-end fair values: $192,000 + $154,700= $346,700.
• c.
The equity method investments will be reported at $236,000. This is
computed using the year-end equity method values (since no information is
available on any dividends or income for those companies): $100,000 +
$136,000= $236,000.
• d.
Unrealized holding losses of $5,200 will appear in the current year’s income
statement. These losses relate to the trading securities; specifically— Barth:
$68,000 - $65,300 = $2,700; Foster: $162,500 - $160,000 = $2,500; total of
$2,700 + $2,500 = $5,200 in unrealized losses reported in income.
• e.
(i)
Unrealized holding losses of $7,300 will appear in the stockholders'
equity section of the December 31 balance sheet as Accumulated Other
Comprehensive Income (AOCI). These losses relate to the available for sale
securities; specifically— McNichols: $197,000 - $192,000 = $5,000; Patell:
$157,000 - $154,700 = $2,300; total of $5,000 + $2,300 = $7,300 in unrealized
losses reported in stockholders' equity.
(cont’d)
Michael Dimond
School of Business Administration
E7-29, cont’d
•
•
•
•
•
e.
(ii)
Unrealized holding losses of $5,200 will be included in retained
earnings on the December 31 balance sheet. These losses relate to the trading
securities; specifically— Barth: $68,000 - $65,300 = $2,700; Foster: $162,500 $160,000 = $2,500; total of $2,700 + $2,500 = $5,200.
(iii) Total unrealized holding losses in equity of $12,500—totals of (i) & (ii)
f.
(i)
A fair-value adjustment to available-for-sale investments of $7,300
will appear in the December 31 balance sheet. See part (e) for the supporting
computations. The fair-value adjustment decreases the book value of the
available for sale securities to their year end fair value.
(ii) A fair-value adjustment to trading investments of $5,200 will appear in the
December 31 balance sheet. See part (e) for supporting computations. The fairvalue adjustment decreases the book value of the trading securities to their year
end fair value.
(iii) Total fair-value adjustment on the balance sheet is $12,500—totals of (i) &
(ii).
Michael Dimond
School of Business Administration
E7-32
Healy
Consolidating
adjustments Consolidated
Miller
Current assets ................. $1,700,000
Investment in Miller ........
500,000
Plant assets, net .............. 3,000,000
Goodwill ...........................
Total assets...................... $5,200,000
$120,000
$530,000
$1,820,000
0
3,425,000
45,000
$5,290,000
Liabilities .......................... $ 700,000
Contributed capital ......... 3,500,000
Retained earnings ........... 1,000,000
Total liabilities &
$5,200,000
stockholders’ equity ......
$ 90,000
400,000
40,000
$ 790,000
3,500,000
1,000,000
.
410,000
.
$530,000
$(500,000)
15,000
45,000
(400,000)
(40,000)
$5,290,000
Michael Dimond
School of Business Administration
E7-33
Rayburn
Consolidating
adjustments Consolidated
Kanodia
Investment in Kanodia ..... $ 600,000
Other assets ....................... 2,300,000 $700,000
Goodwill..............................
Total assets ........................ $2,900,000 $700,000
.
.
Liabilities ............................ $ 900,000 $160,000
Contributed capital ........... 1,400,000 300,000
Retained earnings .............
600,000 240,000
Total liabilities &
stockholders’ equity ....... $2,900,000 $700,000
$(600,000)
20,000
40,000
(300,000)
(240,000)
$
0
3,020,000
40,000
$3,060,000
$1,060,000
1,400,000
600,000
$3,060,000
Michael Dimond
School of Business Administration
E7-37
a.
Cash paid...................................................................
Fair value of shares issued .....................................
Purchase price ..........................................................
Less: Book value of Harris ......................................
Excess payment........................................................
Excess payment assigned to specific
accounts based on fair value:
Buildings ..............................................................
Patent ....................................................................
Goodwill................................................................
Total excess payment ..............................................
$210,000
180,000
390,000
280,000
$110,000
$ 40,000
30,000
40,000
$110,000
b.
Easton,
Co.
Cash
$
Harris
Co.
84,000
Consolidation Consolidated
Entries
Totals
$ 40,000
$ 124,000
Receivables
160,000
90,000
250,000
Inventory
220,000
130,000
350,000
Investment in
Harris
Land
Buildings, net
390,000
100,000
400,000
60,000
110,000
Equipment, net
120,000
50,000
Patent
(390,000)
-
40,000
160,000
550,000
170,000
-
-
30,000
30,000
Goodwill
Totals
$1,474,000
$ 480,000
40,000
40,000
$1,674,000
Accounts payable
Long-term
liabilities
$ 160,000
$ 30,000
$ 190,000
380,000
170,000
550,000
Common stock
Additional paid-in
capital
Retained earnings
500,000
40,000
74,000
-
360,000
240,000
$1,474,000
$ 480,000
Totals
(40,000)
c.
The fair-value adjustment to fixed
assets will be depreciated over the assets’
estimated useful lives. The patent will be
amortized over its useful life. Finally, intangible
assets with an indeterminate useful life (such as
goodwill) are not amortized, but are tested
annually for impairment or more often if
circumstances require.
500,000
74,000
(240,000)
360,000
$1,674,000
Michael Dimond
School of Business Administration
Current liabilities
• Operating
– Accounts payable - Obligations to
others for amounts owed on
purchases of goods and services;
these are usually non-interestbearing.
– Accrued liabilities - Obligations
with no related external
transaction in the current period
(e.g. accruals for employee
wages and taxes, accruals for
other liabilities such as rent,
utilities, and insurance.
• Non-operating
– Short-term interest-bearing loans
- Short-term bank borrowings and
notes expected to mature in
whole or in part during the
upcoming year; this item can
include any accrued interest
payable.
– Current maturities of long-term
debt - Long-term liabilities that
are scheduled to mature in whole
or in part during the upcoming
year.
Michael Dimond
School of Business Administration
Verizon’s current liabilities
Michael Dimond
School of Business Administration
Useful ratios for managing accounts payable
•
How do these relate to the inventory & receivables ratios we computed
previously?
Michael Dimond
School of Business Administration
Warranties and other contingent liabilities
•
•
•
A contingent liability is a potential liability whose occurrence and/or ultimate
amount is dependent upon a future event.
If the obligation is probable and the amount estimable, then a company will
recognize this obligation.
If only one of the criteria is met, the contingent liability is disclosed in the
footnotes.
Michael Dimond
School of Business Administration
Current non-operating liabilities
•
•
•
Short-term bank loans (including the accrual of interest)
Current maturities of long-term debt – long-term liabilities that are scheduled to
mature on whole or in part during the upcoming 12 months are reported as a
current liability.
Companies generally finance seasonal swings in working capital with a bank line
of credit.
Michael Dimond
School of Business Administration
Example: Notes payable
Michael Dimond
School of Business Administration
Bonds
• Bonds are long-term debt
contracts used to raise capital
• Bonds are denominated in a
set amount (most U.S.
corporate bonds are $1,000)
and can be bought and sold
in a secondary market
• The bond indenture specifies
the terms of the bond,
including the rights and
duties, the amounts and
dates involved, standard debt
provisions and restrictive
covenants.
Michael Dimond
School of Business Administration
Bonds: Linking terminology to TVM functions
•
•
•
•
•
PV = Price
FV = Face Value (also called “Par Value.” Usually $1,000)
n = Periods (usually semiannual)
i = Yield
PMT = Coupon Payment
• The Coupon Rate is only used to determine the coupon
payment. For example, a 10% coupon rate on a $1,000 bond
would give a $100 annual payment, which would be $50
semiannually.
• NOTE: If you do not have a financial calculator, there are
tables in the appendix to compute PV & FV
Michael Dimond
School of Business Administration
Bond pricing, yields, etc.
• Bond terminology is what gives most students problems.
Sometimes you need to make assumptions based on how
the question is worded.
• Here’s a typical sort of a bond question:
• XYZ Company has a 10% bond with semiannual payments which matures in
12 years. The market rate for bonds of this risk is currently 8%. What is the
price of this bond?
• The key to solving a question like this is to identify the
relevant information and organize it:
•
•
•
•
•
PV = Price = Unknown. This is what we are solving for.
FV = Face Value = Not stated, so we assume $1,000.
n = Periods = Semiannual for 12 years. 12 x 2 = 24, :. n = 24.
i = Yield = Return demanded ÷ Periods per year = 8% ÷ 2 = 4% semiannual
PMT = Coupon Payment = FV x Coupon Rate ÷ Periods per year = 1,000 x
10% ÷ 2 = 50, :. PMT = 50. The expression “10% bond” means a bond with a
10% coupon annual rate.
Michael Dimond
School of Business Administration
Bond pricing, yields, etc.
• Entering this information in a financial calculator lets us find
an answer.
•
•
•
•
•
•
PV = Price = Unknown. This is what we are solving for.
FV = $1,000.
n = 24 semiannual
i = 4% semiannual
PMT = 50 semiannual
Solve for PV = -1,152.4696
• Notice n, i and PMT are all semiannual values. These must
all be in the same scale: Annual, semiannual, etc.
• The answer appears negative because it is a cash outflow.
The price will be $1,152.47
• Here’s another bond question:
• XYZ Company has a 10% semiannual bond which matures in 12 years and is
selling for $1,050. What is the yield of this bond?
Michael Dimond
School of Business Administration
Bond pricing, yields, etc.
• Let’s try another. Entering this information in a financial
calculator lets us find an answer, but it will be a semiannual
answer.
•
•
•
•
•
•
PV = -1,050 (remember, the price is a cash outflow, so it has a minus sign)
FV = 1,000
n = 24 semiannual
i = Unknown. This is what we are solving for.
PMT = 50 semiannual
Solve for i = 4.6499%
• Remember, n, i and PMT are all semiannual values. The
result the calculator gives is the semiannual interest rate. To
annualize it, multiply it by 2:
• Yield = 2 x semiannual i = 2 x 4.6499% = 9.2998%
Michael Dimond
School of Business Administration
Bond pricing, yields, etc.
• Here’s one more:
• XYZ Company has a 10% bond with semiannual payments which matures in
12 years and is selling for $1,000. What is the yield of this bond?
• In this case, the price and the face value are both 1,000. This
means the bond is selling at par, which means the yield will
equal the coupon rate (10%). To test this:
•
•
•
•
•
•
PV = -1,000
FV = 1,000
n = 24 semiannual
PMT = 50 semiannual
Solve for i = 5.0000% semiannual
Yield = 2 x semiannual i = 2 x 5.0000% = 10%
Michael Dimond
School of Business Administration
More about bonds
• Provisions of bonds
• Convertability: A conversion feature allows bondholders to exchange the bond
for a certain number of shares of stock.
• Callability: A call feature allows the bond issuer to repurchase the bonds
before they mature (for a premium above the face value)
• Warrants: A “sweetener” which allows the bondholders to purchase a certain
number of shares of stock at a specific price & time.
• Current Yield vs Yield to Maturity vs Yield to Call
• Current Yield: Annual Payment ÷ Price
• YTM: Solve for i using the number of periods until the bond matures
(remember to annualize if appropriate)
• YTC: Solve for i using the number of periods until the bond can be called
(remember to annualize if appropriate)
Michael Dimond
School of Business Administration
Bond ratings are driven by financial indicators
Michael Dimond
School of Business Administration
Which drivers matter the most for bond ratings?
Michael Dimond
School of Business Administration
For next week…
• Ch 8 Exercises 8-31, 32
• Prepare for Exam #2
• The following week we will begin chapter 9 and also start
some minicases to prepare you for the final case in week 15
Michael Dimond
School of Business Administration
E8-31 (25 minutes)
a. Selling price of bonds
Present value of principal repayment ($250,000  0.41552) ..............$103,880
Present value of interest payments ($10,000  11.68959) ................. 116,896
Selling price of bonds............................................................................$220,776
Calculator inputs: N =18, I/YR = 5, PMT = 10,000, FV = 250,000,
PV = 220,776.03
b.
Balance Sheet
Transaction
0,776
220,776
h
Cash
Asset
1. Issue
$250,000, 8%
bonds to yield +220,776
(1)
Cash
10%
+
Income Statement
Noncash
LiabilContrib.
Earned
=
+
+
Assets
ities
Capital
Capital
+220,776
= Long-Term
Revenues
–
Expenses
–
=
Net
Income
=
Debt
D
220,776
1,039
1,039
10,000
2. Pay interest –10,000
(2)
Cash
on June 30
D
+1,039
= Long-Term
Debt
–11,039
Retained
Earnings
–
+11,039
Interest
Expense
=
–11,039
1,039
h
10,000
1,091
1,091
10,000
Michael Dimond
School of Business Administration
E8-32 (25 minutes)
a. Selling price of bonds
Present value of principal repayment ($800,000  0.20829) ............ $166,632
Present value of interest payments ($36,000  19.79277) ............... 712,540
Selling price of bonds.......................................................................... $879,172
Calculator inputs: N =40, I/YR = 4, PMT = 36,000, FV = 800,000,
PV = 879,171.10
b.
Balance Sheet
Transaction
9,172
879,172
h
D
Cash
Asset
1. Issue
$800,000, 9% +879,172
bonds to yield
Cash
(1)
8%
+
Noncash
=
Assets
Liabilities
+
Income Statement
Contrib.
Earned
+
Capital
Capital
+879,172
= Long-Term
Revenues
–
Expenses
–
=
Net
Income
=
Debt
879,172
35,167
833
36,000
D
2. Pay interest –36,000
(2)
Cash
on June 30
–833
= Long-Term
Debt
–35,167
Retained
Earnings
–
+35,167
Interest
Expense
=
–35,167
h
36,000
35,134
866
36,000
3. Pay interest
on December –36,000
=
–866
–35,134
–
+35,134
=
Michael Dimond
School of Business Administration
–35,134
Michael Dimond
School of Business Administration