REPORTING
REQUIREMENTS
Chapter 7
CHAPTER 7 OBJECTIVES
Identify the basic reporting requirements for
business acquisitions, security investments,
foreign investments, risk management,
deferred compensation arrangements, and
deferred taxes.
 Understand the primary analytical
implications for each of the six topics
addressed in this chapter.

CHAPTER 7 OBJECTIVES
(CONT.)
Indicate how certain standards deviate
from historical cost reporting and the
all-inclusive concept of net income.
 Relate this chapter’s topics to the
financial statements of Apple Computer,
Inc. and other PC firms.

CHAPTER 7 OBJECTIVES
(CONT.)

Articulate how business maturation,
industry factors, and the transition to
the new economy influence reporting
requirements and analytical
considerations.
BUSINESS ACQUISITIONS
One company (the acquirer) obtains
control of another entity (the target)
 Rationale—enhance shareholder wealth
through

Larger market share
 Increased productivity
 Shared technologies
 Cost reductions

BUSINESS ACQUISITIONS
(CONT.)

Types of business acquisitions



Parent-subsidiary relationship—one company
purchases a majority of another entity’s voting
stock
Merger—acquired company is dissolved and its
assets are merged with those of the acquirer
Business consolidation—newly formed entity is
formed to incorporate assets of combining
companies and the previously existing firms are
dissolved
BUSINESS ACQUISITIONS
(CONT.)

Financial reporting requirements






Purchase method of accounting—GAAP for
business acquisitions
Target’s accounts are revalued to fair value
Goodwill is reported when the purchase price
exceeds fair value of the acquired assets
Goodwill is amortized over its productive life
The FASB recently eliminated the pooling of
interest method as an acceptable alternative to
goodwill
The FASB may eliminate goodwill amortization,
unless the intangible asset is impaired
BUSINESS ACQUISITIONS
(CONT.)
Analytical implications
 Consolidated financial statements

based on the economic entity assumption
 legally separate but economically combined
entities report one set of financial
statements

BUSINESS ACQUISITIONS
(CONT.)
Analytical implications
 Goodwill—complicates analysis because
the account

Lacks a distinct, separate economic entity
 Represents a residual value (purchase price
less fair net asset values)
 Is amortized over time but that
amortization does not affect cash flows

BUSINESS ACQUISITIONS
(CONT.)

Reporting examples and observations of
business acquisitions
Firms tended to consolidate in the PC
industry as it matured in the 1990s
 Despite consolidation, industry remained
fragmented by 1998

BUSINESS ACQUISITIONS
(CONT.)

Apple Computer acquired NeXT Software for
$427 million in 1997




Apple co-founder Steven Jobs was CEO of NeXT
$375 million of the purchase price was allocated to
in-process research and development costs
In-process R&D was written off in the year of
acquisition
Apple reported $52 million of goodwill in acquiring
NeXT
SECURITIES INVESTMENTS
Instruments that demonstrate an
economic interest in other entities
 Equity security—ownership position in
another company
 Debt security—creditor relationship with
a firm or government agency

SECURITIES INVESTMENTS
(CONT.)
Financial reporting requirements
 Investment revenues—reported on the
income statement

debt investments earn interest revenue
(income)
 equity investments earn dividend revenue
(income)

SECURITIES INVESTMENTS
(CONT.)
Financial reporting requirements
 Realized gains and losses





Reported on the income statement
Arise when security investments are sold for more
or less than their reported value
Securities held at the end of a reporting period
(Exhibit 7-1)
Balance sheet classifications depend on


Type of security (debt or equity)
Management’s intent (length of expected
ownership)
SECURITIES INVESTMENTS
(CONT.)
Financial reporting requirements
 Unrealized gains and losses





The difference between fair value and cost or
previously reported fair value
Applies to trading and available-for-sale securities
Disclosed on income statement for trading
securities
Disclosed as part of shareholders’ equity for
available-for-sale securities
SECURITIES INVESTMENTS
(CONT.)

Investments are either passive or active




Passive investments—investor does not
significantly influence investee’s operations
Passive investments consist of all debt and trading
and available-for-sale equity investments
Active investments—investor significantly
influences investee’s operations
Active investments consist of active minority and
majority equity investments
SECURITIES INVESTMENTS
(CONT.)

Analytical implications
Investment revenues and realized gains
and losses reported after operating income
 Unrealized gain and loss treatment depend
on classification of security
 If reported on the income statement,
unrealized gains and losses increase
volatility of net income

SECURITIES INVESTMENTS
(CONT.)

Reporting examples and observations of
security investments
Apple Computer reported only availablefor-trading securities
 Changes in investments’ fair value reported
as part of shareholders’ equity
 No significant affect on income as a result
of securities investments

FOREIGN INVESTMENTS

Multinational enterprises
Source material, manufacture goods, and
sell products throughout the world
 GAAP requires multinational parent firms to
consolidate majority ownership positions in
foreign subsidiaries

FOREIGN INVESTMENTS
(CONT.)
Financial reporting requirements
 Two methods of consolidating majorityowned foreign investments

Current rate method—translates foreign
financial statements on the basis of current
exchange rates
 Temporal method—remeasures foreign
financial statements on the basis of both
historical and current exchange rates

FOREIGN INVESTMENTS
(CONT.)
Functional currency—a foreign
subsidiaries’ primary currency in
conducting economic activities
 Functional currency determines which
reporting method is used

Current rate method is used if the foreign
currency is the functional currency
 Temporal rate method is used if the dollar
is the functional currency

FOREIGN INVESTMENTS
(CONT.)

Analytical considerations
Translation method affects disclosures
 Remeasurement gains and losses
(temporal method) are reported on the
income statement
 The temporal method reports gains and
losses on a cumulative basis as part of
shareholders’ equity

FOREIGN INVESTMENTS
(CONT.)

Reporting examples and observations of
foreign investments
Apple, Compaq, Dell, and Gateway
 U. S. firms with international business
operations
 Global presence increased during the
period of analysis
 Increased globalization required greater
organizational structure and asset control

FOREIGN INVESTMENTS
(CONT.)

Apple Computer reported four foreign
subsidiaries in 1998
Subsidiaries’ domestic currencies were their
functional currencies
 The temporal method of conversion was
used
 Apple reported cumulative adjustments to
shareholders’ equity

RISK MANAGEMENT

Strategies and tactics
Used to reduce financial exposure inherent
in certain transactions
 Often
complex, creative, and risky
transactions

RISK MANAGEMENT (CONT.)

Financial Reporting Requirements
Derivatives are financial tools that help
companies manage risk
 A derivative’s value is based on another
resource’s worth (e.g., forward contracts
on inventory)

RISK MANAGEMENT (CONT.)

Traditional GAAP
Derivative transactions went unreported
(off-balance sheet)
 They were based on mutual promises (as
opposed to arms length transactions)


Current GAAP
Derivatives have economic value
 Reported at fair value on the balance sheet

RISK MANAGEMENT (CONT.)

Analytical Implications



Fair value adjustments reported on either the
income statement (gains and losses) or the
balance sheet (shareholders’ equity adjustments)
Market value adjustments increase the volatility of
earnings and shareholders’ equity
Credit risk—corporate exposure if the counter
party to a risk management transaction fails to
fulfill agreement
RISK MANAGEMENT (CONT.)

Reporting examples and observations of risk
management





New FASB was not in place until after 1998
Apple Computer engaged in transactions with an
exposure to risk
Notes payable were issued at fixed interest rates
Short-term security investments earned variable
interest rates
The company swapped fixed-rate debt for floatingrate debt
DEFERRED COMPENSATION
ARRANGEMENTS

Provides employees with future benefits
for services rendered in current period,
consisting of
pension plans
 other post-retirement benefits
 corporate
contributions to
saving plans

employee’s
DEFERRED COMPENSATION
ARRANGEMENTS (CONT.)

Defined contribution arrangements
Corporate contributions based on
predetermined formula (e.g., percentage of
employee earnings)
 The pension expense is relatively stable
over time (it equals an entity’s required
contributions)
 Employee benefits vary depending on the
earnings of defined contributions

DEFERRED COMPENSATION
ARRANGEMENTS (CONT.)

Defined benefit arrangements
Provide employees with set level of
benefits (e.g., based on years of service)
 The pension expense can vary from year to
year (actuarial assumptions affect it)

DEFERRED COMPENSATION
ARRANGEMENTS (CONT.)
Analytical implications
 Defined benefit plans require detailed
analysis
 Various components of retirement plans
affect disclosures, including

Service costs
 Pension liability
 Pension plan assets

DEFERRED COMPENSATION
ARRANGEMENTS (CONT.)
The rate of return on pension plan assets
does not always equal growth in the pension
liability; pension expense deviates from
normal service cost in such instances
 Plan funding



Over funded—the extent to which plan assets
exceed plan liabilities
Under funded—the extent to which plan liabilities
exceed plan assets
DEFERRED COMPENSATION
ARRANGEMENTS (CONT.)
Reporting examples and observations of
defined contribution arrangements
 The PC industry reflects the new
economy

contribute to employees savings’ plans
 does
not have defined benefit
contribution plans

or
DEFERRED COMPENSATION
ARRANGEMENTS (CONT.)

Apple Computer
Section 401(k) employee savings plan
 Matched employee contributions up to six
percent
 Stock options were another means of
providing compensation to employees

DEFERRED TAXES (CONT.)

Financial reporting requirements




Temporary differences--result because GAAP and
tax laws recognize revenues and expenses in
different reporting periods
A deferred tax account is the disparity between
the book value of an asset or liability (per GAAP)
and its tax basis
Deferred tax liability—future tax obligation
resulting from a temporary difference
Deferred tax asset—future tax savings resulting
from a temporary difference
DEFERRED TAXES (CONT.)

Analytical implications
The balance sheet reports one net current
deferred tax account (asset or liability)
 The balance sheet reports one net
noncurrent deferred tax account (asset or
liability)
 Classification of a deferred tax account as
current or noncurrent is based on the asset
(or liability) that created it

DEFERRED TAXES (CONT.)
Analytical implications
 Unique feature of deferred tax accounts

No predetermined life or finite payment
date (unlike most assets and liabilities)
 Current deferrals can more than offset
reversals of previous ones

DEFERRED TAXES (CONT.)

Reporting examples and observations of
deferred taxes




Apple Computer reported deferred tax current
assets and deferred tax noncurrent liabilities for
the years analyzed
Deferred tax current assets were stable over time
Deferred tax noncurrent liabilities decreased in the
later years of the study
Net operating losses in 1996 and 1997 created
deferred tax assets that offset deferred tax
noncurrent assets