REPORTING REQUIREMENTS

1
REPORTING REQUIREMENTS

• Chapter 7

2
CHAPTER 7 OBJECTIVES

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

3
CHAPTER 7 OBJECTIVES (CONT.)

• Indicate how certain standards deviate from
  historical cost reporting and the all-inclusive
  concept of net income.
• Relate this chapters topics to the financial
  statements of Apple Computer, Inc. and other PC
  firms.

4
CHAPTER 7 OBJECTIVES (CONT.)

• Articulate how business maturation, industry
  factors, and the transition to the new economy
  influence reporting requirements and analytical
  considerations.

5
BUSINESS ACQUISITIONS

• One company (the acquirer) obtains control of
  another entity (the target)
• Rationaleenhance shareholder wealth through
• Larger market share
• Increased productivity
• Shared technologies
• Cost reductions

6
BUSINESS ACQUISITIONS (CONT.)

• Types of business acquisitions
• Parent-subsidiary relationshipone company
  purchases a majority of another entitys voting
  stock
• Mergeracquired company is dissolved and its
  assets are merged with those of the acquirer
• Business consolidationnewly formed entity is
  formed to incorporate assets of combining
  companies and the previously existing firms are
  dissolved

7
BUSINESS ACQUISITIONS (CONT.)

• Financial reporting requirements
• Purchase method of accountingGAAP for business
  acquisitions
• Targets accounts are revalued to fair value
• Goodwill is reported when the purchase price
  exceeds fair value of the acquired assets
• Goodwill is amortized over its productive life
• The FASB recently eliminated the pooling of
  interest method as an acceptable alternative to
  goodwill
• The FASB may eliminate goodwill amortization,
  unless the intangible asset is impaired

8
BUSINESS ACQUISITIONS (CONT.)

• Analytical implications
• Consolidated financial statements
• based on the economic entity assumption
• legally separate but economically combined
  entities report one set of financial statements

9
BUSINESS ACQUISITIONS (CONT.)

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

10
BUSINESS ACQUISITIONS (CONT.)

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

11
BUSINESS ACQUISITIONS (CONT.)

• Apple Computer acquired NeXT Software for 427
  million in 1997
• Apple co-founder Steven Jobs was CEO of NeXT
• 375 million of the purchase price was allocated
  to in-process research and development costs
• In-process RD was written off in the year of
  acquisition
• Apple reported 52 million of goodwill in
  acquiring NeXT

12
SECURITIES INVESTMENTS

• Instruments that demonstrate an economic interest
  in other entities
• Equity securityownership position in another
  company
• Debt securitycreditor relationship with a firm
  or government agency

13
SECURITIES INVESTMENTS (CONT.)

• Financial reporting requirements
• Investment revenuesreported on the income
  statement
• debt investments earn interest revenue (income)
• equity investments earn dividend revenue (income)
  

14
SECURITIES INVESTMENTS (CONT.)

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

15
SECURITIES INVESTMENTS (CONT.)

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

16
SECURITIES INVESTMENTS (CONT.)

• Investments are either passive or active
• Passive investmentsinvestor does not
  significantly influence investees operations
• Passive investments consist of all debt and
  trading and available-for-sale equity investments
• Active investmentsinvestor significantly
  influences investees operations
• Active investments consist of active minority and
  majority equity investments

17
SECURITIES INVESTMENTS (CONT.)

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

18
SECURITIES INVESTMENTS (CONT.)

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

19
FOREIGN INVESTMENTS

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

20
FOREIGN INVESTMENTS (CONT.)

• Financial reporting requirements
• Two methods of consolidating majority-owned
  foreign investments
• Current rate methodtranslates foreign financial
  statements on the basis of current exchange rates
• Temporal methodremeasures foreign financial
  statements on the basis of both historical and
  current exchange rates

21
FOREIGN INVESTMENTS (CONT.)

• Functional currencya foreign subsidiaries
  primary currency in conducting economic
  activities
• Functional currency determines which reporting
  method is used
• Current rate method is used if the foreign
  currency is the functional currency
• Temporal rate method is used if the dollar is the
  functional currency

22
FOREIGN INVESTMENTS (CONT.)

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

23
FOREIGN INVESTMENTS (CONT.)

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

24
FOREIGN INVESTMENTS (CONT.)

• Apple Computer reported four foreign subsidiaries
  in 1998
• Subsidiaries domestic currencies were their
  functional currencies
• The temporal method of conversion was used
• Apple reported cumulative adjustments to
  shareholders equity

25
RISK MANAGEMENT

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

26
RISK MANAGEMENT (CONT.)

• Financial Reporting Requirements
• Derivatives are financial tools that help
  companies manage risk
• A derivatives value is based on another
  resources worth (e.g., forward contracts on
  inventory)

27
RISK MANAGEMENT (CONT.)

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

28
RISK MANAGEMENT (CONT.)

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

29
RISK MANAGEMENT (CONT.)

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

30
DEFERRED COMPENSATION ARRANGEMENTS

• Provides employees with future benefits for
  services rendered in current period, consisting
  of
• pension plans
• other post-retirement benefits
• corporate contributions to employees saving
  plans

31
DEFERRED COMPENSATION ARRANGEMENTS (CONT.)

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

32
DEFERRED COMPENSATION ARRANGEMENTS (CONT.)

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

33
DEFERRED COMPENSATION ARRANGEMENTS (CONT.)

• Analytical implications
• Defined benefit plans require detailed analysis
• Various components of retirement plans affect
  disclosures, including
• Service costs
• Pension liability
• Pension plan assets

34
DEFERRED COMPENSATION ARRANGEMENTS (CONT.)

• The rate of return on pension plan assets does
  not always equal growth in the pension liability
  pension expense deviates from normal service cost
  in such instances
• Plan funding
• Over fundedthe extent to which plan assets
  exceed plan liabilities
• Under fundedthe extent to which plan liabilities
  exceed plan assets

35
DEFERRED COMPENSATION ARRANGEMENTS (CONT.)

• Reporting examples and observations of defined
  contribution arrangements
• The PC industry reflects the new economy
• contribute to employees savings plans
• does not have defined benefit or contribution
  plans

36
DEFERRED COMPENSATION ARRANGEMENTS (CONT.)

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

37
DEFERRED TAXES (CONT.)

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

38
DEFERRED TAXES (CONT.)

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

39
DEFERRED TAXES (CONT.)

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

40
DEFERRED TAXES (CONT.)

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