GAAP Differences andThe Balance Sheet in

Detail

MIM 517Fall 2010Class 2

Learning Objectives

Exposure to real balance sheet complexity Overview of “more complex” line items Key GAAP differences

Gain familiarity with the footnotes

Lets consider what complex financial statements look like

U.S. Balance Sheet

Current Assets Cash & Equivalents Investment/Marketable

Securities Accounts Receivable net of

Allowance for Doubtful Accounts

Inventories Deferred income taxes Other current assets Total current assetsLong term (equity) investmentsBuilding, Machinery, EquipLess: Accumulated DepreciationLandConstruction in ProgressGoodwillIntangible Assets Total Assets

Current Liabilities Accounts payable Accrued expenses Deferred revenue Current portion LTD Total current liabilitiesDeferred income taxesLong Term Debt Total LiabilitiesStockholders’ Equity Common Stock Preferred Stock APIC Retained Earnings Accumulated other

comprehensive income Minority interest Total Stockholders’

equity Total Liab’s & SE’s equity

Accounts Receivable

What does “Net of Allowance for Doubtful Accounts” mean?

Why is AR presented at net realizable value?

NRV involves an estimate Problem 2.13

Inventory

Recorded at cost US: FIFO, LIFO or weighted average IFRS: LIFO prohibited Value at lower of cost or market

Revaluation of inventory If there is an other than temporary decline in

value, inventory must be “written down” Subsequent recovery of value

U.S. may not write back up IFRS may reverse write-down

Inventory continued Ex: Have 3 items in inventory, sell one for $20.

Cost Item 1: $8Cost Item 2: $9Cost Item 3: $10

(1) Under LIFO, what is Net Income?(2) Under FIFO, what is Net Income?(3) Tax consequence? Assume 40% rate.

In times of rising prices, LIFO results in lower NI

Comparability of LIFO vs. FIFO companies. Difference in COGS, Net Income and Inventory Use LIFO reserve to adjust

Deferred Income Taxes

Only occurs if companies have different rules for tax and book accounting

Reconciles tax liability per IRS to book tax expense on I/S. See example on pg. 56-57 for mechanics

Is NOT “taxes payable” U.S. and IFRS similar

Deferred Income Taxes

Deferred Tax Asset: Tax liability per IRS > book tax expense on I/S Commonly due to operating loses and tax

credit carry forwards, or non-cash expenses such as warranty or bad debt write offs.

Deferred Tax Liability: Tax liability per IRS < book tax expense on I/S Commonly due to differences in depreciation

for fixed assets or for receivables growth.

Deferred Income Taxes

Consider Starbucks.1. How are deferred tax assets and deferred

tax liabilities reported at year end?2. Where did you find this information?3. What transactions drove the deferred

taxes?

Accounting for Ownership in Other Companies

Why do companies invest in the securities (stock) of other companies?

U.S. & IFRS Substantially similar treatment, but IFRS does not

use strict % guidelines U.S. generally based upon ownership %

< 20% use Fair Value (Mark-to-Market) Accounting

20% to 50% use Equity Method > 50% use Consolidation accounting

Accounting for Ownership in Other Companies

What is “control”? “The son of HP co-founder William Hewlet

called Carly Fiorina, HP’s chief executive at 10am to say he and his family would publicly oppose the proposed $20 Billion takeover of Compaq Computer Corp…leaving HP’s executives, lawyers and bankers scrambling to do damage control. The Hewlett family and related trust and foundation hold 5% of HP” (WSJ 11/9/01)

Accounting for Ownership in Other Companies: Non-controlling interest

< 20% of debt or equities in other companies Held-to-maturity:

Record debt securities at cost and don’t revalue “Fair value” or “Mark to Market”

Trading: Debt & equities intended to sell. Show at Fair Value in B/S. Unrealized holding gains and

losses are included in income Available for Sale:

All others. Show at Fair Value in B/S. Unrealized holding gains and

losses are included in equity (and comprehensive income) in US but can be included in income under IFRS

Dividends received from investee are added to NI of investor

Accounting for Ownership in Other Companies: Fair Value Method

Example: on 1/1/09 Big company bought shares of Little Company for $100,000. The shares were < 20% of the total outstanding stock of Little Company. On 12/31/09 the shares had a fair value of $125,000. Little had Net Income of $80,000 and dividends of $1000 were paid to Big.

How is this accounted for in the financial statements at 1/1 and 12/31?

If classified as Trading Securities?

If classified as Available for Sale Securities?

Does the Net Income of Little Company get recorded in the books of Big Company?

Accounting for Ownership in Other Co’s: Fair Value Method

Consider Starbucks: 1. How much did Starbucks have in

Available-for sale and trading securities at the end of 2009? Where did you find this?

2. How much unrealized holding gain or loss did Starbucks report for each in 2009? Where would you find this?

Accounting for Ownership in Other Co’s: Fair Value Method

Issues with Fair Value Method How is “fair value” determined?

Level 1: active market Level 2: observable market data other than

quoted market price Level 3: determined only through

“unobservable inputs” and prices based on internal models or estimates

Relevance/Reliability trade-off Classification of Trading vs. AFS

Accounting for Ownership in Other Co’s: Equity Method

Equity Method 20% to 50% Assumed to be “significant influence” unless

evidence to contrary Accounting

Record asset of “Investment in XYZ” Each year investor’s investment increases by share of

investee’s N/I & decrease by dividends received (i.e., share of N/I retained in company)

No adjustment to revalue to market

Accounting for Ownership in Other Co’s: Equity Method

Example: on 1/1/09 Big company bought shares of Little Company for $100,000. The shares were 40% of the total outstanding stock of Little Company. On 12/31/09 the shares had a fair value of $125,000. Little had Net Income of $80,000 and dividends of $1000 were paid to Big.

How is this accounted for in the financial statements at 1/1 and 12/31?

Is the market value at 12/31 relevant?

Accounting for Ownership in Other Co’s: Equity Method

Consider Starbucks: 1. How much did Starbucks have in Equity

Investments at the end of 2009? Where did you find this?

2. What companies were included as equity investees at 9/27/09? Where did you find this?

3. What are the Cost investment? Why are they accounted for at cost rather than fair value?

Accounting for Ownership in Other Companies: Consolidation Method

Consolidation Methods Generally > 50% Full Consolidation accounting

Idea: “Smoosh together” B/S and I/S Mechanics

Eliminate intercompany transactions Eliminate investment account in subsidiary Parent and Sub: Add together assets and liabilities on B/S

and NI Back out Minority owners’ share:

B/S: record “Minority Interest” of assets in equity section

I/S: subtract “Minority Interest” share of NI on I/S

Accounting for Ownership in Other Companies: Equity vs. Consolidation

Implications for Analysis What is “Minority Interest”?

Balance Sheet Equity Method

Ownership share of investee’s net assets included as one line in called Investment in XYZ

Thus Investment in XYZ excludes the proportion “claimed” by the minority shareholders

Consolidation Assets and liabilities include portion “claimed” by minority

owner Minority owner’s share included as one line in equity

How is a 100% Acquisition or Merger Accounted For?

US and IFRS use Purchase Accounting Accounting

Assets and liabilities of acquired co. revalued to FMV Difference between purchase price and FMV net assets

= Goodwill Example:

Purchase company w/ net assets of $40m for $100m. Fair market value of identifiable assets $75m What is goodwill? Does this include brand valuation?

Goodwill is subject to annual impairment test

Consider Starbucks Acquisitions

Other Goodwill Issues

Value of GW in US at 1600 largest public companies estimated to be $1 trillion (KPMG, 2009)

What does an impairment signal (if anything?)

Plant, Property & Equipment (PP&E)

Basis US: Historical cost

Asset may understate economic value Capital intensive co w/ old PPE: overstate ROA

IFRS: Revaluation is permitted if can be reliably est

Depreciation: US: Generally straight line for financial and

accelerated for tax IFRS: Any “acceptable” method reflecting economic

life Impairment

Write-down based on PV of estimated net future cash flows

PPE under IFRS in detail

IAS 16 allows a choice in accounting model: Cost model: The asset is carried at cost less

accumulated depreciation and impairment; or Revaluation model: The asset is carried at fair value

If revaluation model is used, revaluations must be performed regularly to ensure asset’s carrying value equals it’s fair value.

In addition, IAS 16 requires components of an asset with different benefit patterns to be depreciated separately.

Scenario: a company purchases an asset for $100k, with a useful life of 10 years and no estimated residual value. At the beginning of year 2, the company estimates the fair value of the asset to be $110k. What is the carrying value of the asset at the end of year 2 under US GAAP and IFRS?

PP&E US GAAP

IFRS Comments

Cost – beg of year 1 $100,000

$100,000

Less: depreciation (10,000)

(10,000)

Carrying value – end of year 1

$90,000 $90,000

Carrying value – beg of year 2

$90,000 $110,ooo $20,000 other comp income

Less: depreciation (10,000)

*(12,222)

*$110,000 / 9 years

Carrying value – end of year 2

$80,000 $97,778 Subject to revaluation!

Scenario: For the same company in the previous scenario, revenues for year 1 and 2 are $200k and $300k respectively. Assuming all other expenses are the same, what is the difference in net income in each year under US GAAP and IFRS?

Income Statement US GAAP

IFRS Comments

Revenue – year 1 $200,000

$200,000

Less: depreciation expense

(10,000)

(10,000)

Net income – year 1 $190,000

$190,000 No difference

Revenue – year 2 $300,000

$300,ooo

Other comprehensive income

- 20,000 From revaluation

Less: depreciation expense

(10,000)

(12,222)

Net income – year 2 $290,000

$307,778 $17,778 difference!

Intangibles

Definition Identifiable non-monetary asset lacking physical

substance Common Intangibles

Purchased Goodwill Patents, Copyrights, Trademarks Franchises Brands Research and Development Expenditures In-Process R&D (After Dec. 2008)

Purchased as part of a business combination Capitalize as indefinite life Write off if project abandoned or amortize over revenue stream

Accounting for Intangibles US:

Internally developed: expensed when incurred

Exception: direct response advertising can be capitalized

Purchased: capitalized Limited life: amortize over expected useful life Unlimited: subject to annual impairment test

IFRS: Differences

Intangibles revalued to fair value if active market Internal research expenditure: expensed as

incurred Internal development expenditure: capitalized

Leases U.S. and IFRS treatment similar

Capital lease gets treated as a financed purchased of a long-term asset Lessee – Books lease as asset, and value of

future lease payments as liability Lessor – Records receivable & income and

removes equipment from balance sheet.

Operating lease gets treated like a rental Lessee – Rent expense Lessor – Rent income

Lease Classification

Is a Capital lease if non-cancelable and meets one of the following: Transfer of ownership Bargain Purchase Option Lease term is ≥ 75% of economic life NPV of future payments ≥ 90% of current

FMV

Capital leases tend to be less desirable for lessees, and more desirable for lessors

Operating Lease

Why lessees prefer operating leases: No liability on books for future rental

payments Results in more favorable debt-to-equity

relationships or due to debt covenants Is a form of off-balance-sheet financing Only footnote disclosure required for all

non-cancelable operating leases > 1 year.

Operating Leases

Does this treatment seem to fairly reflect the substance of the lease transaction?

Impact of proposed change in accounting for leases?

Consider Starbucks1. Where are Starbucks operating lease

commitments shown?2. How would the change in lease accounting

impact Starbucks’ financial statements?

Retirement Benefits

US and IFRS: Liability accrued on projected benefits

Japan: Pay as you go Liability is understated Example: If the “playing field was

leveled” (Morgan Stanley Study cited in WSJ 4/26/99)

Mitsubishi Motors 1996 profit of $100.5 million would have been a $127.3 million loss

Mazda’s 1996 $152.4 million loss would have widened to $371.0 million.