Download BUSINESS COMBINATIONS

ANALYZING INTER CORPORATE
INVESTMENTS
INVESTMENT SECIRITIES
 Companies invest assets in investment securities
(also called marketable securities).
 Investment securities vary widely in terms of the type
of securities that a company invests in and the purpose
of such investment. Some investments are temporary
repositories of excess cash held as marketable
securities.
INVESTMENT SECIRITIES…
 Investment securities can be in the form of either debt
or equity.
 Debt securities are securities representing a creditor
relationship with another entity—examples are
corporate bonds, government bonds, notes, and
municipal securities.
 Equity securities are securities representing ownership
interest in another entity—examples are common stock
and nonredeemable preferred stock.
Debt Securities
 Debt securities represent creditor relationships with
other entities. Examples are government and
municipal bonds, company bonds and notes, and
convertible debt.
 Debt securities are classified as trading, held to
maturity, or available for sale.
 Accounting guidelines for debt securities differ
depending on the type of security.
Held-to-Maturity Securities.
 These are debt securities that management has both
the ability and intent to hold to maturity.
 They could be either short term (in which case they are
classified as current assets) or long term (in which case
they.
Trading Securities.
 Trading securities are debt (or no influential equity)
securities purchased with the intent of actively
managing them and selling them for profit in the near
future.
 Trading securities are current assets. Companies report
them at aggregate fair value at each balance sheet date.
Unrealized gains or losses (changes in fair value of the
securities held) and realized gains or losses (gains or
losses on sales) are included in net income.
Available-for-Sale Securities.
 These are debt (or no influential equity) securities not
classified as either trading or held-to-maturity
securities.
 These securities are included among current or
noncurrent assets, depending on their maturity and/or
management’s intent regarding their sale. These
securities are reported at fair value on the balance
sheet.
Fair Value
 Fair value of an asset is the amount the asset can be
exchanged for in a current normal transaction
between willing parties. When an asset is regularly
traded, its fair value is readily determinable from its
published market price. If no published market price
exists for an asset, fair value is determined using
historical cost.
Equity Securities
 Equity securities represent ownership interests in
another entity. Examples are common and preferred
stock and rights to acquire or dispose of ownership
interests such as warrants, stock rights, and call and
put options.
Equity Securities…
 Redeemable preferred stock and convertible debt
securities are not considered equity securities (they are
classified as debt securities).
 The two main motivations for a company to purchase
equity securities are
 to exert influence over the directors and management of
another entity (such as suppliers, customers,
subsidiaries) or
 to receive dividend and stock price appreciation
income.
No Influence - Less than 20% Holding.
 When equity securities are nonvoting preferred or
when the investor owns less than 20% of an investee’s
voting stock, the ownership is considered non
influential.
 In these cases, investors are assumed to possess
minimal influence over the investee’s activities.
Significant Influence - Between 20% and 50% Holding.
 Security holdings, even when below 50% of the voting
stock, can provide an investor the ability to exercise
significant influence over an investee’s business
activities.
 Evidence of an investor’s ability to exert significant
influence over an investee’s business activities is
revealed in several ways, including management
representation and participation or influence
conferred as a result of contractual relationships.
Controlling Interest - Holdings of More
than 50%.
 Holdings of more than 50% are referred to as
controlling interests - where the investor is known
as the holding company and the investee as the
subsidiary. Consolidated financial statements are
prepared for holdings of more than 50%.
The Fair Value Option
 A recent standard (SFAS 159) allows companies to
selectively report held-to-maturity and available-forsale securities at fair value.
 If a company chooses this option, then the accounting
for all available-for-sale and held-to-maturity
securities will be similar to that accorded to trading
securities under SFAS 115.
 Specifically, for all investment securities (trading,
available for sale, and held to maturity),
Analyzing Investment Securities
 Analysis of investment securities has at least two main
objectives:
 To separate operating performance from investing (and
financing) performance
 To analyze accounting distortions due to accounting
rules and/or earnings management involving
investment securities. We limit our analysis to debt
securities and non influential (and marketable) equity
securities. Analysis of the remaining equity securities is
discussed later in this chapter.
Transfers between Categories.
 When management’s intent or ability to carry out the
purpose of investment securities significantly changes,
securities usually must be reclassified (transferred to
another class).
 Normally, debt securities classified as held-to-maturity
cannot be transferred to another class except under
exceptional circumstances
Investment Income (Loss)
 The components of investment income (loss) are as
follows:
Year Ended June 30 (in millions) 2002 2003 2004
Dividends and interest.......................................... $2,119 $1,957
$1,892
Net recognized gains (losses) on investments....... (1,807) 44
1,563
Net losses on derivatives...................................... (617) (424)
(268)
Investment income (loss)....................................... $ (305)
$1,577 $3,187
Investment Income (Loss)
 Performance: for this purpose, it is important for an
analyst to remove all gains (losses) relating to investing
activities including dividends, interest income, and
realized and unrealized gains and losses when evaluating
operating performance. An analyst also needs to separate
operating and no operating assets when determining the
return on net operating assets (RNOA).
 As a rule of thumb, all debt securities and marketable no
influential equity securities, and their related income
streams, are viewed as investing activities. Still, an analyst
must review the nature of a company’s business and the
objectives behind different investments before classifying
them as operating or investing. Here are two cases where
the rule of thumb does not always apply:
Analyzing Accounting Distortions from Securities
 SFAS 115 takes an important step towards fair value
accounting for investment securities.
 However, this standard does not fully embrace fair
value accounting.
 Instead, the standard is a compromise between
historical cost and fair value, leaving many unresolved
issues along with opportunities for earnings
management.
Opportunities for gains trading:
 The standard allows opportunities for gains trading with
available-for-sale and held-to-maturity securities.
 Because unrealized gains and losses on available-for-sale
and held-to-maturity securities are excluded from net
income, companies can increase net income by selling
those securities with unrealized gains and holding those
with unrealized losses.
 However, the standard requires unrealized gains and losses
on available-for-sale securities be reported as part of
comprehensive income.
 An analyst must therefore examine comprehensive income
disclosures to ascertain unrealized losses (if any) on unsold
available-for-sale securities.
Liabilities recognized at cost
 Accounting for investment securities is arguably one-
sided. That is, if a company reports its investment
securities at fair value, why not its liabilities?
 For many companies, especially financial institutions,
asset positions are not managed independent of
liability positions.
Inconsistent definition of equity securities
 There is concern that the definition of equity securities is
arbitrary and inconsistent. For instance, convertible bonds
are excluded from equity securities. Yet convertible bonds
often derive much of their value from the conversion
feature and are more akin to equity securities than debt.
 This means an analyst should question the exclusion of
convertible securities from equity. Redeemable preferred
stocks also are excluded from equity securities and,
accordingly, our analysis must review their characteristics
to validate this classification.

Classification based on intent
 Classification of (and accounting for) investment
securities depend on management intent, which refers
to management’s objectives regarding disposition of
securities.
 This intent rule can result in identical debt securities
being separately classified into one or any combination
of all three classes of trading, held-to-maturity, and
available-for-sale securities.
EQUITY METHOD OF ACCOUNTING
 Equity method accounting is required for interoperate
investments in which the investor company can exert
significant influence over, but does not control the
investee. In contrast with passive investments, which
we discussed earlier in this chapter, equity method
investments are reported on the balance sheet at
adjusted cost, not at market value.
 Equity method accounting is generally used for
investments representing 20% to 50% of the voting
stock of a company’s equity securities.
EQUITY METHOD OF ACCOUNTING…
 Analysis Implications of Interoperate Inves-
tments
 Our analysis continues with several important
considerations relating to interoperate investments.
This section discusses the more important implications.
 Recognition of Investee Company Earnings
 Equity method accounting assumes that a dollar earned
by an investee company is equivalent to a dollar earned
for the investor, even if not received in cash.
EQUITY METHOD OF ACCOUNTING…
 Unrecognized Capital Investment
 The investment account is often referred to as a one-line
consolidation.
 This is because it represents the investor’s percentage
ownership in the investee company stockholders’ equity.
 Behind this investment balance are the underlying
assets and liabilities of the investee company.
EQUITY METHOD OF ACCOUNTING…
 Provision for Taxes on Undistributed Subsidiary
Earnings
 When the undistributed earnings of a subsidiary are
included in the pretax accounting income of a parent
company (either through consolidation or equity
method accounting), it can require a concurrent
provision for taxes.
 This provision depends on the action and intent of the
parent company. Current practice assumes all
undistributed earnings transfer to the parent and, thus,
a provision for taxes is made by the parent in the current
period.
Definition of Business Combination
Definition
 Business combination is defined by the IAS as the
joining together of two or more entities. For
accounting purposes a combination is treated as an
acquisition.
 The combination of business entities by merger or
acquisition is very frequent for various reasons
including-
Definition…
 achieving economies of scale and saving of time in
entering a new market.
 A business combination can also be defined as the
bringing together of separate entities or business into
one reporting entity.
 The results of nearly all business combinations is that
one entity the acquirer obtains control of one or more
other businesses the acquire.
Definition…
 If an entity obtains control of one or more other
entities that are not businesses, the bringing together
of those entities is not a business combination.
 When an entity acquires a group of asset or net assets
that does not constitute a business it shall allocated
the cost of the group between the individual
identifiable assets and liabilities in the group based on
them fair values at the date of acquisition.
Definition…
 A business combination may be structured in a variety
of ways for legal, taxation or other reasons. It may
involve the purchase of some of the net assets of
another entity that together from one or more
businesses. It may be affected by the issue of equity
treatments, the transfer of cash, cash equivalents or
other assets, or a combination there of.
Parties involved
 The transaction may be between the shareholder of
the combining entities or between one entity and the
share holders of another entity. It may involve the
establishment of a new entity to control the combining
entities or net assets transferred, or the restructuring
of one or more of combining entities.
Accounting for Business
Combination
 The combination must be accounted for using the
purchase method also referred to as an acquisition.
 The acquiring firm records the identifiable assets and
liabilities at fair value at the date of acquisition.
 The difference between the fair values of the
identifiable asserts and liabilities and the amount paid
is recorded as goodwill.
Accounting for Business
Combination..
 When the acquiring firm picks up the income of the
acquired firm from the date of acquisition, retained
earnings of the acquired firm do not continue.
 The objective of IFRS is to specify the financial
reporting by entity when it undertakes a business
combination.
Accounting for Business Combination..
 IAS in particular specifies that all business
combination should be accounted for by applying the
purchase method, Therefore the acquirer recognize
the acquires identifiable assets, liabilities and
contingent liabilities at their fair value at the
acquisition date and also recognize good will, which is
subsequently tested for impairment rather than
autmotised
Accounting for Business Combination..
 A business combination may result in parent-
subsidiary relationship in which the acquirer is the
parent and the acquire is subsidiary of the acquirer. In
such circumstances, the acquirer applies IFRS in its
consolidated financial statements. It includes its
interests in the acquire in any separate financial
statements it issues as an investment in a subsidiary.
Accounting for Business Combination..
 A business combination may involve the purchase of
assets, including any goodwill of another entity rather
than the purchase of the equity of the other entity
such a combination does not result in a parentsubsidiary relationship.
Steps in applying the acquisition method:
 Identification of the acquirer
 Determination of the acquisition date
 Recognition and measurement of the identifiable
assets acquired, the liabilities assumed and any noncontrolling interest (NCI, formerly called minority
interest) in the acquiree
 Recognition and measurement of goodwill or a gain
from a bargain purchase
Measurement of acquired assets
and liabilities. /Measurement of
NCI.
 Assets and liabilities are measured at their acquisition-
date fair value (with a limited number of specified
exceptions). [IFRS 3.18]
 IFRS 3 allows an accounting policy choice, available on
a transaction by transaction basis, to measure NCI
either at:
 fair value or
 the NCI's proportionate share of net assets of the
acquiree.
Example:
 X Ltd pays 800 to purchase 80% of the shares of Y Ltd. Fair
value of 100% of Y's identifiable net assets is 600. If X elects
to measure noncontrolling interests as their proportionate
interest in the net assets of Y of 120 (20% x 600), the
consolidated financial statements show goodwill of 320
(800 +120 - 600). If X elects to measure noncontrolling
interests at fair value and determines that fair value to be
185, then goodwill of 385 is recognized (800 + 185 - 600).
The fair value of the 20% noncontrolling interest in Y will
not necessarily be proportionate to the price paid by X for
its 80%, primarily due to control premium or discount.
(paragraph B45 of IFRS 3).
Acquired intangible assets./
Goodwill
 Intangible assets must always be recognized and
measured at fair value. There is no 'reliable
measurement' exception
 Goodwill is measured as the difference between:
 the aggregate of (i) the acquisition-date fair value of the
consideration transferred, (ii) the amount of any NCI,
and (iii) in a business combination achieved in stages,
the acquisition-date fair value of the acquirer's
previously-held equity interest in the acquiree; and
Acquired intangible assets./Goodwill..
 the net of the acquisition-date amounts of the
identifiable assets acquired and the liabilities assumed
(measured in accordance with IFRS 3).
 If the difference above is negative, the resulting gain is
recognized as a bargain purchase in profit or loss.
Goodwill & non-controlling interest…
 Goodwill - these are intangible assets acquired by a
company upon its full or partial acquisition of another
company. It may arise if the amount paid for that
company in the name of acquisition exceeds the book
value. Non-Controlling interest refers to the portion of
equity ownership in the subsidiary company net the
portion of equity attributable to the parent company.
 Goodwill upon acquisition can be computed using two
methods;
 Partial method.
 Full method.
Goodwill & non-controlling
interest…
 Partial method entails obtaining the difference
between the consideration paid and the purchaser’s
share of the net identifiable net assets & NCI is
recognized at its share of identifiable net assets and
does not include any good will.
 Full goodwill method this method entails including
of goodwill in for NCI in subsidiary as well as the
controlling interest.
 The following formula is applicable when computing
goodwill through full goodwill method.
 Full goodwill.
Full goodwill/. Partial goodwill
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Purchase consideration……………………………..…………….……XXXXX
Add fair value of NCI…………………………………………………XXXXX
Less fair value of net identifiable assets
In NCI………………………………………………………..…….…..(XXXX)
Goodwill …………………………………………………….….….….XXXXX
Partial goodwill computation method.
Purchase consideration…………………………………………..…..…XXXXX
Fair value of interest in NCI………………………………….……..…XXXXX
Less fair value of net identifiable assets in NCI…………………..…(XXXXX)
Less fair value of identifiable assets attributed
To NCI…………………………………………………………..……..(XXXXX)
Goodwil……………………………………………………………….XXXXXX
Example II
Example II
 Missile acquires a subsidiary on 1 January 2008. The
fair value of the identifiable net assets of the
subsidiary was $2,170m. Missile acquired 70% of the
shares of the subsidiary for $2.145m. The NCI was fair
valued at $683m.
 Requirement:
 Compare the value of goodwill under the partial and
full methods.
Example II…
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Solution
Goodwill based on the partial and full goodwill methods under IFRS 3
(Revised) would be:
Partial goodwill $m
Purchase consideration ………….………….2, 145
Fair value of identifiable net assets……….. (2,170)
NCI (30% x 2,170) …………………………..651
Goodwill …………………………………….626
Full goodwill $m
Purchase consideration …………………….2, 145
NCI …………………………………………..683
…………………………………………… 2,828
Fair value of identifiable net assets……… (2,170)
Goodwill …………………………………658
The difference between the goodwill computed using full goodwill method &
partial goodwill method gives the goodwill attributable to the NCI.
FAIR VALUATION OF ASSETS & LIABILITIES.
 Existing requirements is that all assets and liabilities
be recognized at fair value at the time of acquisition.
Most assets are recognized at fair value with exception
to deferred tax assets and pension obligations.
Contingent assets are not recognized and contingent
liabilities are measured at fair value.
FAIR VALUATION OF ASSETS &
LIABILITIES…
 In cases where an asset is valued upwards, the
resulting entries affect the balance sheet as well as the
income statement. Example, Company X acquired
80% of shares in AB. Prior to acquisition the motor
vehicles had a value of Ksh. 600,000. Upon
acquisition, the motor vehicles were valued at Ksh.
700,000. Depreciation is on straight line basis for 4
years.
FAIR VALUATION OF ASSETS & LIABILITIES…
 The resulting accounting entries should be DR ASSET
account with Ksh. 100,000 & CR Revaluation account
with Ksh. 100,000 to reflect the asset revaluation. Any
depreciation expense incident to revaluation must be
reflected on income statement whereby the following
entries shall be applicable.
 DR - Income statement Depreciation exp. Ksh 150,000
 DR - Income statement, Dep. on revaluation Ksh.
25,000
 CR - Motor vehicle Asset Acc; Ksh 175,000
Consolidating & separating financial statements. (IAS27)
 Revised standard moves the IFRS towards the use of
economic entity approach (current practice is parent
company approach). Economic entity approach treats
all providers of equity capital as shareholders even
though they are not shareholders of the parent
company.
Consolidating & separating financial statements. (IAS27)…
 Disposal of partial interest in subsidiary in which the
parent company retains control does not result in gain or
loss but increase or decrease in equity under economic
entity approach. Purchase of some or all NCI is treated as
treasury transaction therefore accounted for in equity.
 Disposal of partial interest in a subsidiary which the parent
company losses control but retain interest as an associate
creates the recognition of gain or loss on the entire interest.
A gain or loss is realized on the part that has been disposed
off.
DERIVATIVE SECURITIES
 A derivative is a financial instrument whose
value is derived from the value of another asset,
class of assets, or economic variable such as a
stock, bond, commodity price, interest rate, or
currency exchange rate.
 However, a derivative contracted as a hedge can
expose companies to considerable risk.
DERIVATIVE SECURITIES…
 …This is either because it is difficult to find a derivative
that entirely hedges the risk exposure, because the
parties to the derivative contract fail to understand the
potential risks from the instrument, or because the
counterparty (the other entity in the hedge) is not
financially strong. Companies have been known to use
derivatives to speculate.
Defining a Derivative…
 A variety of financial instruments are used for hedging
activities, including the following:
 Futures contract
An agreement between two or more parties to
purchase or sell a certain commodity or financial asset
at a future date (called settlement date) and at a
definite price. Futures exist for most commodities and
financial assets.
 Swap contract
An agreement between two or more parties to
exchange future cash flows. It is common for hedging
risks, especially interest rate and foreign currency
risks.
Defining a Derivative…
 Option contract
- grants a party the right, not the obligation, to
execute a transaction. To illustrate, an option to
purchase a security at a specific contract price at a
future date is likely to be exercised only if the security
price on that future date is higher than the contract
price. An option also can be either a call or a put. A call
option is a right to buy a security (or commodity) at a
specific price on or before the settlement date. A put
option is an option to sell a security (or commodity) at
a specific price on or before the settlement date.
Accounting for Derivatives
 All derivatives, regardless of their nature or purpose,
are recorded at market value on the balance sheet.
 the accounting for derivatives effects both sides of
transaction (wherever applicable) by marking to
market.
 This means if a derivative is an effective hedge, the
effects of changes in fair values usually should cancel
out and have a minimal effect on profits and
stockholders’ equity.
Disclosures for Derivatives
 Companies are required to disclose qualitative and
quantitative information about derivatives both in
notes to financial statements and elsewhere (usually in
the Management’s Discussion and Analysis section).
The purpose of these disclosures is to inform analysts
about potential risks underlying derivative securities.
Analysis of Derivatives
 Objectives for Using Derivatives
 Identifying a company’s objectives for use of
derivatives is important because risk associated with
derivatives is much higher for speculation than for
hedging.
 In the case of hedging, risk does not arise through
strategic choice
Analysis of Derivatives…
 Instead it arises from problems with the hedging
instrument, either because the hedge is imperfect or
because of unforeseen events. In the case of
speculation, a company is making a strategic choice to
bear the risk of market movements.
 Some companies take on such risk because they are in
a position to diversify the risk (in a manner similar to
that of an insurance company). More often, managers
speculate because of “informed hunches” about
market movements.
Analysis of Derivatives…
 Risk Exposure and Effectiveness of Hedging Strategies
 Once an analyst concludes a company is using derivatives for
hedging, the analyst must evaluate the underlying risks for a
company, the company’s risk management strategy, its
hedging activities, and the effectiveness of its hedging
operations.
 SFAS 133 was principally designed to provide readers with
current values of derivative instruments and the effect of
changes in these values on reported profitability. Oftentimes,
however, the fair market values are immaterial and the
notional amounts do not provide information necessary to
evaluate the effectiveness of the company’s hedging activities.
Analysis of Derivatives…
 Transaction-Specific versus Companywide Risk
Exposure
 Companies hedge specific exposures to transactions,
commitments, assets, and/or liabilities.
 While hedging specific exposures usually reduces overall
risk exposure of the company to an underlying economic
variable, companies rarely use derivatives with an aim to
hedge overall companywide risk exposure.
Analysis of Derivatives…
 The relevant analysis question is whether rational
managers enter into derivative contracts that increase
overall companywide risk. In some cases the answer is
yes.
 Such actions can arise because of the size and
complexity of modern businesses and the difficulty of
achieving goal congruence across different divisions of
a company.
Analysis of Derivatives…
 Inclusion in Operating or Non operating Income
 Another analysis issue is whether to view unrealized
(and realized) gains and losses on derivative
instruments as part of operating or non operating
income.
 To the extent derivatives are hedging instruments,
then unrealized and realized gains and losses should
not be included in operating income.
 Also, the fair value of such derivatives should be
excluded from operating assets.
Analysis of Derivatives…
 Do derivates reduce risk?
 Researchers have investigated managerial motivations
for using derivatives, along with the impacts of
derivative use, for company risk.
 While there is mixed evidence about whether
derivatives are used for hedging or speculative
purposes, the preponderance of evidence suggests that
managers use derivatives to hedge overall
companywide risk.
Analysis of Derivatives…
 Global Hedge
 By locating plants in countries where it does business,
so its costs are in the same currency as its revenues,
IBM reduces the impact of currency swings without
hedging. That is, gains and losses (and fair values)
from derivatives is none operating when:
 Hedging activities are not a central part of a company’s
operations and
Analysis of Derivatives…
 Global Hedge…
 Including effects of hedging in operating income
conceals the underlying volatility in operating income
or cash flows.
 However, when a company offers risk management
services as a central part of its operations (as many
financial institutions do), we must view all speculative
gains and losses (and fair values) as part of operating
income (and operating assets or liabilities).
Fair Value Option
 In accounting, fair value is a rational and unbiased
estimate of the potential market price of a good,
service or asset.
 It encompasses acquisition/production/distribution
costs, replacement costs or costs of close substitutes.
 Fair value also takes into account other objective
factors like actual utility at a given level of
development of social productive capability and also
supply and demand.
Fair Value Option
 Under the fair value accounting, asset and liability
values are determined on the basis of their fair values
(typically market prices) on the measurement date.
 Financial Accounting Standards Board (FASB) towards
greater convergence of international accounting
standards to one based more on the information that
are provided by prevailing market prices sometimes
known as a “fair value” or “market to market reporting
system (Hansen 2004).
Scope of the Fair Value Option for Financial
Assets and Financial Liabilities
 This statement permits entities to choose to measure
many financial instruments and certain other items at
fair value.
 The objective is to improve financial reporting by
providing entities with the opportunity to mitigate
volatility in reported earnings caused by measuring
related assets and liabilities differently without having
to apply complex hedge accounting provisions.
Scope of the Fair Value Option for Financial
Assets and Financial Liabilities...
 Eligible items for the measurement option established
by this statement:
 Recognized financial assets and financial liabilities
except:
 An investment in a subsidiary that the entity is required
to consolidate.
 An interest in a variable interest entity that the entity is
required to consolidate.
Scope of the Fair Value Option for Financial Assets and
Financial Liabilities...
 Employers and plans obligations for pension benefits,
other post retirement benefits including health care and
life insurance benefits, post employment benefits,
employees stock option and stock purchase plans and
other forms of differed compensation arrangements as
defined in FASB statement No. 35, No. 87, No. 106, No.
112, No. 123, No. 43, No 146 and No. 158.
 Financial assets and financial liabilities recognized
under leases as defined in FASB statement No.
13(Accounting for Leases).
Scope of the Fair Value Option for Financial Assets and
Financial Liabilities...
 Deposit liabilities, withdraw able on demand of banks,
savings and loan associations, credit unions and other
similar depository institutions.
 Financial instruments that is in whole or in part
classified by the issuer as a component of shareholders
equity.
 Firm commitments that would otherwise not be
recognized at inception and that involve only financial
instruments.
Scope of the Fair Value Option for Financial
Assets and Financial Liabilities...
 Non financial insurance contracts and warranties that
the insurer can settle by paying a third party to provide
those goods and services.
 Host financial instruments resulting from separation
of an embedded non financial derivative instrument
from a non financial hybrid instrument.
Reporting Requirements (How this statement changes current
accounting practices)
 If a company chooses the fair value option for an asset
or liability, then the following reporting rules apply:
 The fair value option established by this statement
permits all entities to choose to measure eligible items
at fair value at specified election dates.
Reporting Requirements (How this statement
changes current accounting practices)
 A business entity shall report unrealized gains and
losses on items on which the fair value option has been
elected in earnings (or another performance indicator if
the business entity does not report earnings) at each
subsequent reporting date.
 A not for profit organization shall report unrealized
losses and gains in its statement of activities or similar
statements.
Therefore the fair value option:
 May be applied instrument by instrument with a few
exceptions such as investments otherwise accounted
for by the equity method.
 Is irrevocable (unless a new election date occurs).
 Is applied only to instruments and not pockets of
instruments.
Fair value measurement – IFRS 13
 Existing requirements is that all assets and liabilities
be recognized at fair value at the time of acquisition.
 Most assets are recognized at fair value with exception
to deferred tax assets and pension obligations.
Contingent assets are not recognized and contingent
liabilities are measured at fair value.
Fair value measurement – IFRS 13
 In cases where an asset is valued upwards, the
resulting entries affect the balance sheet as well as the
income statement. Example, Company X acquired
80% of shares in AB. Prior to acquisition the motor
vehicles had a value of Ksh. 600,000. Upon
acquisition, the motor vehicles were valued at Ksh.
700,000. Depreciation is on straight line basis for 4
years.
Fair value measurement – IFRS 13…
 The resulting accounting entries should be DR ASSET
account with Ksh. 100,000 & CR Revaluation account
with Ksh. 100,000 to reflect the asset revaluation. Any
depreciation expense incident to revaluation must be
reflected on income statement whereby the following
entries shall be applicable.
 DR - income statement Depreciation exp. Ksh 150,000
 DR - Income statement, Dep. On revaluation
Ksh. 25,000
 CR -Motor vehicle Asset Acc; Ksh 175,000
Consolidating & separating
financial statements. (IAS27)
 Revised standard moves the IFRS towards the use of
economic entity approach (current practice is parent
company approach). Economic entity approach treats
all providers of equity capital as shareholders even
though they are not shareholders of the parent
company.
Consolidating & separating
financial statements…
 Disposal of partial interest in subsidiary in which the
parent company retains control does not result in gain or
loss but increase or decrease in equity under economic
entity approach. Purchase of some or all NCI is treated as
treasury transaction therefore accounted for in equity.
 Disposal of partial interest in a subsidiary which the parent
company losses control but retain interest as an associate
creates the recognition of gain or loss on the entire interest.
A gain or loss is realized on the part that has been disposed
off.
Consolidating & separating
financial statements…
Worked example.
 On 1 January 2008, Rage acquired 70% of the equity
interests of Pin, a public limited company. The
purchase consideration comprised cash of $360m. The
fair value of the identifiable net assets was $480m. The
fair value of the NCI in Pin was $210m on 1 January
2008. Rage wishes to use the full goodwill method for
all acquisitions. Rage acquired a further 10% interest
from the NCIs in Pin on 31 December 2008 for a cash
consideration of $85m. The carrying value of the net
assets of Pin was $535m at 31 December 2008.
Consolidating & separating
financial statements…
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KSH (M)
Fair value of consideration for 70% interest ………….…………360
Fair value of NCI ………………………………………………210 570
Fair value of identifiable net assets …..…………………………. (480)
Goodwill …………………………………………………………….90
 Acquisition of further interest
 The net assets of Pin have increased by $(535 - 480) mie $55m
and therefore the NCI has increased by 30% of $55m, i.e. $16.5m.
However,
 Rage has purchased an additional 10% of the shares and this is
treated as a treasury transaction. There is no adjustment to
goodwill on the further acquisition.
Worked example…
KSH (M)
Pin NCI, 1 January 2008 ………….………………………………………………210
Share of increase in net assets in post-acquisition period…………16.5
Net assets, 31 December 2008 …………………………………………..226.5
Transfer to equity of Rage (10/30 x 226.5) ………………………….… (75.5)
Balance at 31 December 2008 – NCI ……………………………………..151
Fair value of consideration ………………………………………………..…….85
Charge to NCI ……………………………………………………………………. (75.5)
Negative movement in equity ……………………..………………………..9.5
INTERNATIONAL TRANSACTIONS - IAS 21
 The Effects of Changes in Foreign Exchange Rates
outlines how to account for foreign currency
transactions and operations in financial statements,
and how to translate financial statements into a
presentation currency.
 An entity is required to determine a functional
currency for each of its operations if necessary based
on the primary economic environment in which it
operates and generally records foreign currency
transactions using the spot conversion rate to that
functional currency on the date of the transaction.
History of IAS 21
 December 1977 - Exposure Draft E11 Accounting for Foreign
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Transactions and Translation of Foreign Financial
Statements
March 1982 - E11 was modified and re-exposed as Exposure
Draft E23 Accounting for the Effects of Changes in Foreign
Exchange Rates
July 1983 - IAS 21 Accounting for the Effects of Changes in
Foreign Exchange Rates
1 January 1985 - Effective date of IAS 21 (1983)
1993 - IAS 21 (1983) was revised as part of the comparability
of financial statements project
History of IAS 21…
 May 1992 - Exposure Draft E44 The Effects of Changes in
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Foreign Exchange Rates
December 1993 - IAS 21 (1993) The Effects of Changes in
Foreign Exchange Rates (revised as part of the
'Comparability of Financial Statements' project)
1 January 1995 - Effective date of IAS 21 (1993)
18 December 2003 - Revised version of IAS 21 issued by the
IASB
1 January 2005 - Effective date of IAS 21 (Revised 2003)
December 2005 - Minor Amendment to IAS 21 relating to
net investment in a foreign operation
1 January 2006 - Effective date of the December 2005
amendments
History of IAS 21…
 Effective date of the December 2005 amendments
 10 January 2008 - Some revisions of IAS 21 as a result of
the Business Combinations Phase II Project relating to
disposals of foreign operations
 1 July 2009 - Effective date of the January 2008
amendments
Summary of IAS 21
 Objective of IAS 21
 The objective of IAS 21 is to prescribe how to include
foreign currency transactions and foreign operations
in the financial statements of an entity and how to
translate financial statements into a presentation
currency. The principal issues are which exchange
rate(s) to use and how to report the effects of changes
in exchange rates in the financial statements
Key definitions IAS 21
 Functional currency: the currency of the primary
economic environment in which the entity operates. (The
term 'functional currency' was used in the 2003 revision of
IAS 21 in place of 'measurement currency' but with
essentially the same meaning.)
 Presentation currency: the currency in which financial
statements are presented.
 Exchange difference: the difference resulting from
translating a given number of units of one currency into
another currency at different exchange rates.
 Foreign operation: a subsidiary, associate, joint venture,
or branch whose activities are based in a country or
currency other than that of the reporting entity.
Basic steps for translating foreign currency amounts
into the functional currency
 Steps apply to a stand-alone entity, an entity with foreign
operations (such as a parent with foreign subsidiaries), or a
foreign operation (such as a foreign subsidiary or branch).
 The reporting entity determines its functional currency
 The entity translates all foreign currency items into its
functional currency
 The entity reports the effects of such translation in
accordance with reporting foreign currency transactions in
the functional currency and reporting the tax effects of
exchange differences.
Foreign currency transactions
 A foreign currency transaction should be recorded
initially at the rate of exchange at the date of the
transaction use of averages is permitted if they are a
reasonable approximation of actual.
 At each subsequent balance sheet dates:
 Foreign currency monetary amounts should be reported
using the closing rate
Foreign currency transactions…
 Non-monetary items carried at historical cost should be
reported using the exchange rate at the date of the
transaction
 Non-monetary items carried at fair value should be
reported at the rate that existed when the fair values
were determined
 If a gain or loss on a non-monetary item is recognized
in other comprehensive income (for example, a
property revaluation under IAS 16), any foreign
exchange component of that gain or loss is also
recognized in other comprehensive income. [IAS 21.30]
Translation from the functional currency to
the presentation currency
 The results and financial position of an entity whose
functional currency is not the currency of a
hyperinflationary economy are translated into a
different presentation currency using the following
procedures: [IAS 21.39]
 Assets and liabilities for each balance sheet presented
(including comparatives) are translated at the closing
rate at the date of that balance sheet
Translation from the functional currency to the
presentation currency…
 Income and expenses for each income statement
(including comparatives) are translated at exchange
rates at the dates of the transactions; and
 All resulting exchange differences are recognized in
other comprehensive income.
Disposal of a foreign operation
 When a foreign operation is disposed of, the
cumulative amount of the exchange differences
recognized in other comprehensive income and
accumulated in the separate component of equity
relating to that foreign operation shall be recognized
in profit or loss when the gain or loss on disposal is
recognized. [IAS 21.48]
Tax effects of exchange differences
 These must be accounted for using IAS 12 Income
Taxes.
 Disclosure
 The amount of exchange differences recognized in profit
or loss (excluding differences arising on financial
instruments measured at fair value through profit or loss
in accordance with IAS 39) [IAS 21.52(a)]
 Net exchange differences recognized in other
comprehensive income and accumulated in a separate
component of equity, and a reconciliation of the amount
of such exchange differences at the beginning and end
of the period [IAS 21.52(b)]
Tax effects of exchange differences…
 When the presentation currency is different from the
functional currency, disclose that fact together with the
functional currency and the reason for using a different
presentation currency [IAS 21.53]
 A change in the functional currency of either the
reporting entity or a significant foreign operation and
the reason therefore [IAS 21.54]
Convenience translations
 Sometimes, an entity displays its financial statements
or other financial information in a currency that is
different from either its functional currency or its
presentation currency simply by translating all
amounts at end-of-period exchange rates.
 This is sometimes called a convenience translation. A
result of making a convenience translation is that the
resulting financial information does not comply with
all IFRS, particularly IAS 21. In this case, the following
disclosures are required: [IAS 21.57]
Convenience translations…
 Clearly identify the information as supplementary
information to distinguish it from the information that
complies with IFRS
 Disclose the currency in which the supplementary
information is displayed
 Disclose the entity's functional currency and the
method of translation used to determine the
supplementary information
OBJECTIVE OF IAS 21
 An entity may carry on foreign activities in two ways.
 It may have transactions in foreign currencies or it may
have foreign operations.
 In addition, an entity may present its financial
statements in a foreign currency.
 The objective of this Standard is to prescribe how to
include foreign currency transactions and foreign
operations in the financial statements of an entity and
how to translate financial statements into a
presentation currency.
Statement of cash flows.
 The following terms are used in this Standard with the
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meanings specified:
Closing rate is the spot exchange rate at the end of the
reporting period.
Exchange difference is the difference resulting from
translating a given number of units of one currency into
another currency at different exchange rates.
Exchange rate is the ratio of exchange for two currencies.
Fair value is the amount for which an asset could be
exchanged, or a liability settled, between knowledgeable,
willing parties in an arm’s length transaction.
Foreign currency is a currency other than the functional
currency of the entity.
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