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The way in which these assets are valued depends upon the way the investment is categorized and the motive behind the investmentInvestments (Financial) and Marketable Securities In the category of investments and marketable securities, accountants consider investments made by firms in the securities or assets of other firms, and other marketable securities including treasury bills or bonds. The way in which these assets are valued depends upon the way the investment is categorized and the motive behind the investment. In general, an investment in the securities of another firm can be categorized as a minority, passive investment;a minority, active investment; or a majority, active investment. The accounting rules vary depending upon the categorization. Minority, Passive Investments If the securities or assets owned in another firm represent less than 20% of the overall ownership of that firm, an investment is treated as a minority, passive investment. These investments have an acquisition value, which represents what the firm originally paid for the securities and often a market value. Accounting principles require that these assets be sub-categorized into one of three groups: investments that will be held to maturity, investments that are available for sale and trading investments. The valuation principles vary for each. * For investments that will be held to maturity, the valuation is at historical cost or book value, and interest or dividends from this investment are shown in the income statement under net interest expenses * For investments that are available for sale, the valuation is at market value, but the unrealized gains or losses are shown as part of the equity in the balance sheet and not in the income statement. Thus, unrealized losses reduce the book value of the equity in the firm, and unrealized gains increase the book value of equity. * For trading investments, the valuation is at market value and the unrealized gains and losses are shown in the income statement. Firms are allowed an element of discretion in the way they classify investments and, subsequently, in the way they value these assets. This classification ensures that firms such as investment banks, whose assets are primarily securities held in other firms for purposes of trading, revalue the bulk of these assets at market levels each period. This is called marking-to-market and provides one of the few instances in which market value trumps book value in accounting statements. Minority, Active Investments If the securities or assets owned in another firm represent between 20% and 50% of the overall ownership of that firm, an investment is treated as a minority, active investment. While these investments have an initial acquisition value, a proportional share (based upon ownership proportion) of the net income and losses made by the firm in which the investment was made, is used to adjust the acquisition cost. In addition, the dividends received from the investment reduce the acquisition cost. This approach to valuing investments is called the equity approach. The market value of these investments is not considered until the investment is liquidated, at which point the gain or loss from the sale, relative to the adjusted acquisition cost is shown as part of the earnings under extraordinary items in that period. Majority, Active Investments If the securities or assets owned in another firm represent more than 50% of the overall ownership of that firm, an investment is treated as a majority active investment2. In this case, the investment is no longer shown as a financial investment but is instead replaced by the assets and liabilities of the firm in which the investment was made. This approach leads to a consolidation of the balance sheets of the two firms, where the assets and liabilities of the two firms are merged and presented as one balance sheet. The share of the firm that is owned by other investors is shown as a minority interest on the liability side of the balance sheet. A similar consolidation occurs in the financial statements of the other firm as well. The statement of cash flows reflects the cumulated cash inflows and outflows of the combined firm. This is in contrast to the equity approach, used for minority active investments, in which only the dividends received on the investment are shown as a cash inflow in the cash flow statement. Here again, the market value of this investment is not considered until the ownership stake is liquidated. At that point, the difference between the market price and the net value of the equity stake in the firm is treated as a gain or loss for the period. Intangible Assets Intangible assets include a wide array of assets ranging from patents and trademarks to goodwill. The accounting standards vary across intangible assets. 1. Patents and Trademarks Patents and trademarks are valued differently depending on whether they are generated internally or acquired. When patents and trademarks are generated from internal sources, such as research, the costs incurred in developing the asset are expensed in that period even though the asset might have a life of several accounting periods. Thus, the intangible asset is not usually valued in the balance sheet of the firm. In contrast, when an intangible asset is acquired from an external party, it is treated as an asset. Intangible assets have to be amortized over their expected lives, with a maximum amortization period of 40 years. The standard practice is to use straight-line amortization. For tax purposes, however, firms are not allowed to amortize goodwill or other intangible assets with no specific lifetime. 2. Goodwill Intangible assets are sometimes the by-products of acquisitions. When a firm acquires another firm, the purchase price is first allocated to tangible assets and then allocated to any intangible assets such as patents or trade names. Any residual becomes goodwill. While accounting principles suggest that goodwill captures the value of any intangibles that are not specifically identifiable, it is really a reflection of the difference between the market value of the firm owning the assets and the book value of assets. This approach is called purchase accountingand it creates an intangible asset (goodwill) which has to be amortized over 40 years. Firms, which do not want to see this charge against their earnings, often use an alternative approach called pooling accounting, in which the purchase price never shows up in the balance sheet. Instead, the book values of the two companies involved in the merger are aggregated to create the consolidated balance of the combined firm.3 3 The Financial Accounting Standards Board (FASB) was considering eliminating the use of pooling and reducing the amortization period for goodwill in purchase accounting to 20 years at the time this book went to print. Illustration 3.1: Asset Values for Boeing and the Home Depot Table 3.1 summarizes asset values, as measured in the balance sheets of Boeing, the aerospace giant, and The Home Depot, a building suppliers retailer, at the end of the 1998 financial year: Table 3.1: Assets: Boeing and the Home Depot BoeingHome DepotNet Fixed Assets$8,589$8,160Goodwill$2,312$140Investments and Notes Receivable$0$41Deferred Income Taxes$411$0Prepaid Pension Expense$3,513$0Customer Financing$4,930$0Other Assets$542$191Current AssetsCash$2,183$62Short-term Marketable Investments$279$0Accounts Receivables$3,288$469Current Portion of Customer Financing$781$0Deferred Income Taxes$1,495$0Inventories$8,349$4,293Other Current Assets$0$109Total Current Assets$16,375$4,933Total Assets$36,672$13,465 There are a number of points worth noting about these asset values. 1. Goodwill: Boeing, which acquired Rockwell in 1996 and McDonnell Douglas in 1997, used purchase accounting for the Rockwell acquisition and pooling for McDonnell Douglas. The goodwill on the balance sheet reflects the excess of acquisition value over book value for Rockwell and is being amortized over 30 years. With McDonnell Douglas, there is no recording of the premium paid on the acquisition among the assets. : Boeing often either provides financing to its customers to acquire its planes or acts as the lessor on the planes. Since these contracts tend to run over several years, the present value of the payments due in future years on the financing and the lease payments is shown as customer financing. The current portion of these payments is shown as accounts receivable. The Home Depot provides credit to its customers as well, but all these payments due are shown as accounts receivable, since they are all short term. 3. Inventorie: Boeing values inventories using the weighted average cost method, while The Home Depot uses the FIFO approach for valuing inventories. 4. Marketable Securitie: Boeing classifies its short term investments as trading investments and records them at market value. The Home Depot has a mix of trading, available-for-sale and held-to-maturity investments and therefore uses a mix of book and market value to value these investments. Boeing records the excess of its pension fund assets over its expected pension fund liabilities as an asset on the balance sheet. Finally, the balance sheet for Boeing fails to report the value of a very significant asset, which is the effect of past research and development expenses. Since accounting convention requires that these be expensed in the year that they occur and not capitalized, the research asset does not show up in the balance sheet. In chapter 9, we will consider how to capitalize research and development expenses and the effects on balance sheets. Measuring Financing Mix The second set of questions that we would like to answer and accounting statements to shed some light on relates to the current value and subsequently the mixture of debt and equity used by the firm. The bulk of the information about these questions is provided on the liability side of the balance sheet and the footnotes. Accounting Principles Underlying Liability and Equity Measurement Just as with the measurement of asset value, the accounting categorization of liabilities and equity is governed by a set of fairly rigid principles. The first is a strict categorization of financing into either a liability or equbtased upon the nature of the obligation. For an obligation to be recognized as a liability, it must meet three requirements: 1. It must be expected to lead to a future cash outflow or the loss of a future cash inflow at some specified or determinable date, 2. The firm cannot avoid the obligation. . The transaction giving rise to the obligation has happened already. In keeping with the earlier principle of conservatism in estimating asset value, accountants recognize as liabilities only cash flow obligations that cannot be avoided. The second principle is that the value of both liabilities and equity in a firm are better estimated using historical costs with accounting adjustments, rather than with expected future cash flows or market value. The process by which accountants measure the value of liabilities and equities is inextricably linked to the way they value assets. Since assets are primarily valued at historical cost or at book value, both debt and equity also get measured primarily at book value. In the section that follows, we will examine the accounting measurement of both liabilities and equity. Measuring the Value of Liabilities and Equities Accountants categorize liabilities into current liabilities, long term debt and long term liabilities that are neither debt nor equity. Next, we will examine the way they measure each of these. Current Liabilities Current liabilities categorizes all obligations that the firm has coming due in the next accounting period. These generally include: 1. Accounts Payable - representing credit received from suppliers and other vendors to the firm. The value of accounts payable represents the amounts due to these creditors. For this item, book and market value should be similar. 2. Short term borrowing - representing short term loans (due in less than a year) taken to finance the operations or current asset needs of the business. Here again, the value shown represents the amounts due on such loans, and the book and market value should be similar, unless the default risk of the firm has changed dramatically since it borrowed the money. 3. Short term portion of long term borrowing - representing the portion of the long term debt or bonds that is coming due in the next year. Here again, the value shown is the actual amount due on these loans, and market and book value should converge as the due date approaches. 4. Other short term liabilities - which is a catch-all component for any other short term liabilities that the firm might have, including wages due to its employees and taxes due to the government. Of all the items on the liability side of the balance sheet, absent outright fraud, current liabilities should be the one for which the accounting estimates of book value and financial estimates of market value are the closest. |
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