Accounting Principles and Standards: For Financial Analysts

 

Accounting Principles and Standards For Financial Analysts

Corporate Finance Institute®

 

FMVA® Certification Program

Corporate Finance Institute®

 

Course Objectives

Understand the fundamental accounting principles that underly accounting standards

Corporate Finance Institute®

Understand why it is important to have useful financial information and the characteristics of useful financial information

Explore in some detail common accounting standards most commonly encountered by financial analysts

 

Accounting Principles Overview

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Session Objectives

Identify some of the different decisions users of financial information make

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Understand the importance of a sound framework for financial information

Understand the key accounting principles that establish the framework for detailed accounting standards

 

The Purpose of Financial Reporting Sound financial reporting provides useful financial information about an entity’s resources and claims against those resources to existing and potential investors, lenders and other users in making decisions relating to that entity. Decisions users of financial information make include:

Buying, selling, or holding equity and debt instruments

Providing or settling loans and other forms of credit

Exercising rights to vote on or influence management's actions that affect the use of the entity's economic resources

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Accounting Principles Overview

Accounting Principles

•

•

Fundamental and concepts that apply to accounting rules in general. These principles provide the framework on which more detailed accounting standards are based. •

Accounting Standards

When accounting principles become generally accepted by businesses and relevant authorities, they are referred to as generally accepted accounting principles or GAAP.

Specify how transactions and other events are to be recognized, measured, presented and disclosed in financial statements.

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Why Accounting Principles Are Important Accounting principles are important as they establish the framework for how transactions are recorded and reported on financial statements. statements. A sound framework produces financial information information that can be relied upon by a variety of interested parties. Ensures reliability and relevance of financial statements

Maintains consistency in financial reporting from company to company across all industries

Sound Framewor k Reduces the risk of erroneous financial reporting by having a defined framework in place

Allows for uniform comparisons between companies

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Fundamental Accounting Principles Accounting principles establish a framework that guides accountants in recording and reporting financial information. Some of the most fundamental accounting principles are as follows:

Accrual Basis of Accounting

Revenue Recognition

Historical Cost

Matching

Materiality

Conservatism

Economic Entity

Going Concern

Monetary Unit

Full Disclosure

Consistency

Objectivity

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Accrual Basis of Accounting Principle

Accrual Basis of Accounting

•

•

States that the financial aspects of economic events are recorded in the accounting period in which they occur regardless of whether cash has been exchanged. exchanged. Accrual accounting is a requirement under Generally Accepted Accounting Standards in most cases.

Cash Basis of Accounting

•

VS.

States that revenues and expenses are recognized only when cash or its equivalent are exchanged.

Accrual Basis of Accounting

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Accrual Basis of Accounting Principle Example:

A utility company provides services to a customer.

The customer receives and then pays the bill at the end of the billing cycle.

Accrual Basis of Accounting The company accrues (records) revenue related to the utility services as soon as they are provided.

As cash has not yet been received, the company will record a receivable from the customer.

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Revenue Recognition Principle Consistent with accrual accounting, the revenue recognition principle states that revenue is earned and recognized upon product delivery or service completion without regard to the timing of cash flow. Example:

A utility company provides services to a customer.

The customer receives and then pays the bill at the end of the billing cycle.

Revenue Recognized

Cash Received

Services Rendered

Payment

The company accrues (records) revenue related to the utility services as soon as they are provided.

Revenue Recognition Principle

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Revenue Recognition Principle Another example:

A customer subscribes to 3 months worth of music streaming services and pays for it entirely upfront.

The service provider will recognize revenues over the 3month period even though all the cash has been received.

Revenue Recognition Principle

Cash Received

Payment Revenue Recognized

Services Rendered

Services Re Rendered

Services Re Rendered

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Historical Cost Principle Assets and liabilities are recoded at the cost at which they were acquired or assumed, assumed, where cost refers to the original amount expended to acquire or assume the item. Assets and liabilities remain on the financial statements at historical cost without being adjusted for changes in market value. Example: Land acquired 10 years ago for $1 million has a market value of $3 million. Despite the value increase, land on the balance sheet remains at $1 million.

Land Value

Financial Statements

10 Years Ago Historical Cost

Today Market Value

$1 Million

$3 Million

$1 Million

Historical Cost Principle

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Matching Principle The costs of doing business should be recorded in the same period as the economic benefits they generate, generate, irrespective as when they are actually paid. Example: Depreciation expense is an example of the use of the matching principle. The cost of a fixed asset is allocated over its useful life as it generates economic benefits over that time. Equipment Cost

Payment Depreciation Expense

Depr De prec ecia iattio ion n Ex Expe pen nse

Equipment Useful Life

Dep De pre reci ciat atio ion n Ex Expe pen nse

Matching Principle

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Materiality Principle Financial information information is material to the financial statements if it would change the opinion or view of a reasonable person.

All material financial information should be included in the

The concept of materiality is relative in size and

Professional  judgement is sometimes required

financial statements. statements.

importance; importance ; what could be material to one company may not be for another.

to decideiswhether amount materialan or not.

Materiality Principle

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Materiality Principle Example: Two companies suffer extraordinary losses of $1 million during a hurricane.

Company A

Company B

Net Income

$10 million

$200 million

Loss

$1 million

$1 million

= 10% of net income

= 0.5% of net income

Loss is material

Loss is immaterial

Materiality Principle

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Conservatism Principle The principle of conservatism provides guidance on how to record transactions particularly those involving uncertainty or estimates. If a situation arises where there are two acceptable alternatives for reporting an item, the alternative that will result in smaller net income and/or asset balances should be used. used. Conservatism Principle

Alternative A

Alternative B

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Conservatism Principle Example: Potential losses from lawsuits are reported on the financial statements or in the notes while potential gains from lawsuits are not reported. The outcome of lawsuits is uncertain:

Potential Gains

Potential Losses

May not be realized and recording them in the financial statements could

Disclosing a potential loss provides information on the magnitude of a

be misleading to its users.

potential future liability.

Do not record in financial

Record in financial

statements

statements

Conservatism Principle

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Economic Entity Principle This principle is important in that it allows financial statement users to assess the value and performance of a business separately from its ownership activity. activity.

Transactions carried out by a business are separated

Transactions carried out by different businesses must

from its owner.

be accounted for separately.

Economic Entity Principle

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Economic Entity Principle Example 1: A business owner purchases an asset with funds from his personal bank account.

The asset cannot be recorded on the financial statements according unless it is sold or contributed to the company.

Economic Entity Principle

Example 2: An owner of two unrelated subsidiaries (a hotel chain and a restaurant chain) will need to maintain separate accounting records for each.

The expenses of one business cannot be combined with the other.

Maintaining separate records will allow the performance and value of each business to be assessed separately.

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Going Concern Principle Financial statements are prepared assuming that the organization will continue to operate its business for the foreseeable future. future. Every decision in a company is taken with the objective of operating the business rather than liquidating it. it. Going concern is a fundamental principle as without this assumption, it is impossible to record items such as: Going Concern Principle

Accrued Expenses

Prepayments

Depreciation of Long-life Assets

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Going Concern Principle Example: COVID-19 has adversely impacted retailers, from coping with furloughs, supply chain challenges, shut down of retail stores and dealing with social distancing requirements.

Many retailers in CBL’s properties had skipped rental payments causing CBL to be unable to pay an $11.8 million interest payment.

In June 2020, mall owner CBL & Associates warned that its ability to continue as a going concern was in doubt.

As a result, CBL violated covenants in its senior secured credit facility.

Going Concern Principle

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Monetary Unit Principle Under the monetary unit principle, only business transactions that are quantifiable and can be expressed in terms of a monetary unit are recorded in the financial statements. Furthermore, the monetary unit must be stable, reliable, relevant, relevant, and useful to all companies. Monetary Unit Principle

Example: Certain economic events are not easily quantified and, therefore, do not appear in the company's accounting records. The immediate value a new executive would bring to a company cannot be expressed in monetary units and is not recorded in the accounting records. records.

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Full Disclosure Principle Any information that would be considered material to a user of the financial statements should be disclosed in the statements or the footnotes thereto.

Full disclosure is important to ensure material facts are known by financial statements users.

This allows them to understand and make judgements of the financial activities of a company.

Full Disclosure Principle

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Full Disclosure Principle Generally, public companies are required to disclose only information that can have a material impact on the financial results of the company. Example: Accounting policies and details of pending litigation are among the items disclosed in Amazon’s notes to the financial statements.

Full Disclosure Principle

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Consistency Principle Consistent information is prepared using the same accounting methods for similar events and transactions over time. Consistency allows for meaningful comparisons:

1. Between different accounting periods

2. Between the financial statements of different companies that use the same accounting policies

Consistency does not preclude changes in accounting policies; policies; they are permitted but must be justified and disclosed in the financial statements.

Consistency Principle

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Consistency Principle Example: A company uses the LIFO (Last-in, First-out) method of inventory valuation and has determined that the FIFO (First-in, First-out) method is more appropriate.

The following year, management determines that the change from LIFO to FIFO will negatively impact net income and wants to make the change back to LIFO.

Another change would violate the consistency principle as there is no justifiable reason to do so.

Consistency Principle

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Objectivity Principle Under the objectivit objectivity y principle, accounting records and financial statements should be independent and free from bias (i.e. verifiable). Financial information that is prepared objectively is more relevant and reliable and thus more useful for users.

Example: An accountant preparing a

He uses amounts displayed in the

This violates the consistency consistenc y principle

company’s financial statements needs to verify accounts receivables.

accounting system rather than the supporting documentation.

as information in the financial statements must be independent and verifiable.

Objectivity Principle

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Usefulness of Financial Information

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Session Objectives

Identify and understand the fundamental traits that characterize useful financial

Identify and understand the characteristics that enhance the usefulness of financial

information

information

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Importance of Useful Financial Information Useful financial information allows users to make informed decisions.

Fundamental Characteristics

Enhancing Characteristi Characteristics cs

For financial information to be useful, it must be:

The usefulness of financial information information is enhanced if it is:

•

•

•

Relevant Faithfully represent what it purports to

Comparable

•

Verifiable

•

Timely

•

Understandable

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Fundamental Characteristics Relevant financial information is capable of making a difference in the decisions made by users. Financial information can make a difference in decisions if it has predictive value and/or confirmatory value.. value

Predictive Value

Confirmatory Value

Information that can be used as an input to predict future outcomes.

Information that provides feedback about (confirms or changes) previous evaluations.

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Fundamental Characteristics Financial information is relevant if it faithfully represents the substance of an economic event.

To be a faithful representation, financial information needs to be:

Complete

Neutral

Free From Errors

• Includes all things necessary (descriptions and explanations) for a user to understand the event being depicted

• Without bias in its selection or presentation

• No errors or omissions in the information and the processes used to produce it

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Enhancing Characteristics The usefulness of financial information information is enhanced if it is comparabl comparable, e, verifiable, timely and understandable.

1. Comparability

2. Verifiability

3. Timeliness

4. Understand Understandability ability

Information that can be compared with similar

Different knowledgeable and independent

Having information available to decision-

Classifying, characterizing Classifying, and presenting

information about other entities and with similar information about the same entity for another period.

observers could reach similar conclusions from the same information.

makers in time to be capable of influencing their decisions.

information clearly and concisely makes it understandable.

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Detailed Accounting Standards

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Introduction to Accounting Standards The objective of accounting standards is to bring uniformity and comparability to the financial statements,, which then allows them to be relied upon by investors, lenders, creditors statements creditors and others. There are two key accounting standards setting bodies in the world:

International Accounting Standards Board (IASB)

International Financial International Reporting Standards (IFRS)

Financial Accounting Standards Board (FASB)

Generally Accepted Accounting Principles (US GAAP)

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Key Accounting Standards Accounting standards are the rules and guidelines issued by the accounting institutions institutions that specify how transactions and other events are to be recognized, measured, presented and disclosed in financial statements.. statements Some of the key standards that are relevant to financial analysts include:

1. Leases

2. Income Taxes

3. Share-based Payments

4. Business Combinations

5. Financing Fees & Transaction Costs

The following materials will address these topics from an IFRS perspective and will note where there are differences with US GAAP.

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Accounting For Leases

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Session Objectives

Identify the criteria needed for a contract to be considered a lease

Calculate amortization and interest expenses following commencement of the lease

Understand the differences in the accounting treatment of finance and operating leases

Calculate the initial lease liability and right-of-use asset balances at lease commencement

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Right to Control A lease is a contract that conveys the right to control the use of an identified asset for a period of time in exchange for consideration.

Right to Control

Right to obtain substant substantially ially all (≥ 90%) of the economic benefits

Right to direct the use of the asset

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Accounting Treatment of Leases

IFRS

All leases are classified as finance leases.. leases •

There are exemptions for shortterm leases (< 1 year) and lowvalue leases (< $5K approximate

US GAAP

VS.

Leases are classified based on whether the arrangement is effectively a purchase of the asset: •

Finance lease (control of the underlying asset is transferred to the lessee)

asset value or less). •

Operating lease (control of the underlying asset is not transferred to the lessee)

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Financial Statement Impact Both finance and operating leases require balance sheet recognition. The type of lease will impact how the lease expense is recognized on the income statement. Finance Lease

Operating Lease

Balance Sheet

01. Right-of-Use Asset 02. Lease Liability

01. Right-of-Use Asset 02. Lease Liability

Income Statement

01. Interest Expense 02. Amortization Expense

01. Lease Expense

Cash Flow Statement

01. Principle Payments 02. Interest Payments

01. Lease Payments

•

Lease components: included in the lease liability (e.g. basic rent)

•

Non-lease components: expensed as incurred incurred (e.g. property taxes, operating operating expenses on the property) property)

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Initial Recognition of Balance Sheet Amounts A right-of-use asset and lease liability must be recognized on the balance sheet for all leases at lease commencement.

Lease Liability = Present value of the remaining lease payments, discounted at either: The rate implicit in the lease lease;; or

•

•

The lessee’s incremental borrowing rate (IBR)

Right-of-Use Asset = The amount of the lease liability at lease commencement + Lease payments made before the commencement date, less any lease incentives received + Initial direct costs incurred

*IBR = The rate of interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to to

obtain an asset of a similar value to the right-of-use asset in a similar economic environment. Corporate Finance Institute®  

Initial Recognition of Balance Sheet Amounts Example: Company ABC enters into a 5-year lease with payments of $20,000 at the end of each year for a total total of $100,000. The rate implicit in the lease is 6%. There are no initial direct costs. What are the initial right-of-use right -of-use asset and lease liability balances?

Lease Liability

Right-of-Use Asset

= PV of Lease Payments

= Lease Liability

= PV of a 5-year annuity with payments of $20,000

= $84,247

= $84,247

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Subsequent Recognition and Measurement Over the lease term, the right-of-use asset must be amortized and interest expense on the lease liability must be recorded. The income statement recognition and classification is based on how the lease is classified. Finance Lease

Operating Lease

Lease Expense

Interest Expense

Amortization Expense

Interest Expense

Amortization Expense

Based on the outstanding lease liability balance

Straight-line over the shorter of the lease term or the asset useful life

Based on the outstanding lease liability balance

Difference between the average annual lease payment and interest expense

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Subsequent Recognition and Measurement Finance Lease Int nter eres estt Expe pens nse e

Operating Lease

Amor Am orti tiza zati tion on Exp xpen ensse

Tota To tall Expe pens nse es

Inte In terres estt Exp xpen ense se

$25,000

$25,000

$20,000

$20,000

$15,000

$15,000

$10,000

$10,000

$5,000

$5,000

$0

$0 Year 1

•

•

•

Year 2

Year 3

Year 4

Year 1

Year 5

Total expenses are usually higher in earlier periods and decrease over time. Amortization expense remains constant during the lease term (straight-line depreciation). Interest expense decreases over time as the lease

•

Amor Am orti tiza zati tion on Exp xpen ensse

Year 2

Year 3

Lea Le ase Exp xpe ense

Year 4

Year 5

The total lease expense equals to the annual lease payment and is constant over the lease term if the lease payments are the same every year.

liability is reduced each year. Corporate Finance Institute®  

Subsequent Recognition and Measurement Example: Continuing from the prior example, the right-of-use asset and lease liability amounts were originally both $84,247. How much interest and amortization expense are recognized in year 1?

Finance Lease

Operating Lease Lease Expense = $20,000

Interest Expense

Amortization Expense Interest Expense

Amortization Expense

= $84,247 x 6%

= $84,247 / 5 years

= $84,247 x 6%

= $20,000 $20,000 - $5,055

= $5,055

= $16,849

= $5,055

= $14,945

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Accounting For Income Taxes

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Session Objectives

Understand the difference between accounting and taxable income and perform a

Understand the difference between carrying value and tax base of assets and liabilities and

reconciliation between the two

quantify each

Calculate temporary differences and related deferred tax amounts on the balance sheet

Identify the circumstances in which taxable or deductible temporary differences arise

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Accounting Treatment of Income Taxes Under both IFRS and US GAAP, income tax expense includes both current and deferred components.

Income Tax Expense

Current Tax Expense

Deferred Tax Expense

The total amount

The amount of tax due to

The amount of tax due to

included on the income statement for the period

the tax authorities in the current period

the tax authorities in future periods

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Accounting Income Versus Taxable Income A key element in determining income and taxable income. income tax expense is understanding the difference between accounting

Accounting Income

•

•

The profit or loss for a period before deducting tax expense Income before tax on the income statement for the period

Taxable Income

VS.

•

The profit or loss for a period determined in accordance with rules established by taxation authorities

•

Taxable Income on tax returns

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Reconciling Accounting Income and Taxable Income Income taxesbetween are based taxable income and not accounting income. Under IFRS, disclosure of a reconciliation taxon expense and accounting income is required. Accounting Income

+

Expenses not deductible under tax laws but recognized for accounting purposes

+

Income included under tax laws but not recognized for accounting purposes

–

Expenses deductible under tax laws but not recognized for accounting purposes

–

Income not included under tax laws but recognized for accounting purposes

=

Taxable Income

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Reconciling Accounting Income and Taxable Income Example:

Company XYZ incurred the following during 2020: •

Accounting income: $50,000

•

Fines and penalties paid: $500

•

Non-taxable income: $2,500

•

Depreciation expense: $1,000

•

Tax Depreciation: $1,500

•

Provision for the 2020 bonus: $1,250

•

2019 bonus paid in 2020: $1,100

Accounting Income

+ + + –

Fines and Penalties Paid

––

$50,000 $500

Depreciation Expense

$1,000

2020 Bonus Provision

$1,250

Tax Depreciation

$1,500

2019 Bonus Paid in 2020 Non-taxable Income

$1,100 $2,500

Fines and penalties are not deductible for tax purposes. Non-taxable income is not recognized for tax purposes. Bonus are tax deductible only in the year they are paid.

= Taxable Income

$47,650

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Carrying Amount Versus Tax Base Example: Carrying Amount

An asset has an original cost of $1,000. •

Accumulated depreciation for accounting purposes: $500

•

Tax depreciation to-date: $800

The net book value of an asset or liability recorded on a company’s balance sheet for accounting purposes

Carrying Amount: Cost

$1,000

Accumulated Depreciation Net Book Value

($500)

$500

Tax Base Tax Base: The amount attributed to an asset or liability for tax purposes

Cost

$1,000

Tax Depreciation To-Date Tax Ba Base se $20 $200 0

($800)

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Temporary Differences Temporary differences therespective differences accounting purposes andare their taxbetween bases. the carrying amount of assets and liabilities for They can also be thought of the differences between accounting income income and taxable income that eventually reverse (are eliminated).

Temporary Difference

Carrying Amount

Tax Base

Permanent differences are differences between the tax and financial reporting of revenue or expense items which will not be

reversed in the future. Corporate Finance Institute®  

General Rules Around Temporary Differences

Give rise to:

Deductible Temporary Differences

Taxable Temporary Differences

Differences that result in amounts that are deductible in determining taxable income of future periods

Differences that result in amounts that are taxable in determining taxable income of future periods

Deferred Tax Assets

Deferred Tax Liabilities

Taxable Income > Accounting In Income

Taxable In Income < Accounting Income

Tax Base > Carrying Amount

Tax Base < Carrying Amount

Generally arise when: 1. Differences result in: 2. Assets:

3. Liabilities:

Carrying Amount

Tax Base

Carrying Amount

Tax Base

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Common Examples of Temporary Differences Installment Sales Capitalized Development Costs Amortized Over

Tax Depreciation > Accounting Depreciation Accrued Expenses

Unearned Revenue

Time

Taxable Temporary Differences

Tax Depreciation < Accounting Depreciation

Tax Losses

Deductible Temporary Differences

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Deferred Tax Assets and Liabilities Deferred tax assets are the amounts of income tax recoverable in future periods. Deferred Tax Asset

Deductible Temporary Difference

Tax Rate

Deferred Tax Asset

Unused Tax Loss or Credit

Tax Rate

Deferred tax liabilities are the amounts of income tax payable in future periods. periods.

Deferred Tax Liability

Taxable Temporary Difference

Tax Rate

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Temporary Differences and Deferred Taxes Example: An asset has an original cost of $10,000. •

•

•

Depreciation for accounting purposes: Straight-line over 10 years

Carrying Amount: Cost

$10,000

Accounting Depreciation Net Book Value

($1,000)

$9,000

Tax depreciation: $2,000 per year Tax rate: 30%

Tax Base: Cost

$10,000

Tax Depreciation Tax Base

($2,000)

$8,000

Taxable Temporary Difference = $9,000 – $8,000 = $1,000

Deferred Tax Liability

$1,000 x 30%

$300

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Accounting For Share-based Payments

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Session Objectives

Gain an understanding of the key elements of share-based payments

Calculate share-based payment expenses under scenarios with service conditions only

Calculate share-based payment expenses under scenarios with both service and performance conditions

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Introduction to Share-based Payments Share-based payment (SBP) transactions occur when an entity receives good or services from a thirdparty and grants equity instruments or cash amounts based on the value of such equity instruments as consideration. Share-based payment awards are common features of employee compensation for directors, senior executives and other employees.

Key elements of share-based payments:

1. SBP Classification

2. Grant Date

3. Vesting Conditions

4. Vesting Period

5. Fair Value at Grant Date

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Share-based Payment Classification The accounting treatment for share-based payment transactions differs depending on the classification. classification.

Cash-settled Payments

Equity-settled Payments

•

Occur when transactions are settled

•

using an entity’s own equity instruments •

Occur when transactions are settled in cash, the amount of which is based on the value of an equity instruments

Typical example: stock options •

Typical example: share appreciation rights

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Determination of Grant Date Grant date is the date an entity grants the right to receive equity instruments to its employee. The grant date occurs when all of the following have occurred:

Agreement

Rights Conferred

Approval

When the terms and conditions are agreed upon and understood by both the entity and its employee.

The right to cash or equity instruments of the entity has been conferred on the employee.

The share-based payment agreement has received the necessary and appropriate approvals.

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Vesting Conditions and Vesting Period Vesting conditions are conditions that determine whether the entity receives the services that entitle the employee to receive the share-based payment.

Vesting period is the period whereby all the specified vesting conditions must be satisfied.

Share-based expense is recognized over the vesting period, or if there is no vesting period, immediately.

Vesting Conditions

Service Conditions

Performance Conditions

Market Conditions

Non-market Conditions

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Determining Fair Value The fair value of equity instruments granted to employees in share-based payment transactions is measured at the grant date (or measurement date). The fair value of equity instruments is not adjusted subsequent to the grant date in respect of changes in market conditions.

1. Market Prices

2. Valuation Techniques

If market prices are available for the actual equity instruments granted, then the estimate of fair value is based on these market prices.

If market prices are not available, then fair value is estimated using a valuation technique (e.g. BlackScholes, binomial pricing models).

Corporate Finance Institute®  

Accounting For Share-based Payments Example #1 (service condition only): only): Company XYZ grants 100 share options to each of its 500 employees, which can be exercised at anytime over 3 years subject to a 2-year service condition. •

•

The fair value of each option is determined to be $20 at the grant date. An estimated 75% of the 500 employees will complete the service condition required for receiving the options.

Employee benefit expense recognition recognition:: Grant Date

Year 1

Year 2

Year 3

Year 4

Total employee benefit expense: $0

+ $375,000 = 100 options x 500

+ $375,000 = 100 x 500 x 75% x

= $750,000

Year 5

employees x 75% x $20 x 1/2 years

$20 x 2/2 years – $375,000 recognized in Year 1

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Accounting For Share-based Payments Example #2 (service and market performance conditions): conditions): Company XYZ grants 100 share options to each of its 500 employees, exercisable over 3 years and subject to:

•

•

i)

A 3-y 3-yea earr ser servi vice ce co cond ndit itio ion; n;

ii)

Company XYZ’s stock price must be at least 25% higher after the 3-year 3-year period compared to at the grant date.

90% of employees are estimated to meet the service condition. The fair value of each option is determined to be $20 at the grant date.

Employee benefit expense recognition recognition:: Grant Date

Year 1

$0

$300,000 = 100 options x 500 employees

Year 2

Year 3

Year 4

Year 5

x 90% x $20 x 1/3 years

Corporate Finance Institute®  

Accounting For Share-based Payments Example #2 continued (service and market performance conditions): conditions): At the end of Year 2, the price of Company XYZ’s stock has fallen and is 5% lower than at the grant date. •

Fewer employees left the company than expected and the revised estimate of employees that will meet the service condition is 95%.

•

The fair value of the options has fallen to $15. (The decrease in fair value of the options does not impact the expense calculation.) Employee benefit expense recognition recognition:: Grant Date

Year 1

Year 2

$333,333 = 100 x 500 x 95% x $20 x 2/3 years

Year 3

Year 4

Year 5

– $300,000 recognized in Year 1

Corporate Finance Institute®  

Accounting For Share-based Payments Example #2 continued (service and market performance conditions): conditions): At the end of Year 3, the price of Company XYZ’s stock has risen and is 25% higher than at the grant date. The fair value of the options has risen to $30. Also, 480 employees have met the service condition.

Employee benefit expense recognition recognition:: Grant Date

Year 1

Year 2

Year 3

$326,667 = 100 x 480 x $20 x 3/3 years – ($300,000 + $333,333) expenses recognized in Year 1 & 2

Year 4

Year 5

Total employee benefit expense = $300,000 + $333,333 + $326,667 = $960,000 Corporate Finance Institute®  

Accounting For Business Combinations

Corporate Finance Institute®  

Session Objectives

Identify the key criteria required for a set to be considered a business

Calculate goodwill arising from a business combination

Apply the general framework used to identify business combinations

Understand each of the steps in applying the acquisition method of accounting for business combinations

Corporate Finance Institute®  

Introduction to Business Combinations A business combination is a transaction or other event in which an acquirer obtains control of one or more businesses.

Business Combination

Acquirer

Control

Acquiree

Corporate Finance Institute®  

Key Elements of Business Combinations

Business

Acquisition Date

Acquirer

Acquiree

An integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing goods or services to customers, generating investment income or other income from ordinary activities

The date on which the acquirer obtains control of the acquiree

The entity that obtains control of the acquiree

The business or businesses that the acquirer obtains control of in a

business combination

Corporate Finance Institute®  

General Framework For Identifying Business Combinations Distinguishing between a business combination and an asset acquisition is important because there are many differences between the accounting treatment for each.

Test For Inputs and Substantive Substantiv e Process (Absence of Outputs) Test for Fair Value Concentration

Test for Outputs Test For Inputs and Substantive Substantiv e Process (Presence of Outputs)

Corporate Finance Institute®  

Fair Value Concentration The fair value concentration test is designed to quickly identify whether a transaction is more akin to an asset acquisition or a business combination. Is > 90% of the value acquired in a single asset or group of similar assets? 

Ye s

Asset Acquisition Test For Inputs and Substantive Substant ive Process

Test for Fair Value Concentration

(Absence of Outputs) Test for Outputs No Test For Inputs and Substantive Substant ive Process

(Presence of Outputs)

Corporate Finance Institute®  

Outputs, Inputs, and Substantive Processes

Inputs

Processes

Outputs

Any economic resources that creates or has the ability to contribute to the creation of outputs when one or more processes are applied to it

Any systems, standards, protocols, conventions, or rules that when applied to inputs, creates, or has the ability to significantly contribute to the creation of outputs

The result of inputs and processes applied to those inputs

Corporate Finance Institute®  

Outputs, Inputs, and Substantive Processes A business needs to have an input and a substantive process that together are critical critical to the ability to create outputs. There are different considerations depending depending on whether the set has outputs or not.

Test For Inputs and Test for Outputs

Ye s

Substantive Process (Absence of Outputs)

Business Combination

Asset Acquisition No

Test: In the absence of outputs, outputs, an input and a substantive process are deemed to be present if: I)

There The re is is a pro proces cesss criti critical cal to pro produc ducing ing out output puts, s, and

II)

Inputs that that include include employees employees that form form an organized organized workfor workforce ce and other inputs inputs that the the workforc workforce e could develop or convert into output.

Corporate Finance Institute®  

Outputs, Inputs, and Substantive Processes A business needs to have an input and a substantive process that together are critical critical to the ability to create outputs. There are different considerations depending depending on whether the set has outputs or not.

Test For Inputs and Test for Outputs

Ye s

Business Combination

Substantive Process (Presence of Outputs)

Asset Acquisition No

Test: In the presence of outputs, outputs, an input and a substantive process process are deemed to be present if there is: I)

An organized organized workf workforce orce with with skills, skills, knowl knowledge edge or experi experience ence critica criticall to produci producing ng outputs; outputs; or

II)

An acquired acquired cont contract ract that that provides provides acces accesss to an an organized organized workf workforce orce;; or

III) A process(es) process(es) that that cannot cannot be replaced withou withoutt significant significant cost, cost, effort effort or delay; delay; or IV) A process( process(es) es) that that is consid considered ered unique unique or or scarce. scarce. Corporate Finance Institute®  

Accounting Treatment For Business Combinations The acquisition method is used to account for business combinations and involves four steps:

01.

02.

03.

04.

Identify the Acquirer

Determine the Acquisition

Recognize and Measure the

Recognize and Measure

Date

Assets Acquired, and the Liabilities Assumed

Goodwill

Corporate Finance Institute®  

Identifying the Acquirer In a business combination, combination, an acquirer must be identified for accounting purposes.

Acquiree

Acquirer Control

Other factors to consider include:

1. Transfer of of cash / assets, exchange of equity

2. Relative voting rights in the combined entity

3. Existence of a large minority voting interest in

4. Board composition of the combined

5. Senior management of the

interests or the assumption of liabilities

the absence of other significant voting interests

entity

combined entity

Corporate Finance Institute®  

The Acquisition Date The acquisition date is the date on which the acquirer obtains control of the acquiree.

All forms of consideration are measured at fair value,

The assets acquired, liabilities assumed, and any

and the acquirer’s equity securities are issued to the seller.

non-controlling interests at are identified and measured fair value.

The acquirer begins consolidating the acquiree, if required.

Corporate Finance Institute®  

Recognizing and Measuring Assets Acquired and the Liabilities Assumed On the acquisition date, the acquirer shall recognize, separately from goodwill, the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree acquiree..

Recognition Principles

Measurement Principles

Identifiable assets acquired and liabilities assumed must:

An acquirer is required to measure the identifiable assets acquired, the

1. Meet Meet the the defini definitio tion n of of asset assetss and liabilities

liabilities assumed, and any noncontrolling interest in the acquiree at their acquisition-date fair values.

2. Be part part of of what what the the acqu acquire irerr and and acquiree exchanged in the

business combination

Corporate Finance Institute®  

Recognizing and Measuring Goodwill Goodwill represents the future economic benefits arising from other assets acquired in a business combination combinatio n that are not individually identified identified and separately recognized.

Consideration Transferred

Goodwill

The difference between consideration transferred by the acquirer to the acquiree and the fair value of the net assets acquired

Measured at fair value and includes: 1.

Assets Ass ets tra transf nsferr erred ed by by the the acqui acquirer rer

2.

Liabiliti Liabil ities es incu incurre rred d by the the acquir acquirer er to the former owners of the

Fair Value of Net Assets Acquired

acquiree; and 3.

Equity int Equity intere erests sts iss issued ued by the acquirer

Corporate Finance Institute®  

Accounting For Financing Fees and Transaction Costs

Corporate Finance Institute®  

Session Objectives

Understand examples of and the accounting for debt issuance costs

Understand examples of and the accounting for share issue costs

Understand examples of and the accounting for transaction costs

Corporate Finance Institute®  

Introduction to Financing Fees and Transaction Costs Financing fees and transaction costs are incurred when companies undertake certain transactions such as securing external financing or business combinations. Financing Fees

Debt Issuance Costs

Share Issue Costs

Transaction Costs

The accounting treatment differs depending on the nature of the cost.

Corporate Finance Institute®  

Debt Issuance Costs Debt issuance costs are the costs incurred by a company when they raise new debt. These costs are recognized initially on the balance sheet as a contra account under liabilities, and then amortized over the term of the related debt liability.

Debt Issuance Costs

Registration Fees

Underwriting Fees

Legal and Accounting Fees

Other Directly Attributable Costs

Corporate Finance Institute®  

Share Issue Costs Share issue costs are the costs incurred by a company when they issue shares to the public. These costs directly reduce the proceeds a company receives from an equity offering.

Share Issue Costs

Registration Fees

Underwriting Fees

Legal and Accounting Fees

Marketing and Administrative Costs

Corporate Finance Institute®  

Transaction Costs Transaction costs are incurred by both acquirers and targets during the course of an M&A transaction. Transaction costs represent services that have been rendered to and consumed by the acquirer and are expensed as they are incurred.

Transaction Costs

Financial Advisory

Legal Fees

Accounting Fees

Related Administrative Costs