71. Consolidated Financial Statements. Консолидированная финансовая отчетность.

The objective of IFRS 10 is to establish principles for the presentation and preparation of consolidated financial statements when an entity controls one or more other entities.

Consolidated Financial Statements - the financial statements of a group in which the assets, liabilities, equity, income, expenses and cash flows of the parent and its subsidiaries are presented as those of a single economic entity

When a company acquires another, and both companies continue their separate legal existence, consolidated financial statements must be presented. The parent company is the company that gains control over the other company. The subsidiary company is the company that the parent acquires. When the parent buys 100 percent of the subsidiary, the resulting consolidated financial statements look the same as they would if the companies were combined into one in a simple merger. A parent prepares consolidated financial statements using uniform accounting policies for like transactions and other events in similar circumstances.

Consolidated Balance Sheet

The purchase method of preparing consolidated financial statements combines similar accounts from the separate statements of the parent and the subsidiaries. It is necessary to eliminate intercompany transactions, debt, receivables and payables between parent and subsidiaries. Besides, when the balance sheets of the two companies are combined, Investment in Subsidiary account in parent company and stockholders’ equity accounts in subsidiary must be eliminated to avoid duplicating them in the consolidated financial statements.

When a parent company purchases less than 100% but more than 50% of a subsidiary’s voting stock, it will have control over the subsidiary, and it must prepare consolidated financial statements. It must also account for the interests of the subsidiary’s stockholders who own less than 50% of the voting stock. These are the minority stockholders, and their minority interest must appear on the consolidated balance sheet as an amount equal to their percentage of ownership times the subsidiary’s net assets.

The Accounting Principles Board has provided the following guidelines for consolidating a purchased subsidiary and its parent when the parent pays more than book value for its investment in the subsidiary: First, all identifiable assets acquired and liabilities assumed in a business combination should be assigned a portion of the cost of the acquired company, normally equal to their fair values at date of acquisition. Second, the excess of the cost of the acquired company over the sum of the amounts assigned to identifiable assets acquired less liabilities assumed should be recorded as goodwill. Goodwill is carried on the balance sheet at cost and is subject to an annual impairment test. When the parent company pays less than book value for its investment in the subsidiary, Opinion No. 16 of the Accounting Principles Board requires that the excess of book value over cost of the investment be used to lower the carrying value of the subsidiary’s long-term assets.

If a company owns more than 50 percent of a foreign subsidiary and thus exercises control, the foreign subsidiary should be included in the consolidated financial statements. The consolidation procedure is the same as the one we described for domestic subsidiaries, except that the statements of the foreign subsidiary must be restated in the reporting currency before consolidation takes place.

Financial management

72. Accounting Rate of Return, Payback, and Profitability Index Methods as Investment Rules. Application and Possible Problems. Учетная норма доходности, отдача и индекс прибыли как правила инвестирования. Применение и возможные проблемы.

The Accounting Rate of Return provides you with the return of the project which should be compared with the cost of raising capital to finance this project. A simple method is to accept any project that has an ARR that is higher than the cost of capital. The ARR has two different formulas that can be used to derive the return of the project.

ARR=Average Annual Profit/Initial Investment, where: 1) Average Annual Profit is the annual cash inflow that the project will generate after deducting depreciation; 2) Initial Investment is the capital expenditure that is required to undertake the project.

ARR=Average Annual Profit/Average Investment, where Average Investment is the capital expenditure that is required to undertake the project plus the salvage value of the machinery divided by two.

Advantages: 1) Simplicity; 2) Accounting date. The accounting rate of return can be readily calculated from the accounting data; 3) Comparability. It offers a certain degree of comparability between projects.

Disadvantages:1) It ignores time value of money. 2) It can be calculated in different ways. There is problem of consistency. 3) It uses accounting income rather than cash flow information.

Payback Period method attempts to forecast how long it will take for the expected net cash inflows to pay back the net investment outlays. The payback period rule for investment decisions states a particular cutoff date. For example, initial investment = 100, yearly income = 50 for 3 years, obviously, PBP = 2 years.

Advantages: Simplicity. Disadvantages:1) It ignores time value of money. 2) It ignores payments after Payback date. 3) It does not account for risk, financing or opportunity cost.

Additional complexity arises when the cash flow changes sign several times; i.e., it contains outflows in the midst or at the end of the project lifetime. The modified payback period algorithm may be applied then. First, the sum of all of the cash outflows is calculated. Then the cumulative positive cash flows are determined for each period. The modified payback period is calculated as the moment in which the cumulative positive cash flow exceeds the total cash outflow.

Profitability index is the ratio of the present value of the future expected cash flows after initial investment divided by the amount of the initial investment. (Profitability Index = Net Present Value / Initial Investment). (There is another version of the profitability index, whereby the present value of all cash inflows is divided by the present value of cash outflows. The resulting ranking will be the same as with the profitability index). It is a useful tool for ranking projects.

At PI=0 – breakeven (NPV=0), if PI > 0 then accept the project, if PI < 0 then reject the project.

Advantages: 1) Simplicity; 2) Possibility to rank projects.

Disadvantages: 1) Problem of multiple CFs (additional negative CF within the range of positive CFs (e.g.: -100; 50; 50; 50; -10; 50…)); 2) Problem of scale (PI can indicate to choose a smaller project with higher PI, but lower NPV).

73. Internal Rate of Return, Net Present Value Methods as Investment Rules. Application and Possible Problems. Внутренняя ставка доходности, чистая дисконтированная стоимость, как инвестиционные правила. Применение и возможные проблемы.

NPV is an indicator of how much value an investment or project adds to the firm. The basis for the NPV method is the assumption that one dollar today is worth more than one dollar tomorrow as today's dollar can be invested and generates interest.

NPV= CF₁/(1+r₁)¹ + CF₂/(1+r₂)²+…-I₀, where r – discount rate (market rate or expected rate of return by shareholders).

The profitability is assessed by examining the return on the invested capital and achieved under the assumption of a discount rate.

NPV rule: accept if > 0, reject if < 0. Participating in a positive NPV project will increase firm’s or shareholder’s wealth.

The NPV method is suitable for both the assessment of new investments as well as the comparison of investment alternatives. The investment with the higher net present value is the more favorable alternative.

Advantages:1) Uses CFs, not earnings; 2) eliminates time component; 3) results in investment decisions that add value. Disadvantages:1) difficult to predict CFs; 2) assumes a constant discount rate over life of investment.

Internal Rate of Return is the most important alternative to the NPV method. The basic rationale behind the IRR method is that it provides a single number summarizing the merits of a project. That number does not depend on the interest rate prevailing in the capital market. That is why it is called the internal rate of return; the number is internal or intrinsic to the project and does not depend on anything except the cash flows of the project.

In case of investing, the project with IRR more or equal to cost of capital must be chosen, in case of financing – vice versa.

To determine IRR, we need to solve the following equation:

Problems: IRR must be used for independent projects with CFs including only one change of sign (i.e. -10; 10; 10…). 1) For mutually exclusive projects IRR can indicate to choose a smaller one with less NPV (scale problem). In this case, the incremental IRR is used. All CFs for 2 mutually exclusive projects are summed for each period, thus, we will obtain one CF range and can calculate IRR. If incremental IRR>discount rate => choose the project which is bigger in volume. 2) If there are more than one change of sign, then the problem of multiple IRRs arises. In such case, Modified IRR must be used. MIRR implies that all the CFs with changes of sign are discounted and then combined with preceding CF_n. By several iterations, it is possible to adjust the CF range so as we are left with only one change in sign. Then, the MIRR rule can be applied.