DEPARTMENT OF FINANCE

FN 301: FINANCIAL ANALYSIS ASSIGNMENT 1

RABIAM HAMIS

2009-04-05494

Question 1
a) Discuss the concept of asymmetric information and explain how it may

cause corporate managers to serve as investors.

Definition: Asymmetric Information Asymmetric information is a situation in which economic agents involved in a transaction have different information. Imperfect information: the absence of certain knowledge by a single person or by more than one party In situations of asymmetric information, the allocation of resources will not be economically efficient. The asymmetry can be resolved directly through appraisal or indirectly through screening, signaling, or contingent payments. The indirect methods depend on inducing self-selection among parties with different characteristics. Screening is an initiative of the party with less information, while signaling is an initiative of the party with better information. When the distribution of information is asymmetric, one or more parties will have imperfect information and hence bear risk. The distribution of risk may conflict with the self-selection needed to resolve the asymmetric information. So a firms managers have information about their firm that outside investors do not have. Therefore, they may be in a better position to value the shares than outside investors. If they believe the market value of the shares is too low, they may repurchase shares. Question 1 b) Assume that after you graduate, you get a job as the chief financial officer of a small company. Explain why being able to forecast the direction of interest rate changes may be critical for your success in that position. Likewise, why are investment bankers concerned about future changes in the interest rate? Answer As the chief financial officier of a small company, the interest rate is very important. In all probability, the company holds some long-term financial instrments. The fluctuations of interest rates have a direct effect on the value of these long-term investments. For example, if interest rates increase, the value of long-term bonds decreases and vice versa. If a company holds long-term financial instruments, an increase in interest rates will cause the value of these instruments to fall. The chief financial officer will be much more successful if he/she can anticipate or forecast changes in interest rates and sell the long term financial instruments before interest 2

rates do increase and the value of the instruments fall. Likewise, if the chief financial officer expects rates to fall, he/she should move available funds into longterm instruments before rates do fall. If successful in this strategy, long term capital gains will be increases and capital losses minimized. Investment bankers hold stockpiles of long-term financial instrments such as bonds. Any increase or decrease of interest rates can drastically change the values of bonds and exposes the investment banker to potential capital gains or losses. Question 1 c) Discuss the importance on quantitative analysis in Debt rating.
Answer Credit rating refers to an expression of an opinion through symbols about the credit worthiness of the issue of securities with regard to a debt instrument. It is the assignment of a symbol of the current opinion of the rating agency on the relative ability and willingness of the issuer of debt instrument to make timely repayment of the interest and principal. Good rating helps the corporate borrowers to raise funds at a cheaper rate.

In determining the rating, both qualitative and quantitative analysis is employed by the credit rating agency. The judgment given is essentially qualitative in nature. It should be noted that credit rating does not amount to a recommendation to purchase, subscribe, and hold or sale a particular debt instrument. So the importance of quantitative analysis in debt has benefits to both the investor and issuer. Benefits to Investors Credit rating symbols provide guidance for ascertaining the risk involved in the issue. It provides a better choice among available investment options. It enables quick decisions and easy understanding of investment opportunities. It informs investors about the financial strength of the issuer and the risks involved along with its safety. Rating ensures a fair assessment of the credibility of the issuer company. It relieves the investors from collecting information about the issuer or the security. Benefits to the issuer Good rating enhances the goodwill and reputation of the issuer company. Highly rated instruments carry lesser returns. It, thus reduces the effective cost of borrowing for the issuer company. Rating acts as a marketing device. The issue is exposed to a wider investor base.

Question 7 a) Explain the kind of non-financial statement information that can have an effect on the company future earnings? Answer Non-Financial Statement Information means Information on the state of the economy, industry and competitive considerations, market forces, technological change, and the quality of management and the workforce are not directly reflected in a company's financial statements. Information on state of economy; business cycles such as recession, boom, all can have effects on company future earnings. Also if the quality of the management and workforce is not good, and if the company is technical laggard, and if the company is an industry that is not growing at fast rate and lack competitive advantage to compete at the market place it can have effects on company future earnings. Question 7 b) How does the choice of an accounting method influence market value of a firms equity or debt security? Debt securities have a maturity value representing the amount to be repaid, a fixed or variable interest rate, and a maturity date, when repayment of the debt is due. Equity securities represent ownership in a company and typically carry the right to collect dividends and to vote on corporate matters. The accounting for an investment in an equity security is determined by the amount of control of and influence over operating decisions the company purchasing the stock has over the company issuing the stock. FASB Statement No. 115, issued in 1993, requires financial statements to classify investment securities according to managements intent in holding the securities. Each class requires different accounting treatment. The four classes are: 1. 2. Held-to-Maturity, debt securities only, intended to be held until they mature. Available-for-Sale, held as a store of excess cash rather than for trading or for influence or control, but not intended to be held to maturity. May be either debt or equity securities. Trading, held for short-term trading purposes in the hope of a rise in price. May be either debt or equity securities

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4. Equity method, equity securities only, purchased with the intent of gaining influence or control over the operations of the investee. Types of Securities Disclosure on the Treatment of Class of securities
Balance Sheet Held to Maturity Debt Amortized cost Temporary Changes of Value Amortized cost

Available for Sale Trading Equity method

Debt and Equity Debt and Equity Equity

Fair market value Fair market value Historical cost adjusted for changes in the net assets of the investee

Reported in stockholders equity Reported on the income statement Not recognized

The reasons for the different accounting treatments reflect the differing purposes for which the securities are held Class of Securities Held to Maturity Types of Securities Debt Disclosure on the Balance Sheet Amortized cost Treatment of Temporary Changes of Value c

Available for Sale Trading Equity method

Debt and Equity Debt and Equity Equity

Fair market value Fair market value Historical cost adjusted for changes in the net assets of the investee

Reported in stockholders equity Reported on the income statement Not recognized

puzzle.
nvestments in Debt and Equity Securities Chapter 14

Among the reasons that companies invest in debt and equity securities of other companies are the following: 1. 2. 3. 4. 5. As a safety cushion, to maintain a large enough liquid investment balance to tide the company over an emergency. To meet cyclical cash needs (for companies in highly seasonal businesses). To gain a return on idle investment To gain influence over the decisions of the company being invested in. To gain complete control over another company. When one company owns more than 50% of another company, the financial statements of the first company must combine the financial performance of the other company (its subsidiary) with its own performance as if the two companies were one single company.

Debt securities have a maturity value representing the amount to be repaid, a fixed or variable interest rate, and a maturity date, when repayment of the debt is due. Equity securities represent ownership in a company and typically carry the right to collect dividends and to vote on corporate matters.

The different accounting treatments are as follows (Exhibit 14-8. page 831):

Class Securities

of

Types Securities

of

Disclosure on the Balance Sheet Amortized cost Fair market value Fair market value Historical cost adjusted for changes in the net assets of the investee

Held to Maturity Available for Sale Trading Equity method

Debt Debt and Equity Debt and Equity Equity

Treatment of Temporary Changes of Value Not recognized Reported in stockholders equity Reported on the income statement Not recognized

The reasons for the different accounting treatments reflect the differing

purposes for which the securities are held. Thus neither equity-method securities nor securities being held to maturity are held to be sold, so that changes in their fair value are not so relevant. Trading securities and availablefor-sale securities are intended to be sold if their price rises high enough: therefore the fair market value is of interest to users of the financial statements. However, available-for-sale securities, unlike trading securities, are not expected to be sold in the current accounting period; consequently the unrealized gains or losses are reported through Accumulated Other Comprehensive Income directly in the Stockholders Equity section of the balance sheet, rather than passing through the income statement into Retained Earnings.

The purchase of debt and equity securities is recorded at cost as with other assets. In the case of debt securities, a minor complication occurs when the security is bought between interest payment dates: then accrued interest must be recognized separately from the investment cost. The interim accrued interest is debited as Interest Receivable and credited to Interest Revenue when received (asset approach). Alternatively, under the revenue approach, the accrued interest paid at the time of purchase may be debited immediately to Interest Revenue and then credited when received. See example on Page 832. In either approach, the interest revenue recognized for the period is the interest earned, not the interest received.

Amortization of premium or discount could be performed for trading and available-for-sale debt securities, but this is not normally done, because the value of the asset is set to the current market value at the end of the accounting period anyway. At acquisition any premium or discount is simply netted with the face value. See page 834.

For held-to-maturity debt securities, amortization of premium or discount is calculated using an amortization table to allow interest revenue and amortization to be recorded separately. This ensures that carrying value of the security equals the maturity value on the maturity date. See example on Page 835.

Recognition of revenue from equity securities depends on the degree of influence or control exercised by the investor over the investee. When the degree of influence or control is sufficiently high, as indicated by representation of the investees board of directors, by interchange of managerial personnel, by investees technological dependence on the investor, or by extent of ownership (50% of common stock, or less than 50% if the remaining ownership is widely held and no significant blocks of shareholders are consistently united in their ownership). These criteria are outlined in APB Opinion No. 18, issued in 1971. The APB recognizes that judgment is required and sets 20% (to 50%) of ownership as a presumptive level for significant influence.

When control exists, the financial statements of parent company and subsidiary must be consolidated in addition to use of the equity method of accounting. Inter-company transactions are eliminated. Control exists when the principal company owns more that 50% of the subsidiary. FASB is currently considering expanding the concept of control to encourage consolidation of subsidiaries for which parent companies have control with less than 50% of ownership.

Ownership interest More than 50% 20 to 50% Less than 20%

Control degree influence Control

or of

Accounting method Equity method and consolidation procedure Equity method Account for as trading or available for sale

Applicable standard APB Opinion No. 18 APB Opinion No. 18 FASB Statement No. 115

Significant influence No significant influence

Revenue for trading and available-for-sale equity securities consists only of dividends declared. Under the equity method, the investment account is periodically adjusted to reflect changes in the underlying net assets of the investee. A proportionate share of investee earnings, after deducting preferred stock dividends declared by the investee, increases the account, a proportionate share of investee losses, and dividends received by the investor decrease it. See Page 838.

Exhibit 14-10 on Page 839 illustrates the difference between the equity method and revenue recognition using FASB Statement No. 115.

When the purchase price of a company acquired by another company differs from the recorded book value of the underlying net assets of the acquired company, the purchase price must be allocated among the assets acquired as explained in Chapter 10. Any part of the purchase price that cannot be so allocated is recorded as goodwill. Goodwill may be negative if the purchase price is less than the total fair value of the net assets acquired. Then the adjusted values are used to determine the depreciation and amortization charges. Corresponding adjustments to the investees reported income may be required when only a portion of the investees stock is purchased. See Pages 840 1.for the details.

Joint ventures are accounted for using the equity method. This is a form of offbalance-sheet financing. The liabilities of the joint venture offset the assets on the balance sheets of the owner companies which do not have to report them as liabilities of their own, although in effect they have jointly borrowed the money.

Changes in the current market value of trading and available-for-sale debt and equity securities are recorded in a Market Adjustment account. Unrealized gains and losses are reported as gains or losses on the income statement (trading securities) or in an equity account: Accumulated Other Comprehensive Income (available-for-sale securities). See Pages 842 845 for an extensive example.

Deciding whether a decline in market value of a security is other than temporary calls for professional judgment. If it is, the loss in value should be credited through the investment account rather than through a market adjustment account and charged against current income, regardless of the classification of the security. See page 846. SEC Staff Accounting Bulletin No. 59 provides some guidance for the accountant: the following criteria should be considered in determining whether a decline in value is other than temporary Length of time under original cost: over six months suggests other than temporary. Financial condition of investee and its industry: losses over several years and poor industry performance suggest other than temporary. Is security intended to be held long enough to recover value?

The sale of an investment security requires the carrying value to be removed from the books and the difference between the carrying value and the cash received to be recorded as a realized gain or loss. In addition, in the case of debt securities an entry is required to record interest earned to the date of the sale and to amortize any premium or discount. See Pages 847-8.

When a portion of an investment securities portfolio is sold during the year, care must be taken to distinguish properly between realized and unrealized gains and losses. Realized gain/loss is the difference between the selling price and the original cost of the securities. Unrealized gain/loss is the amount needed to adjust the end-of-year market adjustment account to its appropriate balance.

The classification of a security, reflecting as it does managements intentions regarding the purpose and length of time for which it is to be held, is subject to change. Should this happen, recognition of previously unrecognized changes in value must be made to ensure that securities are recorded at their value on the date of the reclassification. This also ensures that the category change cannot be

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used to hide unrealized losses. Pages 850 852 treat the changes between the classes described in FASB Statement No. 115. Generally, the security being reclassified is accounted for at its fair value at the time of the transfer, as required by FASB Statement No. 115. This fair value will generally differ from the historical cost, at which the security is being maintained on the books. The historical cost is removed from the old category, the current fair value is entered in the new category, and the difference is treated in one of several manners depending on the categories involved in the reclassification. Exhibit 14-13, Page 850, summarizes the accounting for transfers of securities between categories.

The classification of investment securities affects the statement of cash flows. Purchases and sales of available-for-sale, held-to-maturity and equity-method securities are reported in the Investing Activities section. Purchases and sales of trading securities are reported in the Operating Activities section. When the indirect method is used to compute operating cash flow, adjustments must be made for unrealized gains and losses of trading securities. Also a special adjustment must be made to Operating Activities cash flows associated with equity-method securities to take account of the difference between cash received as dividends and the income reported from the investment. See Pages 853 854.

Realized gains and losses on the sale of investment securities are reported in the income statement in the period of the sale, as Other Revenues and Expenses or as Net Investment Income. Unrealized gains and losses on trading securities are also reported as Other Revenues and Expenses. Unrealized increases and decreases in the value of available-for-sale securities are reported as other comprehensive income and accumulated in the Stockholders Equity section of the balance sheet. Appropriate presentation of individual securities on the balance sheet depends on the intent of management. Trading securities are short term by definition and are presented as current assets. Held-to-maturity securities are always non-current assets unless they mature with a year. Available-for-sale securities are presented as current or non-current according to the intentions of management. FASB Statement No. 115 requires certain additional disclosures in the notes to the financial statements (Page 857).

International accounting for investment securities is very similar to GAAP. The major exception is that under IFRS companies can elect to recognize all unrealized gains and losses--both for trading and available-for-sale securities--in net income for the period. As we have previously discussed, under GAAP only unrealized gains and losses can be reported as net income.

Please skip Chapter 14's extended material relating to accounting for the impairment of a loan.

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Accounting for Equity Securities

An equity security is an investment in stock issued by another company.. If less than 20% of the stock is acquired and no significant influence or control exists, the investment is accounted for using the cost method. If 2050% of the stock is owned, the investor is usually able to significantly influence the company it has invested in. Assuming the investor does not control the number of positions on the Board of Directors or hold key officer positions, this investment would be accounted for using the equity method. If the investor has 50% or more of a company's stock, significant influence and control are deemed to exist and the investor reports its results using consolidated financial statements. Although percent of voting stock owned serves as a guideline, the amount of influence and control is used to determine the accounting for equity securities.

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