Marketable Securities and Valuation Adjustments Objectives ! Understand when accounting departs from the "transactions- based" model and towards market-driven valuations ! Illustrate the role of judgment in applying the lower-of-cost- or-market (LCM) rule for inventory ! Understand how marketable securities are valued on companies' Balance Sheets ! Understand the Income Statement effects of valuation adjustments 15.514 Summer 2003 Session 12 1Should changes in market value be recognized? ! Accounts receivable <Estimates of uncollectibles <Changes in credit risk ! Inventory <Purchase/production cost <Changes in input prices, obsolescence ! Fixed Assets <Acquisition cost (historical basis) < Obsolescence Reliability vs. Relevance 15.514 Summer 2003 Session 12 2Lower of cost or market rule for Inventory < When Market Value of Inventory < Capitalized Cost <Loss on inventory writedown = Capitalized cost - Market Value, added to Cost of Goods Sold <Market value = minimum of replacement cost and selling price <Once inventory written down in the balance sheet, it cannot be “written up” in subsequent periods < Issues <Susceptibility to writedowns of LIFO vs. FIFO <“Hidden reserves” and income smoothing 15.514 Summer 2003 Session 12 3Valuation Adjustments: Royal Precision Royal Precision, Inc. and Subsidiaries Consolidated Statements of Operations Year ended May 31 (000) 2002 2001 2000 Net sales: Golf club shafts $19,833 $26,070 $25,559 Golf club grips 3,729 3,927 4,540 23,562 29,997 30,099 Cost of sales: Golf club shafts 17,430 18,927 17,562 Golf club grips 3,058 3,056 3,137 20,488 21,983 20,699 Gross profit 3,074 8,014 9,400 included in here Net (loss) income $(11,730) $(584) $870 The operating loss for the fiscal year 2002 included the following nonrecurring items: a $1.4 million charge to adjust inventory to its expected net realizable value… 15.514 Summer 2003 Session 12 4What are Marketable Securities? ! Marketable securities <Corporate and government bonds, treasuries < Common stock <Derivative instruments: options, swaps, etc. ! Question <Should changes in market value of Marketable Securities be recognized (i.e., recorded on the I/S and B/S) 15.514 Summer 2003 Session 12 5SFAS 115 ! Mark-to-market accounting: gains and losses treated similarly ! New classifications < Trading securities (debt and equity) < Available for sale (debt and equity) < Held-to-maturity (debt only) ! Controversy: where should changes in market value be reported? 15.514 Summer 2003 Session 12 6Marketable Securities ! Trading securities (debt and equity) <Acquired for short-term profit potential <Changes in market value reported in the income statement, investment marked to market in the balance sheet <Purchases and disposals reported in operating section of SCF ! Held to maturity (debt only) <Acquired with ability and intent to hold to maturity <No changes in market value reported in the income statement, thus investment carried at historical cost in the balance sheet <Interest income reported in operating section of SCF ! Available for sale (debt and equity) <Securities not classified as either of above <Changes in market value reported in “Other Equity” (net of taxes), instead of the income statement! <Purchases and disposals reported in investing section of SCF 15.514 Summer 2003 Session 12 7Intel SCF 2002 2002 2001 2000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,117 1,291 10,535 Adjustments to reconcile net income to net cash provided by operating activities: ...... (Gains) losses on equity securities, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372 466 (3,759) (Gain) loss on investment in Convera . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — 196 (117) Changes in assets and liabilities: Trading assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (444) 898 38 ..... Total adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,012 7,498 2,292 Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,129 8,789 12,827 Cash flows provided by (used for) investing activities: Additions to property, plant and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (4,703) (7,309) (6,674) Acquisitions, net of cash acquired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (57) (883) (2,317) Purchases of available-for-sale investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (6,309) (7,141) (17,188) Maturities and sales of available-for-sale investments . . . . . . . . . . . . . . . . . . . . . . . . 5,634 15,398 17,124 Other investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (330) (395) (980) Net cash used for investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (5,765) (330) (10,035) 15.514 Summer 2003 Session 12 8“Adjunct” account An Illustration: Acquisition and Dividends (2002) On Jan. 1, 2002, Ace acquired 500 common shares of security MITCo for $25/share. C MS +MSadj DTL OE RE Trading: AFS: On Nov. 30, 2002, Ace received $625 in dividends ($1.25/share of MITCo) C MS +MSadj DTL OE RE Trading: AFS: 15.514 Summer 2003 Session 12 9Unrealized Gains and Losses (2002) On Dec. 31, 2002, MITCo is trading at $30/share. Ace elected to keep the shares, and has a tax rate of 30%. 15.514 Summer 2003 Session 12 Trading: C MS +MS DTL OE RE BB: 12,500 EB: AFS: C MS +MS DTL OE RE BB: 12,500 EB: adjadj10Unrealized Gains and Losses (2003) On Dec. 31, 2003, MITCo is trading at $27/share. Ace elected …