Introduction to Financial Accounting, 7th Edition PowerPoint Presentations

1
Chapter 12

Intercorporate Investments and Consolidations
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Learning Objectives

• After studying this chapter, you should be able
  to
• Explain why corporations invest in one another.
• Account for short-term investments in debt
  securities and equity securities.
• Report long-term investments in bonds.
• Contrast the equity and market methods of
  accounting for investments.
• Prepare consolidated financial statements.

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Learning Objectives

• After studying this chapter, you should be able
  to
• Incorporate minority interests into consolidated
  financial statements.
• Explain the economic and reporting role of
  goodwill.

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An Overview ofCorporate Investments

• Corporate managers should invest
  any idle funds on hand just as
  individuals invest any idle cash
  they have on hand.
• Corporate investments can take many forms.
• Many companies invest in short-term and long-term
  debt securities of governments or companies.
• Companies also invest in equity securities of
  other companies.

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Corporate Marriage and Divorce

• Corporate mergers are very common, but not all
  business combinations work.
• Sometimes the assets of a company are sold off
  and the business disappears.
• Often the parent company sells off a business
  unit.
• Another alternative is a spin-off, which occurs
  when shares of a subsidiary are distributed to
  the shareholders of the parent company, and the
  spun-off company becomes a completely separate
  unit.

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Corporate Marriage and Divorce

• Once companies combine, accountants must develop
  ways to report the financial results.
• Once the company determines how the relationship
  will be measured, a question arises about where
  it will be reported on the balance sheet.
• If it is a short-term investment, it should be
  classified as a current asset.
• If it is a long-term investment, it should be
  classified as Investments or as Other Assets.

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Short-Term Investments

• Short-term investment - a temporary investment of
  otherwise idle cash in marketable securities
• Marketable securities - notes, bonds, or stocks
  that can be easily sold
• Short-term investments are expected to be
  converted to cash within twelve months.
• The key point on classification is that
  conversion to cash is immediately available at
  the option of management.

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Short-Term Investments

• Short-term debt securities - largely notes and
  bonds with maturities of one year or less can be
  held to maturity or resold in securities markets
• Certificates of deposit - short-term obligations
  of banks that pay fixed interest
• Commercial paper - short-term notes payable
  issued by large corporations with top credit
  ratings
• U.S. Treasury obligations - interest-bearing
  notes, bonds, and bills issued by the U.S.
  government

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Short-Term Investments

• Short-term equity securities - capital stock in
  other corporations held with the intention to
  liquidate within one year as necessary
• Short-term equity securities are held only for
  short-term cash purposes they are not held for
  reasons of controlling any other corporation
  through ownership of its capital stock.
• Short-term investments are recorded at
  acquisition cost.

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Short-Term Investments

• The way the investments are reported on the
  balance sheet depends on the motives of the
  corporation as to why the corporation purchased
  the securities.
• Short-term securities are classified
  as trading securities,
  held-to-maturity securities, or
  available-for-sale
  securities.

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Short-Term Investments

• Trading securities - current investments in
  equity or debt securities held for short-term
  profit
• Trading securities are reported as current assets
  on the balance sheet.
• They are measured at market value (fair value).
• Both debt and equity securities may be classified
  as trading securities.

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Short-Term Investments

• Held-to-maturity securities - debt securities
  that the investor plans to hold until maturity
• These securities are shown on the balance sheet
  at amortized cost rather than market value.
• Held-to-maturity securities are classified as
  short- or long-term according to the time
  remaining until they mature.
• Only debt securities may be classified as
  held-to-maturity securities because equity
  securities have no maturity date.

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Short-Term Investments

• Available-for-sale securities - investments in
  equity or debt securities that are not held for
  active trading but may be sold before maturity
• These securities are any securities that are
  neither trading securities
  nor held-to-maturity securities.
• Both debt and equity securities may be
  classified as available-for-sale
  securities.

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Changes in Market Pricesof Securities

• Accounting for returns on investments
• Interest revenue is the only return for
  held-to-maturity securities, and it is shown in
  the income statement.
• Returns on trading and available-for-sale
  securities come in two forms.
• Dividend or interest revenue, which are recorded
  in the income statement
• Changes in market value, which is handled
  differently for each classification of security

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Changes in Market Pricesof Securities

• Changes in market values for trading securities
• As market values change, companies report the
  resulting gains and losses in the income
  statement.
• Changes in market values for available-for-sale
  securities
• As market values change, the gains and losses are
  accounted for as unrealized gains and losses in a
  separate valuation allowance account in the
  stockholders equity section of the balance sheet
  rather than in the income statement.

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Changes in Market Pricesof Securities

• This method of accounting for trading and
  available-for-sale securities is called the
  market method.
• The reported values in the balance sheet are the
  market values.
• It is possible for two companies to have
  investments in the same company but account for
  the gains and losses from those investments in
  different ways, depending on whether the
  investments are classified as trading or
  available-for-sale.

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Comprehensive Income

• When investments are treated as
  available-for-sale securities, the changes in
  economic value are not fully revealed in the
  income statement because the changes are shown
  only on the balance sheet.
• To show the effect of these differences,
  comprehensive income is reported along with net
  income.
• Comprehensive income includes both net income and
  changes in the value of available-for-sale
  securities.

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Long-Term Investments in Bonds

• Recall that the issuer of bonds must amortize
  bond discounts and premiums as periodic
  adjustments of interest expense.
• Firms that invest in these bonds use a similar
  method of amortization, but most do not use a
  separate account for unamortized premiums or
  discounts.
• They reduce or increase the investment account
  directly.

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Bonds-Held-to-Maturity

• If bonds are issued to yield a higher interest
  rate than the coupon rate, they are sold at a
  discount.
• Investors pay less than the face amount of the
  bonds.
• Interest takes two forms
• Annual or semiannual cash payments
• A lump sum payment at maturity equal to the
  amount of the discount
• The investor must also amortize the lump sum
  discount over the life of the bonds just as the
  issuer does.

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Bonds-Held-to-Maturity

• The discount is used to make up the difference
  between the coupon interest rate and the market
  interest rate.
• Amortization of the discount increases the
  interest revenue of the investor, just as the
  amortization increases the interest expense of
  the issuer.
• Note that accounting for a premium is similar
  except that the amortization of a premium
  decreases interest revenue of investors and
  interest expense of the issuer.

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Early Extinguishmentof Investment

• For the issuer to extinguish the bonds early, the
  bonds must grant the issuer the right to do so or
  the bondholders must choose to sell the bonds
  back to the issuer.
• The gain or loss on the extinguishment is
  calculated as the difference between the carrying
  amount of the investment (face amount plus any
  unamortized premium or less any unamortized
  discount) and the cash received from the bonds.

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The Market and Equity Methods for Intercorporate
Investments

• The investors accounting for intercorporate
  investments depends on the amount of influence
  the investor can exercise over the investee.
• For ownership of less than 20 of the investee,
  the investor has no influence over the investee,
  and the investor accounts for the investment
  using the market method described earlier.
• For ownership of 20 or more of the investee, the
  investor may be able to exert significant
  influence over the investee, and the investor
  must use the equity method.

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The Market and Equity Methods for Intercorporate
Investments

• Equity method - records the investment at
  acquisition cost and adjusts the investment for
  the investors share of dividends and earnings or
  losses of the investee subsequent to the date of
  investment
• The book value at which the investment is carried
  is increased by the investors share of the
  investees earnings and reduced by dividends
  received from the investee and the investors
  share of the investees losses.

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The Market and Equity Methods for Intercorporate
Investments

• Larks Company pays 150,000 for an investment in
  Dusty Corporation. Dusty Corporation has net
  income of 200,000 for the year and pays
  dividends of 50,000 in total for the year. How
  will these transactions be recorded if Larks
  purchases 5 of the stock of Dusty? How will the
  transactions be recorded if Larks purchases 25
  of Dusty?

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The Market and Equity Methods for Intercorporate
Investments

• If Larks purchases 5 of Dusty, no significant
  influence exists. The investment is recorded
  using the market method as follows
• To record the purchase of the investment
• Investment in Dusty Co. 150,000
• Cash 150,000
• To record the income of Dusty Co.
• No entry required
• To record the receipt of the dividend
• Cash 7,500
• Dividend income (50,000 x 5) 7,500

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The Market and Equity Methods for Intercorporate
Investments

• If Larks purchases 25 of Dusty, significant
  influence does exist. The investment is recorded
  using the equity method as follows
• To record the investment
• Investment in Rusty Co. 150,000
• Cash 150,000
• To record the income of Rusty Co.
• Investment in Rusty Co. 50,000
• Investment income (200,000 x 25)
  50,000
• To record the receipt of dividends
• Cash 12,500
• Investment in Rusty Co. (50,000 x 25)
  12,500

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The Market and Equity Methods for Intercorporate
Investments

• The equity method does a better job of
  recognizing increases or decreases in the
  economic resources that the investor can
  influence.
• The reported net income of the investor company
  is increased by its share of net income or
  decreased by its share of losses recognized by
  the investee.

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Consolidated Financial Statements

• When one company buys a majority (over 50) of
  another company, a parent-subsidiary relationship
  exists.
• Parent company - a company owning more than 50
  of the voting shares of another company
• Subsidiary company - a company owned and
  controlled by a parent company through the
  ownership of more than 50 of the voting stock

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Consolidated Financial Statements

• When a parent-subsidiary relationship exists,
  each company remains a separate legal entity.
• Each company must be accounted for separately and
  has its own set of financial statements.
• These financial statements are then consolidated.
• Consolidated financial statements - combinations
  of the financial positions and earnings reports
  of the parent company with those of various
  subsidiaries into an overall report as a single
  entity

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The Acquisition

• From the parents perspective the purchase is
  simply an exchange of one asset for another,
  usually cash for the stock of the subsidiary.
• Total assets are unaffected. Cash decreases, but
  the investment in the subsidiary increases by the
  same amount.
• From the subsidiarys perspective, nothing
  changes on the books. However, the subsidiary
  now has one major owner - the parent.

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The Acquisition

• Before the purchase

S Shareholders
P Shareholders
Own
Own
P Corporation
S Corporation
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The Acquisition

• Purchase

Cash
P Corporation
S Shareholders
After the Purchase
Shares of S
P Shareholders
Own
P Corporation
and
S Corporation
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The Acquisition

• No books are kept for the consolidated entity.
• Only working papers are used to prepare the
  consolidated financial statements.
• To prepare the consolidated financial statements,
  the financial statement values of the parent and
  all the subsidiaries are added together.
• Remember not to count the ownership interest of
  the parent twice - once as an investment in the
  parents books and once in stockholders equity
  in the subsidiarys books.

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The Acquisition

• Preparing Consolidated Statements

Subsidiary Records
Parent Company Records
Parent Company Financial Statements
Subsidiary Financial Statements
Combine Parent and Subsidiary Financial
Statements on a Work Sheet
Eliminate Double Counting Parents Investment
Against Subsidiary OE Intercompany Receivables
and Payables Intercompany Sales and Purchases
Consolidated Financial Statements
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After Acquisition

• After the acquisition, the parent accounts for
  the investment just as it would using the equity
  method (20-50 ownership) for an unconsolidated
  ownership interest.
• The parents share of the subsidiarys income is
  included in the parents income statement.
• The subsidiarys net income must therefore be
  eliminated from the consolidated financial
  statements so it is not counted twice.

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Intercompany Eliminations

• In many cases, a parent company and its
  subsidiaries transact business with each other.
• Nothing really happens economically - money is
  shifted from one pocket to another.
• The transactions must be eliminated so that they
  are not counted twice in the consolidated
  statements.
• Any elimination journal entries are made only on
  the consolidation work sheet they are not made
  on the books of either company.

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Minority Interests

• Often, a parent company owns less than 100 of a
  subsidiary company.
• Minority interest - the rights of nonmajority
  shareholders in the assets and earnings of a
  company that is consolidated into the accounts of
  the major shareholder
• In the consolidation, all of the subsidiarys
  income is included.
• The share due to minority shareholders is then
  subtracted.

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Minority Interests

• Before the purchase

S Shareholders
P Shareholders
Own
Own
P Corporation
S Corporation
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Minority Interests

• 90 Purchase

P Corporation
S Shareholders
Cash
90 of Shares of S
After the Purchase
P Shareholders
Own
P Corporation
Some Old S Shareholders Hold 10 of S
and
S Corporation
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Defining Control

• GAAP specifies three methods for accounting for
  intercorporate investments.
• Less than 20 - use the market method
• More than 50 - use consolidation
• Between 20 and 50 - use the equity method

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Defining Control

• Whether to use one method or the other may depend
  on the investors ability to exert significant
  influence over the investee.
• In that case, the percentage tests are not hard
  and fast rules.
• Exerting significant influence includes the
  percentage of ownership and other factors such
  as
• Representation on the board of directors
• Participating in policy making processes
• Concentration of ownership

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Purchased Goodwill

• Goodwill - the excess of the cost of an acquired
  company over the sum of the fair market value of
  its identifiable individual assets less the
  liabilities
• Goodwill often results from such factors as
• Brand recognition
• Reputation
• Market share
• Earnings potential
• Location
• Customer list or base

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Goodwill and Abnormal Earnings

• The final price that a company will pay for
  another is the culmination of a bargaining
  process.
• The exact amount of goodwill is subject to the
  negotiating process concerning the final purchase
  price.
• Goodwill is essentially the price paid for
  excess or abnormal earning power.

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Amortization of Goodwill

• Goodwill does not have a perpetual life, but it
  may be maintained by continuous efforts.
• GAAP requires that goodwill be amortized and
  charged as an expense against net income for a
  period not to exceed 40 years.
• Many companies use a much shorter amortization
  period.
• Most companies use straight-line amortization.

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Perspective on Consolidated Statements

• The FASB requires that all subsidiary companies
  must be consolidated regardless of their line of
  business or the parents line of business.
• However, there are exceptions to this rule, but
  they are rare.
• For example, a subsidiary is not consolidated if
  control is likely to be temporary or if that
  control does not rest with the majority owner.

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Equity Affiliates, Minority Interest, and the
Statement of Cash Flows

• If a company has equity affiliates (firms in
  which the company is an equity method investor)
  and uses the direct method of preparing the
  statement of cash flows, no special problems
  arise.
• Only cash received from the affiliate as a
  dividend appears in the operating activities
  section.

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Equity Affiliates, Minority Interest, and the
Statement of Cash Flows

• If a company has equity affiliates and uses the
  indirect method of preparing the statement of
  cash flows, problems may arise.
• Net earnings is increased by the investors share
  of the affiliates earnings or decreased by the
  investors share of the affiliates losses.
• Net income must be adjusted for the affiliates
  shares in order to calculate cash flow from
  operating activities of only that one company.

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Purchased Research and Development

• The basic rule in an acquisition is that the
  books of the acquired company are included in the
  books of the acquiring company at their fair
  market values.
• Research and development (R D) creates a
  special problem.
• When a company acquires another, one asset
  acquired is R D in process, but R D must be
  expensed when incurred therefore, the acquiring
  company must immediately expense the amount paid
  for the R D.

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Summary of Accountingfor Equity Securities
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Introduction to Financial Accounting8th
EditionPowerPoint Presentation

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