intercorporate investments and consolidations

© 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick

Intercorporate Investments and

Consolidations

CHAPTER

11

© 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 2 of 36

Learning Objectives

After studying this chapter, you should be able to1. Explain why corporations invest in one another2. Account for short-term investments in debt

securities and equity securities3. Report long-term investments in bonds4. Contrast the equity and market methods of

accounting for investments5. Prepare consolidated financial statements6. Incorporate minority interests into consolidated

financial statements


Learning Objectives

After studying this chapter, you should be able to7. Explain the economic meaning and financial

reporting of goodwill


Overview of Corporate Investments

• Companies invest in short- and long-term debt securities issued by governments, banks, or corporations

• Companies also invest in corporate equities that may be classified as marketable securities

• Corporations combine in order to – Find the right combination of people and products to

succeed in the long run– Create cost savings from eliminating duplications



• Smaller companies tend to result in more successful mergers

• Companies sometimes sell parts of themselves when they purchase another company

• Spin-offs often separate dissimilar business segments to create opportunities for more creative and innovative growth



• A short-term investment expected to be converted to cash should be carried as a current asset

• Other investments are classified as noncurrent assets and usually appear as either:1. A separate investment category between current

assets and PP&E, or2. A part of other assets below the plant assets

category


Short-Term Investments

• A short-term investment is a temporary investment in marketable securities that are expected to be converted to cash within one year

• Marketable securities are notes, bonds, or stocks that can be easily sold

• Short-term debt securities consist of notes and bonds with maturities of one year or less– Examples: CDs, commercial paper, and Treasury bills


Short-Term Investments

• Short-term equity securities consist of capital stock in other corporations

• Trading securities are short-term investments in debt and equity securities that the company intends to sell shortly

• Held-to-maturity securities are debt securities that the company intends to hold until they mature

• Available for sale securities are neither trading or held-to-maturity securities


Changes in Market Prices of Securities

• Held-to-maturity securities– Recognize interest income on the income statement– Are valued at amortized cost, ignoring changes in

market value• Trading securities

– Recognize dividend and interest revenue on the income statement

– Are valued at market value (market method), recognizing unrealized gains and losses on the income statement



• Available for sale securities– Recognize dividend and interest revenue of the

income statement– Are valued at market value (market method),

recognizing unrealized gains and losses in a separate account in the stockholders’ equity section of the balance sheet (accumulated other comprehensive income)



• The exhibit below illustrates the accounting for trading securities and available-for-sale securities:

End of Period 1 2 3 4 Short-term investment cost 50 50 50 50 Market value 50 45 47 54 Unrealized gain (loss) 0 (5) (3) 4 For trading securities: Income statement presentation: Unrealized gain (loss) on changes in market 0 (5) 2 7 For available-for-sale securities: Owners’ equity presentation: Unrealized gain (loss) 0 (5) (3) 4



• The journal entries for periods 2, 3, and 4 would be:

Period Trading Securities Available-for-sale Securities 2 Unrealized loss* 5 Unrealized gain or loss** 5 Marketable securities 5 Marketable securities 5 3 Marketable securities 2 Marketable securities 2 Unrealized gain* 2 Unrealized gain or loss** 2 4 Marketable securities 7 Marketable securities 7 Unrealized gain* 7 Unrealized gain or loss** 7

* Income statement account ** Balance sheet account (reported in accumulated other comprehensive income)


Long-Term Investments in Bonds

• Using the same data from Chapter 9, but now from the point of view of the investor:– 10,000 $1,000 2-year 10% bonds (5% semi-annually)

are purchased when the annual market interest rate is 12% (6% for each six-month period)

– $965.35 is paid for each bond, for a total cost of $9,653,500

– The issuer recognizes a discount of $346,500 ($10,000,000 - $9,653,500) at issuance

– The investor must also amortized the discount over the 4 semi-annual periods using the interest method



• The journal entries for the purchase and the first two interest payments are:

12/31/03 Investment in bonds 9,653,500Cash 9,653,500

6/30/04 Cash 500,000Investment in bonds 79,207

Interest revenue 579,207*

12/31/04 Cash 500,000Investment in bonds 83,959

Interest revenue 583,959**

* $9,653,500 x .06

** ($9,653,500 - $79,207) x .06



• The discount makes up for the difference between the coupon rate of 10% and the market rate of 12%

• Amortization of a discount increases the interest revenue for the investor

• Amortization increases the investment account directly – a separate discount account is not used for the investor


Early Extinguishment of Investment

• Suppose that the issuer buys back the bonds for $9.6 million on December, 2004, when the amortized cost is $9,816,666, the journal entry for the extinguishment by the investor is:

12/31/04 Cash 9,600,000Loss on disposal of bonds 216,666

Investment in bonds 9,816,666


The Market and Equity Methods

• The investor’s accounting depends on the level of influence of the investor over the investee

• The equity method recognizes increases or decreases in the economic resources that the investor can influence

Percentage Level of Ownership Influence Method Valuation Income Reporting 0 – 20% Nominal Market Market Dividends Separate 20 – 50% Significant Equity Cost + % earnings % earnings Separate - % dividends of of investee investee Over 50% Control Equity Cost + % earnings % earnings Consolidation - % dividends of of investee investee



• Suppose Buyit Corporation invests $80 million in each of two companies:– Passiveco

• Total market value of $800 million (10% ownership)

• Earnings of $120 million• Dividends of $40 million

– Influential• Total market value of $200 million (40%

ownership)• Earnings of $30 million• Dividends of $10 million



• Buyit’s journal entries for (1) acquisition, (2) net income of the investee, and (3) dividends of the investee are (in millions):

• Buyit recognizes income from – Passiveco as dividends are received ($40M x 10%)– Influential as part of its earnings ($30M x 40%)

Market Method – Passiveco Equity Method – Influential

1. Investment in Passiveco 80 1. Investment in Influential 80Cash 80 Cash

80

2. No entry 2. Investment in Influential 12 Investment revenue 12

3. Cash 4 3. Cash 4 Dividend revenue 4 Investment in Influential

4


Consolidated Financial Statements

• When a investor has control over an investee company (over 50% ownership), it must prepare consolidated financial statements

• The investor company is called the parent• The investee company is called the subsidiary• Although both companies remain separate legal

entities, the financial position and earnings reports of the parent are combined with those of the subsidiary


The Acquisition

• Assume two separate companies:– Company P: Assets of $650 million– Company S: Assets of $400 million

• P purchases all of the outstanding stock of S for $213 million in cash

• The journal entry on the books of P (in millions) is:

Investment in S 213

Cash 213


The Acquisition

P Corporation

S Corporation

Cash

S Shares

Purchase

After Purchase

P Corporation

S Corporation

P Shareholders

Consolidated corporation


The Acquisition

• The balance sheets of each company appear as follows before and after the purchase:

THE BALANCE SHEETS

Before Purchase After PurchaseS P S P

Cash 100 300 100 87Net plant 300 350 300 350Investment in S 213Total assets 400 650 400 650

Accounts payable 187 100 187 100Bonds payable 100 100Stockholders' equity 213 450 213 450Total liabilities and SE 400 650 400 650


Preparing Consolidated Statements

Parent Company Records

Subsidiary Records

Combine Parent and Subsidiary Financial Statements on a Work Sheet

Subsidiary Financial

Statements

Consolidated Financial Statements

Parent Company Financial

Statements

Eliminate Double Counting Parent’s Investment Against Subsidiary OE

Intercompany Receivables and Payables Intercompany Sales and Purchases


Preparing Consolidated Statements

• In combining the amounts on the balance sheet, P must eliminate its investment account and the stockholders’ equity of S, which eliminates double-counting of the investment in S

Assets = Liabilities + Owners' EquityCash and Accounts

Investment + Other = Payable, + Stockholders'in S Assets etc. Equity

P's accounts, Jan. 1 before acquisition 650 = 200 + 450Acquisition of S +213 -213 =S's accounts, Jan. 1 400 = 187 + 213Intercompany eliminations -213 = -213Consolidated, Jan. 1 0 + 837 = 387 + 450


After Acquisition

• P continues to use the equity method during the period

• To prepare consolidated statements, P must eliminate:– Its investment account and the SE of the subsidiary

on the consolidated balance sheet– Intercompany revenues and expenses on the income

statement– Other intercompany transactions


Minority Interests

• A parent company may own less than 100% of the outstanding stock (51% - 99%)

• Claims by non-majority stockholders on assets and earnings in the consolidated statements are called minority interests

• Minority interest must be shown on both the consolidated income statement and consolidated balance sheet


Minority Interests

P Corporation

S Corporation

Cash

S Shares

90% Purchase

After Purchase

P Corporation

S Corporation

P Shareholders

Dashed line defines consolidated corporation

P pays cash to some shareholders in S

Some old S shareholders hold

10% of S

Shown as “Minority Interest” in consolidated statements


Purchase Price Not Equal to Book Value

• When the acquiring company pays more than the book value of the acquired company’s net assets, consolidation requires a two-step adjustment:1. All acquired assets and liabilities are shown at their

fair market value (FMV)2. If the purchase price > FMV of the net assets,

goodwill must be shown on the consolidated balance sheet

• Goodwill is the excess of the cost of an acquired company over the sum of the FMV of its identifiable assets less the liabilities


Accounting for Goodwill

• In the previous example, assume that:– P acquired a 100% interest in S for $253 million rather

than $213 million– A building with a book value of $20 million had a FMV

of $35 million• The tabulation of the consolidated balance sheet

including the calculation of goodwill is shown in the next exhibit



Cash and AccountsInvestment + Other + = Payable, + Stockholders'

in S Assets Goodwill etc. EquityP's accounts, Jan. 1 before acquisition 650 = 200 + 450Acquisition of S +253 -253 =S's accounts, Jan. 1 400 = 187 + 213Intercompany eliminations -253 +15 ** +25 * = -213Consolidated, Jan. 1 0 + 812 + 25 * = 387 + 450

*The $25M goodwill would appear in the consolidate balance sheet as a separate intangible asset account**The $15M increase to cash and other assets shows the increase due to the market value of the building exceeding its book value



• Impairment of goodwill occurs when it loses its value subsequent to acquisition

• The consolidated company must record any impairment with a decrease to the goodwill account and a charge to an expense account


Goodwill and Abnormal Earnings

• Goodwill is the price paid for “excess” or “abnormal” earning power

• This abnormal earning power could be due to location, human resource, or reputation advantages

• Normal earnings and excess earnings are capitalized by a multiple

• The multiple for excess earnings is lower since it is riskier


Goodwill and Abnormal Earnings

1. FMV of identifiable assets, less liabilities $800,000

2. Normal annual earnings on net assets at 10% 80,000

3. Actual average annual earnings for past 5 years (including an excess return of $20,000) 100,000

4. Maximum price paid for normal annual earnings (10 x line 2) 800,000

5. Maximum price paid for abnormal annual earnings (which are riskier and thus less valuable per dollar of expected earnings) is 6 times $20,000 120,000

6. Maximum price a purchaser is willing to pay for the company (line 1 plus line 5) $920,000

• The following example assumes a multiple of 10 for normal earnings and 6 for abnormal earnings


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

• The statement of cash flows is affected for a company having equity affiliates (firms for which the investor uses the equity method) in the follow way:– Direct method: A cash dividend received from the

affiliate appears in the operating section– Indirect method: Net income is increased (decreased)

by the investor’s share of its affiliates’ earnings (loss) in the operating section


Summary of Accounting for Equity Securities

Percentage of Type of Balance Sheet Income Statement Major Journal Ownership Accounting Effects Effects Entries 100% Consolidation Assets and liabilities Revenues and Only worksheet are added together. expenses are entries to If price>FMV, goodwill added together. eliminate inter- is shown. Any goodwill company must be checked accounts. for impairment. Greater than Consolidation Same as above, but Same as above, Same as 1, but 50% and less minority interest is minority interest minority interest than 100% recognized. recognized near is included in bottom of income work sheet statement. entries. 20% to and Equity method Investment carried at Equity in earnings Investment xx including 50% cost plus pro rata share (losses) of Equity in earnings xx investee earnings less investee shown To record earnings. dividends received as increase to Cash xx (decrease from) Investment xx income. To record dividends received. Less than 20% Market method Investment carried at Trading securities: Marketable securities xx market annual changes Unrealized gain (loss) xx affect the income To record appreciation. statement. Available-for-sale: Marketable securities xx cum. changes SE xx appear in SE. To record appreciation.

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