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Ch 11

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  • 1. Intercorporate Investments and Consolidations CHAPTER 11
  • 2. 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
      • Incorporate minority interests into consolidated financial statements
  • 3. Learning Objectives
    • After studying this chapter, you should be able to
      • Explain the economic meaning and financial reporting of goodwill
  • 4. 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
  • 5. Overview of Corporate Investments
    • 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
  • 6. Overview of Corporate Investments
    • 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:
      • A separate investment category between current assets and PP&E, or
      • A part of other assets below the plant assets category
  • 7. 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
  • 8. 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
  • 9. 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
  • 10. Changes in Market Prices of Securities
    • 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)
  • 11. Changes in Market Prices of Securities
    • The exhibit below illustrates the accounting for trading securities and available-for-sale securities:
  • 12. Changes in Market Prices of Securities
    • The journal entries for periods 2, 3, and 4 would be:
  • 13. 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
  • 14. Long-Term Investments in Bonds
    • The journal entries for the purchase and the first two interest payments are:
    12/31/03 Investment in bonds 9,653,500 Cash 9,653,500 6/30/04 Cash 500,000 Investment in bonds 79,207 Interest revenue 579,207* 12/31/04 Cash 500,000 Investment in bonds 83,959 Interest revenue 583,959** * $9,653,500 x .06 ** ($9,653,500 - $79,207) x .06
  • 15. Long-Term Investments in Bonds
    • 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
  • 16. 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 9,600,000 Loss on disposal of bonds 216,666 Investment in bonds 9,816,666
  • 17. 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
  • 18. The Market and Equity Methods
    • 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
  • 19. The Market and Equity Methods
    • 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
    • Investment in Passiveco 80 1. Investment in Influential 80 Cash 80 Cash 80
    • No entry 2. Investment in Influential 12 Investment revenue 12
    • Cash 4 3. Cash 4 Dividend revenue 4 Investment in Influential 4
  • 20. 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
  • 21. 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
  • 22. The Acquisition P Corporation S Corporation Cash S Shares Purchase After Purchase P Corporation S Corporation P Shareholders Consolidated corporation
  • 23. The Acquisition
    • The balance sheets of each company appear as follows before and after the purchase:
  • 24. 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
  • 25. 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
  • 26. 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
  • 27. 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
  • 28. 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
  • 29. 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:
      • All acquired assets and liabilities are shown at their fair market value (FMV)
      • 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
  • 30. 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
  • 31. Accounting for Goodwill
  • 32. Accounting for Goodwill
    • 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
  • 33. 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
  • 34. Goodwill and Abnormal Earnings
    • The following example assumes a multiple of 10 for normal earnings and 6 for abnormal earnings
    • FMV of identifiable assets, less liabilities $800,000
    • Normal annual earnings on net assets at 10% 80,000
    • Actual average annual earnings for past 5 years (including an excess return of $20,000) 100,000
    • Maximum price paid for normal annual earnings (10 x line 2) 800,000
    • 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
    • Maximum price a purchaser is willing to pay for the company (line 1 plus line 5) $920,000
  • 35. 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
  • 36. Summary of Accounting for Equity Securities