MANAGEMENT DECISIONS AND FINANCIAL

ACCOUNTING REPORTS

Baginski & Hassell

Chapter 8

• Topics– Methods of accounting for investments in

common stock– “Mark-to-Market accounting” for certain

investments in equity securities

– Opportunity for gains trading– Legal forms of business combinations– Accounting methods for business combinations– Consolidated financial statements

Methods of Accounting for Investments in Common Stock

• Cost Method– Investor has no significant influence over

increase• Presumed to be ownership of < 20% of

investee’s outstanding common stock• Equity method

– Investor has significant influence, but does not have control over investee• Presumed to be ownership of 20% - 50% of

investee’s outstanding common stock

FAQ?

When should a corporation consider consolidation, i.e., consolidated financial statements?

When the investor is “in control” which is clearly the case when over 50% of the investee’s outstanding common shares are owned. Effective control can often take somewhat less than 50%!

Cost Method

• An investor uses the cost method if it has no significant influence over investee– Investment is recorded at the cost of acquiring

the shares

• If marketable, securities are classified as either trading or available-for-sale (in accordance with SFAS No. 115).

• The investee’s pro rata share of dividends declared by investee is recorded as dividend income– Dividend income is shown in the other

income section of the income statement.

– Dividends received are shown as an operating activity in the SCF.

Equity Method• An investor uses the equity method if it has

significant influence over the investee, but it does not have control– The investment is initially recorded at the cost

of acquiring the shares.– The investor’s pro rata share of investee net

income is recorded as (1) an increase in the investment, and (2) investment income (reported in the “other income” section of the income statement; not dependent on cash flows).

Equity Method & Dividend Collections

– The investor’s pro rata share of dividends declared by investee is recorded as a reduction of the investor’s investment

– Under the equity method, the investment is not marked-to-market

Example: Compare and Contrast Cost and Equity Methods

(for long-term investments)

Facts: On January 1, the O’Brien Co. purchased 100,000 shares of Gilly Co.’s common stock for $18 per share (or 15% of Gilly’s outstanding common stock).

For the year, Gilly reported net income of $5,000,000 and declared and paid dividends of $800,000.

Illustration of cost and equity methods

Assumption 1: The investment (15%) does not give O’Brien significant influence

Assumption 2: The investment (15%) does give O’Brien significant influence

The effects on O’Brien’s current year financial statements are as follows:

O’Brien: Cost Method

Balance Sheet

Investment in common stock (1) $1,800,000

Income Statement

Other income: Dividend income (2) 120,000

(1) 100,000 shares × $18(2) $800,000 × 15%

Cost Method, continued

Statement of Cash Flows

Operating Activities

Dividends received $ 120,000

Investing Activities

Purchase of investment (1,800,000)

O’Brien: Equity Method

Balance Sheet

Investment in common stock (1) $2,430,000

Income Statement

Other income: Equity in subsidiary earnings (2) $750,000

(1) ($100,000 shares × $18) + ($5,000,000 × 15%) – ($800,000 × 15%)

(2) $5,000,000 × 15%

Statement of Cash Flows

Operating Activities

Dividends Received

Adjust for non-cash revenue

120,000

(750,000)

Investing Activities

Purchase of investment $(1,800,000)

Equity Method, continued

Compare and Contrast Effect of Cost and Equity Methods

• Balance sheet: Investment account is different– Cost: carry at historical cost– Equity: carry at historical cost adjusted for

• Income statement: Revenue is different– Cost: dividends– Equity: pro-rata share of investee’s Net Income

• Statement of cash flows is different– Cost: no adjustment required for non-cash revenue– Equity: remove non-cash revenue from net income

“Mark-to-Market Accounting” for Investments in Equity

Securities

• SFAS No. 115 classifies certain securities as trading, available-for-sale, or held-to-maturity.

• Equity securities can only be classified as trading or available-for-sale.

Only debt securities can be classified as held-to-maturity.

FMV

• To be classified as trading or available-for-sale, the securities must have readily determinable FMVs.

• Types of equity securities that qualify for trading or available-for-sale classification– Common stock (accounted for under the cost

method)– Preferred stock– Stock rights, warrants, options

SFAS No. 115: Trading and Available-for-Sale Securities

• Trading– Marked-to-Market at balance sheet date– Unrealized gain/loss is reported in the other

income (expenses) section of the income statement

– Unrealized gain/loss is a noncash event that requires adjustment in the operating section of the SCF

• Available-For-Sale– Marked-to-Market at balance sheet date– Unrealized gain/loss is reported in the other

comprehensive income section of the statement of comprehensive income• Other comprehensive income is closed to the

accumulated other comprehensive income section of stockholders’ equity

– Unrealized gain does not impact net income so no adjustment is required on the SCF

Example: Compare and Contrast Trading and Available-For-Sale Classifications

Facts: On January 1, the O’Brien Co. purchased 100,000 shares of Gilly Co.’s common stock for $18 per share (15% of Gilly’s outstanding common stock).

For the year, O’Gill reported net income of $5,000,000 and declared and paid dividends of $800,000.

The investment (15%) does not give O’Brien significant influence therefore the cost method is used.Gilly’s year-end common stock FMV is $20 per share.

Illustration of cost and equity methods

Assumption 1: The investment is classified as trading.

Assumption 2: The investment is classified as available-for-sale.

O’Brien’s current year financial statement effects for the investments are as follows:

O’Brien: Trading Classification

Balance Sheet

Investment in common stock (1) $2,000,000

Income Statement

Other income:

Dividend income (2) $120,000

Unrealized gain (loss) on trading securities (3) 200,000

(1) 100,000 shares × $20(2) $800,000 × 15%(3) 100,000 × ($20 - $18 )

Statement of Comprehensive Income

Other comprehensive income $0

Statement of Cash Flows

Operating Activities

Purchase of investments $(1,800,000)

Dividends received

Adjustment for noncash revenue

120,000

(200,000)

Trading Classification, continued

O’Brien: Available-for-Sale Classification

Balance Sheet

Investment in common stock (1) $2,000,000

Income Statement

Other income: Dividend income (2) $120,000

(1) 100,000 shares × $20(2) $5,000,000 × 15%

Statement of Comprehensive Income

Other comprehensive income(3) $ 200,000

Statement of Cash Flows

Operating Activities

Dividends received $120,000

Investing Activities

Purchase of investments $(1,800,000)

(3)100,000 × ($20 - $18 )

Available-for-Sale Classification, continued

Compare and Contrast Effects of Trading and Available-for-Sale

Classifications

• Balance sheet investment account is the same• Income statement amounts are different• Statement of comprehensive income amounts are

different• Cash flows on the SCF different; classification

affects ‘type’ of cash flow; Trading’s noncash revenue from mark-to-market requires adjustment

Opportunity for “Gains Trading”

• A company with available-for-sale securities has unrealized gains/losses associated with the securities

• “Gains trading” is the strategic planning of sales of available-for-sale securities in such a manner as to create either– profits (sell securities with unrealized gains)– losses (sell securities with unrealized losses)

BUSINESS COMBINATIONS

Legal Forms of Business Combinations

Three general forms (types) of business combinations occur– Merger: One entity retains its identity.– Consolidation: New entity identity is

created.– Parent/Subsidiary Relationship: All

entities maintain identity.

• Merger: A + B = AOne company acquires a second company and the second company ceases to exist.

• Consolidation: A + B = CTwo companies form a third company and the original two companies cease to exist.

• Parent & Subsidiaries: A + B = A + BOne company acquires the common stock of a second company, and after the transaction both companies continue to exist.

Accounting Methods forBusiness Combinations: “Purchase”

• The transaction is recorded at the fair market value of the consideration

given by the acquiring company• The net assets of the acquired company are

written up or down to fair market value

• Any excess of the value paid over the sum of the fair market values of the net assets acquired is recorded as goodwill

Accounting Methods for Business Combinations: “Poolings”

• FASB eliminated ‘pooling’ for all combinations after June 30, 2001

• Historically, many combinations were recorded as pooling– Net assets acquired recorded at their book value– No goodwill was recognized

Goodwill

• Goodwill reported on a balance sheet can only result from a business combination accounted for as a purchase.

• Goodwill is tested annually for impairment

Goodwill Impairment Procedure

1) Compare fair value of the reporting unit to the unit’s book value including goodwill

• If FV > carrying amount, no impairment• If FV < carrying amount, proceed to second step

2) Compare GW’s bookvalue to its implied fair value

• If BV > Implied FV recognizeimpairment equal to the excess

Consolidated Financial Statements

Note: The use of the term consolidation in the next slide is different than when used to refer to the legal form of a type of business combination (i.e., consolidation: A + B = C)

Consolidated Financial Statements

• Companies that reflect a parent/subsidiary relationship prepare consolidated financial statements

• The financial statements of the parent company are combined with those of the subsidiary company(s) into one set of consolidated financial statements

– Intercompany amounts are eliminated in the consolidation process

End of Chapter 8