Copyright © 2006 by South- Western. All rights reserved. CHAPTER 2 WHOLLY OWNED SUBSIDIARIES: POSTCREATION PERIODS

Copyright © 2006 by South-Western. All rights reserved. FOCUS OF CHAPTER 2 Ways to Value the Parent’s Investment Account in POSTCREATION Periods Cost Method vs. Equity Method Driven Consolidation Procedures – Income Statements – Statements of Retained Earnings Parent-Company-Only (PCO) Statements – Articulation with Consolidated Statements

Copyright © 2006 by South-Western. All rights reserved. The Cost Method: How It Works It is cash basis driven: – Record income at the parent level ONLY when sub declares a dividend. – Ignore sub’s earnings. – Do NOT ignore sub’s losses. – Write-down investment ONLY IF value has been impaired. – Write-downs result in a NEW cost basis.

Copyright © 2006 by South-Western. All rights reserved. The Cost Method: How It Works (cont.) It is a one-way street! The investment can be written down— but NEVER written up.

Copyright © 2006 by South-Western. All rights reserved. The Cost Method: Pros & Cons Pros: – Minimal G/L bookkeeping by parent. – Simple consolidation procedures. Cons: – Overly conservative valuation. – Parent can manipulate its reported income. – PCO statements — if used internally or issued — may be of limited value.

Copyright © 2006 by South-Western. All rights reserved. The Cost Method: MAJOR Point of Interest Although the parent CAN manipulate its OWN reported net income, it can NEVER manipulate CONSOLIDATED net income.

Copyright © 2006 by South-Western. All rights reserved. The Equity Method: How It Works It is accrual basis driven: – Record income at the parent level based on sub’s earnings and losses— an AUTOMATIC VALUATION TECHNIQUE. – Sub’s dividends reduce the parent’s investment (the parent has less invested).

Copyright © 2006 by South-Western. All rights reserved. The Equity Method: How It Works (cont.) It is a two-way street! The investment can be: (1) written up AND (2) written down.

Copyright © 2006 by South-Western. All rights reserved. The Equity Method: Pros and Cons Pros: – Based on economic activity—not the parent-controlled dividend policy. – Has 2 built-in checking figures. Cons: – Entails continual bookkeeping. – Unnecessary work if PCO statements are not used internally or issued to outsiders.

Copyright © 2006 by South-Western. All rights reserved. The Equity Method: MAJOR Point of Interest Compared with the cost method, the consolidation entry under the equity method has a “new kid on the block.” A posting must be made to eliminate the subsidiary’s beginning retained earnings.

Copyright © 2006 by South-Western. All rights reserved. The Cost Method: Things to Remember in Consolidation Consolidated NET INCOME does NOT equal the parent’s NET INCOME. Consolidated RETAINED EARNINGS does NOT equal the parent’s RETAINED EARNINGS. P S Sub’s Divies CON. $54,000 + $24,000 - $4,000 = $74,000 P S CON. $103,000 + $20,000 = $123,000

Copyright © 2006 by South-Western. All rights reserved. The Cost Method: Things to Remember in Consolidation NONE of the sub’s beginning or ending RETAINED EARNINGS is eliminated in consolidation. ONLY the parent’s DIVIDENDS are reported in the consolidated column. P S CON. $54,000 + $20,000 = $74,000 P S Sub’s Divies CON. $(51,000) + $(4,000) - $4,000 = $(51,000)

Copyright © 2006 by South-Western. All rights reserved. The Equity Method: Things to Remember in Consolidation Consolidated net income EQUALS the parent’s net income. Consolidated retained earnings EQUALS the parent’s retained earnings. P CON. $74,000 = $74,000 P CON. $123,000 = $123,000

Copyright © 2006 by South-Western. All rights reserved. The Equity Method: Things to Remember in Consolidation ALL of sub’s beginning & ending RETAINED EARNINGS are eliminated in consolidation. ONLY the parent’s DIVIDENDS are reported in the consolidated column (also occurs under the cost method). P S Sub’s Divies CON. $(51,000) + $(4,000) - $4,000 = $(51,000) P S Sub’s R.E. CON. $123,000 + $20,000 - $20,000 = $123,000

Copyright © 2006 by South-Western. All rights reserved. PCO Statements: Presented in Notes to the Consolidated Statements PCO statements are mandatory for publicly owned banks and S&Ls (SEC rules). – Can ONLY use the equity method. Equity method results in 100% articulation between PCO statements and consolidated statements: – SAME net income amounts. – SAME retained earnings amounts.

Copyright © 2006 by South-Western. All rights reserved. PCO Statements: Presented in Notes to the Consolidated Statements Retained Earnings Available for Dividends: – Based on the parent’s G/L amount— NOT on the consolidated retained earnings amount. – Use of the equity method in PCO statements produces IDENTICAL retained earnings amounts. – Use of the cost method in PCO statements creates CONFUSION.

Copyright © 2006 by South-Western. All rights reserved. Consolidation: The Most Important Point of All on Investment Basis The consolidated statement amounts are identical whether the parent uses the cost method or the equity method— this holds true for ALL 3 statements.

Copyright © 2006 by South-Western. All rights reserved. Total Investment Loss Situations: Equity Method Procedures Parent Has GUARANTEED Sub’s Debt: – NO interruption occurs in the application of the equity method. – Parent can lose more than it has invested—parent is “on the hook.”

Copyright © 2006 by South-Western. All rights reserved. Total Investment Loss Situations: Equity Method Procedures (cont.) Parent Has NOT GUARANTEED Sub’s Debt: – Discontinue equity method when sub’s equity reaches zero—resume ONLY WHEN sub’s equity becomes positive. – Parent can NEVER lose more than it has invested.

Copyright © 2006 by South-Western. All rights reserved. AROI Versus IRR: They Serve Entirely Different Purposes Annual Return on Investment (AROI): Tells what was actually earned on an investment EACH year. Based on actual GAAP net income. Can be used to calculate an average AROI covering several years AVG. 18% + 12% + 15% = 45%; 45%/3 = 15%

Copyright © 2006 by South-Western. All rights reserved. AROI Versus IRR: They Serve Entirely Different Purposes Internal Rate of Return (IRR): – An assumed rate covering SEVERAL years. Based on cash flows for those years. – CANNOT show what was actually earned in any GIVEN year. Artificially assumes that each year’s unrecovered investment (at B-O-Y) earns the SAME rate.

Copyright © 2006 by South-Western. All rights reserved. AROI vs. IRR: They Serve Entirely Different Purposes

Copyright © 2006 by South-Western. All rights reserved. Review Question #1 Under the COST METHOD, a sub’s DIVIDENDS would: A.NOT be eliminated in consolidation. B.Be the parent’s investment income. C.Reduce the parent’s investment. D.Increase the parent’s investment. E.None of the above.

Copyright © 2006 by South-Western. All rights reserved. Review Question #1 With Answer Under the COST METHOD, a sub’s DIVIDENDS would: A.NOT be eliminated in consolidation. B.Be the parent’s investment income. C.Reduce the parent’s investment. D.Increase the parent’s investment. E.None of the above.

Copyright © 2006 by South-Western. All rights reserved. Review Question #2 Under the COST METHOD, a sub’s LOSSES would: A.Never reduce the parent’s income. B.Always reduce the parent’s income. C.Always reduce the parent’s investment. D.Always be eliminated in consolidation. E.None of the above.

Copyright © 2006 by South-Western. All rights reserved. Review Question #2 With Answer Under the COST METHOD, a sub’s LOSSES would: A.Never reduce the parent’s income. B.Always reduce the parent’s income. C.Always reduce the parent’s investment. D.Always be eliminated in consolidation. E.None of the above.

Copyright © 2006 by South-Western. All rights reserved. Review Question #3 Under the EQUITY METHOD, a sub’s DIVIDENDS would: A.NOT be eliminated in consolidation. B.Be the parent’s investment income. C.Reduce the parent’s investment. D.Increase the parent’s investment. E.None of the above.

Copyright © 2006 by South-Western. All rights reserved. Review Question #3 With Answer Under the EQUITY METHOD, a sub’s DIVIDENDS would: A.NOT be eliminated in consolidation. B.Be the parent’s investment income. C.Reduce the parent’s investment. D.Increase the parent’s investment. E.None of the above.

Copyright © 2006 by South-Western. All rights reserved. Review Question #4 Under the EQUITY METHOD, a sub’s LOSSES would: A.Never reduce the parent’s income. B.Normally reduce the parent’s income. C.Always reduce the parent’s investment. D.Always be eliminated in consolidation. E.None of the above.

Copyright © 2006 by South-Western. All rights reserved. Review Question #4 With Answer Under the EQUITY METHOD, a sub’s LOSSES would: A.Never reduce the parent’s income. B.Normally reduce the parent’sincome. C.Always reduce the parent’s investment. D.Always be eliminated in consolidation. E.None of the above.

Copyright © 2006 by South-Western. All rights reserved. Review Question #5 On 1/1/04, Paxco invested $500,000 in Saxco (100%-owned). For 2004, Saxco: (1) earned $70,000, (2) declared dividends of $40,000, and (3) paid dividends of $30,000. What amounts does Paxco report? Cost Equity Investment income for Investment in Saxco at Y/E Retained earnings increase

Copyright © 2006 by South-Western. All rights reserved. Review Question #5 With Answer On 1/1/04, Paxco invested $500,000 in Saxco (100%-owned). For 2004, Saxco: (1) earned $70,000, (2) declared dividends of $40,000, and (3) paid dividends of $30,000. What amounts does Paxco report? Cost Equity Investment income for Investment in Saxco at Y/E Retained earnings increase $40,000 $70,000 $500,000 $530,000 $40,000 $70,000

Copyright © 2006 by South-Western. All rights reserved. Review Question #6 A parent can lose MORE THAN than it has invested: A.Only under the cost method. B.Only under the equity method. C.Under either the cost or equity methods. D.Only if the subsidiary is not consolidated. E.None of the above.

Copyright © 2006 by South-Western. All rights reserved. Review Question #6 With Answer A parent can lose MORE THAN than it has invested: A.Only under the cost method. B.Only under the equity method. C.Under either the cost or equity methods. D.Only if the subsidiary is not consolidated. E.None of the above.

Copyright © 2006 by South-Western. All rights reserved. Review Question #7 Parent-company-only (PCO) statements are usually presented in notes only when: A.The parent uses the cost method. B.The parent uses the equity method. C.The subsidiary is not consolidated. D.The SEC’s rules require them. E.None of the above.

Copyright © 2006 by South-Western. All rights reserved. Review Question #7 With Answer Parent-company-only (PCO) statements are usually presented in notes only when: A.The parent uses the cost method. B.The parent uses the equity method. C.The subsidiary is not consolidated. D.The SEC’s rules require them. E.None of the above.

Copyright © 2006 by South-Western. All rights reserved. Review Question #8 When a parent-sub relationship exists, STATE LAWS require dividends to be based on the: A.Parent’s retained earnings. B.Sub’s retained earnings. C.Consolidated retained earnings. D.The lower of the parent’s OR the consolidated retained earnings. E.None of the above.

Copyright © 2006 by South-Western. All rights reserved. Review Question #8 With Answer When a parent-sub relationship exists, STATE LAWS require dividends to be based on the: A.Parent’s retained earnings. B.Sub’s retained earnings. C.Consolidated retained earnings. D.The lower of the parent’s OR the consolidated retained earnings. E.None of the above.

Copyright © 2006 by South-Western. All rights reserved. End of Chapter 2 Time to Clear Things Up— Any Questions?