©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Chapter 18 More on Understanding Corporate Annual Reports

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 1 Contrast accounting for investments using the equity method and the market method.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Intercorporate Investments How do we account for intercorporate investments? Investor holds less than 20% Market Method

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Intercorporate Investments Investor holds between 20% and 50% Equity Method Investor holds more than 50% Consolidation Approach

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Market Method Investment at market value on the balance sheet Trading securities Available-for-sale securities

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Market Method Trading securities are investments that the investor company buys only with intent to resell them shortly. Available-for-sale securities are investments that the investor company has no intention to sell in the near future.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Market Method Investment Returns l Trading securities and available-for-sale securities provide returns to the investor in two ways: 1 Dividend revenue 2 Changes in market value

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Market Method Investment Returns Dividends are recorded on the income statement when earned for both types of investments. Changes in market value are accounted for differently for trading securities than for available-for-sale securities.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Changes in Market Value Trading Securities As the market value of trading securities changes, companies report the gains from increases in price and losses from decreases in price in the income statement.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Changes in Market Value Trading Securities Gains and losses that arise as market values of available-for-sale securities rise and fall are not shown on the income statement. Unrealized gains and losses are added to a separate valuation allowance account in the stockholders’ equity section of the balance sheet.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Equity Method Investment at the acquisition cost adjusted for dividends received and the investor’s share of earnings or losses of the investee after the date of investment.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Equity Method Investors increase income and the carrying amount of the investment by their share of the investee’s earnings. Investors reduce both income and the carrying amount by dividends received from the investee and by their share in the investee’s losses.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 2 Explain the basic ideas and methods used to prepare consolidated financial statements.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Consolidated Financial Statements A company owning 50% of another business’s stock is called the parent company. The company whose stock is owned by the other business is called the subsidiary.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Consolidated Financial Statements Parent companies must issue consolidated financial statements that combine the financial statements of the parent company with those of various subsidiaries, as if they were a single entity.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Acquisition of a Subsidiary l Suppose Company P (parent) acquired 100% of the common stock of Company S (subsidiary) for $210 million in cash at the beginning of the year. l The balance sheet accounts of both companies are analyzed in the following table (in millions of dollars):

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Acquisition of a Subsidiary P’s accounts, January 1 Before acquisition Acquisition of S S’s accounts, January 1 Intercompany elimina- tions for a consolidated balance sheet Consolidated, January – – – Stockholders’ Assets = Liabilities + Equity Investment in S Cash and Other Assets Accounts Payable, Etc. Stock- holders’ Equity += + = = = = =

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Acquisition of a Subsidiary P pays the $210 million to the former owners of S as private investors. The $210 million is not an addition to the existing assets and stockholders’ equity of S.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Acquisition of a Subsidiary Each legal entity has its individual set of books. The consolidated entity does not keep a separate set of books.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Acquisition of a Subsidiary l To avoid double-counting, we eliminate the evidence of ownership present in two places. 1 The Investment in S on P’s books 2 The Stockholders’ Equity on S’s books

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton After Acquisition Investments in 50%- to 100% owned subsidiaries, such as the investment in S, are carried in the investor’s balance sheet by the equity method.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Minority Interests The Minority Interests account shows the outside stockholders’ interest, as opposed to the parent’s interest, in a subsidiary corporation.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Investments in Affiliates Investments in equity securities that represent 20% to 50% ownership are frequently called investments in affiliates or investments in associates. They are accounted for under the equity method.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 3 Describe how goodwill arises and how to account for it.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Accounting for Goodwill l Suppose, using our previous example, that the price were $40 million higher, or a total of $250 million cash. l For simplicity, assume that the fair values of the individual assets of S are equal to their book values. l The balance sheets immediately after the acquisition are:

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Accounting for Goodwill P’s accounts Before acquisition Acquisition S’s accounts Intercompany eliminations Consolidated +250 – – – Stockholder’ Assets = Liabilities + Equity Investment in S Cash and Other Assets Accounts Payable, Etc. Stock- holders’ Equity + = + = = = = = Good- will

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Accounting for Goodwill What if the book values of the individual assets of S are not equal to their fair values?

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Accounting for Goodwill l The usual procedures are: 1 S continues as a going concern and keeps its accounts on the same basis as before. 2 P records its investment at its acquisition cost (the agreed purchase price).

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Accounting for Goodwill 3 For consolidated reporting purposes, we first assign the excess of the acquisition cost over the book value of S to the individual assets, item by item. l Any remaining excess that cannot be identified is labeled as purchased goodwill.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Goodwill and Abnormal Earnings A purchaser may be willing to pay extra for projected excess earnings due to: Greater market share or prime location Excellent management skills or a unique product line Potentially greater efficiency

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 4 Explain and use a variety of popular financial ratios.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Financial Statements Financial statements, expressed in component percentages, are called common-size statements. Investors and creditors often use ratios computed from published financial statements to analyze companies.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Some Typical Financial Ratios – Current ratio – Average collection period in days – Current debt to equity – Total debt to equity – Gross profit rate or percentage

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Some Typical Financial Ratios – Return on sales – Return on stockholders’ equity – Earnings per share – Price earnings – Dividend yield – Dividend payout

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Comparisons l Evaluation of a financial ratio requires a comparison. l There are three main types of comparisons: 1 With a company’s own historical ratios (called time-series comparisons)

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Comparisons 2 With general rules of thumb or benchmarks 3 With ratios of other companies or with industry averages for the same period (called cross-sectional comparisons)

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Operating Performance Ratios l The rate of return on invested capital is an important measure of overall accomplishment: ROI = Income ÷ Invested capital

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Operating Performance Ratios l Operating performance is best measured by pretax operating rate of return on average total assets: Pretax operating rate of return = Operating income on average total assets ÷ Average total assets

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 5 Identify the major implications that efficient stock markets have for accounting.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Efficient Capital Market l An efficient capital market is one in which market prices “fully reflect” all information available to the public.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Implications for Accounting in Efficient Stock Markets Financial ratios and other data such as reported earnings help predict such economic phenomena as financial failure or earnings growth. Accounting reports are only one source of information.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Implications for Accounting in Efficient Stock Markets The market as a whole generally sees through any attempts by companies to gain favor through the choice of accounting policies that tend to boost immediate income. In the aggregate, the market is not fooled by companies that choose the least-conservative accounting policies.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Implications for Accounting in Efficient Stock Markets Thus there is evidence that the stock markets may indeed be “efficient,” at least in their reflection of most accounting data.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 6 Understand how financial analysts use ratios and other analysis techniques to interpret the consolidated financial statements of a company.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Interpret Financial Statements Financial analysts and other investment advisors use financial statements to analyze the prospects for companies that they consider for investment. They use financial ratios and other techniques together with other information to make investment decisions.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton End of Chapter 18