© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Chapter 12 Intercorporate Investments and Consolidations

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Learning Objectives After studying this chapter, you should be able to: u Explain why corporations invest in one another. u Account for short-term investments in debt securities and equity securities. u Report long-term investments in bonds. u Contrast the equity and market methods of accounting for investments. u Prepare consolidated financial statements.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Learning Objectives After studying this chapter, you should be able to: u Incorporate minority interests into consolidated financial statements. u Explain the economic and reporting role of goodwill.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott An Overview of Corporate Investments u Corporate managers should invest any idle funds on hand just as individuals invest any idle cash they have on hand. u Corporate investments can take many forms. Many companies invest in short-term and long-term debt securities of governments or companies. Companies also invest in equity securities of other companies.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Corporate Marriage and Divorce u Corporate mergers are very common, but not all business combinations work. Sometimes the assets of a company are sold off and the business disappears. Often the parent company sells off a business unit. Another alternative is a spin-off, which occurs when shares of a subsidiary are distributed to the shareholders of the parent company, and the spun-off company becomes a completely separate unit.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Corporate Marriage and Divorce u Once companies combine, accountants must develop ways to report the financial results. u Once the company determines how the relationship will be measured, a question arises about where it will be reported on the balance sheet. If it is a short-term investment, it should be classified as a current asset. If it is a long-term investment, it should be classified as Investments or as Other Assets.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Short-Term Investments u Short-term investment - a temporary investment of otherwise idle cash in marketable securities Marketable securities - notes, bonds, or stocks that can be easily sold Short-term investments are expected to be converted to cash within twelve months. The key point on classification is that conversion to cash is immediately available at the option of management.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Short-Term Investments u Short-term debt securities - largely notes and bonds with maturities of one year or less; can be held to maturity or resold in securities markets Certificates of deposit - short-term obligations of banks that pay fixed interest Commercial paper - short-term notes payable issued by large corporations with top credit ratings U.S. Treasury obligations - interest-bearing notes, bonds, and bills issued by the U.S. government

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Short-Term Investments u Short-term equity securities - capital stock in other corporations held with the intention to liquidate within one year as necessary Short-term equity securities are held only for short- term cash purposes; they are not held for reasons of controlling any other corporation through ownership of its capital stock. Short-term investments are recorded at acquisition cost.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Short-Term Investments u The way the investments are reported on the balance sheet depends on the motives of the corporation as to why the corporation purchased the securities. Short-term securities are classified as trading securities, held-to-maturity securities, or available-for-sale securities.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Short-Term Investments u Trading securities - current investments in equity or debt securities held for short-term profit Trading securities are reported as current assets on the balance sheet. They are measured at market value (fair value). Both debt and equity securities may be classified as trading securities.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Short-Term Investments u Held-to-maturity securities - debt securities that the investor plans to hold until maturity These securities are shown on the balance sheet at amortized cost rather than market value. Held-to-maturity securities are classified as short- or long-term according to the time remaining until they mature. Only debt securities may be classified as held-to- maturity securities because equity securities have no maturity date.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Short-Term Investments u Available-for-sale securities - investments in equity or debt securities that are not held for active trading but may be sold before maturity These securities are any securities that are neither trading securities nor held-to-maturity securities. Both debt and equity securities may be classified as available-for-sale securities.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Changes in Market Prices of Securities u Accounting for returns on investments: Interest revenue is the only return for held-to-maturity securities, and it is shown in the income statement. Returns on trading and available-for-sale securities come in two forms. –Dividend or interest revenue, which are recorded in the income statement –Changes in market value, which is handled differently for each classification of security

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Changes in Market Prices of Securities u Changes in market values for trading securities: As market values change, companies report the resulting gains and losses in the income statement. u Changes in market values for available-for-sale securities: As market values change, the gains and losses are accounted for as unrealized gains and losses in a separate valuation allowance account in the stockholders’ equity section of the balance sheet rather than in the income statement.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Changes in Market Prices of Securities u This method of accounting for trading and available-for-sale securities is called the market method. The reported values in the balance sheet are the market values. It is possible for two companies to have investments in the same company but account for the gains and losses from those investments in different ways, depending on whether the investments are classified as trading or available-for-sale.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Comprehensive Income u When investments are treated as available-for- sale securities, the changes in economic value are not fully revealed in the income statement because the changes are shown only on the balance sheet. u To show the effect of these differences, comprehensive income is reported along with net income. Comprehensive income includes both net income and changes in the value of available-for-sale securities.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Long-Term Investments in Bonds u Recall that the issuer of bonds must amortize bond discounts and premiums as periodic adjustments of interest expense. u Firms that invest in these bonds use a similar method of amortization, but most do not use a separate account for unamortized premiums or discounts. They reduce or increase the investment account directly.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Bonds-Held-to-Maturity u If bonds are issued to yield a higher interest rate than the coupon rate, they are sold at a discount. Investors pay less than the face amount of the bonds. Interest takes two forms: –Annual or semiannual cash payments –A lump sum payment at maturity equal to the amount of the discount The investor must also amortize the lump sum discount over the life of the bonds just as the issuer does.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Bonds-Held-to-Maturity u The discount is used to make up the difference between the coupon interest rate and the market interest rate. Amortization of the discount increases the interest revenue of the investor, just as the amortization increases the interest expense of the issuer. u Note that accounting for a premium is similar except that the amortization of a premium decreases interest revenue of investors and interest expense of the issuer.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Early Extinguishment of Investment u For the issuer to extinguish the bonds early, the bonds must grant the issuer the right to do so or the bondholders must choose to sell the bonds back to the issuer. u The gain or loss on the extinguishment is calculated as the difference between the carrying amount of the investment (face amount plus any unamortized premium or less any unamortized discount) and the cash received from the bonds.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott The Market and Equity Methods for Intercorporate Investments u The investor’s accounting for intercorporate investments depends on the amount of influence the investor can exercise over the investee. For ownership of less than 20% of the investee, the investor has no influence over the investee, and the investor accounts for the investment using the market method described earlier. For ownership of 20% or more of the investee, the investor may be able to exert significant influence over the investee, and the investor must use the equity method.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott The Market and Equity Methods for Intercorporate Investments u Equity method - records the investment at acquisition cost and adjusts the investment for the investor’s share of dividends and earnings or losses of the investee subsequent to the date of investment The book value at which the investment is carried is increased by the investor’s share of the investee’s earnings and reduced by dividends received from the investee and the investor’s share of the investee’s losses.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott The Market and Equity Methods for Intercorporate Investments Larks Company pays $150,000 for an investment in Dusty Corporation. Dusty Corporation has net income of $200,000 for the year and pays dividends of $50,000 in total for the year. How will these transactions be recorded if Larks purchases 5% of the stock of Dusty? How will the transactions be recorded if Larks purchases 25% of Dusty?

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott The Market and Equity Methods for Intercorporate Investments If Larks purchases 5% of Dusty, no significant influence exists. The investment is recorded using the market method as follows: To record the purchase of the investment: Investment in Dusty Co.150,000 Cash150,000 To record the income of Dusty Co.: No entry required To record the receipt of the dividend: Cash 7,500 Dividend income ($50,000 x 5%) 7,500

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott The Market and Equity Methods for Intercorporate Investments If Larks purchases 25% of Dusty, significant influence does exist. The investment is recorded using the equity method as follows: To record the investment: Investment in Rusty Co. 150,000 Cash 150,000 To record the income of Rusty Co.: Investment in Rusty Co. 50,000 Investment income ($200,000 x 25%) 50,000 To record the receipt of dividends: Cash 12,500 Investment in Rusty Co. ($50,000 x 25%) 12,500

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott The Market and Equity Methods for Intercorporate Investments u The equity method does a better job of recognizing increases or decreases in the economic resources that the investor can influence. The reported net income of the investor company is increased by its share of net income or decreased by its share of losses recognized by the investee.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Consolidated Financial Statements u When one company buys a majority (over 50%) of another company, a parent-subsidiary relationship exists. Parent company - a company owning more than 50% of the voting shares of another company Subsidiary company - a company owned and controlled by a parent company through the ownership of more than 50% of the voting stock

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Consolidated Financial Statements u When a parent-subsidiary relationship exists, each company remains a separate legal entity. Each company must be accounted for separately and has its own set of financial statements. These financial statements are then consolidated. Consolidated financial statements - combinations of the financial positions and earnings reports of the parent company with those of various subsidiaries into an overall report as a single entity

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott The Acquisition u From the parent’s perspective the purchase is simply an exchange of one asset for another, usually cash for the stock of the subsidiary. Total assets are unaffected. Cash decreases, but the investment in the subsidiary increases by the same amount. u From the subsidiary’s perspective, nothing changes on the books. However, the subsidiary now has one major owner - the parent.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott The Acquisition Before the purchase P Corporation P Corporation S Corporation S Corporation S Shareholders S Shareholders P Shareholders Own

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott The Acquisition Purchase P Corporation P Corporation S Shareholders S Shareholders Cash Shares of S After the Purchase P Shareholders P Shareholders S Corporation P Corporation Own and

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott The Acquisition u No books are kept for the consolidated entity. Only working papers are used to prepare the consolidated financial statements. u To prepare the consolidated financial statements, the financial statement values of the parent and all the subsidiaries are added together. Remember not to count the ownership interest of the parent twice - once as an investment in the parent’s books and once in stockholders’ equity in the subsidiary’s books.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott The Acquisition Preparing Consolidated Statements Parent Company Financial Statements Parent Company Financial Statements Subsidiary Financial Statements Subsidiary Financial Statements Parent Company Records Combine Parent and Subsidiary Financial Statements on a Work Sheet Eliminate Double Counting Parent’s Investment Against Subsidiary OE Intercompany Receivables and Payables Intercompany Sales and Purchases Consolidated Financial Statements Consolidated Financial Statements Subsidiary Records Subsidiary Records

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott After Acquisition u After the acquisition, the parent accounts for the investment just as it would using the equity method (20-50% ownership) for an unconsolidated ownership interest. The parent’s share of the subsidiary’s income is included in the parent’s income statement. The subsidiary’s net income must therefore be eliminated from the consolidated financial statements so it is not counted twice.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Intercompany Eliminations u In many cases, a parent company and its subsidiaries transact business with each other. Nothing really happens economically - money is shifted “from one pocket to another.” The transactions must be eliminated so that they are not counted twice in the consolidated statements. Any elimination journal entries are made only on the consolidation work sheet; they are not made on the books of either company.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Minority Interests u Often, a parent company owns less than 100% of a subsidiary company. Minority interest - the rights of nonmajority shareholders in the assets and earnings of a company that is consolidated into the accounts of the major shareholder In the consolidation, all of the subsidiary’s income is included. The share due to minority shareholders is then subtracted.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Minority Interests Before the purchase P Corporation P Corporation S Corporation S Corporation S Shareholders S Shareholders P Shareholders Own

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Minority Interests 90% Purchase P Corporation P Corporation S Shareholders S Shareholders Cash 90% of Shares of S After the Purchase P Shareholders P Shareholders S Corporation P Corporation Own and Some Old S Shareholders Hold 10% of S Some Old S Shareholders Hold 10% of S

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Defining Control u GAAP specifies three methods for accounting for intercorporate investments. Less than 20% - use the market method More than 50% - use consolidation Between 20% and 50% - use the equity method

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Defining Control u Whether to use one method or the other may depend on the investor’s ability to exert significant influence over the investee. In that case, the percentage tests are not hard and fast rules. Exerting significant influence includes the percentage of ownership and other factors such as: –Representation on the board of directors –Participating in policy making processes –Concentration of ownership

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Purchased Goodwill u Goodwill - the excess of the cost of an acquired company over the sum of the fair market value of its identifiable individual assets less the liabilities Goodwill often results from such factors as: –Brand recognition –Reputation –Market share –Earnings potential –Location –Customer list or base

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Goodwill and Abnormal Earnings u The final price that a company will pay for another is the culmination of a bargaining process. The exact amount of goodwill is subject to the negotiating process concerning the final purchase price. Goodwill is essentially the price paid for “excess” or “abnormal” earning power.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Amortization of Goodwill u Goodwill does not have a perpetual life, but it may be maintained by continuous efforts. u GAAP requires that goodwill be amortized and charged as an expense against net income for a period not to exceed 40 years. Many companies use a much shorter amortization period. Most companies use straight-line amortization.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Perspective on Consolidated Statements u The FASB requires that all subsidiary companies must be consolidated regardless of their line of business or the parent’s line of business. u However, there are exceptions to this rule, but they are rare. For example, a subsidiary is not consolidated if control is likely to be temporary or if that control does not rest with the majority owner.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Equity Affiliates, Minority Interest, and the Statement of Cash Flows u If a company has equity affiliates (firms in which the company is an equity method investor) and uses the direct method of preparing the statement of cash flows, no special problems arise. Only cash received from the affiliate as a dividend appears in the operating activities section.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Equity Affiliates, Minority Interest, and the Statement of Cash Flows u If a company has equity affiliates and uses the indirect method of preparing the statement of cash flows, problems may arise. Net earnings is increased by the investor’s share of the affiliate’s earnings or decreased by the investor’s share of the affiliate’s losses. Net income must be adjusted for the affiliate’s shares in order to calculate cash flow from operating activities of only that one company.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Purchased Research and Development u The basic rule in an acquisition is that the books of the acquired company are included in the books of the acquiring company at their fair market values. u Research and development (R & D) creates a special problem. When a company acquires another, one asset acquired is R & D in process, but R & D must be expensed when incurred; therefore, the acquiring company must immediately expense the amount paid for the R & D.

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Summary of Accounting for Equity Securities

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th EditionHorngren, Sundem, and Elliott Introduction to Financial Accounting 8th Edition PowerPoint Presentation Developed by: Eddie Metrejean, MTAX, CPA University of Mississippi Images provided by New Vision Technology nvtech.com