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 investees outstanding common stock Equity method Investor has significant influence, but does not have control over investee Presumed to be ownership of 20% - 50% of investees 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 investees 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 investees 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 investors 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 investors pro rata share of dividends declared by investee is recorded as a reduction of the investors 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 OBrien Co. purchased 100,000 shares of Gilly Co.s common stock for $18 per share (or 15% of Gillys 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 OBrien significant influence

Assumption 2: The investment (15%) does give OBrien significant influence The effects on OBriens current year financial statements are as follows:

OBrien: Cost Method

Balance Sheet Investment in common stock (1) Income Statement $1,800,000

Other income: Dividend income (2)

(1) (2)

120,000

100,000 shares $18

$800,000 15%

Cost Method, continued

Statement of Cash Flows Operating Activities Dividends received $ 120,000

Investing Activities
Purchase of investment (1,800,000)

OBrien: Equity Method

Balance Sheet Investment in common stock (1) Income Statement

$2,430,000

Other income: Equity in subsidiary earnings (2)

(1)

$750,000

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

(2)

Equity Method, continued

Statement of Cash Flows
Operating Activities

Dividends Received Adjust for non-cash revenue Investing Activities

Purchase of investment

120,000 (750,000)
$(1,800,000)

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 investees 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

FMV

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.

 To be classified as trading or available-forsale, 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 Availablefor-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 OBrien Co. purchased 100,000 shares of Gilly Co.s common stock for $18 per share (15% of Gillys outstanding common stock).

For the year, OGill reported net income of $5,000,000 and declared and paid dividends of $800,000.
The investment (15%) does not give OBrien significant influence therefore the cost method is used. Gillys year-end common stock FMV is $20 per share.

Illustration of cost and equity methods Assumption 1: Assumption 2: The investment is classified as trading. The investment is classified as available-for-sale.

OBriens current year financial statement effects for the investments are as follows:

OBrien: Trading Classification

Balance Sheet Investment in common stock (1) Income Statement Other income: Dividend income (2) Unrealized gain (loss) on trading securities (3)
(1) 100,000

$2,000,000

$120,000 200,000

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

Trading Classification, continued

Statement of Comprehensive Income

Other comprehensive income

Statement of Cash Flows

$0

Operating Activities
Purchase of investments Dividends received Adjustment for noncash revenue $(1,800,000) 120,000 (200,000)

OBrien: Available-for-Sale Classification

Balance Sheet Investment in common stock (1) Income Statement Other income: Dividend income (2)
(1) 100,000

$2,000,000
$120,000

shares $20 (2) $5,000,000 15%

Available-for-Sale Classification, continued

Statement of Comprehensive Income Other comprehensive income(3) Statement of Cash Flows Operating Activities Dividends received Investing Activities Purchase of investments
(3)100,000

200,000

$120,000 $(1,800,000)

($20 - $18 )

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; Tradings 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 = A

One company acquires a second company and the second company ceases to exist.
Consolidation: A + B = C

Two companies form a third company and the original two companies cease to exist.
Parent & Subsidiaries: A + B = A + B

One company acquires the common stock of a second company, and after the transaction both companies continue to exist.

Accounting Methods for Business 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 units book value including goodwill
If FV > carrying amount, no impairment If FV < carrying amount, proceed to second step

2) Compare GWs bookvalue to its implied fair value

If BV > Implied FV recognize impairment 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