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Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential
McGraw-Hill/Irwin Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objective 1
Understand and explain how ownership and control can influence the accounting for investments in common stock.
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Accounting for Investments in Common Stock The method used to account for investments in common stock depends on:
the level of influence or control that the investor is able to exercise over the investee.
choices made by the investor because of options available.
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Usually equity method and consolidation (but cost method is also okay here)
Significant influence
50%
Used for reporting investments in equity securities when both consolidation and equity-method reporting are inappropriate
Used when the investor exercises significant influence over the operating and financial policies of the investee and consolidation is not appropriate
May not be used in place of consolidation if consolidation is appropriate Its primary use is in reporting nonsubsidiary investments
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Involves combining for financial reporting the individual assets, liabilities, revenues, and expenses of two or more related companies as if they were part of a single company Normally is appropriate when one company, referred to as the parent, controls another company, referred to as a subsidiary A subsidiary that is not consolidated with the parent is referred to as an unconsolidated subsidiary and is shown as an investment on the parents balance sheet.
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Learning Objective 2
Prepare journal entries using the cost method for accounting for investments
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S
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Assume P Corp creates a subsidiary, S Corp, and invests $100,000 cash in exchange for all of the $1 par common stock (1,000 shares). What journal entries would P and S make at the time of the investment?
P S
P Corp: Investment in S Corp Cash S Corp: Cash Common Stock Additional PICCS
100,000
100,000 100,000 1,000 99,000
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The investment remains on parents books at cost Record income at the parent level ONLY when sub declares a dividend. Generally, the subs income does not affect parents investment account balance. However, the parent cannot ignore the subs losses. Parent writes-down investment ONLY IF value has been impaired. Write-downs result in a NEW cost basis.
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Investment Account
Cost Impairment Loss
Minimal G/L bookkeeping by parent Simple consolidation procedures Overly conservative valuation Parent can manipulate its reported income.
Cons
The Cost Method: Key Concept Although the parent can manipulate its own reported net income, it can never manipulate consolidated net income.
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The Cost Method Used when the investor lacks the ability either to control or to exercise significant influence over the investee. Accounting Procedures
The cost method is consistent with the treatment normally accorded noncurrent assets.
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Income from the investment is recognized as dividends are declared by the investee.
Recognition of investment income before a dividend declaration is inappropriate.
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100,000
100,000
4,000 4,000
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Liquidating dividends: Dividends declared by the investee in excess of its earnings since acquisition by the investor from the investors viewpoint The investors share of these liquidating dividends is treated as a return of capital, and the investment account balance is reduced by that amount. These dividends usually are not liquidating dividends from the investees point of view.
Does not create any major problems when the cost method is used. Potential difficulty: liquidating dividend determination
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Changes resulting from stock dividends, stock splits, or reverse splits receive no formal recognition in the accounts of the investor Recorded at cost similar to initial purchase New percentage ownership is calculated to determine whether switch to the equity method is required
Sales of shares
Accounted for in the same manner as the sale of any other noncurrent asset
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Learning Objective 3
Prepare journal entries using the equity method for accounting for investments.
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Record income at the parent level based on subs earnings and lossesa built in valuation technique.
It isnt the same as fair value accounting. Nevertheless, the investment generally goes up and down based on the operations of the investee company.
Subs dividends reduce the parents investment (the parent has less invested).
Adj. Bal.
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Based on economic activitynot the parentcontrolled dividend policy. Has two built-in checking figures:
Cons
Requires continual bookkeeping. Unnecessary work if PCO statements are not used internally or issued to outsiders.
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The Equity Method The equity method is intended to reflect the investors changing equity or interest in the investee. The investment is recorded at the initial purchase price and adjusted each period for the investors share of the investees profits or losses and the dividends declared by the investee.
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In the absence of evidence to the contrary, an investor holding 20 percent or more of an investees voting stock is presumed to have the ability to exercise significant influence over the investee.
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The investor records its investment at the original cost This amount is adjusted periodically:
Reported by Investee
Net income Net loss Dividend declaration
Recognition of income
This entry (equity accrual) is normally is made as an adjusting entry at the end of the period If the investee reports a loss, the investor recognizes its share of the loss and reduces the carrying amount of the investment by that amount
12,000 12,000
4,000
No income earned by the investee before the date of acquisition may be accrued by the investor
The amount of income earned by the investee from the date of acquisition to the end of the fiscal period may need to be estimated by the investor in recording the equity accrual
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If the equity method was being used to account for shares already held, the acquisition involves adding the cost of the new shares to the investment account and applying the equity method from the date of acquisition forward. New and old investments in the same stock are combined for financial reporting purposes.
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Treated the same as the sale of any noncurrent asset First, the investment account is adjusted to the date of sale for the investors share of the investees current earnings Then, a gain or loss is recognized for the difference between the proceeds received and the carrying amount of the shares sold If only part of the investment is sold, the investor must decide whether to continue using the equity method or to change to the cost method
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Learning Objective 4
Understand and explain differences between the cost and equity methods.
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Cost Method
Original cost
Equity Method
Original Cost
Original cost
Original cost increased (decreased) by investors share of investees income (loss) and decreased by investors share of investees dividends
Investee dividends from earnings since acquisition by investor Investee dividends in excess of earnings since acquisition by investor
Reduction of investment
Reduction of investment
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Investment in Sub
Beginning balance Ending balance Net income Ending balance 500
Net Loss
400 200 Dividends 550
100
50
$500 COST!!!
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200 200 50 50
Dividends
Ending Balance 550
50
Ending Balance 200
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Cost Method
Investment in Soup Corp. Cash No Entry 500 500
50
50
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Learning Objective 5
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Option available only for investments that are not required to be consolidated Rather than using the cost or equity method to report nonsubsidiary investments in common stock, investors may report those investments at fair value The investor remeasures the investment to its fair value at the end of each period The change in value is then recognized in income for the period Normally the investor recognizes dividend income in the same manner as under the cost method
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200,000
200,000
1,500 1,500
March 31, 20X1 Investment in Barclay Stock Unrealized Gain on Increase in Value of Barclay Stock
Record increase in value of Barclay stock.
7,000 7,000
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Learning Objective 6
Make calculations and prepare basic elimination entries for a simple consolidation.
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The subsidiary is wholly owned. It is either a created subsidiary or we assume it is purchased for an amount equal to the book value of net assets.
Wholly Owned Subsidiary Partially Owned Subsidiary
Chapter 2
Chapter 4
Chapter 3
Chapter 5
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Certain accounts need to be eliminated in the consolidation process to avoid double counting.
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Income Statement
Revenues Expense Expense Net Income Statement of Retained Earnings Retained Earnings (1/1) Add: Net Income Less: Dividends Retained Earnings (12/31) Balance Sheet Assets Total Assets
Liabilities
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Overview of the Consolidation Process In the consolidation worksheet, the three financial statements need to articulate.
Net income from the income statement carries down to the statement of retained earnings.
The ending balance in retained earnings carries down to the balance sheet.
Elimination entries are entered into the Elimination Entries column (debit or credit) to eliminate any amounts that would result in double counting.
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It represents the initial investment adjusted for the parents cumulative share of the subsidiarys income and dividends.
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Investment in Sub
Beginning balance Ending balance Net income Ending balance 500
Net Loss
400 200 Dividends 550
100
50
The subsidiarys paid-in capital accounts (original investment) Beginning retained earnings (past earnings / dividends) The subsidiarys current year earnings and dividends
Basic Elimination Entry Common Stock Additional Paid-in Capital Income from Soup Corp. Retained Earnings (BB) Dividends Declared Investment in Soup Corp. Original amount invested (100%) Original amount invested (100%) Soup Corp.s reported income Beginning balance in retained earnings 100% of Soup Corp.s dividends Net book value in investment account
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Learning Objective 7
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100 50
50 450
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200 200
100 0 50 150
150 150
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The Equity Method: Things to Remember in Consolidation Consolidated net income EQUALS the parents net income.
Parent $350
Consolidated $350
Consolidated $400
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Group Exercise 1
Pinkett, Inc. Income Statement Sales Less: COGS Less: Depreciation Expense Less: Other Expenses Income from Smith, Inc. Net Income Statement of Retained Earnings Beginning Balance Net Income Less: Dividends Declared Ending Balance Balance Sheet Cash Accounts Receivable Inventory Investment in Smith, Inc. Property, Plant, & Equipment Less: Accumulated Depreciation Total Assets Accounts Payable Long-term Debt Common Stock Retained Earnings Total Liabilities & Equity 840,000 (516,000) (12,000) (192,000) 36,000 156,000 Smith, Inc. 300,000 (156,000) (10,000) (98,000) 36,000 Elimination Entries DR CR Consolidated
REQUIRED Assume Pinkett acquired Smith on 1/1/11 Prepare all elimination entries as of 12/31/11.
54,000 114,000 204,000 156,000 336,000 (144,000) 720,000 168,000 360,000 12,000 180,000 720,000
48,000 66,000 90,000 210,000 (30,000) 384,000 84,000 144,000 60,000 96,000 384,000
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Group Exercise 1
Objective:
Eliminate equity accounts of Sub Eliminate equity method accounts of Parent.
Common Stock
Retained Earnings
20,000 20,000
Accumulated Depreciation
20,000
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0 12,000 12,000
54,000 114,000 204,000 156,000 336,000 (144,000) 720,000 168,000 360,000 12,000 180,000 720,000
48,000 66,000 90,000 210,000 (30,000) 384,000 84,000 144,000 60,000 96,000 384,000 156,000 20,000 20,000 20,000 176,000
12,000 12,000
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Appendix 2B
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(100) 200 50 50
$ $
The investment account is generally exactly equal to the sum of the subsidiarys paid-in capital accounts. Unless the parent records an impairment loss. 50 450 500
Under the cost method, we also eliminate dividends from sub to parent. 50 50
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(100) 200 50 50
50 50 50 50
$ $
500
50 450 50 550
50 50
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REQUIRED Prepare all consolidation entries as of 12/31/X3. Prepare a consolidation worksheet at 12/31/X3. What is the maximum dividend the parent could declare ($84,000 or $180,000) if cash were available?
$ $
54,000 114,000 204,000 60,000 336,000 (144,000) 624,000 168,000 360,000 12,000 84,000 624,000
48,000 66,000 90,000 210,000 (30,000) 384,000 84,000 144,000 60,000 96,000 384,000
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$ $
54,000 114,000 204,000 60,000 336,000 (144,000) 624,000 168,000 360,000 12,000 84,000 624,000
48,000 66,000 90,000 210,000 (30,000) 384,000 84,000 144,000 60,000 96,000 384,000
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P $200
S $200
CONS $350
Consolidated retained earnings does NOT equal the parents retained earnings. P $350 S $50 CONS $400
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PCO Statements: Presented in Notes to the Consolidated Statements Retained Earnings Available for Dividends:
Based on the parents G/L amountnot 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.
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Conclusion
The End