Accounting Clinic V Mc GrawHillIrwin The Mc GrawHill

Accounting Clinic V Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -1

Prepared by: Nir Yehuda With contributions by Stephen H. Penman – Columbia University

Types of Equity Investments and their Accounting Treatment Minority, passive Market to Market: See Accounting Clinic III Minority, active Equity Method Majority, active Consolidation Accounting Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -3

Minority, passive investments The acquiring company owns such a small percentage of the other corporation’s shares that it cannot control or exert significant influence over the other company. GAAP views investments of less than 20 percent of the voting stock of another company as minority, passive investments in most cases. The accounting for marketable securities is applied in this case, with investments classified as trading securities or available for sale. See Accounting Clinic III. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -4

Minority, active investments an investor acquires shares of another corporation so that it can exert significant influence over the other company’s activities even without owning a majority of the voting stock. GAAP views investments of between 20 and 50 percent of the voting stock of another company as minority, active investments “unless evidence indicates that significant influence cannot be exercised”. The equity method is used in this case. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -5

Majority, active investments an investor acquires shares of another corporation so that it can control the other company. GAAP views ownership of more than 50 percent of the voting stock of another company as implying an ability to control, unless there is evidence to the contrary. Consolidation accounting is used in this case. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -6

Equity Method - Introduction The equity method records the initial purchase of an investment at acquisition cost, just as is done under the market value method. Each period, the investor treats as revenue its proportionate share of the periodic earnings, not the dividends, of the investee. The investor treats dividends declared by the investee as a reduction in the investment account. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -7

Equity Method - Rationale Why don’t we mark to market such investments? Under the market value method for securities available for sale, the investor recognizes income statement effects only when it receives a dividend (revenue) or sells some of the investment (gain or loss). As the investor by assumption, exerts significant influence over the investee, it can affect the dividend policy, which in turn affects income. ÞThe investor can manipulate its own income. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -8

Example – Equity Method (No Differential) On 12/31/2003 firm A purchases 40% of the outstanding shares of firm B for $1. 2 M. The book value of firm B equals its market value at this date ($ 3 M). There is no differential (between market value and book value). At 2004 firm B reports income of $250, 000 and pays dividend of $100, 000. At 2005 firm B reports earnings of $500, 000 and pays dividends of $225, 000. How and in what amount should this investment be presented on Firm A’s balance sheet on December 31, 2004 and 2005? Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -9

Journal Entries: At the Acquisition Date Investment in Stock of B 1, 200, 000 Cash 1, 200, 000 To record the acquisition of 40 percent of firm B 1, 200, 000=40% x 3, 000 Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -10

Year 2004 Investment in Stock of B 100, 000 Equity in Earnings of Affiliate 100, 000 To record A’s share in the income earned by B Cash 40, 000 Investment in Stock of B 40, 000 To record dividends received from B Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -11

Year 2005 Investment in Stock of B 200, 000 Equity in Earnings of Affiliate 200, 000 To record A’s share in the income earned by firm B Cash Investment in Stock of B 90, 000 To record dividend received from firm B Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -12

Firm A’s “Investment in B” account now has a balance of $1, 370, 000 by the end of 2005: Investment in Stock of B (1) 1, 200, 000 (2) 100, 000 (4) 200, 000 40, 000 (3) 90, 000 (5) Bal. 1, 370, 000 Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -13

At each point in time the investment in firm B can be written as firm A’s Share in B’s equity. For the date of the acquisition (as we saw before) $1, 200, 000 = 40%*$3, 000 Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -14

For the end of 2005 B’s Equity is as follows: 12/31/2003 2004 Income Dividend 2005 Income Dividend 12/31/2005 $3, 000 250, 000 (100, 000) 500, 000 (225, 000) 3, 425, 000 Therefore the investment equals to: 40%*$3, 425, 000 = 1, 370, 000 Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -15

Equity method – Difference Between the Cost of Investment and the Underlying Book Value: Recognize a Differential The purchase price paid for the shares acquired is usually the market price. There is often a difference between the cost of the investment and the proportionate share of the investee’s book value. This difference is referred to as differential. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -16

This differential can result from two main sources: The investee’s recorded assets may be worth more than their book values. There is an unrecorded goodwill associated with the excess earning power of the investee. The differential associated with depreciable or amortizable assets should be amortized on the investor’s book in order to reflect the decline in service of those assets during the period. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -17

Example – Equity Method with a Differential Firm A purchased 30% of the common stock of firm B on January, 1 2004, for $190, 000. Firm B has a book value of $500, 000 at the date of the acquisition, The market value of its net assets is $570, 000. In this case there is a differential of 40, 000, computed as follows: Investment cost $190, 000 Share at the BV of B (=30% x 500, 000) (150, 000) Differential $40, 000 Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -18

Further assume that the 70, 000 excess of fair value over book value of firm B consists of 20, 000 increase in land 50, 000 increase in equipment. The proportional share of firm A is as follows: Land Equipment Total Increase $20, 000 50, 000 $70, 000 A’s 30% share $6, 000 15, 000 $21, 000 Thus $19, 000 (40, 000 -21, 000) is assigned to goodwill. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -19

Mc. Graw-Hill/Irwin Cost of the investment 190, 000 MV of net identifiable assets (30%*570, 000) BV of net identifiable assets (30%*$500, 000) 171, 000 150, 000 Excess of MV over Goodwill BV of net identifiable assets Total differential $40, 000 The allocation of the differential can be illustrated as follows: © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -20

The portion of the differential related to land goodwill is not amortized (land has unlimited economic life). The portion of the differential related to the equipment will be amortized over the rest of its useful life (from the acquisition date on). In this example, assume 5 years straight line amortization. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -21

Firm B reports net income of 80, 000 for 2004 and declares dividend of 20, 000. The journal entries will be: Investment in B Cash (to record initial acquisition) 190, 000 Investment in B 24, 000 Equity in Earnings of Affiliate (30%*80, 000) Cash Investment in B (30%*20, 000) Mc. Graw-Hill/Irwin 24, 000 6, 000 © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. 6, 000 Clinic 5 -22

Equity in Earnings of Affiliate Investment in B (15, 000/ 5 years) 3, 000 (to record the amortization of differential allocated to equipment) The investment account in the end of the year would be 1/1/2004 Income from B Dividend from B Equipment depreciation 12/31/2004 Mc. Graw-Hill/Irwin $190, 000 24, 000 (6, 000) (3, 000) $205, 000 © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -23

At each point in time the investment in B can be written as: Share in B’s Equity + Unamortized differential For the date of the acquisition (1/1/2004) 190, 000 = 150, 000 + 40, 000 (This is how we calculated the differential in the first place!) Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -24

For the end of the year B’s Equity is as follows: 1/1/2004 $500, 000 Income 80, 000 Dividend (20, 000) 12/31/2004 $560, 000 The differential is 40, 000 – 3, 000 = 37, 000 or: 19, 000 goodwill 6, 000 allocated to land 12, 000 allocated to equipment (0. 8*15, 000) 37, 000 Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -25

Therefore the investment at the end of the year (12/31/2004) equals to: 30%*560, 000 + 37, 000 = 205, 000 A’s share of Unamortized B’s Equity differential Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -26

“Negative” Goodwill When the fair market value of the assets acquired exceeds the acquisition cost, the excess is first used to reduce the carrying value of noncurrent, nonfinancial assets. If such assets are reduced to zero, any additional amount is recognized as extraordinary gain. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -27

Majority Active Investments: Consolidation Accounting In a business combination, one company (The Parent company) gains control over another company (The Subsidiary or Sub. ). Until 2001, two consolidation methods were used for mergers and acquisitions: the purchase method and the pooling of interests method. In 2001, the FASB discontinued the pooling method (Statement 141) Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -28

The Meaning of Control An entity that has the ability to elect a majority of the board of directors of another entity has control over it. Control enables the parent: Direct the sub to expand, contract or distribute cash to the parent. Establish the sub. financing structure. Fire and hire the sub. management. Set compensation level for the sub. management. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -29

The Means of Control Legal Control – owning more than 50% of the subsidiary’s outstanding voting stock. The parent has the legal right to elect the majority of the board of directors. Effective Control – when the majority of the board of directors can be elected by means other then having legal control. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -30

Three categories of business combination 1. Merger - one firm acquires the assets and liabilities of one or more other firms in exchange for cash, stock or other compensation. The acquired firm ceases to exist as a separate legal entity. 100% ownership. 2. Statutory Consolidation – A new firm is formed to issue stock in exchange for the stock of the two or more consolidating firms. The acquired firms cease to exist as separate legal entities. 100% ownership. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -31

Three categories of business combination (cont. ) In merger and statutory consolidation there is only one firm existing after the business combination therefore there is only one set of books. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -32

Three categories of business combination (cont. ) 3. Acquisition – One firm acquires the majority of the common stock of another company and each company continues its legal existence. Each company must be accounted for separately and prepare its own set of financial statements. These financial statements are then consolidated. Consolidated financial statements combination of the financial statements of the parent company with those of the subs. an overall report as if they were a single entity Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -33

Consolidation Process Eliminating worksheet entries are made to reflect the two separate companies’ statements as one economic entry. No consolidation elimination entries are recorded on the books of either the parent or the subsidiary. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -34

Consolidation - Rationale Economically, the parent has the power to liquidate the subsidiary into a branch. In this case the current legal structure of two separate companies will cease to exist. Therefore the parent and the sub are treated as a single legal entity. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -35

Purchase Method for Business Combinations The business combinations are accounted for using the purchase method Under this method, acquisitions are measured on the basis of the fair values exchanged. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -36

Consolidation - Wholly Owned Sub. Before the purchase A Shareholders After the Purchase B Shareholders A Corporation Mc. Graw-Hill/Irwin B Corporation © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. B Corporation Clinic 5 -37

Wholly Owned Subsidiaries From the parent’s perspective the purchase is an exchange of one asset for another, usually cash for the stock of the subsidiary. Consolidated net income equals the parent’s net income. Consolidated retained earnings equals the parent’s retained earnings. All of sub. ’s beginning & ending retained earnings are eliminated in consolidation. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -38

Partially Owned Subsidiaries Often, a parent company owns less than 100 percent of a subsidiary company. Minority interest – BS account that reflects the rights of non-majority shareholders in the assets and liabilities of a company that is consolidated into the accounts of the major shareholder. On the consolidated BS appears after long term debt but before stockholders’ equity (Quasi liability). Minority income – IS account that reflects the share of non-majority shareholders in the earnings of a the consolidated firm. On the consolidated IS appears as a line item deduction. Minority interest is calculated using BV of the acquired firm. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -39

Consolidation – 80% Owned Sub. Before the Purchase A Shareholders B Shareholders After the Purchase A Shareholders A Corporation B Corporation Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Some of former B shareholders hold 20% of B Clinic 5 -40

Example - Consolidation On 12. 31. 01 Company A purchased 75% of the common stock of Company B for $20, 000. Any differential is alloacted to goodwill. The Balance sheets and income statements of the two companies for 12. 31. 01 and 12. 31. 02 are presented on the next slides. On 12. 31. 01 Company B gave a loan of $14, 000 to company A. Required: Prepare consolidated financial statements Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -41

Balance Sheets Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -42

Income Statements Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -43

Investment Under Equity Method – Differential Calculation The sub: Paid In Capital Retained Earnings 20, 000 4, 000 24, 000 Purchased 75% (18, 000) Payment (cost of acquisition) 20, 000 Differential 2, 000 The differential is attributed to goodwill and is not amortized Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -44

Investment Under Equity Method – Investment Account O. B. Income Total Mc. Graw-Hill/Irwin $20, 000 (75%*24, 000 + 2, 000) 3, 000 (75%*4, 000) 23, 000 (75%*28, 000 +2, 000) © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -45

Balance Sheet Consolidation – 31. 12. 01 Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -46

Balance Sheet Consolidation – 31. 12. 02 Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -47

Income Statement Consolidation – 2002 Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -48

Differential Allocated to Identifiable Assets Differential allocated to identifiable assets will be presented as part of these assets on the balance sheet. It’s amortization will be added to the amortization or depreciation of those assets. Two main concepts: Parent company concept (the common) – just the parent’s share of an asset markups is shown on the balance sheet. The entity concept – 100% of an asset markups is shown on the balance sheet. Minority interest is calculated using fair market value. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -49

Intercompany Transactions The parent company and the sub. might transact business with each other. From an economic point of view, nothing happens – as an entity can not trade with itself! The transactions must be eliminated so that they are not counted twice in the consolidated statements. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -50

Purchased Goodwill - the excess of the cost of an acquired company over the sum of the fair market value of its net identifiable individual assets Goodwill usually results from one or more of the following: • • Mc. Graw-Hill/Irwin brand name Good employees customer loyalty monopoly power © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -51

Recognition and Measurement of Goodwill The Financial Accounting Standards Board (FASB) issued Statement No. 142, Goodwill and Other Intangible Assets on July 20, 2001 Goodwill should not be amortized. Goodwill should be tested for impairment at a level of reporting referred to as a reporting unit. A reporting unit is an operating segment or one level below an operating segment A component of an operating segment is a reporting unit if the component constitutes a business for which discrete financial information is available and segment management regularly reviews the operating results of that component. Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -52

Recognition and Measurement of Goodwill of a reporting unit should be tested for impairment on an annual basis and between annual tests in certain circumstances. The annual goodwill impairment test may be performed any time during the fiscal year provided the test is performed at the same time every year. Different reporting units may be tested for impairment at different times. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -53

Goodwill Impairment Test – Step 1 The first step of the goodwill impairment test, compares the fair value of a reporting unit with its carrying amount, including goodwill. If the fair value of a reporting unit > its carrying amount, goodwill of the reporting unit is considered not impaired, thus the second step of the impairment test is unnecessary. If the carrying amount of a reporting unit > its fair value, the second step of the goodwill impairment test should be performed. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -54

Goodwill Impairment Test – Step 2 The second step of the goodwill impairment test compares the implied fair value of reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of reporting unit goodwill > the implied fair value of that goodwill, an impairment loss should be recognized in an amount equal to that excess. The loss recognized cannot exceed the carrying amount of goodwill. After a goodwill impairment loss is recognized, the adjusted carrying amount of goodwill should be its new accounting basis. Subsequent reversal of a previously recognized goodwill impairment loss is prohibited once the measurement of that loss is completed. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -55

Goodwill impairment - Triggering Events Goodwill of a reporting unit should be tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -56

Examples of Triggering Events A significant adverse change in legal factors or in the business climate An adverse action or assessment by a regulator Unanticipated competition A loss of key personnel A more-likely-than-not expectation that a reporting unit or a significant portion of a reporting unit will be sold or otherwise disposed of The testing for recoverability under Statement 121 of a significant asset group within a reporting unit Recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a component of a reporting unit. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -57

Financial Statement Presentation The aggregate amount of goodwill should be presented as a separate line item in the balance sheet. The aggregate amount of goodwill impairment losses should be presented as a separate line item in the income statement before the subtotal income from continuing operations (or similar caption) unless a goodwill impairment loss is associated with a discontinued operation. A goodwill impairment loss associated with a discontinued operation should be included (on a net-of-tax basis) within the results of discontinued operations. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -58

Pooling of Interests Under APB 16, business combinations were accounted for using one of two methods, the pooling-of-interests method (pooling method) or the purchase method. Use of the pooling method was required whenever 12 criteria were met; otherwise, the purchase method was to be used. Because those 12 criteria did not distinguish economically dissimilar transactions, similar business combinations were accounted for using different methods that produced dramatically different financial statement results. Pooling accounting is no longer allowed. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2007 All rights reserved. Clinic 5 -59