Intercorporate Investments and Consolidations 2006 Prentice Hall Business

Learning Objectives After studying this chapter, you should be able to 1. Explain why corporations invest in one another 2. Account for short-term investments in debt securities and equity securities 3. Report long-term investments in bonds 4. Contrast the equity and market methods of accounting for investments 5. Prepare consolidated financial statements 6. Incorporate minority interests into consolidated financial statements © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 2

Learning Objectives After studying this chapter, you should be able to 7. Explain the economic meaning and financial reporting of goodwill © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 3

Overview of Corporate Investments • Companies invest in short- and long-term debt securities issued by governments, banks, or corporations • Companies also invest in corporate equities that may be classified as marketable securities • Corporations combine in order to – Find the right combination of people and products to succeed in the long run – Create cost savings from eliminating duplications © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 4

Overview of Corporate Investments • Smaller companies tend to result in more successful mergers • Companies sometimes sell parts of themselves when they purchase another company • Spin-offs often separate dissimilar business segments to create opportunities for more creative and innovative growth © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 5

Overview of Corporate Investments • A short-term investment expected to be converted to cash should be carried as a current asset • Other investments are classified as noncurrent assets and usually appear as either: 1. A separate investment category between current assets and PP&E, or 2. A part of other assets below the plant assets category © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 6

Short-Term Investments • A short-term investment is a temporary investment in marketable securities that are expected to be converted to cash within one year • Marketable securities are notes, bonds, or stocks that can be easily sold • Short-term debt securities consist of notes and bonds with maturities of one year or less – Examples: CDs, commercial paper, and Treasury bills © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 7

Short-Term Investments • Short-term equity securities consist of capital stock in other corporations • Trading securities are short-term investments in debt and equity securities that the company intends to sell shortly • Held-to-maturity securities are debt securities that the company intends to hold until they mature • Available for sale securities are neither trading or held-to-maturity securities © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 8

Changes in Market Prices of Securities • Held-to-maturity securities – Recognize interest income on the income statement – Are valued at amortized cost, ignoring changes in market value • Trading securities – Recognize dividend and interest revenue on the income statement – Are valued at market value (market method), recognizing unrealized gains and losses on the income statement © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 9

Changes in Market Prices of Securities • Available for sale securities – Recognize dividend and interest revenue of the income statement – Are valued at market value (market method), recognizing unrealized gains and losses in a separate account in the stockholders’ equity section of the balance sheet (accumulated other comprehensive income) © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 10

Changes in Market Prices of Securities • The exhibit below illustrates the accounting for trading securities and available-for-sale securities: © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 11

Changes in Market Prices of Securities • The journal entries for periods 2, 3, and 4 would be: © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 12

Long-Term Investments in Bonds • Using the same data from Chapter 9, but now from the point of view of the investor: – 10, 000 $1, 000 2 -year 10% bonds (5% semi-annually) are purchased when the annual market interest rate is 12% (6% for each six-month period) – $965. 35 is paid for each bond, for a total cost of $9, 653, 500 – The issuer recognizes a discount of $346, 500 ($10, 000 - $9, 653, 500) at issuance – The investor must also amortized the discount over the 4 semi-annual periods using the interest method © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 13

Long-Term Investments in Bonds • The journal entries for the purchase and the first two interest payments are: 12/31/03 6/30/04 12/31/04 Investment in bonds Cash 9, 653, 500 Cash Investment in bonds Interest revenue 500, 000 79, 207 Cash Investment in bonds Interest revenue 500, 000 83, 959 579, 207* 583, 959** * $9, 653, 500 x. 06 ** ($9, 653, 500 - $79, 207) x. 06 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 14

Long-Term Investments in Bonds • The discount makes up for the difference between the coupon rate of 10% and the market rate of 12% • Amortization of a discount increases the interest revenue for the investor • Amortization increases the investment account directly – a separate discount account is not used for the investor © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 15

Early Extinguishment of Investment • Suppose that the issuer buys back the bonds for $9. 6 million on December, 2004, when the amortized cost is $9, 816, 666, the journal entry for the extinguishment by the investor is: 12/31/04 Cash Loss on disposal of bonds Investment in bonds © 2006 Prentice Hall Business Publishing 9, 600, 000 216, 666 Introduction to Financial Accounting, 9/e 9, 816, 666 Horngren/Sundem/Elliott/Philbrick 16

The Market and Equity Methods • The investor’s accounting depends on the level of influence of the investor over the investee • The equity method recognizes increases or decreases in the economic resources that the investor can influence © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 17

The Market and Equity Methods • Suppose Buyit Corporation invests $80 million in each of two companies: – Passiveco • Total market value of $800 million (10% ownership) • Earnings of $120 million • Dividends of $40 million – Influential • Total market value of $200 million (40% ownership) • Earnings of $30 million • Dividends of $10 million © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 18

The Market and Equity Methods • Buyit’s journal entries for (1) acquisition, (2) net income of the investee, and (3) dividends of the investee are (in millions): Market Method – Passiveco 1. Investment in Passiveco Cash Equity Method – Influential 80 80 2. No entry 3. Cash 4 Dividend revenue 4 1. Investment in Influential Cash 80 2. Investment in Influential Investment revenue 12 3. Cash Investment in Influential 80 12 4 4 • Buyit recognizes income from – Passiveco as dividends are received ($40 M x 10%) – Influential as part of its earnings ($30 M x 40%) © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 19

Consolidated Financial Statements • When a investor has control over an investee company (over 50% ownership), it must prepare consolidated financial statements • The investor company is called the parent • The investee company is called the subsidiary • Although both companies remain separate legal entities, the financial position and earnings reports of the parent are combined with those of the subsidiary © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 20

The Acquisition • Assume two separate companies: – Company P: Assets of $650 million – Company S: Assets of $400 million • P purchases all of the outstanding stock of S for $213 million in cash • The journal entry on the books of P (in millions) is: Investment in S Cash © 2006 Prentice Hall Business Publishing 213 Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 21

The Acquisition Purchase P Corporation Cash S Shares S Corporation After Purchase P Shareholders P Corporation Consolidated corporation S Corporation © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 22

The Acquisition • The balance sheets of each company appear as follows before and after the purchase: © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 23

Preparing Consolidated Statements Parent Company Records Subsidiary Records Parent Company Financial Statements Subsidiary Financial Statements 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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 24

Preparing Consolidated Statements • In combining the amounts on the balance sheet, P must eliminate its investment account and the stockholders’ equity of S, which eliminates double-counting of the investment in S © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 25

After Acquisition • P continues to use the equity method during the period • To prepare consolidated statements, P must eliminate: – Its investment account and the SE of the subsidiary on the consolidated balance sheet – Intercompany revenues and expenses on the income statement – Other intercompany transactions © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 26

Minority Interests • A parent company may own less than 100% of the outstanding stock (51% - 99%) • Claims by non-majority stockholders on assets and earnings in the consolidated statements are called minority interests • Minority interest must be shown on both the consolidated income statement and consolidated balance sheet © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 27

Minority Interests 90% Purchase P Corporation Cash S Shares S Corporation P pays cash to some shareholders in S After Purchase P Shareholders P Corporation Dashed line defines consolidated corporation © 2006 Prentice Hall Business Publishing S Corporation Introduction to Financial Accounting, 9/e Shown as “Minority Interest” in consolidated statements Some old S shareholders hold 10% of S Horngren/Sundem/Elliott/Philbrick 28

Purchase Price Not Equal to Book Value • When the acquiring company pays more than the book value of the acquired company’s net assets, consolidation requires a two-step adjustment: 1. All acquired assets and liabilities are shown at their fair market value (FMV) 2. If the purchase price > FMV of the net assets, goodwill must be shown on the consolidated balance sheet • Goodwill is the excess of the cost of an acquired company over the sum of the FMV of its identifiable assets less the liabilities © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 29

Accounting for Goodwill • In the previous example, assume that: – P acquired a 100% interest in S for $253 million rather than $213 million – A building with a book value of $20 million had a FMV of $35 million • The tabulation of the consolidated balance sheet including the calculation of goodwill is shown in the next exhibit © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 30

Accounting for Goodwill © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e

Accounting for Goodwill • Impairment of goodwill occurs when it loses its value subsequent to acquisition • The consolidated company must record any impairment with a decrease to the goodwill account and a charge to an expense account © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 32

Goodwill and Abnormal Earnings • Goodwill is the price paid for “excess” or “abnormal” earning power • This abnormal earning power could be due to location, human resource, or reputation advantages • Normal earnings and excess earnings are capitalized by a multiple • The multiple for excess earnings is lower since it is riskier © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 33

Goodwill and Abnormal Earnings • The following example assumes a multiple of 10 for normal earnings and 6 for abnormal earnings 1. FMV of identifiable assets, less liabilities $800, 000 2. Normal annual earnings on net assets at 10% 80, 000 3. Actual average annual earnings for past 5 years (including an excess return of $20, 000) 100, 000 4. Maximum price paid for normal annual earnings (10 x line 2) 800, 000 5. Maximum price paid for abnormal annual earnings (which are riskier and thus less valuable per dollar of expected earnings) is 6 times $20, 000 120, 000 6. Maximum price a purchaser is willing to pay for the company (line 1 plus line 5) © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e $920, 000 Horngren/Sundem/Elliott/Philbrick 34

Equity Affiliates, Minority Interest, and the Statement of Cash Flows • The statement of cash flows is affected for a company having equity affiliates (firms for which the investor uses the equity method) in the follow way: – Direct method: A cash dividend received from the affiliate appears in the operating section – Indirect method: Net income is increased (decreased) by the investor’s share of its affiliates’ earnings (loss) in the operating section © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 35