© 2002 prentice hall business publications introduction to financial accounting, 8th...

© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott

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Chapter 12

Intercorporate Investmentsand Consolidations


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Learning ObjectivesAfter studying this chapter, you should be able to: Explain why corporations invest in one another. Account for short-term investments in debt securities

and equity securities. Report long-term investments in bonds. Contrast the equity and market methods of accounting

for investments. Prepare consolidated financial statements.


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Learning ObjectivesAfter studying this chapter, you should be able to: Incorporate minority interests into consolidated financial

statements. Explain the economic and reporting role of goodwill.


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An Overview ofCorporate Investments

Corporate managers should invest any idle funds on hand just as individuals invest any idle cash they have on hand.

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.


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Corporate Marriage and Divorce 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.


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Corporate Marriage and Divorce Once companies combine, accountants must

develop ways to report the financial results.

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.


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Short-Term Investments 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.


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Short-Term Investments 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


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Short-Term Investments 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.


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Short-Term Investments 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.


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Short-Term Investments 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.


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Short-Term Investments 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.


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Short-Term Investments 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.


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Changes in Market Pricesof Securities

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


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Changes in market values for trading securities:• As market values change, companies report the

resulting gains and losses in the income statement.

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.


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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.


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Comprehensive Income 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.

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.


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Long-Term Investments in Bonds Recall that the issuer of bonds must amortize

bond discounts and premiums as periodic adjustments of interest expense.

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.


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Bonds-Held-to-Maturity 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.


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Bonds-Held-to-Maturity 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.

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.


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Early Extinguishmentof Investment

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.

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.


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The Market and Equity Methods for Intercorporate Investments

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.


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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.


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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?


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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

Cash 150,000

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


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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


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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.


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Consolidated Financial Statements 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


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Consolidated Financial Statements 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


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The Acquisition 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.

From the subsidiary’s perspective, nothing changes on the books. However, the subsidiary now has one major owner - the parent.


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The AcquisitionBefore the purchase

PCorporation

PCorporation

SCorporation

SCorporation

SShareholders

SShareholders

PShareholders

Own Own


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The AcquisitionPurchase

PCorporation

PCorporation

SShareholders

SShareholders

Cash

Shares of S After the Purchase

PShareholders

PShareholders

S CorporationS Corporation

P CorporationP CorporationOwn

and


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The Acquisition No books are kept for the consolidated entity.

• Only working papers are used to prepare the consolidated financial statements.

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.


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The AcquisitionPreparing Consolidated Statements

Parent CompanyFinancial Statements

Parent CompanyFinancial Statements

SubsidiaryFinancial Statements

SubsidiaryFinancial Statements

Parent CompanyRecords

Combine Parent and SubsidiaryFinancial Statements on a Work Sheet

Eliminate Double CountingParent’s Investment Against Subsidiary OE

Intercompany Receivables and PayablesIntercompany Sales and Purchases

ConsolidatedFinancial Statements

ConsolidatedFinancial Statements

SubsidiaryRecords

SubsidiaryRecords


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After Acquisition 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.


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Intercompany Eliminations 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.


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Minority Interests 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.


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Minority InterestsBefore the purchase

PCorporation

PCorporation

SCorporation

SCorporation

SShareholders

SShareholders

PShareholders

Own Own


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Minority Interests 90% Purchase

PCorporation

PCorporation

SShareholders

SShareholders

Cash

90% of Shares of SAfter the Purchase

PShareholders

PShareholders

S CorporationS Corporation

P CorporationP CorporationOwn

and Some OldS ShareholdersHold 10% of S

Some OldS ShareholdersHold 10% of S


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Defining Control 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


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Defining Control 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


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Purchased Goodwill 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


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Goodwill and Abnormal Earnings 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.


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Amortization of Goodwill Goodwill does not have a perpetual life, but it

may be maintained by continuous efforts.

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.


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Perspective on Consolidated Statements

The FASB requires that all subsidiary companies must be consolidated regardless of their line of business or the parent’s line of business.

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.


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Equity Affiliates, Minority Interest, and the Statement of Cash

Flows 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.


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Equity Affiliates, Minority Interest, and the Statement of Cash

Flows 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.


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Purchased Research and Development

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.

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.


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Summary of Accountingfor Equity Securities

Percentage ofOwnership

Type ofAccounting

Balance SheetEffects

Income StatementEffects

Major Journal Entries

100% Consolidation Assets and liabilitiesadded together;goodwill is shown

Revenues andexpenses addedtogether; goodwillamortized

None, except in worksheets to eliminateintercompany accountsand transactions

More than 50%and less than100%

Consolidation Same as above, butrecognition givento minorityinterests

Same as above, butrecognition givento minorityinterests

Same as above, butrecognition given tominority interests

20% up to andincluding50%

Equity method Investment carried atcost plus share ofearnings lessdividends received

Equity in earnings ofaffiliates shownand included in netincome

Entries to record earningsand dividends

Below 20% Market method Investment carried atmarket value

Trading - changesaffect net income.

Available-for-sale -changes shown inequity section.

Entries to recordappreciation ordepreciation in value


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Introduction to Financial Accounting

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