Presentation on theme: "Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential Note: Students sometimes like to print."— Presentation transcript:
1 Chapter 2Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No DifferentialNote: Students sometimes like to print slides as “handouts” with 1, 2, 3, 4, 6, or 9 slides per page for taking notes in class. It is sometimes best to print them using the “pure black and white” option on the color/gray scale dropdown menu to avoid dark boxes that are not conducive to note taking. Be aware that many instructors will only cover a sub-set of the slides available in this file. Also note that we have removed slides containing solutions to group or individual in-class exercises. You may want to print some slides (such as worksheets or slides with a large quantity of calculations) as a full page slide to facilitate working the exercise in class.
2 for investments in common stock. Learning Objective 1Understand and explain how ownership and control can influence the accountingfor investments in common stock.
3 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.
5 Investment vs. Ownership Consolidation eliminates the investment account and replaces it with “the detail.”Account for as trading, AFS, or Cost InvestmentsOwnership PercentageUsually equity method and consolidation (but cost method is also okay here)Equity method or Fair Value OptionNosignificantinfluenceSignificantinfluenceControlWhy is the cost method okay?100%0%20%50%
6 Accounting for Investments in Common Stock The Cost MethodUsed for reporting investments in equity securities when both consolidation and equity-method reporting are inappropriateThe Equity MethodUsed when the investor exercises significant influence over the operating and financial policies of the investee and consolidation is not appropriateMay not be used in place of consolidation if consolidation is appropriateIts primary use is in reporting nonsubsidiary investments6
7 Accounting for Investments in Common Stock ConsolidationInvolves 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 companyNormally is appropriate when one company, referred to as the parent, controls another company, referred to as a subsidiaryA subsidiary that is not consolidated with the parent is referred to as an unconsolidated subsidiary and is shown as an investment on the parent’s balance sheet.7
8 Practice Quiz Question #1 If Company A purchases 45% of the outstanding common stock of Company B, the investment in Company B should be accounted fora. as an available-for-sale investment.b. as a consolidated subsidiary.c. as a trading investment.d. as an equity method investment.e. none of the above.
9 Learning Objective 2Prepare journal entries using the cost method for accounting for investments
10 The Cost Method: How It Works Record the investment at “cost.”General Rule:Leave it on the books at cost.PS
11 The Cost Method: How It Works ReviewAssume 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 Corp:PS Corp:S
12 The Cost Method: How It Works General RuleThe investment remains on parent’s books at costRecord income at the parent level ONLY when sub declares a dividend.Generally, the sub’s income does not affect parent’s investment account balance.However, the parent cannot ignore the sub’s losses.Parent writes-down investment ONLY IF value has been impaired.Write-downs result in a NEW cost basis.
13 The Cost Method: How It Works The cost method is a one-way street!The investment can be written down—but never written up.Investment Account
14 The Cost Method: Pros & Cons Minimal G/L bookkeeping by parentSimple consolidation proceduresConsOverly conservative valuationParent can manipulate its reported income.Why?Parent controls when sub pays dividends!PCO statements—if used internally or issued—may be misleading.
15 The Cost Method: Key Concept Although the parent can manipulate its own reported net income, it can never manipulate consolidated net income.
16 Accounting Procedures The Cost MethodUsed when the investor lacks the ability either to control or to exercise significant influence over the investee.Accounting ProceduresThe cost method is consistent with the treatment normally accorded noncurrent assets.16
17 The Cost MethodAt the time of purchase, the investor records its investment in common stock at the total cost incurred in making the purchase.The investment continues to be carried at its original cost until the time of sale.Income from the investment is recognized as dividends are declared by the investee.Recognition of investment income before a dividend declaration is inappropriate.17
18 Example: The Cost Method ABC Company acquires 20 percent of XYZ Company’s common stock for $100,000 at the beginning of the year but does not gain significant influence over XYZ. During the year, XYZ has net income of $60,000 and pays dividends of $20,000. ABC Company records the following entries:18
19 The Cost MethodDeclaration of dividends in excess of earnings since acquisitionLiquidating dividends: Dividends declared by the investee in excess of its earnings since acquisition by the investor from the investor’s viewpointThe investor’s 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 investee’s point of view.Acquisition at interim dateDoes not create any major problems when the cost method is used.Potential difficulty: liquidating dividend determination19
20 The Cost Method Changes in the number of shares held Changes resulting from stock dividends, stock splits, or reverse splits receive no formal recognition in the accounts of the investorPurchases of additional sharesRecorded at cost similar to initial purchaseNew percentage ownership is calculated to determine whether switch to the equity method is requiredSales of sharesAccounted for in the same manner as the sale of any other noncurrent asset20
21 Practice Quiz Question #2 Under the cost method, a sub’s dividends would: a. NOT be eliminated in consolidation.b. be the parent’s income from investment.c. decrease the parent’s investment account.d. increase the parent’s investment account.e. none of the above.
22 Learning Objective 3Prepare journal entries using the equity method for accounting for investments.
23 The Equity Method: How It Works The equity method is accrual basis driven:Record income at the parent level based on sub’s earnings and losses—a built in valuation technique.It isn’t the same as fair value accounting.Nevertheless, the investment generally goes up and down based on the operations of the investee company.Sub’s dividends reduce the parent’s investment (the parent has less invested).Investment in SubIncome from Sub
24 The Equity Method: How It Works The equity method is a two-way street!The investment can be:written up based on the sub’s income ANDwritten down based on sub losses and dividends
25 The Equity Method: Pros and Cons Based on economic activity—not the parent-controlled dividend policy.Has two built-in checking figures:Consolidated NI = Parent’s NIConsolidated RE = Parent’s REConsRequires continual bookkeeping.Unnecessary work if PCO statements are not used internally or issued to outsiders.
26 The Equity MethodThe equity method is intended to reflect the investor’s changing equity or interest in the investee.The investment is recorded at the initial purchase price and adjusted each period for the investor’s share of the investee’s profits or losses and the dividends declared by the investee.26
27 The Equity MethodAPB Opinion No. 18 (as amended) requires that the equity method be used for:Corporate joint venturesCompanies in which the investor’s voting stock interest gives the investor the “ability to exercise significant influence over operating and financial policies” of that company“Significant influence” criterion – 20 percent ruleIn the absence of evidence to the contrary, an investor holding 20 percent or more of an investee’s voting stock is presumed to have the ability to exercise significant influence over the investee.27
28 Investor’s equity in the investee The Equity MethodInvestor’s equity in the investeeThe investor records its investment at the original costThis amount is adjusted periodically:Reported by InvesteeEffect on Investor’s AccountsNet incomeRecord income from investmentIncrease investment accountNet lossRecord loss from investmentDecrease investment accountDividend declarationRecord asset (cash or receivable)28
29 Example: The Equity Method ABC Company acquires significant influence over XYZ Company by purchasing 20 percent of the common stock of the XYZ Company for $100,000, XYZ earns income of $60,000 and pays dividends of $20,000.Recognition of incomeThis entry (equity accrual) is normally is made as an adjusting entry at the end of the periodIf the investee reports a loss, the investor recognizes its share of the loss and reduces the carrying amount of the investment by that amount29
30 Example: The Equity Method Recognition of dividendsCarrying amount of the investmentInvestment in XYZ Common Stock30
31 Acquisition at Interim Date The Equity MethodAcquisition at Interim DateNo income earned by the investee before the date of acquisition may be accrued by the investorAcquisition between balance sheet datesThe 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 accrual31
32 Purchases of additional shares The Equity MethodPurchases of additional sharesIf 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.32
33 The Equity Method Sale of shares Treated the same as the sale of any noncurrent assetFirst, the investment account is adjusted to the date of sale for the investor’s share of the investee’s current earningsThen, a gain or loss is recognized for the difference between the proceeds received and the carrying amount of the shares soldIf only part of the investment is sold, the investor must decide whether to continue using the equity method or to change to the cost method33
34 Practice Quiz Question #3 Under the equity method, a sub’s dividends would: a. NOT be eliminated in consolidation.b. be the parent’s income from investment.c. decrease the parent’s investment account.d. increase the parent’s investment account.e. none of the above.
35 Practice Quiz Question #4 Under the equity method, a sub’s losses would: a. never reduce the parent’s income.b. normally reduce the parent’s income.c. always reduce the parent’s income.d. always be eliminated in consolidation.e. none of the above.
36 Learning Objective 4Understand and explain differences between the cost and equity methods.
37 The Cost and Equity Methods Compared ItemCost MethodEquity MethodRecorded amount of investment at date of acquisitionOriginal costOriginal CostUsual carrying amount of investment subsequent to acquisitionOriginal cost increased (decreased) by investor’s share of investee’s income (loss) and decreased by investor’s share of investee’s dividendsIncome recognition by investorInvestor’s share of investee’s dividends declared from earnings since acquisitionInvestor’s share of investee’s earnings since acquisition, whether distributed or notInvestee dividends from earnings since acquisition by investorIncomeReduction of investmentInvestee dividends in excess of earnings since acquisition by investor37
38 Example: Equity Method versus Cost Method Pea Corporation created Soup Corporation with a transfer of $500 cash. During Soup Corp.’s first year of operations, it generated a net loss of $100 and paid no dividends. During Soup Corp.’s second year of operations, it generated net income of $200 and paid dividends of $50. What is the balance in the Investment in Sub account on Parent’s books at the end of year 2 using the equity method?Investment in SubWhat if Parent uses the cost method?What journal entries would Parent make under each method?38
39 Summary of Year 1 Equity Method Entries Investment in Soup Corp.Income from Soup Corp.
40 Summary of Year 2 Equity Method Entries Investment in Soup Corp.Income from Soup Corp.
41 Example: Equity versus Cost Method Equity MethodCost Method
42 Practice Quiz Question #5 On 1/1/X4, Phillip invested $650,000 in Sleeper (100% owned). For 20X4, Sleeper:(1) earned $90,000,(2) declared dividends of $60,000, and(3) paid dividends of $40,000.What amounts does Phillip report?Cost EquityInvestment income for 20X4Investment in Sleeper at year-endRetained earnings increase
43 Prepare journal entries using the fair value option. Learning Objective 5Prepare journal entries using the fair value option.
44 The Fair Value OptionFASB 159 permits but does not require companies to make fair value measurementsOption available only for investments that are not required to be consolidatedRather than using the cost or equity method to report nonsubsidiary investments in common stock, investors may report those investments at fair valueThe investor remeasures the investment to its fair value at the end of each periodThe change in value is then recognized in income for the periodNormally the investor recognizes dividend income in the same manner as under the cost method44
45 Example: The Fair Value Option Ajax Corporation purchases 40 percent of Barclay Company’s common stock on January 1, 20X1, for $200,000. Barclay has net assets on that date with a book value of $400,000 and fair value of $465,000. On March 1, 20X1, Ajax receives a cash dividend of $1,500 from Barclay. On March 31, 20X1, Ajax determines the fair value of its investment in Barclay to be $207,000. During the first quarter of 20X1, Ajax records the following entries:January 1, 20X1March1, 20X1March 31, 20X145
46 Make calculations and prepare basic elimination entries for a simple Learning Objective 6Make calculations and prepare basic elimination entries for a simpleconsolidation.
47 Overview of the Consolidation Process Chapter 2 introduces the most simple setting for a consolidation.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 SubsidiaryPartially Owned SubsidiaryInvestment = Book ValueChapter 2Chapter 3Investment > Book ValueChapter 4Chapter 5
48 Overview of the Consolidation Process The objective is to combine the financial statements of two or more entities as if they are a single corporation.The consolidation worksheet facilitates the combining of the two companies.Certain accounts need to be eliminated in the consolidation process to avoid “double counting.”Replaces “one-line” consolidation with the “detail.”
49 The Consolidation Worksheet (Fig. 2-3, p. 68) Elimination EntriesParentSubsidiaryDRCRConsolidatedIncome StatementRevenuesExpenseNet IncomeStatement of Retained EarningsRetained Earnings (1/1)Add: Net IncomeLess: DividendsRetained Earnings (12/31)Balance SheetAssetsTotal AssetsLiabilitiesEquityCommon StockRetained EarningsTotal Liabilities and Equity
50 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.”
51 The Basic Elimination Entry: The Equity Method What needs to be eliminated?The parent’s investment accountIt represents the initial investment adjusted for the parent’s cumulative share of the subsidiary’s income and dividends.The parent’s income from sub accountThe subsidiary’s equity accounts
52 Example: Equity Method Pea Corporation created Soup Corporation with a transfer of $500 cash. During Soup Corp.’s first year of operations, it generated a net loss of $100 and paid no dividends. During Soup Corp.’s second year of operations, it generated net income of $200 and paid dividends of $50. What is the balance in the Investment in Sub account on Parent’s books at the end of year 2 using the equity method?Investment in SubWhat accounts need to be eliminated?How are they eliminated?52
53 The Basic Elimination Entry: Equity Method The investment account represents the initial investment adjusted for the parents cumulative share of the subsidiary’s income and dividends.Therefore, the elimination entry eliminates:The subsidiary’s paid-in capital accounts (original investment)Beginning retained earnings (past earnings / dividends)The subsidiary’s current year earnings and dividendsGenerically, it looks like this:Common Stock XXXAdditional Paid-in Capital XXXRetained Earnings (Beginning Balance) XXXIncome from Sub XXXDividends Declared XXXInvestment in Sub XXX
54 The Basic Elimination Entry: Equity Method Additional Total Common Paid-In Retained Book Value Stock Capital Earnings=++Beginning Book Value 400) (100)+ Net Income 200) 200)Dividends (50) (50)Ending Book Value 550) )Note that the “blue” numbers appear in the basic elimination entry.Note that this is a deficit balance!Basic Elimination EntryCommon StockAdditional Paid-in CapitalIncome from Soup Corp.Retained Earnings (BB)Dividends DeclaredInvestment in Soup Corp.Original amount invested (100%)Soup Corp.’s reported incomeBeginning balance in retained earnings100% of Soup Corp.’s dividendsNet book value in investment account
55 Basic Elimination Entry: The Equity Method Common Stock 50Additional Paid-in Capital 450Income from Soup Corp. 200Retained Earnings (BB) 100Dividends Declared 50Investment in Soup Corp. 550Investment in Soup Corp.Income from Soup Corp.
56 Prepare a consolidation worksheet. Learning Objective 7Prepare a consolidation worksheet.
58 The Equity Method: Things to Remember in Consolidation Consolidated net income EQUALS the parent’s net income.Consolidated retained earnings EQUALS the parent’s retained earnings.Parent Consolidated=Parent Consolidated=
59 Group Exercise 1 REQUIRED Assume Pinkett acquired Smith on 1/1/11 Prepare all elimination entries as of 12/31/11.Prepare a consolidation worksheet at 12/31/11.Assume Smith’s accumulated depreciation on 1/1/11 was $20,000.
60 Group Exercise 1 Objective: Book Value Calculations Eliminate equity accounts of SubEliminate equity method accounts of Parent.Book Value CalculationsTotal Common Retained Book Value Stock Earnings=+Original Book Value+ Net IncomeDividendsEnding Book ValueBasic Elimination EntryCommon StockRetained Earnings (BB)Income from Smith, Inc.Dividends DeclaredInvestment in Smith, Inc.
61 Group Exercise 1: Solution The optional accumulated depreciation elimination entry:Accumulated DepreciationBuildings and EquipmentProperty, Plant & EquipmentAccumulated Depreciation210,00020,000
65 The Basic Elimination Entry: The Cost Method The investment account is generally exactly equal to the sum of the subsidiary’s paid-in capital accounts.Unless the parent records an impairment loss.Under the cost method, we also eliminate dividends from sub to parent.Common Stock 50Additional Paid-in Capital 450Investment in Sub 500Dividend Income 50Dividends Declared 50
66 Consolidation Entries: Cost Method — Complete the Worksheet
67 Group Exercise 1: Cost Method Consolidation REQUIREDPrepare 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?
69 The Cost Method: Things to Remember in Consolidation Consolidated net income does NOT equal the parent’s net income.Consolidated retained earnings does NOT equal the parent’s retained earnings.P S Sub’s Div CONS$200 + $200 $50 = $350P S CONS$350 + $50 = $400
70 Consolidation: The Most Important Point of All on Investment Basis The consolidated statement amounts are identical whether the parent uses the cost method or the equity method—this holds true for all three statements.EquityMethodConsolidatedStatementsCostMethodConsolidatedStatements=
71 PCO Statements: Presented in Notes to the Consolidated Statements Retained Earnings Available for Dividends:Based on the parent’s G/L amount—not 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.