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MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS Baginski & Hassell.

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Presentation on theme: "MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS Baginski & Hassell."— Presentation transcript:

1 MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS Baginski & Hassell

2 Chapter 8

3 Topics –Methods of accounting for investments in common stock –Mark-to-Market accounting for certain investments in equity securities –Opportunity for gains trading –Legal forms of business combinations –Accounting methods for business combinations –Consolidated financial statements

4 Methods of Accounting for Investments in Common Stock Cost Method –Investor has no significant influence over increase Presumed to be ownership of < 20% of investees outstanding common stock Equity method –Investor has significant influence, but does not have control over investee Presumed to be ownership of 20% - 50% of investees outstanding common stock

5 FAQ? When should a corporation consider consolidation, i.e., consolidated financial statements? When the investor is in control which is clearly the case when over 50% of the investees outstanding common shares are owned. Effective control can often take somewhat less than 50%!

6 Cost Method An investor uses the cost method if it has no significant influence over investee –Investment is recorded at the cost of acquiring the shares If marketable, securities are classified as either trading or available-for-sale (in accordance with SFAS No. 115).

7 The investees pro rata share of dividends declared by investee is recorded as dividend income –Dividend income is shown in the other income section of the income statement. –Dividends received are shown as an operating activity in the SCF.

8 Equity Method An investor uses the equity method if it has significant influence over the investee, but it does not have control –The investment is initially recorded at the cost of acquiring the shares. –The investors pro rata share of investee net income is recorded as (1) an increase in the investment, and (2) investment income (reported in the other income section of the income statement; not dependent on cash flows).

9 Equity Method & Dividend Collections –The investors pro rata share of dividends declared by investee is recorded as a reduction of the investors investment –Under the equity method, the investment is not marked-to-market

10 Example: Compare and Contrast Cost and Equity Methods (for long-term investments) Facts: On January 1, the OBrien Co. purchased 100,000 shares of Gilly Co.s common stock for $18 per share (or 15% of Gillys outstanding common stock). For the year, Gilly reported net income of $5,000,000 and declared and paid dividends of $800,000.

11 Illustration of cost and equity methods Assumption 1:The investment (15%) does not give OBrien significant influence Assumption 2:The investment (15%) does give OBrien significant influence The effects on OBriens current year financial statements are as follows:

12 OBrien: Cost Method Balance Sheet Investment in common stock (1) $1,800,000 Income Statement Other income: Dividend income (2) 120,000 (1) 100,000 shares × $18 (2) $800,000 × 15%

13 Cost Method, continued Statement of Cash Flows Operating Activities Dividends received $ 120,000 Investing Activities Purchase of investment(1,800,000)

14 OBrien: Equity Method Balance Sheet Investment in common stock (1) $2,430,000 Income Statement Other income: Equity in subsidiary earnings (2) $750,000 (1) ($100,000 shares × $18) + ($5,000,000 × 15%) – ($800,000 × 15%) (2) $5,000,000 × 15%

15 Statement of Cash Flows Operating Activities Dividends Received Adjust for non-cash revenue 120,000 (750,000) Investing Activities Purchase of investment$(1,800,000) Equity Method, continued

16 Compare and Contrast Effect of Cost and Equity Methods Balance sheet: Investment account is different –Cost: carry at historical cost –Equity: carry at historical cost adjusted for Income statement: Revenue is different –Cost: dividends –Equity: pro-rata share of investees Net Income Statement of cash flows is different –Cost: no adjustment required for non-cash revenue –Equity: remove non-cash revenue from net income

17 Mark-to-Market Accounting for Investments in Equity Securities SFAS No. 115 classifies certain securities as trading, available-for-sale, or held-to-maturity. Equity securities can only be classified as trading or available-for-sale. Only debt securities can be classified as held-to-maturity. FMV

18 To be classified as trading or available-for- sale, the securities must have readily determinable FMVs. Types of equity securities that qualify for trading or available-for-sale classification –Common stock (accounted for under the cost method) –Preferred stock –Stock rights, warrants, options

19 SFAS No. 115: Trading and Available- for-Sale Securities Trading –Marked-to-Market at balance sheet date –Unrealized gain/loss is reported in the other income (expenses) section of the income statement –Unrealized gain/loss is a noncash event that requires adjustment in the operating section of the SCF

20 Available-For-Sale –Marked-to-Market at balance sheet date –Unrealized gain/loss is reported in the other comprehensive income section of the statement of comprehensive income Other comprehensive income is closed to the accumulated other comprehensive income section of stockholders equity –Unrealized gain does not impact net income so no adjustment is required on the SCF

21 Example: Compare and Contrast Trading and Available-For-Sale Classifications Facts: On January 1, the OBrien Co. purchased 100,000 shares of Gilly Co.s common stock for $18 per share (15% of Gillys outstanding common stock). For the year, OGill reported net income of $5,000,000 and declared and paid dividends of $800,000. The investment (15%) does not give OBrien significant influence therefore the cost method is used. Gillys year-end common stock FMV is $20 per share.

22 Illustration of cost and equity methods Assumption 1:The investment is classified as trading. Assumption 2:The investment is classified as available-for-sale. OBriens current year financial statement effects for the investments are as follows:

23 OBrien: Trading Classification Balance Sheet Investment in common stock (1) $2,000,000 Income Statement Other income: Dividend income (2) $120,000 Unrealized gain (loss) on trading securities (3) 200,000 (1) 100,000 shares × $20 (2) $800,000 × 15% (3) 100,000 × ($20 - $18 )

24 Statement of Comprehensive Income Other comprehensive income$0 Statement of Cash Flows Operating Activities Purchase of investments$(1,800,000) Dividends received Adjustment for noncash revenue 120,000 (200,000) Trading Classification, continued

25 OBrien: Available-for-Sale Classification Balance Sheet Investment in common stock (1) $2,000,000 Income Statement Other income: Dividend income (2) $120,000 (1) 100,000 shares × $20 (2) $5,000,000 × 15%

26 Statement of Comprehensive Income Other comprehensive income (3) $ 200,000 Statement of Cash Flows Operating Activities Dividends received$120,000 Investing Activities Purchase of investments$(1,800,000) (3) 100,000 × ($20 - $18 ) Available-for-Sale Classification, continued

27 Compare and Contrast Effects of Trading and Available-for-Sale Classifications Balance sheet investment account is the same Income statement amounts are different Statement of comprehensive income amounts are different Cash flows on the SCF different; classification affects type of cash flow; Tradings noncash revenue from mark-to-market requires adjustment

28 Opportunity for Gains Trading A company with available-for-sale securities has unrealized gains/losses associated with the securities Gains trading is the strategic planning of sales of available-for-sale securities in such a manner as to create either –profits (sell securities with unrealized gains) –losses (sell securities with unrealized losses)

29 BUSINESS COMBINATIONS

30 Legal Forms of Business Combinations Three general forms (types) of business combinations occur –Merger: One entity retains its identity. –Consolidation: New entity identity is created. –Parent/Subsidiary Relationship: All entities maintain identity.

31 Merger: A + B = A One company acquires a second company and the second company ceases to exist. Consolidation: A + B = C Two companies form a third company and the original two companies cease to exist. Parent & Subsidiaries: A + B = A + B One company acquires the common stock of a second company, and after the transaction both companies continue to exist.

32 Accounting Methods for Business Combinations: Purchase The transaction is recorded at the fair market value of the consideration given by the acquiring company The net assets of the acquired company are written up or down to fair market value Any excess of the value paid over the sum of the fair market values of the net assets acquired is recorded as goodwill

33 Accounting Methods for Business Combinations: Poolings FASB eliminated pooling for all combinations after June 30, 2001 Historically, many combinations were recorded as pooling –Net assets acquired recorded at their book value –No goodwill was recognized

34 Goodwill Goodwill reported on a balance sheet can only result from a business combination accounted for as a purchase. Goodwill is tested annually for impairment

35 Goodwill Impairment Procedure 1)Compare fair value of the reporting unit to the units book value including goodwill If FV > carrying amount, no impairment If FV < carrying amount, proceed to second step 2)Compare GWs bookvalue to its implied fair value If BV > Implied FV recognize impairment equal to the excess

36 Consolidated Financial Statements Note: The use of the term consolidation in the next slide is different than when used to refer to the legal form of a type of business combination (i.e., consolidation: A + B = C)

37 Consolidated Financial Statements Companies that reflect a parent/subsidiary relationship prepare consolidated financial statements The financial statements of the parent company are combined with those of the subsidiary company(s) into one set of consolidated financial statements –Intercompany amounts are eliminated in the consolidation process

38 End of Chapter 8


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