1. MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS
Baginski & Hassell

2. Firms' Equity Securities
Chapter 8
INVESTING DECISIONS
Investing in Other
Firms' Equity Securities

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 investee’s outstanding common stock
Equity method
Investor has significant influence, but does not have control over investee
Presumed to be ownership of 20% - 50% of investee’s 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 investee’s 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 investee’s 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 investor’s 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 investor’s pro rata share of dividends declared by investee is recorded as a reduction of the investor’s 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 O’Brien Co. purchased 100,000 shares of Gilly Co.’s common stock for $18 per share (or 15% of Gilly’s 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 O’Brien significant influence
Assumption 2:
The investment (15%) does give O’Brien significant influence
The effects on O’Brien’s current year financial statements are as follows:

12. O’Brien: 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
$ ,000
Investing Activities
Purchase of investment
(1,800,000)

14. O’Brien: 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. Equity Method, continued
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)

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 investee’s 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
FMV
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.

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
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 O’Brien Co. purchased 100,000 shares of Gilly Co.’s common stock for $18 per share (15% of Gilly’s outstanding common stock).
For the year, O’Gill reported net income of $5,000,000 and declared and paid dividends of $800,000.
The investment (15%) does not give O’Brien significant influence therefore the cost method is used.
Gilly’s 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.
O’Brien’s current year financial statement effects for the investments are as follows:

23. O’Brien: 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. Trading Classification, continued
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)

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

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; Trading’s 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
Compare fair value of the reporting unit to the unit’s book value including goodwill
If FV > carrying amount, no impairment
If FV < carrying amount, proceed to second step
Compare GW’s 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