3 Topics Methods of accounting for investments in common stock “Mark-to-Market accounting” for certain investments in equity securitiesOpportunity for gains tradingLegal forms of business combinationsAccounting methods for business combinationsConsolidated financial statements
4 Methods of Accounting for Investments in Common Stock Cost MethodInvestor has no significant influence over increasePresumed to be ownership of < 20% of investee’s outstanding common stockEquity methodInvestor has significant influence, but does not have control over investeePresumed 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 MethodAn investor uses the cost method if it has no significant influence over investeeInvestment is recorded at the cost of acquiring the sharesIf 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 MethodAn investor uses the equity method if it has significant influence over the investee, but it does not have controlThe 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 investmentUnder 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 influenceAssumption 2:The investment (15%) does give O’Brien significant influenceThe effects on O’Brien’s current year financial statements are as follows:
12 O’Brien: Cost Method Balance Sheet Investment in common stock (1) $1,800,000Income StatementOther income: Dividend income (2)120,000(1) 100,000 shares × $18(2) $800,000 × 15%
13 Cost Method, continued Statement of Cash Flows Operating Activities Dividends received$ ,000Investing ActivitiesPurchase of investment(1,800,000)
15 Equity Method, continued Statement of Cash FlowsOperating ActivitiesDividends ReceivedAdjust for non-cash revenue120,000(750,000)Investing ActivitiesPurchase of investment$(1,800,000)
16 Compare and Contrast Effect of Cost and Equity Methods Balance sheet: Investment account is differentCost: carry at historical costEquity: carry at historical cost adjusted forIncome statement: Revenue is differentCost: dividendsEquity: pro-rata share of investee’s Net IncomeStatement of cash flows is differentCost: no adjustment required for non-cash revenueEquity: remove non-cash revenue from net income
17 “Mark-to-Market Accounting” for Investments in Equity Securities FMVSFAS 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 classificationCommon stock (accounted for under the cost method)Preferred stockStock rights, warrants, options
19 SFAS No. 115: Trading and Available-for-Sale Securities Marked-to-Market at balance sheet dateUnrealized gain/loss is reported in the other income (expenses) section of the income statementUnrealized gain/loss is a noncash event that requires adjustment in the operating section of the SCF
20 Available-For-SaleMarked-to-Market at balance sheet dateUnrealized gain/loss is reported in the other comprehensive income section of the statement of comprehensive incomeOther comprehensive income is closed to the accumulated other comprehensive income section of stockholders’ equityUnrealized 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 SheetInvestment in common stock (1)$2,000,000Income StatementOther income:Dividend income (2)$120,000Unrealized 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 IncomeOther comprehensive income$0Statement of Cash FlowsOperating ActivitiesPurchase of investments$(1,800,000)Dividends receivedAdjustment for noncash revenue120,000(200,000)
25 O’Brien: Available-for-Sale Classification Balance SheetInvestment in common stock (1)$2,000,000Income StatementOther income: Dividend income (2)$120,000(1) 100,000 shares × $20(2) $5,000,000 × 15%
26 Available-for-Sale Classification, continued Statement of Comprehensive IncomeOther comprehensive income(3)$ ,000Statement of Cash FlowsOperating ActivitiesDividends received$120,000Investing ActivitiesPurchase of investments$(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 sameIncome statement amounts are differentStatement of comprehensive income amounts are differentCash 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 eitherprofits (sell securities with unrealized gains)losses (sell securities with unrealized losses)
30 Legal Forms of Business Combinations Three general forms (types) of business combinations occurMerger: One entity retains its identity.Consolidation: New entity identity is created.Parent/Subsidiary Relationship: All entities maintain identity.
31 Merger: A + B = AOne company acquires a second company and the second company ceases to exist.Consolidation: A + B = CTwo companies form a third company and the original two companies cease to exist.Parent & Subsidiaries: A + B = A + BOne 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 companyThe net assets of the acquired company are written up or down to fair market valueAny 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, 2001Historically, many combinations were recorded as poolingNet assets acquired recorded at their book valueNo goodwill was recognized
34 GoodwillGoodwill 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 goodwillIf FV > carrying amount, no impairmentIf FV < carrying amount, proceed to second stepCompare GW’s bookvalue to its implied fair valueIf 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 statementsThe financial statements of the parent company are combined with those of the subsidiary company(s) into one set of consolidated financial statementsIntercompany amounts are eliminated in the consolidation process