Intercorporate Investments and Consolidations CHAPTER 11

Learning Objectives After 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 Incorporate minority interests into consolidated financial statements

Learning Objectives After studying this chapter, you should be able to Explain the economic meaning and financial reporting of goodwill

Overview of Corporate Investments Companies invest in short- and long-term debt securities issued by governments, banks, or corporations Companies also invest in corporate equities that may be classified as marketable securities Corporations combine in order to Find the right combination of people and products to succeed in the long run Create cost savings from eliminating duplications

Overview of Corporate Investments Smaller companies tend to result in more successful mergers Companies sometimes sell parts of themselves when they purchase another company Spin-offs often separate dissimilar business segments to create opportunities for more creative and innovative growth

Overview of Corporate Investments A short-term investment expected to be converted to cash should be carried as a current asset Other investments are classified as noncurrent assets and usually appear as either: A separate investment category between current assets and PP&E, or A part of other assets below the plant assets category

Short-Term Investments A short-term investment is a temporary investment in marketable securities that are expected to be converted to cash within one year Marketable securities are notes, bonds, or stocks that can be easily sold Short-term debt securities consist of notes and bonds with maturities of one year or less Examples: CDs, commercial paper, and Treasury bills

Short-Term Investments Short-term equity securities consist of capital stock in other corporations Trading securities are short-term investments in debt and equity securities that the company intends to sell shortly Held-to-maturity securities are debt securities that the company intends to hold until they mature Available for sale securities are neither trading or held-to-maturity securities

Changes in Market Prices of Securities Held-to-maturity securities Recognize interest income on the income statement Are valued at amortized cost, ignoring changes in market value Trading securities Recognize dividend and interest revenue on the income statement Are valued at market value (market method), recognizing unrealized gains and losses on the income statement

Changes in Market Prices of Securities Available for sale securities Recognize dividend and interest revenue of the income statement Are valued at market value (market method), recognizing unrealized gains and losses in a separate account in the stockholders’ equity section of the balance sheet (accumulated other comprehensive income)

Changes in Market Prices of Securities The exhibit below illustrates the accounting for trading securities and available-for-sale securities:

Changes in Market Prices of Securities The journal entries for periods 2, 3, and 4 would be:

Long-Term Investments in Bonds Using the same data from Chapter 9, but now from the point of view of the investor: 10,000 $1,000 2-year 10% bonds (5% semi-annually) are purchased when the annual market interest rate is 12% (6% for each six-month period) $965.35 is paid for each bond, for a total cost of $9,653,500 The issuer recognizes a discount of $346,500 ($10,000,000 - $9,653,500) at issuance The investor must also amortized the discount over the 4 semi-annual periods using the interest method

Long-Term Investments in Bonds The journal entries for the purchase and the first two interest payments are: 12/31/03 Investment in bonds 9,653,500 Cash 9,653,500 6/30/04 Cash 500,000 Investment in bonds 79,207 Interest revenue 579,207* 12/31/04 Cash 500,000 Investment in bonds 83,959 Interest revenue 583,959** * $9,653,500 x .06 ** ($9,653,500 - $79,207) x .06

Long-Term Investments in Bonds The discount makes up for the difference between the coupon rate of 10% and the market rate of 12% Amortization of a discount increases the interest revenue for the investor Amortization increases the investment account directly – a separate discount account is not used for the investor

Early Extinguishment of Investment Suppose that the issuer buys back the bonds for $9.6 million on December, 2004, when the amortized cost is $9,816,666, the journal entry for the extinguishment by the investor is: 12/31/04 Cash 9,600,000 Loss on disposal of bonds 216,666 Investment in bonds 9,816,666

The Market and Equity Methods The investor’s accounting depends on the level of influence of the investor over the investee The equity method recognizes increases or decreases in the economic resources that the investor can influence

The Market and Equity Methods Suppose Buyit Corporation invests $80 million in each of two companies: Passiveco Total market value of $800 million (10% ownership) Earnings of $120 million Dividends of $40 million Influential Total market value of $200 million (40% ownership) Earnings of $30 million Dividends of $10 million

The Market and Equity Methods Buyit’s journal entries for (1) acquisition, (2) net income of the investee, and (3) dividends of the investee are (in millions): Buyit recognizes income from Passiveco as dividends are received ($40M x 10%) Influential as part of its earnings ($30M x 40%) Market Method – Passiveco Equity Method – Influential Investment in Passiveco 80 1. Investment in Influential 80 Cash 80 Cash 80 No entry 2. Investment in Influential 12 Investment revenue 12 Cash 4 3. Cash 4 Dividend revenue 4 Investment in Influential 4

Consolidated Financial Statements When a investor has control over an investee company (over 50% ownership), it must prepare consolidated financial statements The investor company is called the parent The investee company is called the subsidiary Although both companies remain separate legal entities, the financial position and earnings reports of the parent are combined with those of the subsidiary

The Acquisition Assume two separate companies: Company P: Assets of $650 million Company S: Assets of $400 million P purchases all of the outstanding stock of S for $213 million in cash The journal entry on the books of P (in millions) is: Investment in S 213 Cash 213

Consolidated corporation The Acquisition Purchase Cash P Corporation S Corporation S Shares After Purchase P Shareholders P Corporation Consolidated corporation S Corporation

The Acquisition The balance sheets of each company appear as follows before and after the purchase:

Preparing Consolidated Statements Parent Company Records Subsidiary Records Parent Company Financial Statements Subsidiary Financial Statements Combine Parent and Subsidiary Financial Statements on a Work Sheet Eliminate Double Counting Parent’s Investment Against Subsidiary OE Intercompany Receivables and Payables Intercompany Sales and Purchases Consolidated Financial Statements

Preparing Consolidated Statements In combining the amounts on the balance sheet, P must eliminate its investment account and the stockholders’ equity of S, which eliminates double-counting of the investment in S

After Acquisition P continues to use the equity method during the period To prepare consolidated statements, P must eliminate: Its investment account and the SE of the subsidiary on the consolidated balance sheet Intercompany revenues and expenses on the income statement Other intercompany transactions

Minority Interests A parent company may own less than 100% of the outstanding stock (51% - 99%) Claims by non-majority stockholders on assets and earnings in the consolidated statements are called minority interests Minority interest must be shown on both the consolidated income statement and consolidated balance sheet

Some old S shareholders hold 10% of S Minority Interests 90% Purchase P pays cash to some shareholders in S Cash P Corporation S Corporation S Shares After Purchase P Shareholders Shown as “Minority Interest” in consolidated statements P Corporation Dashed line defines consolidated corporation Some old S shareholders hold 10% of S S Corporation

Purchase Price Not Equal to Book Value When the acquiring company pays more than the book value of the acquired company’s net assets, consolidation requires a two-step adjustment: All acquired assets and liabilities are shown at their fair market value (FMV) If the purchase price > FMV of the net assets, goodwill must be shown on the consolidated balance sheet Goodwill is the excess of the cost of an acquired company over the sum of the FMV of its identifiable assets less the liabilities

Accounting for Goodwill In the previous example, assume that: P acquired a 100% interest in S for $253 million rather than $213 million A building with a book value of $20 million had a FMV of $35 million The tabulation of the consolidated balance sheet including the calculation of goodwill is shown in the next exhibit

Accounting for Goodwill

Accounting for Goodwill Impairment of goodwill occurs when it loses its value subsequent to acquisition The consolidated company must record any impairment with a decrease to the goodwill account and a charge to an expense account

Goodwill and Abnormal Earnings Goodwill is the price paid for “excess” or “abnormal” earning power This abnormal earning power could be due to location, human resource, or reputation advantages Normal earnings and excess earnings are capitalized by a multiple The multiple for excess earnings is lower since it is riskier

Goodwill and Abnormal Earnings The following example assumes a multiple of 10 for normal earnings and 6 for abnormal earnings FMV of identifiable assets, less liabilities $800,000 Normal annual earnings on net assets at 10% 80,000 Actual average annual earnings for past 5 years (including an excess return of $20,000) 100,000 Maximum price paid for normal annual earnings (10 x line 2) 800,000 Maximum price paid for abnormal annual earnings (which are riskier and thus less valuable per dollar of expected earnings) is 6 times $20,000 120,000 Maximum price a purchaser is willing to pay for the company (line 1 plus line 5) $920,000

Equity Affiliates, Minority Interest, and the Statement of Cash Flows The statement of cash flows is affected for a company having equity affiliates (firms for which the investor uses the equity method) in the follow way: Direct method: A cash dividend received from the affiliate appears in the operating section Indirect method: Net income is increased (decreased) by the investor’s share of its affiliates’ earnings (loss) in the operating section

Summary of Accounting for Equity Securities