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Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Chapter 17 Understanding and Analyzing Consolidated Financial Statements

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Chapter 17 Learning Objectives 1. Contrast accounting for investments using the equity method and the market-value method. 2. Explain the basic ideas and methods used to prepare consolidated financial statements. 3. Describe how goodwill arises and how to account for it. 4. Use financial statement analysis to evaluate an organization’s performance. 5. Explain and use a variety of popular financial ratios. 6. Identify the major implications that efficient stock markets have for accounting.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Intercorporate Investments How do we account for intercorporate investments? Investor holds less than 20% Market-value method Learning Objective 1

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Intercorporate Investments Investor holds between 20% and 50% Investor holds more than 50% Equity method Consolidation approach

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Market-Value Method Trading securities are investments that the investor company buys only with intent to resell them shortly. Available-for-sale securities are investments that the investor company has no intention to sell in the near future.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Market-Value Method Trading securities and available-for-sale securities provide returns to the investor in two ways: Dividend revenue Changes in market value

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Market-Value Method Dividends are recorded on the income statement when earned for both types of investments. It also accounts for changes in market value for both types of investments by increasing or decreasing the value of the asset. On the owners’ equity side, changes in market value are accounted for differently for trading securities than for available-for-sale securities.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Changes in Market Value The only difference between trading securities and available-for-sale securities is how the change in market value gets incorporated into stockholders’ equity. For trading securities, price increases and decreases are included in net income and become part of retained earnings. For available-for-sale securities, price increases and decreases affect a different component of stockholders’ equity, other comprehensive income/loss.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Changes in Market Value Summary of Trading and Available-for-Sale Securities

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Equity Method They must use the equity method of accounting for an investment by adjusting the acquisition cost of the investment for the investor’s share of earnings or losses of the investee after the date of investment and for dividends received. Companies that have the power to exert significant influence on investees usually hold 20% to 50% of the common shares of the investee.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Consolidated Financial Statements Learning Objective 2 When a company has effective control over another company, it usually means that it owns more than 50% of the company’s stock. The controlling company is the parent company and the controlled company is the subsidiary. Although parent and subsidiary companies typically are separate legal entities, in many regards they function as one unit.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Consolidated Financial Statements Parent companies issue consolidated financial statements that combine the financial statements of the parent company with those of its subsidiaries. That is, the parent and subsidiary companies are Accounted for as if they were a single entity. Subsidiaries often limit risk, save income taxes, help conform to government regulations, and allow a parent to do business in a foreign country.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Acquisition of a Subsidiary Suppose Company P (parent) acquired 100% of the common stock of Company S (subsidiary) for $210 million in cash at the beginning of the year. Accountants must avoid double-counting assets, liabilities, and stockholders’ equities consolidating parent and subsidiary financial statements.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Acquisition of a Subsidiary P purchases the common stock of S by paying the $210 million to the former owners of S, private investors, not to S itself. P’s purchase of stock in S does not affect S’s books. Consolidated statements combine all assets and liabilities of both the parent and the subsidiary but eliminates instances of double counting. S does not disappear, but it lives on as a separate legal entity with a different owner. Each legal entity has its individual set of books.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Acquisition of a Subsidiary Investment in S appears in the first column only because it is a focal point in this chapter, not because it comes first in actual balance sheets.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Acquisition of a Subsidiary Each legal entity has its individual set of books. The consolidated entity does not keep a separate set of books. Balance sheet accounts:

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall To avoid double-counting, the evidence of ownership is eliminated that is present in two places: The Investment in S on P’s books The Stockholders’ Equity on S’s books Recognizing Income after Acquisition

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Recognizing Income after Acquisition P accounts for S’s net income by increasing its investment in S account and its stockholders’ equity account (in the form of retained earnings) by its share (100%) of the $50 million income. A parent company carries its investment in subsidiaries, such as this investment in S, on its balance sheet by the equity method.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Recognizing Income after Acquisition P’s statement shows its own sales and expenses plus its share of S’s net income (as the equity method requires). The consolidated statement (the last column) adds together all the revenues and expenses of the parent (first column) and the subsidiary (second column).

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Recognizing Income after Acquisition Changes in P’s accounts, S’s accounts, and the consolidated accounts in (in millions of dollars):

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Noncontrolling Interests If a parent holds less than 100% (but more than 50%) of a subsidiary’s stock, a noncontrolling interests account is used to summarize the outside stockholders’ interest in a subsidiary corporation. A consolidated balance sheet includes 100% of the assets and liabilities of a subsidiary even when the parent owns less than 100%. The non- controlling interests account is necessary to summarize the outside ownership interest.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Noncontrolling Interests Noncontrolling interests account in consolidated statements

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Consolidated Income statements (in millions) Noncontrolling Interests

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Noncontrolling Interests Consolidated Balance Sheet (in millions)

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Accounting for Goodwill One more complication arises when a company purchases more than 50% of another company. The total purchase price paid by P often exceeds the book values of the net assets acquired. Also, the purchase price often exceeds the sum of the fair-market values (current values) of the identifiable individual assets less the liabilities. Learning Objective 3

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Accounting for Goodwill Companies record goodwill as an asset when one company purchases another and pays more than the sum of the fair values of the assets and liabilities acquired. A purchaser may be willing to pay more than the fair values because the acquired company is able to generate abnormally high earnings.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Accounting for Goodwill The balance sheets immediately after the acquisition: Suppose P acquired a 100% interest in S for $210 million. Suppose P paid $40 million more, or a total of $250 million cash.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Accounting for Goodwill A purchaser may be willing to pay extra because it expects excess earnings from: 1.potential efficiencies gained by combination, rearrangement, or elimination of duplicate facilities and administration, 2.excellent general management skills present in the purchased company, 3.a unique product line, and/or 4.an established brand name and reputation.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Accounting for Goodwill Suppose P paid $40 million more, a total of $250 million cash for S. The fair value of S’s equipment exceeded its book value by $30 million. What if the book values of the individual assets of S are not equal to their fair values?

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Accounting for Goodwill The $30 million would appear in the consolidated balance sheet as a part of the equipment account and $10 million in the goodwill account. The $10 million “goodwill” appears in the consolidated balance sheet as a separate intangible asset account. It remains on the balance sheet until management judges that its value is impaired—it is evident that the advantages that created the goodwill are no longer present.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Analysis of Financial Statements Learning Objective 4 Financial analysts and other investment advisors use financial statements to assess the prospects for companies that they consider for investment. They use various financial ratios and other techniques, together with other information, to make investment decisions.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Component Percentages To compare companies that differ in size, analysts often apply percentage relationships, called component percentages, to income statements and balance sheets. Financial statements, expressed in component percentages, are called common-size statements.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Component Percentages Common-Size Statements (in millions, except percentages)

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Management’s Discussion and Analysis (MD&A) MDA is the section of annual reports and 10-K filings that concentrates on explaining the major changes in the income statement, liquidity, and capital resources, and the impact of inflation from one year to the next. Corporate annual reports to the public and 10- K filings with the SEC must contain a section called management’s discussion and analysis.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Time-Series Comparisons Analysts rely heavily on the trend of a company’s ratios, annual reports typically contain a table of comparative statistics for 5 or 10 years.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Uses of Ratios There are three main types of comparisons: (1) time-series comparisons with a company’s own historical ratios, (2) benchmark comparisons with general rules of thumb, (3) cross-sectional comparisons with ratios of similar companies or with industry averages or “best-practices” ratios for the same period. Learning Objective 5 Evaluations of financial ratios require comparisons.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Typical Financial Ratios

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Operating Performance Ratios Rate of return on invested capital is a measure of overall accomplishment. ROI = Income ÷ Invested capital Operating performance is best measured by pretax operating rate of return on average total assets Operating income ÷ Average total assets

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Efficient Markets and Investor Decisions The role of accounting information would be to help investors identify the different degrees of risk among various stocks. An efficient capital market is one in which market prices fully reflect all information available to the public. Learning Objective 6 The hallmarks of the approach are risk control, high diversification, and low turnover of securities.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Efficient Markets and Investor Decisions The market as a whole generally sees through any attempts by companies to gain favor through the choice of accounting policies that tend to boost immediate income. In the aggregate, the market is not fooled by companies that choose the least-conservative accounting policies. There is evidence that the stock markets may indeed be “efficient,” at least in their reflection of most accounting data.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Efficient Markets and Investor Decisions Investors have two basic choices: (1) trust their investment decisions to experts, such as investment advisers or mutual fund portfolio managers, or (2) carefully analyze information from a variety of sources, including companies’ financial statements, and make their own investment decisions.

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