Chapter 15 Active Investments In Corporations Chapter 15 Active Investments In Corporations Mark Higgins

Transparency 15-2 Nature of Investments in Corporations Passive Investment in Corporation – The acquisition of another entity’s stock with the intent earn a return on the investment (i.e., Chapter 10 – Marketable Securities). Active Investment in Corporation – The acquisition of another entity’s stock with the intent to obtain influence or control the operations of that company.

Transparency 15-3 Investments in Corporations Terminology F The entity purchasing the stock is termed the investor. FThe company whose stock is purchased, the investee.

Transparency 15-4 Investments in Corporations A corporation becomes an active investor with the intent to: F Increase efficiency of its present operations (e.g., through the purchase of a company in the same line of business). F Gain access to raw materials, distribution services, or markets (e.g., through a vertical integration). F Exploit its expertise by improving operations of the inefficiently run investee.

Transparency 15-5 Economic Rationale for Investing in Another Corporations The economic rationale for a corporation becoming an active investor is that it believes the combined value through efficiencies, vertical integration, etc., of the two entities will exceed the sum value of the separate entities.

Transparency 15-6 Economic Rationale Example The fair market value of Rhody is $18 million. Rhody decides to acquire the Minuteman Company, which has a fair market value of $8 million. Rhody believes that through operating efficiencies the combined entity is worth $32 million. How much would Rhody be willing to pay for the Minuteman Company?

Transparency 15-7 Economic Rationale Example Since the combined value of the two entities is $6 million more than the sum value of the entities, Rhody would be willing to pay $14 million (a $6 million dollar premium) for Minuteman. $18 million + $ 8 million = $26 million $32 million - $26 million = $ 6 million

Transparency 15-8 Accounting for Investments in Corporations GAAP requires a corporation that owns all or parts of other corporations to report on the relevant economic entity, regardless of the legal ownership structure. This is usually accomplished in one of two ways: Consolidation – If ownership interest exceeds 50%, the operations of the investee company are included in the financial statements (e.g., income statement, balance sheet etc.) of the entity. Minority interest – An ownership interest of 50% or less in the investee’s total stock outstanding.

Transparency 15-9 Accounting for Minority Interests Acconting for a minority interest depends on the size of the minority interest. Small Minority Interest - are generally defined as less than 20% ownership. These are accounted for as available-for-sale securities as discussed in Chapter 10. Large Minority Interest – are between 20% and 50% employ, the equity method to account for holdings. This method summarizes the ownership of the subsidiary as an asset line item and is not adjusted to reflect changes in the market value of the investment.

Transparency Equity Method Example On January 1, 2005, Rhody Corporation acquires a 30% interest (45,000 shares) in Huskie Corporation for $540,000. What is the entry Rhody would make to record the purchase of Huskie stock?

Transparency Equity Method Example The journal entry to record the investment is: Investment in unconsolidated affiliate 540,000 Cash 540,000

Transparency Equity Method Example On December 31, 2005, Huskie Corporation reports net income of $130,000. What impact does this have on Rhody’s investment in Huskie?

Transparency Equity Method Example Rhody will increase its investment in Huskie by its pro rata share $39,000 ($130,000 x 30%) of Huskies’ net income. Investment in Unconsolidated Affiliate 39,000 Equity in net earnings of unconsolidated affiliate 39,000

Transparency Equity Method Example On January 15, 2006, Huskie Corporation declares a dividend of $20,000 payable on January 31, What impact does this have on Rhody’s investment in Huskie?

Transparency Equity Method Example Rhody will decrease its investment in Huskie by its pro rata share $6,000 ($20,000 x 30%) of the dividend. Declaration Date: Dividend receivable 6,000 Investment in Unconsolidated Affiliate 6,000 Payment Date: Cash 6,000 Dividend receivable 6,000

Transparency Consolidated Financial Statements When a corporation’s ownership interest exceeds 50%, the consolidated financial statements (e.g., income statement, balance sheet, cash flow statement) reflect the combined activity for the year of all the entities minus any related party transactions (e.g., sales between the entities).

Transparency Consolidation Example Rhody owns 100% of Minuteman Corporation. During the year, Rhody had sales of $100 million and Minuteman had sales of $40 million, of which $6 million were sales to Rhody. What will Rhody report as total sales for the year?

Transparency Consolidation Example Since $6 million of Minuteman’s sales are to Rhody, the consolidated entity must reduce its combined sales of $140 ($100 + $40) by the $6 million of related party sales. Thus, Rhody will report total sales of $134 million ($100 + $40 - $6).

Transparency Treatment of Minority Interest on Consolidated Financial Statements Balance Sheet: If a corporation holds more than a 50% interest but less than a 100% interest in another entity, this minority interest represents the minority owners’ claims against the net assets of the subsidiary. This account will usually appear after the liabilities, but before the shareholders’ equity section, in the consolidated balance sheet.

Transparency Treatment of Minority Interest on Consolidated Financial Statements Income Statement: The consolidated income statement lists all revenue and expenses for the combined entities. The pro rata amount of income not belonging to the parent is captured in a line item called “minority interest”. Cash Flow Statement: Minority interest is added back to the cash flow statement because it reduced net income but does not require the use of cash.