1. Intercorporate Investments and Consolidations
CHAPTER 11

2. 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

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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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)

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

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

13. 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)
$ 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

14. 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, Cash 9,653,500
6/30/04 Cash , Investment in bonds , Interest revenue ,207*
12/31/04 Cash , Investment in bonds , Interest revenue ,959**
* $9,653,500 x .06
** ($9,653,500 - $79,207) x .06

15. 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

16. 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, Loss on disposal of bonds , Investment in bonds 9,816,666

17. 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

18. 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

19. 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 Investment in Influential 80 Cash Cash
No entry Investment in Influential Investment revenue
Cash Cash Dividend revenue Investment in Influential

20. 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

21. 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
Cash

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

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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. Accounting for Goodwill

32. 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

33. 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

34. 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% ,000
Actual average annual earnings for past 5 years (including an excess return of $20,000) ,000
Maximum price paid for normal annual earnings (10 x line 2) ,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
Maximum price a purchaser is willing to pay for the company (line 1 plus line 5) $920,000

35. 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

36. Summary of Accounting for Equity Securities