1. MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS Baginski & Hassell Electronic presentation adaptation by Dr. Barbara L. Hassell & Dr. Harold O. Wilson

2. Chapter 8

3. Topics –Methods of accounting for investments in common stock –“Mark-to-Market accounting” for certain investments in equity securities –Opportunity for gains trading –Legal forms of business combinations –Accounting methods for business combinations –Consolidated financial statements

4. Methods of Accounting for Investments in Common Stock Cost Method –Investor has no significant influence over increase Presumed to be ownership of < 20% of investee’s outstanding common stock Equity method –Investor has significant influence, but does not have control over investee Presumed 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 Method An investor uses the cost method if it has no significant influence over investee –Investment is recorded at the cost of acquiring the shares If 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 Method An investor uses the equity method if it has significant influence over the investee, but it does not have control –The 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 (to be in the other income section of the income statement, not dependent on cash flows).

9. Equity Method & Dividend Collections –The investee’s pro rata share of dividends declared by investee is recorded as a reduction of the investor’s investment –If the equity method is used, the common stock is precluded from being 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 influence Assumption 2:The investment (15%) does give O’Brien significant influence The effects on O’Brien’s current year financial statements are as follows:

12. O’Brien: Cost Method Balance Sheet Investment in common stock (1) $1,800,000 Income Statement Other income: Dividend income (2) 120,000 (1) 100,000 shares x $18 (2) $800,000 x 15%

13. Statement of Cash Flows Operating Activities Dividends received $ 120,000 Investing Activities Purchase of investments(1,800,000)

14. O’Brien: Equity Method Balance Sheet Investment in common stock (1) $2,430,000 Income Statement Other income: Equity in subsidiary earnings (2) $750,000 (1) ($100,000 shares x $18) + ($5,000,000 x 15%) – ($800,000 x 15%) (2) $5,000,000 x 15%

15. Statement of Cash Flows Investing Activities Purchase of investments$(1,800,000) Dividends received120,000

16. Compare and Contrast Effect of Cost and Equity Methods Balance sheet: Investment account is different. Income statement: “Dividend” is different. Cash flows on the SCF are the same in total, but dividends collected are presented in different sections.

17. “Mark-to-Market Accounting” for Investments in Equity Securities SFAS No. 115 classifies certain securities as trading, available-for-sale, or held-to-maturity. Equity securities can only be classified as either trading or available-for-sale. Only debt securities can be classified as held-to-maturity. FMV

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 classification –Common stock (accounted for under the cost method) –Preferred stock –Stock rights, warrants, options

19. SFAS No. 115: Trading and Available- for-Sale Securities Trading –Marked-to-Market at balance sheet date –Unrealized gain/loss is reported in the other income (expenses) section of the income statement –Treated as an operating activity on the SCF because the securities are purchased with the sole intent of selling them in the short-term

20. Available-For-Sale –Marked-to-Market at balance sheet date –Unrealized gain/loss is reported in the other comprehensive income section of the statement of comprehensive income Other comprehensive income is closed to the accumulated other comprehensive income section of stockholders’ equity –Treated as an investing activity on the SCF Exception: Dividends received classified as an operating activity

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 (or 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 Sheet Investment in common stock (1) $2,000,000 Income Statement Other income: Dividend income (2) $120,000 Unrealized gain (loss) on trading securities (3) 200,000 (1) 100,000 shares x $20 (2)$ 800,000 x 15% (3) 100,000 x ($20 - $18 )

24. Statement of Comprehensive Income Other comprehensive income$0 Statement of Cash Flows Operating Activities Purchase of investments$(1,800,000) Dividends received120,000

25. O’Brien: Available-for-Sale Classification Balance Sheet Investment in common stock (1) $2,000,000 Income Statement Other income: Dividend income (2) $120,000 (1) 100,000 shares x $20 (2)$ 5,000,000 x 15%

26. Statement of Comprehensive Income Other comprehensive income (3) $ 200,000 Statement of Cash Flows Operating Activities Dividends received$120,000 Investing Activities Purchase of investments$(1,800,000) (3) 100,000 x ($20 - $18 )

27. Compare and Contrast Effects of Trading and Available-for-Sale Classifications Balance sheet investment account is the same Income statement amounts are different Statement of comprehensive income amounts are different Cash flows on the SCF are the same amounts, but are classified as different types of activities

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 either –profits (sell securities with unrealized gains) –losses (sell securities with unrealized losses)

29. BUSINESS COMBINATIONS

30. Legal Forms of Business Combinations Three general forms (types) of business combinations occur –Merger: One entity retains its identity. –Consolidation: New entity identity is created. –Parent/Subsidiary Relationship: All entities maintain identity.

31. Merger: A + B = A One company acquires a second company and the second company ceases to exist. Consolidation: A + B = C Two companies form a third company and the original two companies cease to exist. Parent & Subsidiaries: A + B = A + B One 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 up by the acquiring company The net assets of the acquired company are written up or down to fair market value Any excess of the fair market 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” The transaction is recorded at the book value of the “acquired” company’s net assets. The net assets of the “acquiring” company are at book values. No goodwill is recognized in the books. NOTE: There are strong indications that changes in “poolings” are pending

34. Goodwill Goodwill reported on a balance sheet can only result from a business combination accounted for as a purchase. Goodwill is amortized over its estimated useful life [as goodwill has no legal life!] not to exceed a GAAP upper limit. –The upper limit at the time of writing this text is 40 years, but the upper limit is scheduled to change to 20 years

35. Goodwill Impairment Periodically, goodwill should [must?] be assessed for possible impairment! –Compare the book value of the goodwill to the total estimated, undiscounted future cash flow associated with the goodwill –No impairment if the book value is less than the total estimated, undiscounted future cash flow

36. An impairment is deemed to have occurred if the book value is greater than the total estimated, undiscounted future cash flow –Goodwill is then written down to the present value of the future estimated cash flows –An impairment charge (expense) is recorded, equal to the excess of the book value over the present value of the future estimated cash flows

37. 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)

38. Consolidated Financial Statements Companies that reflect a parent/subsidiary relationship prepare consolidated financial statements The financial statements of the parent company are combined with those of the subsidiary companies into one set of consolidated financial statements –Intercompany amounts are eliminated in the consolidation process

39. End of Chapter 8