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Intercorporate Investments and Consolidations

Intercorporate Investments and Consolidations

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Intercorporate Investments and Consolidations

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  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) • $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

  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 9,653,500 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

  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 9,600,000 Loss on disposal of bonds 216,666 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 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

  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 213 Cash 213

  22. 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. 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% 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

  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