Equity Investment Accounting Rationale

Accounting for Business Combinations Accounting Investments and Acquisitions Agenda ¾ Understand that the accounting method used for acquisitions depends on the extent to which the investor exerts influence over the investee. ¾ Understand the effects of dividends received and investee income on the financial statements of the investor under the equity method. ¾ Understand the effects of consolidated accounting on the balance sheet and income statement of the investor. Investments in the Stock of Other Companies ¾ The accounting method for stock investments depends on the degree of influence the investing company has on the decisions of the investee. ¾ Three methods of accounting for this investment: Ownership: <20% 20-50% >50% Influence: “passive” “significant influence” “controlling” Reporting Method: Mark-tomarket Equity Consolidation Equity Investment Accounting Rationale ¾For any company: Ending RE = Beginning RE + Net Income – Dividends ¾Following the same logic => Ending value of investment on investing company’s books = Beginning value of investment + investor’s share of investee’s net income – investor’s share of investee’s dividends Significant Influence Î Equity Method ¾ Assume the following events 1. Purchase: Investor acquires 48,000 shares amounting to 40% of EE Corporation for $10 per share 2. Dividends: EE Corporation pays a dividend of $60,000 or 50 cents per share 3. Affiliate earnings: EE Corporation Earns $100,000 in Net Income ¾ Record these events on BSE of investor company. 1. Purchase 2. Dividends 3. Aff. earnings Cash (480,000) 24,000 Long-term Investment 480,000 (24,000) 40,000 R/E Comment 40% × $60,000 40,000 Investment income Equity Investment Journal Entries – For The Investing Company ¾ At the time of investment ƒ Dr Long Term Investments ƒ Cr Cash 480,000 480,000 ¾ At the time of dividends payment ƒ Dr Cash ƒ Cr Long Term Investments 24,000 24,000 ¾ At the time investee declares net income ƒ Dr Long Term Investments ƒ Cr Investment income 40,000 40,000 Control Î Consolidation Method ¾ When the investor controls the investee, ƒ The investor corporation = parent. ƒ The investee corporation = subsidiary. ƒ The parent prepares consolidated financial statements that treat the parent and the subsidiary as a single economic entity even though they are separate legal entities. ¾ Consolidated financial reporting brings together multiple sets of financial records at the time of reporting to outsiders ƒ Each subsidiary maintains its own set of books that is independent of who owns it, whether it is one person/company or one million. ƒ Parent has its set of books pre-consolidation. Consolidation Method: Initial purchase ¾ P Co. acquires 100% of S Co.’s stock for $110 cash. ¾ Assume the book value of S’s assets, liabilities, and shareholder’s equity equal their market value. P Co. P Co. pre-acq. post-acq. Cash, other assets $ 500 Investment in S 500 Liabilities S. E. 200 300 500 Consolidated S Co.Adjustment P+S $ 150 150 40 110 150 Consolidation Method: Initial purchase ¾ P Co. acquires 100% of S Co.’s stock for $110 cash. ¾ Assume the book value of S’s assets, liabilities, and shareholder’s equity equal their market value. P Co. P Co. pre-acq. post-acq. Cash, other assets $ 500 390 Investment in S 110 500 500 Liabilities S. E. 200 300 500 Consolidated S Co.Adjustment P+S $ 150 150 40 110 150 Consolidation Method: Initial purchase ¾ P Co. acquires 100% of S Co.’s stock for $110 cash. ¾ Assume the book value of S’s assets, liabilities, and shareholder’s equity equal their market value. P Co. P Co. pre-acq. post-acq. Cash, other assets $ 500 390 Investment in S 110 500 500 Liabilities S. E. 200 300 500 200 300 500 Consolidated S Co.Adjustment P+S $ 150 150 40 110 150 Consolidation Method: Initial purchase ¾ P Co. acquires 100% of S Co.’s stock for $110 cash. ¾ Assume the book value of S’s assets, liabilities, and shareholder’s equity equal their market value. P Co. P Co. pre-acq. post-acq. Cash, other assets $ 500 390 Investment in S 110 500 500 Liabilities S. E. 200 300 500 200 300 500 Consolidated S Co.Adjustment P+S $ 150 540 150 40 110 150 240 Consolidation Method: Initial purchase ¾ P Co. acquires 100% of S Co.’s stock for $110 cash. ¾ Assume the book value of S’s assets, liabilities, and shareholder’s equity equal their market value. P Co. P Co. pre-acq. post-acq. Cash, other assets $ 500 390 Investment in S 110 500 500 Liabilities S. E. 200 300 500 200 300 500 Eliminated Consolidated S Co.Adjustment P+S $ 150 540 –110 150 40 110 150 240 –110 Consolidation Method: Initial purchase ¾ P Co. acquires 100% of S Co.’s stock for $110 cash. ¾ Assume the book value of S’s assets, liabilities, and shareholder’s equity equal their market value. P Co. P Co. pre-acq. post-acq. Cash, other assets $ 500 390 Investment in S 110 500 500 Liabilities S. E. 200 300 500 200 300 500 Eliminated Consolidated S Co.Adjustment P+S $ 150 540 –110 0 150 540 40 110 150 –110 240 300 540 Intuition Behind Consolidation Method ¾ The effect of consolidation is to treat P’s purchase of S as if P purchased the assets and liabilities of S. ƒ The equity of S does not appear in P’s consolidated financial reports. ƒ The equity of the consolidated entity reflects the ownership of the parent (P Co.) by its shareholders. Schematic of a 100% Acquisition After Before Shareholders of P Shareholders of P $ P Co. shares Shareholders of S P Co. S Co. S Co. ÎConsolidated equity reflects ownership interest of P’s shareholders Consolidation: Post-purchase Events ¾ P Co. owns 100% of S Co.’s stock. ¾ Prepare a consolidated income statement using the following separate income statements for P and S. Sales Expenses Investment income Net income P Co. 600 – 450 150 Consolidated S Co. Adjustment P+S $ 180 – 160 20 -20 Consolidation: Post-purchase Events ¾ P Co. owns 100% of S Co.’s stock. ¾ Prepare a consolidated income statement using the following separate income statements for P and S. Sales Expenses Investment income Net income P Co. 600 – 450 150 20 170 Consolidated S Co. Adjustment P+S $ 180 – 160 20 -20 Consolidation: Post-purchase Events ¾ P Co. owns 100% of S Co.’s stock. ¾ Prepare a consolidated income statement using the following separate income statements for P and S. Sales Expenses Investment income Net income P Co. 600 – 450 150 20 170 Consolidated S Co. Adjustment P+S $ 180 780 – 160 – 610 20 170 -20 Consolidation: Post-purchase Events ¾ P Co. owns 100% of S Co.’s stock. ¾ Prepare a consolidated income statement using the following separate income statements for P and S. Sales Expenses Investment income Net income P Co. 600 – 450 150 20 170 Consolidated S Co. Adjustment P+S $ 180 780 – 160 – 610 20 170 -– 20 0 20 170 <100% Acquisition After Before Shareholders of P Shareholders of P $ P Co. shares D Shareholders of S P Co. S Co. S Co. Minority Shareholders of S Consolidated Entity ÎConsolidated equity reflects ownership interest of P’s shareholders Consolidation Method when Price ≠ FV ≠ BV ¾ We previously assumed that: ƒ Price paid for S’s equity = Book Value of S’s equity, and ƒ Fair Value of S’s net assets = Book Value of S’s net assets ¾ In practice this is unlikely. ¾ For consolidation purposes: 1. First adjust S balance sheet items (both assets and liabilities) to their fair market values (including identifiable intangible assets such as trademarks). 2. Then any excess of purchase price over the total fair value of these net assets equals goodwill. ¾ GW = Purchase Price – Fair Value(Id. Net Assets) Consolidation: Initial purchase 100% Purchase and Price ≠ FV ≠ BV ¾ P Co. acquires 100% of S Co.’s stock for $180 cash. ¾ Book and Fair values of S’s net assets are as given below. P Co. P Co. pre-acq. post-acq. Cash, other assets $ 500 Investment in S Goodwill 500 Liabilities S. E. 200 300 500 BV S Co. $ 150 FV S Co. 190 150 40 110 150 30 Consol Adj. P+S Consolidation: Initial purchase 100% Purchase and Price ≠ FV ≠ BV ¾ P Co. acquires 100% of S Co.’s stock for $180 cash. ¾ Book and Fair values of S’s net assets are as given below. P Co. P Co. pre-acq. post-acq. Cash, other assets $ 500 320 Investment in S 180 Goodwill 500 500 Liabilities S. E. 200 300 500 200 300 500 BV S Co. $ 150 FV S Co. 190 150 40 110 150 30 Consol Adj. P+S Consolidation: Initial purchase 100% Purchase and Price ≠ FV ≠ BV ¾ P Co. acquires 100% of S Co.’s stock for $180 cash. ¾ Book and Fair values of S’s net assets are as given below. P Co. P Co. pre-acq. post-acq. Cash, other assets $ 500 320 Investment in S 180 Goodwill 500 500 Liabilities S. E. 200 300 500 200 300 500 BV S Co. $ 150 FV S Co. 190 150 20 210 40 110 150 30 180 210 FV(net assets of S) = 190 – 30 = 160 GW = Price paid – FV(net assets of S) = 180 – 160 = 20 Consol Adj. P+S Consolidation: Initial purchase 100% Purchase and Price ≠ FV ≠ BV ¾ P Co. acquires 100% of S Co.’s stock for $180 cash. ¾ Book and Fair values of S’s net assets are as given below. P Co. P Co. pre-acq. post-acq. Cash, other assets $ 500 320 Investment in S 180 Goodwill 500 500 Liabilities S. E. 200 300 500 200 300 500 BV S Co. $ 150 FV S Co. 190 150 20 210 Consol Adj. P+S 510 –180 0 20 530 40 110 150 30 180 210 230 300 530 FV(net assets of S) = 190 – 30 = 160 GW = Price paid – FV(net assets of S) = 180 – 160 = 20 –180 What Happens To Goodwill in Subsequent Years? ¾After goodwill is determined, it has to be “assigned” to specific business units within the merged entity (FAS 142) ¾Before July 2001 (FAS 142), goodwill had to amortized over a maximum period of forty years ¾Now, goodwill does not have to be amortized ¾It is tested for impairment annually Goodwill Impairment ¾ What is goodwill impairment? ƒ Reduction in value of goodwill ¾ When does impairment occur? ƒ Technically speaking when “implied goodwill” from fair value of business unit is below book value of goodwill assigned to that unit. ƒ Requires accountants to value unlisted business units of the merged entity! ¾ What happens when goodwill is impaired? ƒ Company writes down the value of goodwill and recognizes a corresponding loss in the Income Statement Goodwill impairment charges ¾ In practice, what do you think will trigger goodwill impairment? ƒ Decline in stock prices ¾ In 2002, American companies wrote off close to $750 billion (HUGE write-downs by AOL Time Warner, AT&T, Nortel, Corning, Blockbuster) ¾ An additional $200 billion of goodwill impairment charges expected in 2003. Issues In Goodwill Accounting ¾Under FAS 142, what exactly does goodwill capture? ƒ The value of synergies ¾What does goodwill impairment imply? ƒ Synergies lost ¾What else could they be the result of? ƒ A desire to “clear the decks”, or, in other words, our old friend “the big bath” Overall Idea Behind Consolidation Adjustments ¾ Consolidation combines the financial statements of parent and subsidiaries, resulting in one set of F/S. ¾ But there are numerous items that appear twice. ¾ Adjustments correct for the double-counting that would result from simply adding the financial statements together. ¾ Some other adjustments we haven’t addressed: ƒ Inter-company receivables and payables ƒ Inter-company sales, costs, and profits ƒ Following through the adjustments of S’s net assets to FV Summary ¾ Accounting for long-term investments depends on degree of influence as determined by percentage holdings. ¾ In equity method and consolidation, the investment account: ƒ increases when investee earns profits and ƒ decreases and when investee pays dividends. ¾ Consolidation process: ƒ Shows the combined F/S of parent and sub, and ƒ Removes any double-counting ¾ Acquirer records goodwill when it pays more than fair value of the investee’s net assets. ¾ Goodwill accounting raises some fairly complicated issues