Investments, and Business Combinations

Accounting for Business Combinations Corporate 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. 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