Accounting Clinic V - Columbia Business School

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2009 All rights reserved. Clinic 5-1

Accounting Clinic V

Prepared by: Nir Yehuda

With contributions by

Stephen H. Penman – Columbia University


Types of Equity Investments and

their Accounting Treatment

Minority, passive

Mark to Market: See Accounting Clinic III

Minority, active

Equity Method

Majority, active

Consolidation Accounting


Minority, passive investments

The acquiring company owns such a small percentage of the other corporation’s shares that it cannot control or exert significant influence over the other company.

GAAP views investments of less than 20 percent of the voting stock of another company as minority, passive investments in most cases.

The accounting for marketable securities is applied in this case, with investments classified as trading securities or available for sale. See Accounting Clinic III.


Minority, active investments

an investor acquires shares of another corporation so that it can exert significant influence over the other company’s activities even without owning a majority of the voting stock.

GAAP views investments of between 20 and 50 percent of the voting stock of another company as minority, active investments “unless evidence indicates that significant influence cannot be exercised”.

The equity method is used in this case.


Majority, active investments

an investor acquires shares of another corporation so that it can control the other company.

GAAP views ownership of more than 50 percent of the voting stock of another company as implying an ability to control, unless there is evidence to the contrary.

Consolidation accounting is used in this case.


Equity Method - Introduction

The equity method records the initial purchase of

an investment at acquisition cost, just as is done

under the market value method.

Each period, the investor treats as revenue its

proportionate share of the periodic earnings, not

the dividends, of the investee.

The investor treats dividends declared by the

investee as a reduction in the investment account.


Equity Method - Rationale

Why don’t we mark to market such investments?

Under the market value method for securities available

for sale, the investor recognizes income statement

effects only when it receives a dividend (revenue) or

sells some of the investment (gain or loss).

As the investor by assumption, exerts significant

influence over the investee, it can affect the dividend

policy, which in turn affects its income.

The investor can manipulate its own income.


Example – Equity Method

(No Differential)

On 12/31/2003 firm A purchases 40% of the outstanding shares of firm B for $1.2M. The book value of firm B equals its market value at this date ($ 3M). There is no differential (between market value and book value).

At 2004 firm B reports income of $250,000 and pays dividend of $100,000.

At 2005 firm B reports earnings of $500,000 and pays dividends of $225,000.

How and in what amount should this investment be presented on Firm A’s balance sheet on December 31, 2004 and 2005?


Journal Entries:

At the Acquisition Date

Investment in Stock of B 1,200,000

Cash 1,200,000

To record the acquisition of 40 percent of firm B

1,200,000=40% x 3,000,000


Year 2004

Investment in Stock of B 100,000

Equity in Earnings of Affiliate 100,000

To record A’s share in the income earned by B

Cash 40,000


To record dividends received from B


Year 2005



To record A’s share in the income earned by firm B

Cash 90,000


To record dividend received from firm B


Firm A’s “Investment in B” account now

has a balance of $1,370,000 by the end of

2005:

Investment in Stock of B

(1) 1,200,000

(2) 100,000

(4) 200,000

40,000 (3)

90,000 (5)

Bal. 1,370,000


At each point in time the investment in firm

B can be written as firm A’s Share in B’s

equity.

For the date of the acquisition (as we saw

before)

$1,200,000 = 40%*$3,000,000


For the end of 2005

B’s Equity is as follows:

12/31/2003 $3,000,000

2004 Income 250,000

Dividend (100,000)

2005 Income 500,000

Dividend (225,000)

12/31/2005 3,425,000

Therefore the investment equals to:

40%*$3,425,000 = 1,370,000


Equity method – Difference Between the Cost

of Investment and the Underlying Book

Value: Recognize a Differential

The purchase price paid for the shares

acquired is usually the market price.

There is often a difference between the cost

of the investment and the proportionate

share of the investee’s book value.

This difference is referred to as differential.


The Differential

The differential can result from three

sources:

The investee’s recorded tangible assets may be

worth more than their book values.

The investee may have identifiable intangible

assets that have been acquired, eg., a brand

There is an unrecorded goodwill associated

with the excess earning power of the investee.


Example – Equity Method with a

Differential

Firm A purchased 30% of the common stock of firm B on January, 1 2004, for $190,000. Firm B has a book value of $500,000 at the date of the acquisition, The market value of its net assets is $570,000.

In this case there is a differential of 40,000, computed as follows:

Investment cost $190,000

Share at the BV of B (=30% x 500,000) (150,000)

Differential $40,000


Further assume that the 70,000 excess of fair value over book value of firm B consists of 20,000 for added value of land and 50,000 for equipment. The proportional share of firm A is as follows:

Total Increase A’s 30% share

Land $20,000 $6,000

Equipment 50,000 15,000 $70,000 $21,000

Thus $19,000 (40,000-21,000) is assigned to goodwill.


The allocation of the differential can be

illustrated as follows:

Tota

l dif

fere

nti

al $

40

,000

190,000

171,000

150,000

Cost of the

investment

MV of net

identifiable assets

(30%*570,000)

BV of net

identifiable assets

(30%*$500,000)

Go

od

wil

l E

xce

ss o

f M

V

ov

er B

V o

f net

iden

tifi

able

ass

ets


Identifiable Intangibles

The firm might be buying identifiable intangible

assets that are not on the balance sheet of the

investee. For example, the investee may have a

brand that is not recorded as an asset.

In this case, the excess of purchase price over the

fair value of the tangible assets is divided between

the fair value of the intangible assets and

goodwill, rather than to goodwill alone.


The portion of the differential related to land and goodwill is not amortized (land has unlimited economic life). Goodwill is impaired (written down) only if its value is deemed to be less than its carrying value.

The portion of the differential related to the equipment will be amortized over the rest of its useful life (from the acquisition date on). In this example, assume 5 years straight line amortization.

(If there are identifiable intangible assets, they will be amortized over their estimated lives.)


Firm B reports net income of 80,000 for 2004 and declares dividend of 20,000.

The journal entries will be:

Investment in B 190,000

Cash 190,000

(to record initial acquisition)



(80,000*30%)

Cash 6,000


(20,000*30%)




(15,000/ 5 years)

(to record the amortization of differential allocated to equipment)

The investment account in the end of the year would be

1/1/2004 $190,000

Income from B 24,000

Dividend from B (6,000)

Equipment depreciation (3,000)

12/31/2004 $205,000


At each point in time the investment in B

can be written as:

Share in B’s Equity + Unamortized

differential

For the date of the acquisition (1/1/2004)

190,000 = 150,000 + 40,000

(This is how we calculated the differential in the

first place!)


For the end of the year

B’s Equity is as follows:

1/1/2004 $500,000

Income 80,000

Dividend (20,000)

12/31/2004 $560,000

The differential is 40,000 – 3,000 = 37,000 or:

19,000 goodwill

6,000 allocated to land

12,000 allocated to equipment (0.8*15,000)

37,000


Therefore the investment at the end of the year (12/31/2004) equals to:

30%*560,000 + 37,000 = 205,000

(The firm will also check to see if goodwill should be impaired)

A’s share of

B’s Equity

Unamortized

differential


“Negative” Goodwill

When the fair market value of the assets

acquired exceeds the acquisition cost, the

excess is first used to reduce the carrying

value of noncurrent, nonfinancial assets.

If such assets are reduced to zero, any

additional amount is recognized as

extraordinary gain.


Majority Active Investments:

Consolidation Accounting

In a business combination, one company

(The Parent company) gains control over

another company (The Subsidiary or Sub.).

Until 2001, two consolidation methods were used

for mergers and acquisitions: the purchase method

and the pooling of interests method. In 2001, the

FASB discontinued the pooling method

(Statement 141)


The Meaning of Control

An entity that has the ability to elect a majority of

the board of directors of another entity has control

over it.

Control enables the parent:

Direct the sub to expand, contract or distribute cash to

the parent.

Establish the sub. financing structure.

Fire and hire the sub. management.

Set compensation level for the sub. management.


The Means of Control

Legal Control –

owning more than 50% of the subsidiary’s outstanding voting stock.

The parent has the legal right to elect the majority of the board of directors.

Effective Control – when the majority of the board of directors can be elected by means other then having legal control.


Three categories of business

combination

1. Merger - one firm acquires the assets and liabilities of one or more other firms in exchange for cash, stock or other compensation. The acquired firm ceases to exist as a separate legal entity. 100% ownership.

2. Statutory Consolidation – A new firm is formed to issue stock in exchange for the stock of the two or more consolidating firms. The acquired firms cease to exist as separate legal entities. 100% ownership.



combination (cont.)

In merger and statutory consolidation there

is only one firm existing after the business

combination therefore there is only one set

of books.



combination (cont.)

3. Acquisition – One firm acquires the majority of the common stock of another company and each company continues its legal existence.

Each company must be accounted for separately and prepare its own set of financial statements.

These financial statements are then consolidated.

Consolidated financial statements - combination of the financial statements of the parent company with those of the subs. an

overall report as if they were a single entity


Consolidation Process

Eliminating worksheet entries are made to

reflect the two separate companies’

statements as one economic entry.

No consolidation elimination entries are

recorded on the books of either the parent or

the subsidiary.


Consolidation - Rationale

Economically, the parent has the power to

liquidate the subsidiary into a branch. In

this case the current legal structure of two

separate companies will cease to exist.

Therefore the parent and the sub are treated

as a single legal entity.


Purchase Method for Business

Combinations

The business combinations are accounted

for using the purchase method.

Under this method, acquisitions are

measured on the basis of the fair values

exchanged.


Consolidation - Wholly Owned Sub.

Before the purchase

A

Corporation

B

Corporation

B

Shareholders

A

Shareholders

After the Purchase

A

Shareholders

B Corporation

A Corporation


Wholly Owned Subsidiaries

From the parent’s perspective the purchase is an exchange of one asset for another, usually cash for the stock of the subsidiary.

Consolidated net income equals the parent’s net income.

Consolidated retained earnings equals the parent’s retained earnings.

All of sub.’s beginning & ending retained earnings are eliminated in consolidation.


Partially Owned Subsidiaries

Often, a parent company owns less than 100 percent of a subsidiary company.

Minority (noncontrolling) interest – BS reflects the rights of non-majority shareholders in the assets and liabilities of a company that is consolidated into the accounts of the major shareholder. On the consolidated BS the non controlling interest is included in stockholders’ equity.

Minority income – IS account that reflects the share of noncontrolling shareholders in the earnings of a the consolidated firm. On the consolidated IS appears as a line item deduction.

Noncontrolling interest is calculated using BV of the acquired firm.


Consolidation – 80% Owned Sub.

Before the Purchase

A

Corporation

B

Corporation

B

Shareholders

A

Shareholders

After the Purchase

A

Shareholders

B Corporation

A Corporation

Some of former

B shareholders

hold 20% of B


Example - Consolidation

On 12.31.01 Company A purchased 75% of the common stock of Company B for $20,000. Any differential is alloacted to goodwill.

The Balance sheets and income statements of the two companies for 12.31.01 and 12.31.02 are presented on the next slides.

On 12.31.01 Company B gave a loan of $14,000 to company A.

Required:

Prepare consolidated financial statements


Balance Sheets Company A Company B

12.31.01 12.31.02 12.31.01 12.31.02 Cash 14,000 7,000 8,000 7,000

A/R 11,000 14,000 3,000 20,000

Loan to A --- --- --- 14,000

Inventory 40,000 30,000 28,000 25,000

Investment in B 20,000 23,000 --- ---

PPE, net 15,000 14,000 20,000 18,000

Building, net 12,000 11,000 10,000 8,000

Total Assets 112,000 99,000 69,000 92,000

A/P 28,000 8,000 11,000 29,000

Other payables 10,000 7,000 14,000 15,000

Loan from B --- 14,000 --- ---

Long term loan 12,000 4,000 20,000 20,000

Paid In Capital 50,000 50,000 20,000 20,000

Retained earnings 12,000 15,000 4,000 8,000

112,000 99,000 69,000 92,000


Income Statements

2002 Company A Company B Sales 50,000 33,000

Cost of goods sold (48,000) (22,000)

SG&A (6,000) (2,500)

Depreciation (2,000) (4,000)

Operating Income 4,000 4,500

Interest Expense (4,000) (500)

Equity in subsidiary’s income 3,000 -

Net Income 3,000 4,000


Investment Under Equity Method

– Differential Calculation

The sub: Paid In Capital 20,000

Retained Earnings 4,000

24,000

Purchased 75% (18,000)

Payment (cost of acquisition) 20,000

Differential 2,000

The differential is attributed to goodwill and is not

amortized


Investment Under Equity Method

– Investment Account

O.B. $20,000 (75%*24,000 + 2,000)

Income 3,000 (75%*4,000)

Total 23,000 (75%*28,000 +2,000)


Balance Sheet Consolidation –

31.12.01

Company A Company B Add (Subtract) 12.31.02

Cash 14,000 8,000 22,000

A/R 11,000 3,000 14,000

Inventory 40,000 28,000 68,000

Investment in B 20,000 - (20,000) -

PPE, net 15,000 20,000 35,000

Building, net 12,000 10,000 22,000

Goodwill - - 2,000 2,000

Total Assets 112,000 69,000 (18,000) 163,000

A/P 28,000 11,000 39,000

Other payables 10,000 14,000 24,000

Long term loan 12,000 20,000 32,000

Minority interest - - 6,000 6,000

Paid In Capital 50,000 20,000 (20,000) 50,000

Retained earnings 12,000 4,000 (4,000) 12,000

112,000 69,000 (18,000) 163,000


Balance Sheet Consolidation –

31.12.02

Company A Company B Add (Subtract) 12.31.02

Cash 7,000 7,000 13,000

A/R 14,000 20,000 34,000

Inventory 30,000 25,000 55,000

Loan to A - 14,000 (14,000) -

Investment in B 23,000 - (23,000) -

PPE, net 14,000 18,000 32,000

Building, net 11,000 8,000 19,000

Goodwill - - 2,000 2,000

99,000 92,000 (35,000) 156,000

A/P 9,000 29,000 38,000

Other payables 7,000 15,000 22,000

Loan from B 14,000 - (14,000) -

Long term loan 4,000 20,000 24,000

Minority interest - - 7,000 7,000

Paid In Capital 50,000 20,000 (20,000) 50,000

Retained earnings 15,000 8,000 (8,000) 15,000

99,000 92,000 (35,000) 156,000


Income Statement Consolidation

– 2002 2002 Company A Company B Add

(Subtract)

Total

Sales 50,000 33,000 83,000

Cost of goods sold (38,000) (22,000) (60,000)

SG&A (6,000) (2,500) (8,500)

Depreciation - PPE (2,000) (4,000) (3,000)

Operating Income 4,000 4,500 8,500

Interest expense (4,000) (500) (4,500)

Equity in subsidiary’s income 3,000 - (3,000) -

Minority income - - (1,000) (1,000)

Net Income 3,000 4,000 (4,000) 3,000


Differential Allocated to

Identifiable Assets

Differential allocated to identifiable assets will be presented as part of these assets on the balance sheet. It’s amortization will be added to the amortization or depreciation of those assets.

Two main concepts:

Parent company concept (the common) – just the parent’s share of an asset markups is shown on the balance sheet.

The entity concept – 100% of an asset markups is shown on the balance sheet. Minority interest is calculated using fair market value.


Intercompany Transactions

The parent company and the sub. might

transact business with each other.

From an economic point of view, nothing

happens – as an entity can not trade with itself!

The transactions must be eliminated so that

they are not counted twice in the consolidated

statements.


Purchased Goodwill

Goodwill - the excess of the cost of an acquired

company over the sum of the fair market value of

its net identifiable individual assets

Goodwill usually results from one or more of the

following: • brand name

• Good employees

• customer loyalty

• monopoly power


Recognition and Measurement of

Goodwill

The Financial Accounting Standards Board (FASB) issued Statement No. 142, Goodwill and Other Intangible Assets on July 20, 2001

Goodwill should not be amortized. Goodwill should be tested for impairment at a level of reporting referred to as a reporting unit.

A reporting unit is an operating segment or one level below an operating segment A component of an operating segment is a reporting unit if the component constitutes a business for which discrete financial information is available and segment management regularly reviews the operating results of that component.

Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value.


Recognition and Measurement of

Goodwill

Goodwill of a reporting unit should be tested for impairment on an annual basis and between annual tests in certain circumstances.

The annual goodwill impairment test may be performed any time during the fiscal year provided the test is performed at the same time every year. Different reporting units may be tested for impairment at different times.


Goodwill Impairment Test – Step 1

The first step of the goodwill impairment test, compares the fair value of a reporting unit with its carrying amount, including goodwill.

If the fair value of a reporting unit > its carrying amount, goodwill of the reporting unit is considered not impaired, thus the second step of the impairment test is unnecessary.

If the carrying amount of a reporting unit > its fair value, the second step of the goodwill impairment test should be performed.


Goodwill Impairment Test – Step 2

The second step of the goodwill impairment test compares the implied fair value of reporting unit goodwill with the carrying amount of that goodwill.

If the carrying amount of reporting unit goodwill > the implied fair value of that goodwill, an impairment loss should be recognized in an amount equal to that excess.

The loss recognized cannot exceed the carrying amount of goodwill.

After a goodwill impairment loss is recognized, the adjusted carrying amount of goodwill should be its new accounting basis.

Subsequent reversal of a previously recognized goodwill impairment loss is prohibited once the measurement of that loss is completed.


Goodwill impairment - Triggering

Events

Goodwill of a reporting unit should be tested for

impairment between annual tests if an event

occurs or circumstances change that would more

likely than not reduce the fair value of a reporting

unit below its carrying amount.


Examples of Triggering Events

A significant adverse change in legal factors or in the business climate

An adverse action or assessment by a regulator

Unanticipated competition

A loss of key personnel

A more-likely-than-not expectation that a reporting unit or a significant portion of a reporting unit will be sold or otherwise disposed of

The testing for recoverability under Statement 121 of a significant asset group within a reporting unit

Recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a component of a reporting unit.


Financial Statement Presentation

The aggregate amount of goodwill should be presented as

a separate line item in the balance sheet.

The aggregate amount of goodwill impairment losses

should be presented as a separate line item in the income

statement before the subtotal income from continuing

operations (or similar caption) unless a goodwill

impairment loss is associated with a discontinued

operation. A goodwill impairment loss associated with a

discontinued operation should be included (on a net-of-tax

basis) within the results of discontinued operations.


Pooling of Interests

Under APB 16, business combinations were accounted for using one of two methods, the pooling-of-interests method (pooling method) or the purchase method. Use of the pooling method was required whenever 12 criteria were met; otherwise, the purchase method was to be used. Because those 12 criteria did not distinguish economically dissimilar transactions, similar business combinations were accounted for using different methods that produced dramatically different financial statement results.

Pooling accounting is no longer allowed.

Accounting Clinic V - Columbia Business School

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