5
CHAPTER
Analyzing Financing
Activities
Intercorporate investments — investments by one
corporation in the equity securities of another
corporation
Parent — corporation who controls,
generally through ownership of equity
securities,the activities of another
separate legal entity known as a
subsidiary
Parent-subsidiary relation —when one corporation
owns all or a majority of the voting equity securities of
another corporation
Intercorporate Investments
Definitions
Two basic methods for a parent to account for its
ownership in a subsidiary,
1,Consolidated Financial Statements
2,Equity method accounting
Intercorporate Investments
Accounting
Consolidated financial statements report the results of operations and
financial condition of a parent corporation and its subsidiaries in one set of
statements
Consolidation involves two steps,aggregation and
elimination
Aggregation of assets,liabilities,revenues,
and expenses of subsidiaries with the
parent
Elimination of intercompany transactions
(and accounts) between subsidiaries and the parent
Note,Minority interest represents the portion of a subsidiary’s equity
securities owned by other than the parent company
Intercorporate Investments
Consolidated Financial Statements
Basic Technique of Consolidation
The Facts,
? Pharmaceutical Corp (parent) acquires Silicon Supplies
(subsidiary)
? Assets and liabilities in the balance sheet of
Silicon Supplies are at fair values
? Pharmaceutical pays $78,000 (in millions) for
90% of Silicon Supplies’ common stock
— fair values of net assets acquired equal
90% of $80,000,or $72,000
? Accounts receivable of Pharmaceutical
include $4,000 owed to it by
Silicon Supplies
Intercorporate Investments
Illustration of Consolidation
Intercorporate Investments
Pharmaceutical Corp and Silicon Supplies
Consolidated Balance Sheet Worksheet
Adjustments
Pharma- Silicon and
ceutical Supplies Elminiations Minority Consoli-
Corporation Company Dr,Cr,Interest dated
Assets
Cash 16,000 11,000 27,000
Accounts receivable 32,000 19,000 (4,000) 47,000
Inventories 42,000 18,000 60,000
Fixed Assets 64,000 42,000 106,000
Investment in Silicon
Fair value at acquisition 72,000 — (72,000) —
Excess of cost over fair value (goodwill) 6,000 — 6,000
Total assets 232,000 90,000 246,000
Liabilities and Equity
Accounts payable 12,000 10,000 4,000 18,000
Capital stock,
Pharmaceutical Corporation 120,000 120,000
Silicon Supplies Company 50,000 45,000 5,000
Retained earnings,
Pharmaceutical Corporation 100,000 100,000
Silicon Supplies Company 30,000 27,000 3,000
Minority interest 8,000
Minority Total liabilities and equity 232,000 90,000 246,000
? Income statement of Silicon Supplies is combined with that
of Pharmaceutical Corp
? 10% share of the minority interest in the net income or loss
of Silicon Supplies for the period is deducted from the
consolidated income (or loss) and added to the minority’s
interest to show the consolidated net results of operations
of the total entity
? Any intercompany profits on sales of inventories held by
the consolidated entity at year-end,along with any
intercompany profits on other asset transactions,are
eliminated
Pharmaceutical Corp and Silicon Supplies
Consolidated Income Statement Steps
Intercorporate Investments
ED establishes presumption of control if an entity,
? Has a majority voting interest in or a right to appoint a majority of
an entity’s governing body
? Has a large minority voting interest and no other party or
organized group of parties has a significant voting interest
? Has a unilateral ability to (1) obtain a majority voting interest in or
(2) obtain a right to appoint a majority of the corporation’s
governing body through the present ownership of convertible
securities or other rights that are currently exercisable at the
option of the holder and the expected benefit from converting
those securities or exercising that right exceeds its expected cost
? Is the only general partner in a limited partnership
and no other partner or organized group of
partners has the current ability to dissolve the
limited partnership or otherwise remove
the general partner
Intercorporate Investments
Exposure Draft on Consolidation
FASB
Equity method accounting—reports the parent’s
investment in the subsidiary,and the parent’s share of
the subsidiary’s results,as line
items in the parent’s financial
statements (referred to as
one-line consolidation)
Note,Generally used for
investments representing
20 to 50 percent of the voting stock
of a company’s equity securities--main difference
between consolidation and equity method accounting
rests in the level of detail reported in financial
statements
Intercorporate Investments
Equity Method Accounting
? Intercompany profits and losses are eliminated until realized by the investor or investee
? Difference between the cost of an investment and the amount of equity in net assets of an investee is
accounted for as if the investee is a consolidated subsidiary—amortization of any goodwill is required
? Investment(s) in common stock is shown in the balance sheet of an investor as a single amount,and the
investor’s share of earnings or losses of an investee(s) is ordinarily shown in the income statement as a
single amount except for any extraordinary items and prior period adjustments that are separately
classified in the investor’s income statement
? Capital transactions of an investee affecting the investor’s share in the equity of the investee are
accounted for as if the investee is a consolidated subsidiary
? Selling stock of an investee by an investor is accounted for as a gain or loss equal to the difference
between the stock’s selling price and carrying amount when sold
? If an investee’s financial statements are not sufficiently timely for an investor to apply the equity method,
the investor should record its share of the earnings or losses of an investee from the most recent
financial statements
? Loss in value of an investment that is other than a temporary decline is recognized the same as a loss in
value of other long term assets
? An investor should discontinue equity method accounting when the investment (and net advances) is
reduced to zero,and should not provide for additional losses unless the investor has guaranteed
obligations of the investee or is otherwise committed to providing further financial support to the
investee; if the investee subsequently reports net income,the investor should resume equity method
accounting only after its share of that net income equals the share of net losses not recognized during
the period it suspended the equity method
? When an investee has outstanding cumulative preferred stock,an investor computes its share of
earnings (losses) after deducting the investee’s preferred dividends,whether or not such dividends are
declared
? Carrying amount of an investment in common stock of an investee that qualifies for equity method
accounting can differ from the equity in net assets of the investee—this difference affects determination
of the investor’s share of earnings or losses of an investee as if the investee is a consolidated
subsidiary; if the investor is unable to link this difference to specific accounts of the investee,the
difference is considered goodwill and amortized
Intercorporate Investments
Procedures in Equity Method Accounting
Intercorporate Investments
Analysis Implications
Validity of Taking Up Earnings— dollar-for-dollar equivalence of
earnings cannot be taken for granted because,
? A regulatory authority can sometimes intervene in a subsidiary’s
? dividend policy
? A subsidiary can operate in a country where restrictions exist on
remittance of earnings or where the value of currency can
deteriorate rapidly
? Dividend restrictions in loan agreements can
limit earnings accessibility
? Presence of a stable or powerful minority
interest can reduce a parent’s discretion
in setting dividend or other policies
Intercorporate Investments
Analysis Implications
Provision for Taxes on Undistributed Subsidiary Earnings
? Current practice assumes all undistributed earnings transfer to
the parent and that a provision for taxes is made by the parent
in the current period
? The decision on whether taxes are provided on undistributed
earnings is that of management
? Management must report the amount of
earnings for which no income taxes are
provided by the parent
Intercorporate Investments
Analysis Implications
Debt in Consolidated Financial Statements
? Liabilities in consolidated financial statements do not operate
as a lien upon a common pool of assets
? Creditors,whether secured or unsecured,have recourse in the
event of default only to assets owned by the specific
corporation that incurred the liability
? If a parent company guarantees a liability of a subsidiary,then
the creditor has the guarantee as
additional security with potential recourse
provisions
? To assess the security of liabilities,analysis
must examine the individual financial statements of each
subsidiary
Intercorporate Investments
Analysis Implications
Additional Limitations of Consolidated Financial Statements
? Financial statements of the individual companies comprising the larger entity
are not always prepared on a comparable basis—these differences can inhibit
homogeneity and impair the validity of ratios,trends,and other analyses
? Consolidated financial statements do not reveal restrictions on use of cash for
individual companies--these factors obscure analysis of liquidity
? Companies in poor financial condition sometimes combine with financially
strong companies,thus obscuring analysis
? Extent of intercompany transactions is unknown unless the procedures
underlying the consolidation process are reported
? Consolidated retained earnings actually available for payment of dividends are
difficult to establish unless reported
? Composition of minority interest (e.g.,between common and preferred) cannot
be determined from a,combined” minority interest amount in the consolidated
balance sheet
? Aggregation of dissimilar enterprises can distort ratios and other relations—for
example,current assets of finance subsidiaries are not generally available to
satisfy current liabilities of the parent; assets and liabilities of separate entities
are not interchangeable
Business Combinations
Definitions
Business combinations—refer to the merger,acquisition,reorganization,
or restructuring of two or more businesses to form another business entity
Motivations
? enhance company image and growth potential
? acquiring valuable materials and facilities
? acquiring technology and marketing channels
? securing financial resources
? strengthening management
? enhancing operating efficiency
? encouraging diversification
? rapidity in market entry
? achieving economies of scale
? acquiring tax advantages
? management prestige and perquisites
? management compensation
Business Combinations
C om pa n i e s R e po rt i n g B u s i n e s s C om bi n a t i on s
No combinations,
67%
With
Combinations,33%
Source:Accounting Trends & Techniques
Business Combinations
Accounting
Two methods of accounting for business combinations,
? Pooling accounting —reflects merging of two shareholder
groups through an exchange of equity securities to share in
future risks and opportunities; prior ownership interests
continue and the recorded assets and liabilities of the
constituent companies are carried forward to the combined
entity at their recorded amounts
? Purchase accounting—reflects acquisition of one or more
companies by another company; acquiror continues operating,
while the acquired company disappears; acquiror records the
acquired assets
(including goodwill)
and liabilities
at fair values
at date of acquisition
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C o m pa ni e s R e po rt i ng B us i ne s s C o m bi na t i o ns
Business Combinations
Accounting for Business Combinations
Pooling
accounting,9%
Purchase
accounting,91%
Source:Accounting Trends & Techniques
Business Combinations
Pooling Accounting Criteria
There are 12 conditions for a business combination to be treated as a
pooling of interests—they can be grouped into three categories,
? attributes of the combining companies
? absence of planned transactions
? manner of combining interests
These conditions attempt to identify a situation where ownership in net
assets is not transferred from one group of owners to another—that is,there
is clear continuity of ownership (see APB 16 for details)
A crucial condition is that the surviving corporation must exchange at
least 90 percent of the outstanding common stock of the combining
company for voting common stock of
the surviving corporation—this
ensures the common shareholders
of the combining companies continue
as voting common shareholders
of the new combined entity
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Business Combinations
Purchase Accounting Concerns
Valuing the Consideration—a problem in purchase accounting is
determining the total cost of the acquired entity
Contingent Consideration—a company usually records the amount of
any contingent consideration payable in accordance with a purchase
agreement when the contingency is resolved and the consideration is
issued or issuable
Allocating Total Cost—once a company determines the total cost of an
acquired entity,it is necessary to allocate this cost to individual assets
received; the excess of total cost over the amounts assigned to identifiable
assets acquired,less liabilities assumed,is recorded as goodwill
In-Process Research & Development (IPR&D)— some companies are
writing off a large portion of an acquisition’s costs as purchased research
and development,
Business Combinations
Illustration of Pooling Accounting
Facts,
? Company Buy issues 1,200,000 of $1 par value
common shares for all common shares of
Company Sell
? Transaction qualifies as a pooling
,
Business Combinations
Illustration of Pooling Accounting—“Statutory Merger”
Summary of Pro Forma Combined Balance Sheet (in thousands)
Adjustments
Company Company
Buy Sell Debit Credit Combined
Total assets $157,934 $28,013 — — $185,947
Total liabilities $42,591 $11,218 — — $53,809
Stockholders’ equity,
Company Buy,
Preferred stock 810 — — — 810
Common stock 7,572 — — $1,200 8,772
Company Sell,
Common stock — 1,285 $1,285 — —
Additional paid-in capital 31,146 137 — 85 31,368
Retained earnings 75,815 15,373 — — 91,188
Total stockholders’ equity $115,343 $16,795 $1,285 $1,285 $132,138
Total liabilities and equity $157,934 $28,013 $1,285 $1,285 $185,947
Business Combinations
Illustration of Pooling Accounting—“Statutory Merger”
Accounting entry made by Company Buy for the pooling with
Company Sell is (in thousands),
Assets 28,013
Liabilities 11,218
Common stock 1,200
Additional Paid-In Capital ($137 + $85) 222
Retained Earnings 15,373
To record the issuance of 1,200,000 shares of
$1 par value common stock for the merged net
assets of Sell and to increase retained earnings
for the balance of retained earnings of Sell at
date of acquisition,
Business Combinations
Illustration of Pooling Accounting— Merger
Summary of Pro Forma Balance Sheet (in thousands)
Company Company Buy Only
Buy Adjustments
Before After
Pooling Debit Credit Pooling
Assets—before pooling $157,934 — — $157,934
Investment in Company Sell — $16,795 — 16,795
Total Assets $157,934 $16,795 — $174,729
Total Liabilities $42,591 — — $42,591
Stockholders’ equity,
Company Buy,
Preferred stock 810 — — 810
Common stock 7,572 — $1,200 8,772
Company Sell,Common stock — — — —
Additional paid-in capital 31,146 — 222 31,368
Retained earnings 75,815 — — 75,815
Retained earnings from pooled company — — 15,373 15,373
Total stockholders’ equity $115,343 — $16,795 $132,138
Total liabilities and equity $157,934 — $16,795 $174,729
Business Combinations
Illustration of Pooling Accounting—“Statutory Merger”
Accounting entry made by Company Buy for the pooling (merger)
with Company Sell is (in thousands),
Investment in Company Sell 16,795
Common Stock 1,200
Additional Paid-In Capital 222
Retained Earnings from Pooled Company 15,373
To record the issuance of 1,200,000 shares of $1
par value common stock for the common stock
of Sell and to increase retained earnings
for the balance of retained earnings of Sell
at date of acquisition,
Business Combinations
Illustration of Purchase Accounting
Fact,Company Buy acquires Company Sell for $25,000,000 cash
Summary of Pro Forma Consolidated Balance Sheet (in thousands)
Company Combining and
Sell (at fair Consolidating
values on Adjustments
Company date of After
Buy acquisition) Debit Credit Purchase
Assets
Assets (exclusive of goodwill) $157,934 $34,000 — $25,000 $166,934
Goodwill — — $4,000 — 4,000
Total assets $157,934 $34,000 $4,000 $25,000 $170,934
Liabilities and Equity
Liabilities $42,591 $13,000 — — $ 55,591
Stockholders’ equity,
Company Buy,
Preferred stock 810 — — — 810
Common stock 7,572 — — — 7,572
Additional paid-in capital 31,146 — — — 31,146
Retained earnings 75,815 — — — 75,815
Net assets at fair value of
Company Sell — 21,000 21,000 — —
Total stockholders’ equity $115,343 $21,000 $21,000 — $115,343
Total liabilities and equity $157,934 $34,000 $25,000 $25,000 $170,934
Business Combinations
Illustration of Purchase Accounting
Accounting entry made by Company Buy for the purchase of
Company Sell is (in thousands),
Investment in Company Sell 25,000,000
Cash 25,000,000
Business Combinations
Analysis Implications of Pooling vs,Purchase
Likely consequences from pooling accounting for the combined company that
distinguish it from purchase accounting,
? Assets are acquired and carried at book value and not market value as reflected in
consideration given— to the extent goodwill is purchased,the acquiring company does
not report it on its balance sheet
? Understatement of assets yields understatement in combined company equity
? Understatement of assets (including inventory,property,plant,equipment,goodwill,
and intangibles) yields understatement of expenses (such as cost of goods sold,
depreciation,amortization) and overstatement of income
? Understatement of assets yields not only understatement of expenses but potential
overstatement of gains on asset disposition; the combined company reports in its
income any gains on sales of assets,yet these gains potentially arise at time of
acquisition and are carried forward at unrealistically low amounts only to be
recognized at disposition
? Understatement of invested equity or overstatement of income yields overstatement in
return on investment
? Retained earnings of the acquired entity are carried forward to the combined company
? Income statements and balance sheets of the combined entity are restated for all
periods reported; under purchase accounting they are combined and reported
post acquisition— although pro forma statements showing pre-acquisition combined results are
typically furnished
Business Combinations
Analysis Implications
Managerial Latitude in Accounting for Combinations—analysis must
be alert to understatement of assets and overstatement of liabilities
resulting from provisions for future costs and losses
Consequences of Accounting for Goodwill—goodwill is not permanent
and the present value of super earnings declines as they extend further into
the future
Reporting of Earnings—earnings reported can be misleading; some firms
report goodwill amortization,net of tax,separately from other components
of earnings and some high-tech companies report earnings that excludes
charges for many intangible assets picked up in an acquisition
Push-Down Accounting—a controversial issue is how
the acquired company (from a purchase) reports assets
and liabilities in its separate financial statements (if that
company survives as a separate entity) Preparers
Business Combinations
G o o d w i l l A m o r ti z a ti o n Pe r i o d s
0 10 20 30 40 50 60
O t h e r
E s t i m a t e d l i f e
1 0 - 1 5 y e a r s
2 0 y e a r s
2 5 - 3 0 y e a r s
N o t e x c e e d i n g 4 0 y e a r s
4 0 y e a r s
P e r c e n t o f c o m p a n i e s
Source:Accounting Trends & Techniques
International Activities
Reporting of International Activities
Analysis obstacles with companies that operate in more than one country subdivide
into two categories,
? Obstacles due to differences in
accounting practices peculiar to a country
where operations exist
? Obstacles arising from translation of assets,liabilities,and
equities into the home-country measuring unit
International Activities
Reporting of International Activities
Four basic accounting systems,
? British-American-Dutch system
? Continental system
? South American system
? Socialist system
International Activities
Translation of Foreign Currencies
Current-noncurrent method—translates current assets and liabilities at
current rates,and noncurrent assets and liabilities at historical rates
Monetary-nonmonetary
method—translates monetary
assets and liabilities at current
rates,and nonmonetary assets
and liabilities at historical rates
Current rate method—translates all assets and liabilities at
current rates
Temporal method—translates
cash,receivables,payables,and
other assets and liabilities
measured at present or future
prices at current rates,and assets
and liabilities measured at past prices (historical costs) at historical rates
C o m p a n i e s R e p o r t i n g F o r e i g n C u r r e n c y
T r a n s l a t i o n A d j u s t m e n t s
Tr a n s l a t i o n s
N o t r a n s l a t i o n s
International Activities
No translations,
39%
Translations,61%
Source:Accounting Trends & Techniques
International Activities
Functional Currency Approach
Emphasizes a,local perspective”—that is,a foreign subsidiary is treated as a
separate business entity,and financial statements of this business entity are
prepared using the local currency
Two main objectives of
functional currency
approach,
? provide information compatible with the expected economic
effects of an exchange rate change on an entity’s cash flows
and equity
? reflect in consolidated
statements the financial results
and relations of a subsidiary
measured in the currency of the
economic environment in which
it operates—referred to as its functional currency
(management determines the functional currency of a foreign subsidiary)
International Activities
Accounting using Functional Currency Approach
Major provisions of accounting for foreign currency translation using a
functional currency approach are,
? Translation requires identifying the functional currency of the entity—
generally the currency of the country in which the subsidiary is located; all
financial statement elements of the foreign entity are measured using the
functional currency,but in conformity with the parent’s accounting practices
? Translation from the functional currency into the reporting currency is required,
if they are different—this translation occurs at the current exchange rate,except
for revenues and expenses that are translated at the average current exchange
rate during the period
? Translation adjustments are not included in income—they are reported and
accumulated as a separate component of equity until such time the parent sells
or completely or substantially liquidates the net investment in the foreign entity;
translation adjustments are removed from equity and included as gains or losses
in determining income for the period when such sale or liquidation occurs
? Exchange gains and losses attributable to intercompany foreign currency
transactions,and balances that are of a trading nature,are included in income;
but those attributable to long-term financing or capital transactions,where
settlement is not expected for the foreseeable future,are reported as a separate
component of equity
International Activities
Illustration of Foreign Currency Translation
Facts
? BritCo,a wholly owned U.K,subsidiary of DollarCo,incorporates when exchange rate is ￡1 = US$1.10;
Other exchange rates are,
January 1,Year 6 ￡1 = US$1.20
December 31,Year 6 ￡1 = US$1.40
Average for Year 6 ￡1 = US$1.30
? Receivables,payables,and noncurrent liability amounts are denominated in local currency
? Dollar balance of Retained Earnings at December 31,Year 5,is $60,000
? Cumulative Foreign Exchange Translation Adjustment at December 31,Year 5,is $30,000 (Cr.)
? BritCo’s December 31,Year 6,trial balance conforms to DollarCo’s accounting principles; the pound (￡)
is the functional currency of BritCo,
Debit Credit
Cash ￡0,100,000
Accounts receivable 300,000
Inventories,at cost 500,000
Prepaid expenses 25,000
Property,plant,and equipment (net) 1,000,000
Long-term note receivable 75,000
Accounts payable ￡0,500,000
Current portion of long-term debt 100,000
Long-term debt 900,000
Capital stock 300,000
Retained earnings,January 1,Year 6 50,000
Sales 5,000,000
Cost of sales 4,000,000
Depreciation 300,000
Other expenses 550,000
￡6,850,000 ￡6,850,000
? Sales,purchases,and all operating expenses occur evenly throughout the year—accordingly,cost of
sales is convertible by use of the average rate
? Income tax consequences,if any,are ignored
International Activities
Illustration of Foreign Currency Translation
BritCo
Translated Balance Sheet and Income Statement
Exchange Code or
￡ Rate Explanation* US $
Balance Sheet
Cash 100,000 1.4 C 140,000
Accounts receivable 300,000 1.4 C 420,000
Inventories,at cost 500,000 1.4 C 700,000
Prepaid expenses 25,000 1.4 C 35,000
Property,plant,and equipment (net) 1,000,000 1.4 C 1,400,000
Long-term note receivable 75,000 1.4 C 105,000
Total assets 2,000,000 2,800,000
Accounts payable 500,000 1.4 C 700,000
Current portion of long-term debt 100,000 1.4 C 140,000
Long-term debt 900,000 1.4 C 1,260,000
Total liabilities 1,500,000 2,100,000
Capital stock 300,000 1.1 H 330,000
Retained earnings,
Balance,1/1/Year 6 50,000 B 60,000
Current year net income 150,000 F 195,000
Balance,12/31/Year 6 200,000 255,000
Cumulative foreign exchange
translation adjustment,
Balance,1/1/Year 6 B 30,000
Current year translation adjustment G 85,000
Balance,12/31/ Year 6 115,000
Total stockholders’ equity 500,000 700,000
Total liabilities and equity 2,000,000 2,800,000
Income Statement
Sales 5,000,000 1.3 A 6,500,000
Cost of sales (4,000,000) 1.3 A (5,200,000)
Depreciation (300,000) 1.3 A (390,000)
Other expenses (550,000) 1.3 A (715,000)
Net income 150,000 195,000
*Translation code or explanation,C = Current rate,H = Historical rate,A = Average rate,B = Balance in U.S,dollars at the beginning of
the period,F = Per income statement,G = Amount needed to balance the financial statements,
International Activities
Analysis Implications of Foreign Currency Translation
Temporal method—most faithful to and consistent with historical cost
accounting; current practice does not follow the temporal method except in
two cases,
? When a foreign entity is
merely an extension of the
parent and,thus,the
functional currency is
that of the parent
? When hyperinflation causes
translation of nonmonetary
assets to unrealistically low
reported values because
of using the current rate
International Activities
Analysis Implications of Foreign Currency Translation
Functional currency approach with use of current exchange rates—this is
current practice; selectively introduces current value accounting and allows gains
and losses to bypass the income statement
? Translation exposure is measured by size of the net investment
? Translation adjustment is determined from net investment multiplied by
change in exchange rates
? Currency translation affects equity (not income)
? Translated income varies directly with changes in exchange rates
? Income includes results of completed foreign exchange transactions
? Any gain or loss on translation of a current payable by subsidiary to
parent flows through consolidated income
? Decline in the dollar relative to other currencies increases income of
consolidated foreign subsidiaries
? It is management’s decision whether the functional currency is the local
currency
? Yields substantial changes in equity because of changes in the
cumulative translation adjustment (CTA)
CHAPTER
Analyzing Financing
Activities
Intercorporate investments — investments by one
corporation in the equity securities of another
corporation
Parent — corporation who controls,
generally through ownership of equity
securities,the activities of another
separate legal entity known as a
subsidiary
Parent-subsidiary relation —when one corporation
owns all or a majority of the voting equity securities of
another corporation
Intercorporate Investments
Definitions
Two basic methods for a parent to account for its
ownership in a subsidiary,
1,Consolidated Financial Statements
2,Equity method accounting
Intercorporate Investments
Accounting
Consolidated financial statements report the results of operations and
financial condition of a parent corporation and its subsidiaries in one set of
statements
Consolidation involves two steps,aggregation and
elimination
Aggregation of assets,liabilities,revenues,
and expenses of subsidiaries with the
parent
Elimination of intercompany transactions
(and accounts) between subsidiaries and the parent
Note,Minority interest represents the portion of a subsidiary’s equity
securities owned by other than the parent company
Intercorporate Investments
Consolidated Financial Statements
Basic Technique of Consolidation
The Facts,
? Pharmaceutical Corp (parent) acquires Silicon Supplies
(subsidiary)
? Assets and liabilities in the balance sheet of
Silicon Supplies are at fair values
? Pharmaceutical pays $78,000 (in millions) for
90% of Silicon Supplies’ common stock
— fair values of net assets acquired equal
90% of $80,000,or $72,000
? Accounts receivable of Pharmaceutical
include $4,000 owed to it by
Silicon Supplies
Intercorporate Investments
Illustration of Consolidation
Intercorporate Investments
Pharmaceutical Corp and Silicon Supplies
Consolidated Balance Sheet Worksheet
Adjustments
Pharma- Silicon and
ceutical Supplies Elminiations Minority Consoli-
Corporation Company Dr,Cr,Interest dated
Assets
Cash 16,000 11,000 27,000
Accounts receivable 32,000 19,000 (4,000) 47,000
Inventories 42,000 18,000 60,000
Fixed Assets 64,000 42,000 106,000
Investment in Silicon
Fair value at acquisition 72,000 — (72,000) —
Excess of cost over fair value (goodwill) 6,000 — 6,000
Total assets 232,000 90,000 246,000
Liabilities and Equity
Accounts payable 12,000 10,000 4,000 18,000
Capital stock,
Pharmaceutical Corporation 120,000 120,000
Silicon Supplies Company 50,000 45,000 5,000
Retained earnings,
Pharmaceutical Corporation 100,000 100,000
Silicon Supplies Company 30,000 27,000 3,000
Minority interest 8,000
Minority Total liabilities and equity 232,000 90,000 246,000
? Income statement of Silicon Supplies is combined with that
of Pharmaceutical Corp
? 10% share of the minority interest in the net income or loss
of Silicon Supplies for the period is deducted from the
consolidated income (or loss) and added to the minority’s
interest to show the consolidated net results of operations
of the total entity
? Any intercompany profits on sales of inventories held by
the consolidated entity at year-end,along with any
intercompany profits on other asset transactions,are
eliminated
Pharmaceutical Corp and Silicon Supplies
Consolidated Income Statement Steps
Intercorporate Investments
ED establishes presumption of control if an entity,
? Has a majority voting interest in or a right to appoint a majority of
an entity’s governing body
? Has a large minority voting interest and no other party or
organized group of parties has a significant voting interest
? Has a unilateral ability to (1) obtain a majority voting interest in or
(2) obtain a right to appoint a majority of the corporation’s
governing body through the present ownership of convertible
securities or other rights that are currently exercisable at the
option of the holder and the expected benefit from converting
those securities or exercising that right exceeds its expected cost
? Is the only general partner in a limited partnership
and no other partner or organized group of
partners has the current ability to dissolve the
limited partnership or otherwise remove
the general partner
Intercorporate Investments
Exposure Draft on Consolidation
FASB
Equity method accounting—reports the parent’s
investment in the subsidiary,and the parent’s share of
the subsidiary’s results,as line
items in the parent’s financial
statements (referred to as
one-line consolidation)
Note,Generally used for
investments representing
20 to 50 percent of the voting stock
of a company’s equity securities--main difference
between consolidation and equity method accounting
rests in the level of detail reported in financial
statements
Intercorporate Investments
Equity Method Accounting
? Intercompany profits and losses are eliminated until realized by the investor or investee
? Difference between the cost of an investment and the amount of equity in net assets of an investee is
accounted for as if the investee is a consolidated subsidiary—amortization of any goodwill is required
? Investment(s) in common stock is shown in the balance sheet of an investor as a single amount,and the
investor’s share of earnings or losses of an investee(s) is ordinarily shown in the income statement as a
single amount except for any extraordinary items and prior period adjustments that are separately
classified in the investor’s income statement
? Capital transactions of an investee affecting the investor’s share in the equity of the investee are
accounted for as if the investee is a consolidated subsidiary
? Selling stock of an investee by an investor is accounted for as a gain or loss equal to the difference
between the stock’s selling price and carrying amount when sold
? If an investee’s financial statements are not sufficiently timely for an investor to apply the equity method,
the investor should record its share of the earnings or losses of an investee from the most recent
financial statements
? Loss in value of an investment that is other than a temporary decline is recognized the same as a loss in
value of other long term assets
? An investor should discontinue equity method accounting when the investment (and net advances) is
reduced to zero,and should not provide for additional losses unless the investor has guaranteed
obligations of the investee or is otherwise committed to providing further financial support to the
investee; if the investee subsequently reports net income,the investor should resume equity method
accounting only after its share of that net income equals the share of net losses not recognized during
the period it suspended the equity method
? When an investee has outstanding cumulative preferred stock,an investor computes its share of
earnings (losses) after deducting the investee’s preferred dividends,whether or not such dividends are
declared
? Carrying amount of an investment in common stock of an investee that qualifies for equity method
accounting can differ from the equity in net assets of the investee—this difference affects determination
of the investor’s share of earnings or losses of an investee as if the investee is a consolidated
subsidiary; if the investor is unable to link this difference to specific accounts of the investee,the
difference is considered goodwill and amortized
Intercorporate Investments
Procedures in Equity Method Accounting
Intercorporate Investments
Analysis Implications
Validity of Taking Up Earnings— dollar-for-dollar equivalence of
earnings cannot be taken for granted because,
? A regulatory authority can sometimes intervene in a subsidiary’s
? dividend policy
? A subsidiary can operate in a country where restrictions exist on
remittance of earnings or where the value of currency can
deteriorate rapidly
? Dividend restrictions in loan agreements can
limit earnings accessibility
? Presence of a stable or powerful minority
interest can reduce a parent’s discretion
in setting dividend or other policies
Intercorporate Investments
Analysis Implications
Provision for Taxes on Undistributed Subsidiary Earnings
? Current practice assumes all undistributed earnings transfer to
the parent and that a provision for taxes is made by the parent
in the current period
? The decision on whether taxes are provided on undistributed
earnings is that of management
? Management must report the amount of
earnings for which no income taxes are
provided by the parent
Intercorporate Investments
Analysis Implications
Debt in Consolidated Financial Statements
? Liabilities in consolidated financial statements do not operate
as a lien upon a common pool of assets
? Creditors,whether secured or unsecured,have recourse in the
event of default only to assets owned by the specific
corporation that incurred the liability
? If a parent company guarantees a liability of a subsidiary,then
the creditor has the guarantee as
additional security with potential recourse
provisions
? To assess the security of liabilities,analysis
must examine the individual financial statements of each
subsidiary
Intercorporate Investments
Analysis Implications
Additional Limitations of Consolidated Financial Statements
? Financial statements of the individual companies comprising the larger entity
are not always prepared on a comparable basis—these differences can inhibit
homogeneity and impair the validity of ratios,trends,and other analyses
? Consolidated financial statements do not reveal restrictions on use of cash for
individual companies--these factors obscure analysis of liquidity
? Companies in poor financial condition sometimes combine with financially
strong companies,thus obscuring analysis
? Extent of intercompany transactions is unknown unless the procedures
underlying the consolidation process are reported
? Consolidated retained earnings actually available for payment of dividends are
difficult to establish unless reported
? Composition of minority interest (e.g.,between common and preferred) cannot
be determined from a,combined” minority interest amount in the consolidated
balance sheet
? Aggregation of dissimilar enterprises can distort ratios and other relations—for
example,current assets of finance subsidiaries are not generally available to
satisfy current liabilities of the parent; assets and liabilities of separate entities
are not interchangeable
Business Combinations
Definitions
Business combinations—refer to the merger,acquisition,reorganization,
or restructuring of two or more businesses to form another business entity
Motivations
? enhance company image and growth potential
? acquiring valuable materials and facilities
? acquiring technology and marketing channels
? securing financial resources
? strengthening management
? enhancing operating efficiency
? encouraging diversification
? rapidity in market entry
? achieving economies of scale
? acquiring tax advantages
? management prestige and perquisites
? management compensation
Business Combinations
C om pa n i e s R e po rt i n g B u s i n e s s C om bi n a t i on s
No combinations,
67%
With
Combinations,33%
Source:Accounting Trends & Techniques
Business Combinations
Accounting
Two methods of accounting for business combinations,
? Pooling accounting —reflects merging of two shareholder
groups through an exchange of equity securities to share in
future risks and opportunities; prior ownership interests
continue and the recorded assets and liabilities of the
constituent companies are carried forward to the combined
entity at their recorded amounts
? Purchase accounting—reflects acquisition of one or more
companies by another company; acquiror continues operating,
while the acquired company disappears; acquiror records the
acquired assets
(including goodwill)
and liabilities
at fair values
at date of acquisition
De
bt
De
bt
De
bt
De
bt
C o m pa ni e s R e po rt i ng B us i ne s s C o m bi na t i o ns
Business Combinations
Accounting for Business Combinations
Pooling
accounting,9%
Purchase
accounting,91%
Source:Accounting Trends & Techniques
Business Combinations
Pooling Accounting Criteria
There are 12 conditions for a business combination to be treated as a
pooling of interests—they can be grouped into three categories,
? attributes of the combining companies
? absence of planned transactions
? manner of combining interests
These conditions attempt to identify a situation where ownership in net
assets is not transferred from one group of owners to another—that is,there
is clear continuity of ownership (see APB 16 for details)
A crucial condition is that the surviving corporation must exchange at
least 90 percent of the outstanding common stock of the combining
company for voting common stock of
the surviving corporation—this
ensures the common shareholders
of the combining companies continue
as voting common shareholders
of the new combined entity
De
bt
De
bt
De
bt
De
bt
Business Combinations
Purchase Accounting Concerns
Valuing the Consideration—a problem in purchase accounting is
determining the total cost of the acquired entity
Contingent Consideration—a company usually records the amount of
any contingent consideration payable in accordance with a purchase
agreement when the contingency is resolved and the consideration is
issued or issuable
Allocating Total Cost—once a company determines the total cost of an
acquired entity,it is necessary to allocate this cost to individual assets
received; the excess of total cost over the amounts assigned to identifiable
assets acquired,less liabilities assumed,is recorded as goodwill
In-Process Research & Development (IPR&D)— some companies are
writing off a large portion of an acquisition’s costs as purchased research
and development,
Business Combinations
Illustration of Pooling Accounting
Facts,
? Company Buy issues 1,200,000 of $1 par value
common shares for all common shares of
Company Sell
? Transaction qualifies as a pooling
,
Business Combinations
Illustration of Pooling Accounting—“Statutory Merger”
Summary of Pro Forma Combined Balance Sheet (in thousands)
Adjustments
Company Company
Buy Sell Debit Credit Combined
Total assets $157,934 $28,013 — — $185,947
Total liabilities $42,591 $11,218 — — $53,809
Stockholders’ equity,
Company Buy,
Preferred stock 810 — — — 810
Common stock 7,572 — — $1,200 8,772
Company Sell,
Common stock — 1,285 $1,285 — —
Additional paid-in capital 31,146 137 — 85 31,368
Retained earnings 75,815 15,373 — — 91,188
Total stockholders’ equity $115,343 $16,795 $1,285 $1,285 $132,138
Total liabilities and equity $157,934 $28,013 $1,285 $1,285 $185,947
Business Combinations
Illustration of Pooling Accounting—“Statutory Merger”
Accounting entry made by Company Buy for the pooling with
Company Sell is (in thousands),
Assets 28,013
Liabilities 11,218
Common stock 1,200
Additional Paid-In Capital ($137 + $85) 222
Retained Earnings 15,373
To record the issuance of 1,200,000 shares of
$1 par value common stock for the merged net
assets of Sell and to increase retained earnings
for the balance of retained earnings of Sell at
date of acquisition,
Business Combinations
Illustration of Pooling Accounting— Merger
Summary of Pro Forma Balance Sheet (in thousands)
Company Company Buy Only
Buy Adjustments
Before After
Pooling Debit Credit Pooling
Assets—before pooling $157,934 — — $157,934
Investment in Company Sell — $16,795 — 16,795
Total Assets $157,934 $16,795 — $174,729
Total Liabilities $42,591 — — $42,591
Stockholders’ equity,
Company Buy,
Preferred stock 810 — — 810
Common stock 7,572 — $1,200 8,772
Company Sell,Common stock — — — —
Additional paid-in capital 31,146 — 222 31,368
Retained earnings 75,815 — — 75,815
Retained earnings from pooled company — — 15,373 15,373
Total stockholders’ equity $115,343 — $16,795 $132,138
Total liabilities and equity $157,934 — $16,795 $174,729
Business Combinations
Illustration of Pooling Accounting—“Statutory Merger”
Accounting entry made by Company Buy for the pooling (merger)
with Company Sell is (in thousands),
Investment in Company Sell 16,795
Common Stock 1,200
Additional Paid-In Capital 222
Retained Earnings from Pooled Company 15,373
To record the issuance of 1,200,000 shares of $1
par value common stock for the common stock
of Sell and to increase retained earnings
for the balance of retained earnings of Sell
at date of acquisition,
Business Combinations
Illustration of Purchase Accounting
Fact,Company Buy acquires Company Sell for $25,000,000 cash
Summary of Pro Forma Consolidated Balance Sheet (in thousands)
Company Combining and
Sell (at fair Consolidating
values on Adjustments
Company date of After
Buy acquisition) Debit Credit Purchase
Assets
Assets (exclusive of goodwill) $157,934 $34,000 — $25,000 $166,934
Goodwill — — $4,000 — 4,000
Total assets $157,934 $34,000 $4,000 $25,000 $170,934
Liabilities and Equity
Liabilities $42,591 $13,000 — — $ 55,591
Stockholders’ equity,
Company Buy,
Preferred stock 810 — — — 810
Common stock 7,572 — — — 7,572
Additional paid-in capital 31,146 — — — 31,146
Retained earnings 75,815 — — — 75,815
Net assets at fair value of
Company Sell — 21,000 21,000 — —
Total stockholders’ equity $115,343 $21,000 $21,000 — $115,343
Total liabilities and equity $157,934 $34,000 $25,000 $25,000 $170,934
Business Combinations
Illustration of Purchase Accounting
Accounting entry made by Company Buy for the purchase of
Company Sell is (in thousands),
Investment in Company Sell 25,000,000
Cash 25,000,000
Business Combinations
Analysis Implications of Pooling vs,Purchase
Likely consequences from pooling accounting for the combined company that
distinguish it from purchase accounting,
? Assets are acquired and carried at book value and not market value as reflected in
consideration given— to the extent goodwill is purchased,the acquiring company does
not report it on its balance sheet
? Understatement of assets yields understatement in combined company equity
? Understatement of assets (including inventory,property,plant,equipment,goodwill,
and intangibles) yields understatement of expenses (such as cost of goods sold,
depreciation,amortization) and overstatement of income
? Understatement of assets yields not only understatement of expenses but potential
overstatement of gains on asset disposition; the combined company reports in its
income any gains on sales of assets,yet these gains potentially arise at time of
acquisition and are carried forward at unrealistically low amounts only to be
recognized at disposition
? Understatement of invested equity or overstatement of income yields overstatement in
return on investment
? Retained earnings of the acquired entity are carried forward to the combined company
? Income statements and balance sheets of the combined entity are restated for all
periods reported; under purchase accounting they are combined and reported
post acquisition— although pro forma statements showing pre-acquisition combined results are
typically furnished
Business Combinations
Analysis Implications
Managerial Latitude in Accounting for Combinations—analysis must
be alert to understatement of assets and overstatement of liabilities
resulting from provisions for future costs and losses
Consequences of Accounting for Goodwill—goodwill is not permanent
and the present value of super earnings declines as they extend further into
the future
Reporting of Earnings—earnings reported can be misleading; some firms
report goodwill amortization,net of tax,separately from other components
of earnings and some high-tech companies report earnings that excludes
charges for many intangible assets picked up in an acquisition
Push-Down Accounting—a controversial issue is how
the acquired company (from a purchase) reports assets
and liabilities in its separate financial statements (if that
company survives as a separate entity) Preparers
Business Combinations
G o o d w i l l A m o r ti z a ti o n Pe r i o d s
0 10 20 30 40 50 60
O t h e r
E s t i m a t e d l i f e
1 0 - 1 5 y e a r s
2 0 y e a r s
2 5 - 3 0 y e a r s
N o t e x c e e d i n g 4 0 y e a r s
4 0 y e a r s
P e r c e n t o f c o m p a n i e s
Source:Accounting Trends & Techniques
International Activities
Reporting of International Activities
Analysis obstacles with companies that operate in more than one country subdivide
into two categories,
? Obstacles due to differences in
accounting practices peculiar to a country
where operations exist
? Obstacles arising from translation of assets,liabilities,and
equities into the home-country measuring unit
International Activities
Reporting of International Activities
Four basic accounting systems,
? British-American-Dutch system
? Continental system
? South American system
? Socialist system
International Activities
Translation of Foreign Currencies
Current-noncurrent method—translates current assets and liabilities at
current rates,and noncurrent assets and liabilities at historical rates
Monetary-nonmonetary
method—translates monetary
assets and liabilities at current
rates,and nonmonetary assets
and liabilities at historical rates
Current rate method—translates all assets and liabilities at
current rates
Temporal method—translates
cash,receivables,payables,and
other assets and liabilities
measured at present or future
prices at current rates,and assets
and liabilities measured at past prices (historical costs) at historical rates
C o m p a n i e s R e p o r t i n g F o r e i g n C u r r e n c y
T r a n s l a t i o n A d j u s t m e n t s
Tr a n s l a t i o n s
N o t r a n s l a t i o n s
International Activities
No translations,
39%
Translations,61%
Source:Accounting Trends & Techniques
International Activities
Functional Currency Approach
Emphasizes a,local perspective”—that is,a foreign subsidiary is treated as a
separate business entity,and financial statements of this business entity are
prepared using the local currency
Two main objectives of
functional currency
approach,
? provide information compatible with the expected economic
effects of an exchange rate change on an entity’s cash flows
and equity
? reflect in consolidated
statements the financial results
and relations of a subsidiary
measured in the currency of the
economic environment in which
it operates—referred to as its functional currency
(management determines the functional currency of a foreign subsidiary)
International Activities
Accounting using Functional Currency Approach
Major provisions of accounting for foreign currency translation using a
functional currency approach are,
? Translation requires identifying the functional currency of the entity—
generally the currency of the country in which the subsidiary is located; all
financial statement elements of the foreign entity are measured using the
functional currency,but in conformity with the parent’s accounting practices
? Translation from the functional currency into the reporting currency is required,
if they are different—this translation occurs at the current exchange rate,except
for revenues and expenses that are translated at the average current exchange
rate during the period
? Translation adjustments are not included in income—they are reported and
accumulated as a separate component of equity until such time the parent sells
or completely or substantially liquidates the net investment in the foreign entity;
translation adjustments are removed from equity and included as gains or losses
in determining income for the period when such sale or liquidation occurs
? Exchange gains and losses attributable to intercompany foreign currency
transactions,and balances that are of a trading nature,are included in income;
but those attributable to long-term financing or capital transactions,where
settlement is not expected for the foreseeable future,are reported as a separate
component of equity
International Activities
Illustration of Foreign Currency Translation
Facts
? BritCo,a wholly owned U.K,subsidiary of DollarCo,incorporates when exchange rate is ￡1 = US$1.10;
Other exchange rates are,
January 1,Year 6 ￡1 = US$1.20
December 31,Year 6 ￡1 = US$1.40
Average for Year 6 ￡1 = US$1.30
? Receivables,payables,and noncurrent liability amounts are denominated in local currency
? Dollar balance of Retained Earnings at December 31,Year 5,is $60,000
? Cumulative Foreign Exchange Translation Adjustment at December 31,Year 5,is $30,000 (Cr.)
? BritCo’s December 31,Year 6,trial balance conforms to DollarCo’s accounting principles; the pound (￡)
is the functional currency of BritCo,
Debit Credit
Cash ￡0,100,000
Accounts receivable 300,000
Inventories,at cost 500,000
Prepaid expenses 25,000
Property,plant,and equipment (net) 1,000,000
Long-term note receivable 75,000
Accounts payable ￡0,500,000
Current portion of long-term debt 100,000
Long-term debt 900,000
Capital stock 300,000
Retained earnings,January 1,Year 6 50,000
Sales 5,000,000
Cost of sales 4,000,000
Depreciation 300,000
Other expenses 550,000
￡6,850,000 ￡6,850,000
? Sales,purchases,and all operating expenses occur evenly throughout the year—accordingly,cost of
sales is convertible by use of the average rate
? Income tax consequences,if any,are ignored
International Activities
Illustration of Foreign Currency Translation
BritCo
Translated Balance Sheet and Income Statement
Exchange Code or
￡ Rate Explanation* US $
Balance Sheet
Cash 100,000 1.4 C 140,000
Accounts receivable 300,000 1.4 C 420,000
Inventories,at cost 500,000 1.4 C 700,000
Prepaid expenses 25,000 1.4 C 35,000
Property,plant,and equipment (net) 1,000,000 1.4 C 1,400,000
Long-term note receivable 75,000 1.4 C 105,000
Total assets 2,000,000 2,800,000
Accounts payable 500,000 1.4 C 700,000
Current portion of long-term debt 100,000 1.4 C 140,000
Long-term debt 900,000 1.4 C 1,260,000
Total liabilities 1,500,000 2,100,000
Capital stock 300,000 1.1 H 330,000
Retained earnings,
Balance,1/1/Year 6 50,000 B 60,000
Current year net income 150,000 F 195,000
Balance,12/31/Year 6 200,000 255,000
Cumulative foreign exchange
translation adjustment,
Balance,1/1/Year 6 B 30,000
Current year translation adjustment G 85,000
Balance,12/31/ Year 6 115,000
Total stockholders’ equity 500,000 700,000
Total liabilities and equity 2,000,000 2,800,000
Income Statement
Sales 5,000,000 1.3 A 6,500,000
Cost of sales (4,000,000) 1.3 A (5,200,000)
Depreciation (300,000) 1.3 A (390,000)
Other expenses (550,000) 1.3 A (715,000)
Net income 150,000 195,000
*Translation code or explanation,C = Current rate,H = Historical rate,A = Average rate,B = Balance in U.S,dollars at the beginning of
the period,F = Per income statement,G = Amount needed to balance the financial statements,
International Activities
Analysis Implications of Foreign Currency Translation
Temporal method—most faithful to and consistent with historical cost
accounting; current practice does not follow the temporal method except in
two cases,
? When a foreign entity is
merely an extension of the
parent and,thus,the
functional currency is
that of the parent
? When hyperinflation causes
translation of nonmonetary
assets to unrealistically low
reported values because
of using the current rate
International Activities
Analysis Implications of Foreign Currency Translation
Functional currency approach with use of current exchange rates—this is
current practice; selectively introduces current value accounting and allows gains
and losses to bypass the income statement
? Translation exposure is measured by size of the net investment
? Translation adjustment is determined from net investment multiplied by
change in exchange rates
? Currency translation affects equity (not income)
? Translated income varies directly with changes in exchange rates
? Income includes results of completed foreign exchange transactions
? Any gain or loss on translation of a current payable by subsidiary to
parent flows through consolidated income
? Decline in the dollar relative to other currencies increases income of
consolidated foreign subsidiaries
? It is management’s decision whether the functional currency is the local
currency
? Yields substantial changes in equity because of changes in the
cumulative translation adjustment (CTA)
