Accounting Clinic V
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
With contributions by
Stephen H. Penman – Columbia University
Clinic V-2
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
Clinic V-3
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.
Clinic V-4
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.
Clinic V-5
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.
Clinic V-6
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.
Clinic V-7
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.
Clinic V-8
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?
Clinic V-9
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
Clinic V-10
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
Investment in Stock of B
40,000
To record dividends received from B
Clinic V-11
Year 2005
Investment in Stock of B
200,000
Equity in Earnings of Affiliate
200,000
To record A’s share in the income earned by firm B
Cash
Investment in Stock of B
90,000
90,000
To record dividend received from firm B
Clinic V-12
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
Clinic V-13
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
Clinic V-14
For the end of 2005
B’s Equity is as follows:
12/31/2003
2004
Income
Dividend
2005
Income
Dividend
12/31/2005
$3,000,000
250,000
(100,000)
500,000
(225,000)
3,425,000
Therefore the investment equals to:
40%*$3,425,000 = 1,370,000
Clinic V-15
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.
Clinic V-16
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.
Clinic V-17
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
Clinic V-18
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:
Land
Equipment
Total Increase
$20,000
50,000
$70,000
A’s 30% share
$6,000
15,000
$21,000
Thus $19,000 (40,000-21,000) is assigned to
goodwill.
Clinic V-19
Cost of the
investment
MV of net
identifiable assets
(30%*570,000)
BV of net
identifiable assets
(30%*$500,000)
190,000
171,000
Excess of MV Goodwill
over BV of net
identifiable assets
Total differential $40,000
The allocation of the differential can be
illustrated as follows:
150,000
Clinic V-20
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.
Clinic V-21
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.)
Clinic V-22
Firm B reports net income of 80,000 for 2004 and declares
dividend of 20,000.
The journal entries will be:
Investment in B
Cash
(to record initial acquisition)
190,000
190,000
Investment in B
24,000
Equity in Earnings of Affiliate
(80,000*30%)
24,000
Cash
Investment in B
(20,000*30%)
6,000
6,000
Clinic V-23
Equity in Earnings of Affiliate
Investment in B
(15,000/ 5 years)
3,000
3,000
(to record the amortization of differential allocated to
equipment)
The investment account in the end of the year would be
1/1/2004
Income from B
Dividend from B
Equipment depreciation
12/31/2004
$190,000
24,000
(6,000)
(3,000)
$205,000
Clinic V-24
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!)
Clinic V-25
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
Clinic V-26
Therefore the investment at the end of the year
(12/31/2004) equals to:
30%*560,000 + 37,000 = 205,000
A’s share of Unamortized
B’s Equity differential
(The firm will also check to see if goodwill should be
impaired)
Clinic V-27
“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.
Clinic V-28
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)
Clinic V-29
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.
Clinic V-30
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.
Clinic V-31
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.
Clinic V-32
Three categories of business
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.
Clinic V-33
Three categories of business
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
Clinic V-34
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.
Clinic V-35
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.
Clinic V-36
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.
Clinic V-37
Consolidation - Wholly Owned Sub.
Before the purchase
A
Shareholders
B
Shareholders
After the Purchase
A
Shareholders
A Corporation
A
Corporation
B
Corporation
B Corporation
Clinic V-38
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.
Clinic V-39
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.
Clinic V-40
Consolidation – 80% Owned Sub.
Before the Purchase
A
Shareholders
B
Shareholders
After the Purchase
A
Shareholders
A Corporation
A
Corporation
B
Corporation
B Corporation
Some of former
B shareholders
hold 20% of B
Clinic V-41
Example - Consolidation
On 12.31.01 Company A purchased 75% of the
common stock of Company B for $20,000. Any
differential is allocated 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
Clinic V-42
Balance Sheets
Company A
12.31.01
12.31.02
Company B
12.31.01
12.31.02
Cash
A/R
Loan to A
Inventory
Investment in B
PPE, net
Building, net
Total Assets
14,000
11,000
--40,000
20,000
15,000
12,000
112,000
7,000
14,000
--30,000
23,000
14,000
11,000
99,000
8,000
3,000
--28,000
--20,000
10,000
69,000
7,000
20,000
14,000
25,000
--18,000
8,000
92,000
A/P
Other payables
Loan from B
Long term loan
Paid In Capital
Retained earnings
28,000
10,000
--12,000
50,000
12,000
112,000
8,000
7,000
14,000
4,000
50,000
15,000
99,000
11,000
14,000
--20,000
20,000
4,000
69,000
29,000
15,000
--20,000
20,000
8,000
92,000
Clinic V-43
Income Statements
2002
Company A Company B
Sales
Cost of goods sold
SG&A
Depreciation
Operating Income
Interest Expense
Equity in subsidiary’s income
Net Income
50,000
(48,000)
(6,000)
(2,000)
4,000
(4,000)
3,000
3,000
33,000
(22,000)
(2,500)
(4,000)
4,500
(500)
4,000
Clinic V-44
Investment Under Equity Method
– Differential Calculation
The sub: Paid In Capital
Retained Earnings
20,000
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
Clinic V-45
Investment Under Equity Method
– Investment Account
O.B.
Income
Total
$20,000 (75%*24,000 + 2,000)
3,000 (75%*4,000)
23,000 (75%*28,000 +2,000)
Clinic V-46
Balance Sheet Consolidation –
31.12.01
Cash
A/R
Inventory
Investment in B
PPE, net
Building, net
Goodwill
Total Assets
A/P
Other payables
Long term loan
Minority interest
Paid In Capital
Retained earnings
Company A
14,000
11,000
40,000
20,000
15,000
12,000
112,000
Company B
8,000
3,000
28,000
20,000
10,000
69,000
28,000
10,000
12,000
50,000
12,000
112,000
11,000
14,000
20,000
20,000
4,000
69,000
Add (Subtract)
2,000
(18,000)
12.31.02
22,000
14,000
68,000
35,000
22,000
2,000
163,000
6,000
(20,000)
(4,000)
(18,000)
39,000
24,000
32,000
6,000
50,000
12,000
163,000
(20,000)
Clinic V-47
Balance Sheet Consolidation –
31.12.02
Cash
A/R
Inventory
Loan to A
Investment in B
PPE, net
Building, net
Goodwill
A/P
Other payables
Loan from B
Long term loan
Minority interest
Paid In Capital
Retained earnings
Company A
7,000
14,000
30,000
23,000
14,000
11,000
99,000
Company B
7,000
20,000
25,000
14,000
18,000
8,000
92,000
9,000
7,000
14,000
4,000
50,000
15,000
99,000
29,000
15,000
20,000
20,000
8,000
92,000
Add (Subtract)
(14,000)
(23,000)
2,000
(35,000)
(14,000)
7,000
(20,000)
(8,000)
(35,000)
12.31.02
13,000
34,000
55,000
32,000
19,000
2,000
156,000
38,000
22,000
24,000
7,000
50,000
15,000
156,000
Clinic V-48
Income Statement Consolidation
– 2002
Company A
Sales
Cost of goods sold
SG&A
Depreciation - PPE
Operating Income
Interest expense
Equity in subsidiary’s income
Minority income
Net Income
50,000
(38,000)
(6,000)
(2,000)
4,000
(4,000)
3,000
3,000
2002
Company B
Add
(Subtract)
33,000
(22,000)
(2,500)
(4,000)
4,500
(500)
4,000
(3,000)
(1,000)
(4,000)
Total
83,000
(60,000)
(8,500)
(3,000)
8,500
(4,500)
(1,000)
3,000
Clinic V-49
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.
Clinic V-50
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.
Clinic V-51
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
Clinic V-52
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.
Clinic V-53
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.
Clinic V-54
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.
Clinic V-55
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.
Clinic V-56
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.
Clinic V-57
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.
Clinic V-58
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.
Clinic V-59
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.
Clinic V-60