Chapter 18
More on Understanding
Corporate Annual Reports
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Learning Objective 1
Contrast accounting for
investments using the equity
method and the market method.
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Intercorporate Investments
How do we account for intercorporate investments?
Investor holds less than 20%
Market Method
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Intercorporate Investments
Investor holds between 20% and 50%
Equity Method
Investor holds more than 50%
Consolidation
Approach
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Market Method
Investment at market value
on the balance sheet
Trading securities
Available-for-sale securities
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Market Method
Trading securities are investments that the
investor company buys only with intent to
resell them shortly.
Available-for-sale securities are investments
that the investor company has no intention
to sell in the near future.
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Market Method
Investment Returns

1
2
Trading securities and available-for-sale
securities provide returns to the investor in
two ways:
Dividend revenue
Changes in market value
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Market Method
Investment Returns
Dividends are recorded on the income
statement when earned for both types
of investments.
Changes in market value are accounted
for differently for trading securities than
for available-for-sale securities.
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Changes in Market Value
Trading Securities
As the market value of trading securities
changes, companies report the gains from
increases in price and losses from decreases
in price in the income statement.
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Changes in Market Value
Trading Securities
Gains and losses that arise as market values of
available-for-sale securities rise and fall are not
shown on the income statement.
Unrealized gains and losses are added to a
separate valuation allowance account in the
stockholders’ equity section of the balance sheet.
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Equity Method
Investment at the acquisition cost adjusted
for dividends received and the investor’s
share of earnings or losses of the investee
after the date of investment.
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Equity Method
Investors increase income and the carrying
amount of the investment by their share of
the investee’s earnings.
Investors reduce both income and the
carrying amount by dividends received
from the investee and by their share in
the investee’s losses.
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Learning Objective 2
Explain the basic ideas and
methods used to prepare
consolidated financial
statements.
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Consolidated
Financial Statements
A company owning 50% of another business’s
stock is called the parent company.
The company whose stock is owned by the
other business is called the subsidiary.
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Consolidated
Financial Statements
Parent companies must issue consolidated
financial statements that combine the
financial statements of the parent company
with those of various subsidiaries, as if
they were a single entity.
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Acquisition of a Subsidiary
Suppose Company P (parent) acquired
100% of the common stock of Company S
(subsidiary) for $210 million in cash at the
beginning of the year.
 The balance sheet accounts of both
companies are analyzed in the following
table (in millions of dollars):

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Acquisition of a Subsidiary
Stockholders’
Assets
= Liabilities + Equity
Cash and
Accounts
StockInvestment + Other = Payable, + holders’
in S
Assets
Etc.
Equity
P’s accounts, January 1
Before acquisition
Acquisition of S
S’s accounts, January 1 +210
Intercompany eliminations for a consolidated
balance sheet
–210
Consolidated, January 1
0
+
650
–210
400
=
=
=
840
=
=
200
+
450
190
+
210
390
–210
+ 450
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Acquisition of a Subsidiary
P pays the $210 million to the former
owners of S as private investors.
The $210 million is not an addition to
the existing assets and stockholders’
equity of S.
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Acquisition of a Subsidiary
Each legal entity has its
individual set of books.
The consolidated entity does not
keep a separate set of books.
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Acquisition of a Subsidiary

1
2
To avoid double-counting, we eliminate the
evidence of ownership present in two
places.
The Investment in S on P’s books
The Stockholders’ Equity on S’s books
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After Acquisition
Investments in 50%- to 100% owned
subsidiaries, such as the investment in
S, are carried in the investor’s balance
sheet by the equity method.
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Minority Interests
The Minority Interests account shows
the outside stockholders’ interest, as
opposed to the parent’s interest, in a
subsidiary corporation.
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Investments in Affiliates
Investments in equity securities that represent 20%
to 50% ownership are frequently called investments
in affiliates or investments in associates.
They are accounted for under the equity method.
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Learning Objective 3
Describe how goodwill arises
and how to account for it.
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Accounting for Goodwill
Suppose, using our previous example, that
the price were $40 million higher, or a total
of $250 million cash.
 For simplicity, assume that the fair values of
the individual assets of S are equal to their
book values.
 The balance sheets immediately after the
acquisition are:

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Accounting for Goodwill
Stockholder’
Assets
= Liabilities + Equity
Cash and
Accounts
StockInvestment + Good- + Other = Payable, + holders’
in S
Assets
Etc.
Equity
will
P’s accounts
Before acquisition
Acquisition
+250
S’s accounts
Intercompany
eliminations
–250
Consolidated
0
+
+
40
40
+
650
–250
400
=
=
=
800
=
=
200
+
450
190
+
210
+
–210
450
390
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Accounting for Goodwill
What if the book values
of the individual assets
of S are not equal to
their fair values?
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Accounting for Goodwill

1
2
The usual procedures are:
S continues as a going concern and keeps its
accounts on the same basis as before.
P records its investment at its acquisition
cost (the agreed purchase price).
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Accounting for Goodwill
For consolidated reporting purposes, we
first assign the excess of the acquisition cost
over the book value of S to the individual
assets, item by item.
 Any remaining excess that cannot be
identified is labeled as purchased goodwill.
3
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Goodwill and
Abnormal Earnings
A purchaser may be willing to pay extra
for projected excess earnings due to:
Greater market share or prime location
Excellent management skills or a unique
product line
Potentially greater efficiency
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Learning Objective 4
Explain and use a variety of
popular financial ratios.
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Financial Statements
Financial statements, expressed in
component percentages, are called
common-size statements.
Investors and creditors often use
ratios computed from published
financial statements to analyze
companies.
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Some Typical Financial Ratios
–
–
–
–
–
Current ratio
Average collection period in days
Current debt to equity
Total debt to equity
Gross profit rate or percentage
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Some Typical Financial Ratios
–
–
–
–
–
–
Return on sales
Return on stockholders’ equity
Earnings per share
Price earnings
Dividend yield
Dividend payout
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Comparisons
Evaluation of a financial ratio requires a
comparison.
 There are three main types of comparisons:
1 With a company’s own historical ratios
(called time-series comparisons)

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Comparisons
2
3
With general rules of thumb or benchmarks
With ratios of other companies or with
industry averages for the same period
(called cross-sectional comparisons)
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Operating Performance Ratios

The rate of return on invested capital is
an important measure of overall
accomplishment:
ROI = Income ÷ Invested capital
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Operating Performance Ratios

Operating performance is best measured by
pretax operating rate of return on average
total assets:
Pretax operating rate of return
= Operating income on average total assets
÷ Average total assets
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Learning Objective 5
Identify the major implications
that efficient stock markets
have for accounting.
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Efficient Capital Market

An efficient capital market is one in which
market prices “fully reflect” all information
available to the public.
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Implications for Accounting
in Efficient Stock Markets
Financial ratios and other data such as
reported earnings help predict such
economic phenomena as financial
failure or earnings growth.
Accounting reports are only one
source of information.
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Implications for Accounting
in Efficient Stock Markets
In the aggregate, the market is not fooled by
companies that choose the least-conservative
accounting policies.
The market as a whole generally sees through
any attempts by companies to gain favor
through the choice of accounting policies
that tend to boost immediate income.
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Implications for Accounting
in Efficient Stock Markets
Thus there is evidence that the stock markets
may indeed be “efficient,” at least in their
reflection of most accounting data.
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Learning Objective 6
Understand how financial
analysts use ratios and other
analysis techniques to interpret
the consolidated financial
statements of a company.
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Interpret Financial Statements
Financial analysts and other investment
advisors use financial statements to
analyze the prospects for companies
that they consider for investment.
They use financial ratios and other
techniques together with other information
to make investment decisions.
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End of Chapter 18
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