MANAGEMENT DECISIONS
AND FINANCIAL
ACCOUNTING REPORTS
Baginski & Hassell
Chapter 8
• Topics
– Methods of accounting for investments in
common stock
– “Mark-to-Market accounting” for certain
investments in equity securities
– Opportunity for gains trading
– Legal forms of business combinations
– Accounting methods for business combinations
– Consolidated financial statements
Methods of Accounting for Investments
in Common Stock
• Cost Method
– Investor has no significant influence over
increase
• Presumed to be ownership of < 20% of
investee’s outstanding common stock
• Equity method
– Investor has significant influence, but does not
have control over investee
• Presumed to be ownership of 20% - 50% of
investee’s outstanding common stock
FAQ?
When should a corporation consider
consolidation, i.e., consolidated
financial statements?
When the investor is “in control” which is
clearly the case when over 50% of the
investee’s outstanding common shares are
owned. Effective control can often take
somewhat less than 50%!
Cost Method
• An investor uses the cost method if it has no
significant influence over investee
– Investment is recorded at the cost of acquiring
the shares
• If marketable, securities are classified as
either trading or available-for-sale (in
accordance with SFAS No. 115).
• The investee’s pro rata share of dividends
declared by investee is recorded as
dividend income
– Dividend income is shown in the
other income section of the
income statement.
– Dividends received are shown
as an operating activity in the
SCF.
Equity Method
• An investor uses the equity method if it has
significant influence over the investee, but
it does not have control
– The investment is initially recorded at the cost
of acquiring the shares.
– The investor’s pro rata share of investee net
income is recorded as (1) an increase in the
investment, and (2) investment income
(reported in the “other income” section of the
income statement; not dependent on cash
flows).
Equity Method & Dividend
Collections
– The investor’s pro rata share of dividends
declared by investee is recorded as a reduction
of the investor’s investment
– Under the equity method, the investment is not
marked-to-market
Example: Compare and Contrast
Cost and Equity Methods
(for long-term investments)
Facts: On January 1, the O’Brien Co.
purchased 100,000 shares of Gilly Co.’s
common stock for $18 per share (or 15%
of Gilly’s outstanding common stock).
For the year, Gilly reported net income of
$5,000,000 and declared and paid dividends
of $800,000.
Illustration of cost and equity methods
Assumption 1: The investment (15%) does not
give O’Brien significant influence
Assumption 2: The investment (15%) does give
O’Brien significant influence
The effects on O’Brien’s current year financial
statements are as follows:
O’Brien: Cost Method
Balance Sheet
Investment in common stock (1)
$1,800,000
Income Statement
Other income: Dividend income (2)
(1)
100,000 shares × $18
(2)
$800,000 × 15%
120,000
Cost Method, continued
Statement of Cash Flows
Operating Activities
Dividends received
$
120,000
Investing Activities
Purchase of investment
(1,800,000)
O’Brien: Equity Method
Balance Sheet
Investment in common stock (1)
Income Statement
Other income: Equity in subsidiary
earnings (2)
$2,430,000
$750,000
(1)
($100,000 shares × $18) + ($5,000,000 × 15%) –
($800,000 × 15%)
(2)
$5,000,000 × 15%
Equity Method, continued
Statement of Cash Flows
Operating Activities
Dividends Received
Adjust for non-cash revenue
Investing Activities
Purchase of investment
120,000
(750,000)
$(1,800,000)
Compare and Contrast Effect of
Cost and Equity Methods
• Balance sheet: Investment account is different
– Cost: carry at historical cost
– Equity: carry at historical cost adjusted for
• Income statement: Revenue is different
– Cost: dividends
– Equity: pro-rata share of investee’s Net Income
• Statement of cash flows is different
– Cost: no adjustment required for non-cash revenue
– Equity: remove non-cash revenue from net income
“Mark-to-Market Accounting” for
Investments in Equity Securities
FMV
• SFAS No. 115 classifies certain
securities as trading, available-for-sale,
or held-to-maturity.
• Equity securities can only be classified as
trading or available-for-sale.
Only debt securities can be classified
as held-to-maturity.
• To be classified as trading or available-forsale, the securities must have readily
determinable FMVs.
• Types of equity securities that qualify for
trading or available-for-sale classification
– Common stock (accounted for under the cost
method)
– Preferred stock
– Stock rights, warrants, options
SFAS No. 115: Trading and Availablefor-Sale Securities
• Trading
– Marked-to-Market at balance sheet date
– Unrealized gain/loss is reported in the other
income (expenses) section of the income
statement
– Unrealized gain/loss is a noncash event that
requires adjustment in the operating section of
the SCF
• Available-For-Sale
– Marked-to-Market at balance sheet date
– Unrealized gain/loss is reported in the other
comprehensive income section of the statement
of comprehensive income
• Other comprehensive income is closed to the
accumulated other comprehensive income
section of stockholders’ equity
– Unrealized gain does not impact net income so
no adjustment is required on the SCF
Example: Compare and Contrast Trading
and Available-For-Sale Classifications
Facts: On January 1, the O’Brien Co. purchased
100,000 shares of Gilly Co.’s common stock for $18 per
share (15% of Gilly’s outstanding common stock).
For the year, O’Gill reported net income of $5,000,000
and declared and paid dividends of $800,000.
The investment (15%) does not give O’Brien significant
influence therefore the cost method is used.
Gilly’s year-end common stock FMV is $20 per share.
Illustration of cost and equity methods
Assumption 1:
The investment is classified as
trading.
Assumption 2:
The investment is classified as
available-for-sale.
O’Brien’s current year financial statement effects
for the investments are as follows:
O’Brien: Trading Classification
Balance Sheet
Investment in common stock (1)
Income Statement
Other income:
Dividend income (2)
Unrealized gain (loss) on trading
securities (3)
(1) 100,000
shares × $20
(2) $800,000 × 15%
(3) 100,000 × ($20 - $18 )
$2,000,000
$120,000
200,000
Trading Classification, continued
Statement of Comprehensive Income
Other comprehensive income
$0
Statement of Cash Flows
Operating Activities
Purchase of investments
Dividends received
Adjustment for noncash revenue
$(1,800,000)
120,000
(200,000)
O’Brien: Available-for-Sale Classification
Balance Sheet
Investment in common stock (1)
Income Statement
Other income: Dividend income (2)
(1) 100,000
shares × $20
(2) $5,000,000 × 15%
$2,000,000
$120,000
Available-for-Sale Classification, continued
Statement of Comprehensive Income
Other comprehensive income(3)
Statement of Cash Flows
Operating Activities
Dividends received
Investing Activities
Purchase of investments
(3)100,000
× ($20 - $18 )
$
200,000
$120,000
$(1,800,000)
Compare and Contrast Effects of
Trading and Available-for-Sale
Classifications
• Balance sheet investment account is the same
• Income statement amounts are different
• Statement of comprehensive income amounts are
different
• Cash flows on the SCF different; classification
affects ‘type’ of cash flow; Trading’s noncash
revenue from mark-to-market requires
adjustment
Opportunity for “Gains Trading”
• A company with available-for-sale
securities has unrealized gains/losses
associated with the securities
• “Gains trading” is the strategic planning of
sales of available-for-sale securities in such
a manner as to create either
– profits (sell securities with unrealized gains)
– losses (sell securities with unrealized losses)
BUSINESS COMBINATIONS
Legal Forms of Business
Combinations
Three general forms (types) of business
combinations occur
– Merger: One entity retains its identity.
– Consolidation: New entity identity is
created.
– Parent/Subsidiary Relationship: All
entities maintain identity.
• Merger: A + B = A
One company acquires a second company
and the second company ceases to exist.
• Consolidation: A + B = C
Two companies form a third company and
the original two companies cease to exist.
• Parent & Subsidiaries: A + B = A + B
One company acquires the common stock
of a second company, and after the
transaction both companies continue to
exist.
Accounting Methods for
Business Combinations: “Purchase”
• The transaction is recorded at the fair
market value of the consideration given
by the acquiring company
• The net assets of the acquired company are
written up or down to fair market value
• Any excess of the value paid over the sum
of the fair market values of the net
assets acquired is recorded as goodwill
Accounting Methods for
Business Combinations: “Poolings”
• FASB eliminated ‘pooling’ for all
combinations after June 30, 2001
• Historically, many combinations were
recorded as pooling
– Net assets acquired recorded at their book value
– No goodwill was recognized
Goodwill
• Goodwill reported on a balance
sheet can only result from a business
combination accounted for as a purchase.
• Goodwill is tested annually for impairment
Goodwill Impairment Procedure
1) Compare fair value of the reporting unit to
the unit’s book value including goodwill
•
•
If FV > carrying amount, no impairment
If FV < carrying amount, proceed to second step
2) Compare GW’s bookvalue to its implied fair
value
•
If BV > Implied FV recognize
impairment equal to the excess
Consolidated Financial
Statements
Note: The use of the term consolidation in
the next slide is different than when used
to refer to the legal form of a type of
business combination (i.e., consolidation:
A + B = C)
Consolidated Financial Statements
• Companies that reflect a parent/subsidiary
relationship prepare consolidated financial
statements
• The financial statements of the parent company
are combined with those of the subsidiary
company(s) into one set of consolidated financial
statements
– Intercompany amounts are eliminated in the
consolidation process
End of Chapter 8