Intercorporate Investments and Consolidations

CHAPTER 
11
Learning Objectives
After studying this chapter, you should be able to
•	Explain why corporations invest in one another
•	Account for short-term investments in debt securities and equity securities
•	Report long-term investments in bonds
•	Contrast the equity and market methods of accounting for investments
•	Prepare consolidated financial statements
•	Incorporate minority interests into consolidated financial statements
Learning Objectives
After studying this chapter, you should be able to
•	Explain the economic meaning and financial reporting of goodwill
Overview of Corporate Investments
•	Companies invest in short- and long-term debt securities issued by governments, banks, or corporations
•	Companies also invest in corporate equities that may be classified as marketable securities
•	Corporations combine in order to 
–	Find the right combination of people and products to succeed in the long run
–	Create cost savings from eliminating duplications
Overview of Corporate Investments
•	Smaller companies tend to result in more successful mergers
•	Companies sometimes sell parts of themselves when they purchase another company
•	Spin-offs often separate dissimilar business segments to create opportunities for more creative and innovative growth

Overview of Corporate Investments
•	A short-term investment expected to be converted to cash should be carried as a current asset
•	Other investments are classified as noncurrent assets and usually appear as either:
•	A separate investment category between current assets and PP&E, or
•	A part of other assets below the plant assets category
Short-Term Investments
•	A short-term investment is a temporary investment in marketable securities that are expected to be converted to cash within one year
•	Marketable securities are notes, bonds, or stocks that can be easily sold
•	Short-term debt securities consist of notes and bonds with maturities of one year or less
–	Examples: CDs, commercial paper, and Treasury bills

Short-Term Investments
•	Short-term equity securities consist of capital stock in other corporations
•	Trading securities are short-term investments in debt and equity securities that the company intends to sell shortly
•	Held-to-maturity securities are debt securities that the company intends to hold until they mature
•	Available for sale securities are neither trading or held-to-maturity securities
Changes in Market Prices 
of Securities
•	Held-to-maturity securities
–	Recognize interest income on the income statement
–	Are valued at amortized cost, ignoring changes in market value
•	Trading securities
–	Recognize dividend and interest revenue on the income statement
–	Are valued at market value (market method), recognizing unrealized gains and losses on the income statement
Changes in Market Prices 
of Securities
•	Available for sale securities
–	Recognize dividend and interest revenue of the income statement
–	Are valued at market value (market method), recognizing unrealized gains and losses in a separate account in the stockholders’ equity section of the balance sheet (accumulated other comprehensive income)
Changes in Market Prices 
of Securities
•	The exhibit below illustrates the accounting for trading securities and available-for-sale securities:
Changes in Market Prices 
of Securities
•	The journal entries for periods 2, 3, and 4 would be:
Long-Term Investments in Bonds
•	Using the same data from Chapter 9, but now from the point of view of the investor:
–	10,000 $1,000 2-year 10% bonds (5% semi-annually) are purchased when the annual market interest rate is 12% (6% for each six-month period)
–	$965.35 is paid for each bond, for a total cost of $9,653,500
–	The issuer recognizes a discount of $346,500 ($10,000,000 - $9,653,500) at issuance
–	The investor must also amortized the discount over the 4 semi-annual periods using the interest method
Long-Term Investments in Bonds
•	The journal entries for the purchase and the first two interest payments are:
Long-Term Investments in Bonds
•	The discount makes up for the difference between the coupon rate of 10% and the market rate of 12%
•	Amortization of a discount increases the interest revenue for the investor
•	Amortization increases the investment account directly – a separate discount account is not used for the investor
Early Extinguishment of Investment
•	Suppose that the issuer buys back the bonds for $9.6 million on December, 2004, when the amortized cost is $9,816,666, the journal entry for the extinguishment by the investor is:
The Market and Equity Methods
•	The investor’s accounting depends on the level of influence of the investor over the investee
•	The equity method recognizes increases or decreases in the economic resources that the investor can influence
The Market and Equity Methods
•	Suppose Buyit Corporation invests $80 million in each of two companies:
–	Passiveco
•	Total market value of $800 million (10% ownership)
•	Earnings of $120 million
•	Dividends of $40 million
–	Influential
•	Total market value of $200 million (40% ownership)
•	Earnings of $30 million
•	Dividends of $10 million
The Market and Equity Methods
•	Buyit’s journal entries for (1) acquisition, (2) net income of the investee, and (3) dividends of the investee are (in millions):

•	Buyit recognizes income from 
–	Passiveco as dividends are received ($40M x 10%)
–	Influential as part of its earnings ($30M x 40%)
Consolidated Financial Statements
•	When a investor has control over an investee company (over 50% ownership), it must prepare consolidated financial statements
•	The investor company is called the parent
•	The investee company is called the subsidiary
•	Although both companies remain separate legal entities, the financial position and earnings reports of the parent are combined with those of the subsidiary
The Acquisition
•	Assume two separate companies:
–	Company P: Assets of $650 million
–	Company S: Assets of $400 million
•	P purchases all of the outstanding stock of S for $213 million in cash
•	The journal entry on the books of P (in millions) is:
The Acquisition
The Acquisition
•	The balance sheets of each company appear as follows before and after the purchase:
Preparing Consolidated Statements
Preparing Consolidated Statements
•	In combining the amounts on the balance sheet, P must eliminate its investment account and the stockholders’ equity of S, which eliminates double-counting of the investment in S
After Acquisition
•	P continues to use the equity method during the period
•	To prepare consolidated statements, P must eliminate:
–	Its investment account and the SE of the subsidiary on the consolidated balance sheet
–	Intercompany revenues and expenses on the income statement
–	Other intercompany transactions
Minority Interests
•	A parent company may own less than 100% of the outstanding stock (51% - 99%)
•	Claims by non-majority stockholders on assets and earnings  in the consolidated statements are called minority interests
•	Minority interest must be shown on both the consolidated income statement and consolidated balance sheet
Minority Interests
Purchase Price Not Equal 
to Book Value
•	When the acquiring company pays more than the book value of the acquired company’s net assets, consolidation requires a two-step adjustment:
•	All acquired assets and liabilities are shown at their fair market value (FMV)
•	If the purchase price > FMV of the net assets, goodwill must be shown on the consolidated balance sheet
•	Goodwill is the excess of the cost of an acquired company over the sum of the FMV of its identifiable assets less the liabilities
Accounting for Goodwill
•	In the previous example, assume that:
–	P acquired a 100% interest in S for $253 million rather than $213 million
–	A building with a book value of $20 million had a FMV of $35 million
•	The tabulation of the consolidated balance sheet including the calculation of goodwill is shown in the next exhibit
Accounting for Goodwill
Accounting for Goodwill
•	Impairment of goodwill occurs when it loses its value subsequent to acquisition
•	The consolidated company must record any impairment with a decrease to the goodwill account and a charge to an expense account

Goodwill and Abnormal Earnings
•	Goodwill is the price paid for “excess” or “abnormal” earning power
•	This abnormal earning power could be due to location, human resource, or reputation advantages
•	Normal earnings and excess earnings are capitalized by a multiple 
•	The multiple for excess earnings is lower since it is riskier
Goodwill and Abnormal Earnings
•	The following example assumes a multiple of 10 for normal earnings and 6 for abnormal earnings
Equity Affiliates, Minority Interest, 
and the Statement of Cash Flows
•	The statement of cash flows is affected for a company having equity affiliates (firms for which the investor uses the equity method) in the follow way:
–	Direct method: A cash dividend received from the affiliate appears in the operating section
–	Indirect method: Net income is increased (decreased) by the investor’s share of its affiliates’ earnings (loss) in the operating section
Summary of Accounting for 
Equity Securities