© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 1
Chapter 12
Intercorporate Investmentsand Consolidations
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 2
Learning ObjectivesAfter 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.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 3
Learning ObjectivesAfter studying this chapter, you should be able to: Incorporate minority interests into consolidated financial
statements. Explain the economic and reporting role of goodwill.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 4
An Overview ofCorporate Investments
Corporate managers should invest any idle funds on hand just as individuals invest any idle cash they have on hand.
Corporate investments can take many forms.• Many companies invest in short-term and long-term
debt securities of governments or companies.• Companies also invest in equity securities of other
companies.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 5
Corporate Marriage and Divorce Corporate mergers are very common, but not all
business combinations work.• Sometimes the assets of a company are sold off and
the business disappears.• Often the parent company sells off a business unit.• Another alternative is a spin-off, which occurs when
shares of a subsidiary are distributed to the shareholders of the parent company, and the spun-off company becomes a completely separate unit.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 6
Corporate Marriage and Divorce Once companies combine, accountants must
develop ways to report the financial results.
Once the company determines how the relationship will be measured, a question arises about where it will be reported on the balance sheet.• If it is a short-term investment, it should be classified
as a current asset.• If it is a long-term investment, it should be classified as
Investments or as Other Assets.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 7
Short-Term Investments Short-term investment - a temporary investment
of otherwise idle cash in marketable securities• Marketable securities - notes, bonds, or stocks that
can be easily sold• Short-term investments are expected to be converted
to cash within twelve months.• The key point on classification is that
conversion to cash is immediately available at the option of management.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 8
Short-Term Investments Short-term debt securities - largely notes and
bonds with maturities of one year or less; can be held to maturity or resold in securities markets• Certificates of deposit - short-term obligations of
banks that pay fixed interest• Commercial paper - short-term notes payable issued
by large corporations with top credit ratings• U.S. Treasury obligations - interest-bearing notes,
bonds, and bills issued by the U.S. government
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 9
Short-Term Investments Short-term equity securities - capital stock in
other corporations held with the intention to liquidate within one year as necessary• Short-term equity securities are held only for short-
term cash purposes; they are not held for reasons of controlling any other corporation through ownership of its capital stock.
• Short-term investments are recorded at acquisition cost.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 10
Short-Term Investments The way the investments are reported on the
balance sheet depends on the motives of the corporation as to why the corporation purchased the securities.• Short-term securities are classified
as trading securities, held-to-maturity securities, or available-for-sale securities.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 11
Short-Term Investments Trading securities - current investments in equity
or debt securities held for short-term profit• Trading securities are reported as current assets on the
balance sheet.• They are measured at market value (fair value).• Both debt and equity securities may be classified as
trading securities.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 12
Short-Term Investments Held-to-maturity securities - debt securities that
the investor plans to hold until maturity• These securities are shown on the balance sheet at
amortized cost rather than market value.• Held-to-maturity securities are classified as short- or
long-term according to the time remaining until they mature.
• Only debt securities may be classified as held-to-maturity securities because equity securities have no maturity date.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 13
Short-Term Investments Available-for-sale securities - investments in
equity or debt securities that are not held for active trading but may be sold before maturity• These securities are any securities
that are neither trading securities nor held-to-maturity securities.
• Both debt and equity securities may be classified as available-for-sale securities.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 14
Changes in Market Pricesof Securities
Accounting for returns on investments:• Interest revenue is the only return for held-to-maturity
securities, and it is shown in the income statement.• Returns on trading and available-for-sale securities
come in two forms.– Dividend or interest revenue, which are recorded in the
income statement
– Changes in market value, which is handled differently for each classification of security
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 15
Changes in Market Pricesof Securities
Changes in market values for trading securities:• As market values change, companies report the
resulting gains and losses in the income statement.
Changes in market values for available-for-sale securities:• As market values change, the gains and losses are
accounted for as unrealized gains and losses in a separate valuation allowance account in the stockholders’ equity section of the balance sheet rather than in the income statement.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 16
Changes in Market Pricesof Securities
This method of accounting for trading and available-for-sale securities is called the market method.• The reported values in the balance sheet are the
market values.• It is possible for two companies to have investments
in the same company but account for the gains and losses from those investments in different ways, depending on whether the investments are classified as trading or available-for-sale.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 17
Comprehensive Income When investments are treated as available-for-
sale securities, the changes in economic value are not fully revealed in the income statement because the changes are shown only on the balance sheet.
To show the effect of these differences, comprehensive income is reported along with net income.• Comprehensive income includes both net income and
changes in the value of available-for-sale securities.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 18
Long-Term Investments in Bonds Recall that the issuer of bonds must amortize
bond discounts and premiums as periodic adjustments of interest expense.
Firms that invest in these bonds use a similar method of amortization, but most do not use a separate account for unamortized premiums or discounts.• They reduce or increase the investment account
directly.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 19
Bonds-Held-to-Maturity If bonds are issued to yield a higher interest rate
than the coupon rate, they are sold at a discount.• Investors pay less than the face amount of the bonds.• Interest takes two forms:
– Annual or semiannual cash payments
– A lump sum payment at maturity equal to the amount of the discount
• The investor must also amortize the lump sum discount over the life of the bonds just as the issuer does.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 20
Bonds-Held-to-Maturity The discount is used to make up the difference
between the coupon interest rate and the market interest rate.• Amortization of the discount increases the interest
revenue of the investor, just as the amortization increases the interest expense of the issuer.
Note that accounting for a premium is similar except that the amortization of a premium decreases interest revenue of investors and interest expense of the issuer.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 21
Early Extinguishmentof Investment
For the issuer to extinguish the bonds early, the bonds must grant the issuer the right to do so or the bondholders must choose to sell the bonds back to the issuer.
The gain or loss on the extinguishment is calculated as the difference between the carrying amount of the investment (face amount plus any unamortized premium or less any unamortized discount) and the cash received from the bonds.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 22
The Market and Equity Methods for Intercorporate Investments
The investor’s accounting for intercorporate investments depends on the amount of influence the investor can exercise over the investee.• For ownership of less than 20% of the investee, the
investor has no influence over the investee, and the investor accounts for the investment using the market method described earlier.
• For ownership of 20% or more of the investee, the investor may be able to exert significant influence over the investee, and the investor must use the equity method.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 23
The Market and Equity Methods for Intercorporate Investments
Equity method - records the investment at acquisition cost and adjusts the investment for the investor’s share of dividends and earnings or losses of the investee subsequent to the date of investment• The book value at which the investment is carried is
increased by the investor’s share of the investee’s earnings and reduced by dividends received from the investee and the investor’s share of the investee’s losses.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 24
The Market and Equity Methods for Intercorporate Investments
Larks Company pays $150,000 for an investment in Dusty Corporation. Dusty Corporation has net income of $200,000 for the year and pays dividends of $50,000 in total for the year. How will these transactions be recorded if Larks purchases 5% of the stock of Dusty? How will the transactions be recorded if Larks purchases 25% of Dusty?
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 25
The Market and Equity Methods for Intercorporate Investments
If Larks purchases 5% of Dusty, no significant influence exists. The investment is recorded using the market method as follows:
To record the purchase of the investment:Investment in Dusty Co. 150,000
Cash 150,000
To record the income of Dusty Co.:No entry required
To record the receipt of the dividend:Cash 7,500
Dividend income ($50,000 x 5%) 7,500
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 26
The Market and Equity Methods for Intercorporate Investments
If Larks purchases 25% of Dusty, significant influence does exist. The investment is recorded using the equity method as follows:
To record the investment:Investment in Rusty Co. 150,000 Cash 150,000
To record the income of Rusty Co.:Investment in Rusty Co. 50,000 Investment income ($200,000 x 25%) 50,000
To record the receipt of dividends:Cash 12,500 Investment in Rusty Co. ($50,000 x 25%) 12,500
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 27
The Market and Equity Methods for Intercorporate Investments
The equity method does a better job of recognizing increases or decreases in the economic resources that the investor can influence.• The reported net income of the investor company is
increased by its share of net income or decreased by its share of losses recognized by the investee.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 28
Consolidated Financial Statements When one company buys a majority (over 50%) of
another company, a parent-subsidiary relationship exists.• Parent company - a company owning more than 50%
of the voting shares of another company• Subsidiary company - a company owned and
controlled by a parent company through the ownership of more than 50% of the voting stock
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 29
Consolidated Financial Statements When a parent-subsidiary relationship exists,
each company remains a separate legal entity.• Each company must be accounted for separately and
has its own set of financial statements.• These financial statements are then consolidated.• Consolidated financial statements - combinations of
the financial positions and earnings reports of the parent company with those of various subsidiaries into an overall report as a single entity
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 30
The Acquisition From the parent’s perspective the purchase is
simply an exchange of one asset for another, usually cash for the stock of the subsidiary.• Total assets are unaffected. Cash decreases, but the
investment in the subsidiary increases by the same amount.
From the subsidiary’s perspective, nothing changes on the books. However, the subsidiary now has one major owner - the parent.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 31
The AcquisitionBefore the purchase
PCorporation
PCorporation
SCorporation
SCorporation
SShareholders
SShareholders
PShareholders
Own Own
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 32
The AcquisitionPurchase
PCorporation
PCorporation
SShareholders
SShareholders
Cash
Shares of S After the Purchase
PShareholders
PShareholders
S CorporationS Corporation
P CorporationP CorporationOwn
and
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 33
The Acquisition No books are kept for the consolidated entity.
• Only working papers are used to prepare the consolidated financial statements.
To prepare the consolidated financial statements, the financial statement values of the parent and all the subsidiaries are added together.• Remember not to count the ownership interest of the
parent twice - once as an investment in the parent’s books and once in stockholders’ equity in the subsidiary’s books.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 34
The AcquisitionPreparing Consolidated Statements
Parent CompanyFinancial Statements
Parent CompanyFinancial Statements
SubsidiaryFinancial Statements
SubsidiaryFinancial Statements
Parent CompanyRecords
Combine Parent and SubsidiaryFinancial Statements on a Work Sheet
Eliminate Double CountingParent’s Investment Against Subsidiary OE
Intercompany Receivables and PayablesIntercompany Sales and Purchases
ConsolidatedFinancial Statements
ConsolidatedFinancial Statements
SubsidiaryRecords
SubsidiaryRecords
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 35
After Acquisition After the acquisition, the parent accounts for the
investment just as it would using the equity method (20-50% ownership) for an unconsolidated ownership interest.• The parent’s share of the subsidiary’s income is
included in the parent’s income statement.• The subsidiary’s net income must therefore be
eliminated from the consolidated financial statements so it is not counted twice.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 36
Intercompany Eliminations In many cases, a parent company and its
subsidiaries transact business with each other. • Nothing really happens economically - money is
shifted “from one pocket to another.”• The transactions must be eliminated so that they are
not counted twice in the consolidated statements.• Any elimination journal entries are made only on the
consolidation work sheet; they are not made on the books of either company.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 37
Minority Interests Often, a parent company owns less than 100% of
a subsidiary company. • Minority interest - the rights of nonmajority
shareholders in the assets and earnings of a company that is consolidated into the accounts of the major shareholder
• In the consolidation, all of the subsidiary’s income is included.
• The share due to minority shareholders is then subtracted.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 38
Minority InterestsBefore the purchase
PCorporation
PCorporation
SCorporation
SCorporation
SShareholders
SShareholders
PShareholders
Own Own
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 39
Minority Interests 90% Purchase
PCorporation
PCorporation
SShareholders
SShareholders
Cash
90% of Shares of SAfter the Purchase
PShareholders
PShareholders
S CorporationS Corporation
P CorporationP CorporationOwn
and Some OldS ShareholdersHold 10% of S
Some OldS ShareholdersHold 10% of S
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 40
Defining Control GAAP specifies three methods for accounting for
intercorporate investments.• Less than 20% - use the market method• More than 50% - use consolidation• Between 20% and 50% - use the equity method
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 41
Defining Control Whether to use one method or the other may
depend on the investor’s ability to exert significant influence over the investee.• In that case, the percentage tests are not hard and fast
rules.• Exerting significant influence includes the percentage
of ownership and other factors such as:– Representation on the board of directors
– Participating in policy making processes
– Concentration of ownership
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 42
Purchased Goodwill Goodwill - the excess of the cost of an acquired
company over the sum of the fair market value of its identifiable individual assets less the liabilities• Goodwill often results from such factors as:
– Brand recognition
– Reputation
– Market share
– Earnings potential
– Location
– Customer list or base
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 43
Goodwill and Abnormal Earnings The final price that a company will pay for
another is the culmination of a bargaining process.• The exact amount of goodwill is subject to the
negotiating process concerning the final purchase price.
• Goodwill is essentially the price paid for “excess” or “abnormal” earning power.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 44
Amortization of Goodwill Goodwill does not have a perpetual life, but it
may be maintained by continuous efforts.
GAAP requires that goodwill be amortized and charged as an expense against net income for a period not to exceed 40 years.• Many companies use a much shorter amortization
period.• Most companies use straight-line amortization.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 45
Perspective on Consolidated Statements
The FASB requires that all subsidiary companies must be consolidated regardless of their line of business or the parent’s line of business.
However, there are exceptions to this rule, but they are rare.• For example, a subsidiary is not consolidated if
control is likely to be temporary or if that control does not rest with the majority owner.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 46
Equity Affiliates, Minority Interest, and the Statement of Cash
Flows If a company has equity affiliates (firms in which
the company is an equity method investor) and uses the direct method of preparing the statement of cash flows, no special problems arise.• Only cash received from the affiliate as a dividend
appears in the operating activities section.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 47
Equity Affiliates, Minority Interest, and the Statement of Cash
Flows If a company has equity affiliates and uses the
indirect method of preparing the statement of cash flows, problems may arise.• Net earnings is increased by the investor’s share of
the affiliate’s earnings or decreased by the investor’s share of the affiliate’s losses.
• Net income must be adjusted for the affiliate’s shares in order to calculate cash flow from operating activities of only that one company.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 48
Purchased Research and Development
The basic rule in an acquisition is that the books of the acquired company are included in the books of the acquiring company at their fair market values.
Research and development (R & D) creates a special problem.• When a company acquires another, one asset acquired
is R & D in process, but R & D must be expensed when incurred; therefore, the acquiring company must immediately expense the amount paid for the R & D.
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 49
Summary of Accountingfor Equity Securities
Percentage ofOwnership
Type ofAccounting
Balance SheetEffects
Income StatementEffects
Major Journal Entries
100% Consolidation Assets and liabilitiesadded together;goodwill is shown
Revenues andexpenses addedtogether; goodwillamortized
None, except in worksheets to eliminateintercompany accountsand transactions
More than 50%and less than100%
Consolidation Same as above, butrecognition givento minorityinterests
Same as above, butrecognition givento minorityinterests
Same as above, butrecognition given tominority interests
20% up to andincluding50%
Equity method Investment carried atcost plus share ofearnings lessdividends received
Equity in earnings ofaffiliates shownand included in netincome
Entries to record earningsand dividends
Below 20% Market method Investment carried atmarket value
Trading - changesaffect net income.
Available-for-sale -changes shown inequity section.
Entries to recordappreciation ordepreciation in value
© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
12 - 50
Introduction to Financial Accounting
8th EditionPowerPoint Presentation
Developed by:
Eddie Metrejean, MTAX, CPAUniversity of Mississippi
Images provided by New Vision Technology1-800-387-0732
nvtech.com