Business & Finance Case Study: AT&T Business Acquisitions Assignment
Intercorporate Investments
Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 17
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Learning Objectives After studying this chapter, you will understand: 1
How to account for investments in debt securities.
How an investor’s degree of influence over an investee company determines the accounting treatment of equity investments and why.
How fair value accounting is applied to equity securities.
How to apply the equity method and the fair value option.
What consolidated financial statements are, how they are prepared under the acquisition method, and how noncontrolling interests are measured and reported.
How goodwill arises and when it is considered impaired and written down.
How business combinations were previously accounted for under the purchase and pooling of interests methods and how the method used to record an acquisition in the past affects financial analysis, even today.
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Learning Objectives After studying this chapter, you will understand: 2
What variable interest entities (VIEs) are and when they must be consolidated.
The major differences between IFRS and U.S. GAAP related to accounting for financial assets, consolidations, special purpose entities (SPEs) or VIEs, and joint ventures.
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Accounting for Investments in Debt Securities
Investments in debt securities are classified as held-to-maturity, trading securities, or available-for-sale securities.
Held-to-maturity securities are those that the firm has both the intent and the ability to hold until the maturity date.
Trading securities are investments that are part of an actively managed investment portfolio designed to achieve trading gains.
Available-for-sale securities are investments that do not qualify for either of the above.
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Accounting for Held-to-Maturity Securities 1
Debt securities (e.g., bonds and notes) that a firm intends to hold to maturity are generally accounted for at amortized cost.
The investment account is adjusted for the amortization of premium or discount in each period.
Interest income is recognized following the effective interest method.
No adjustment is made for a change in the fair value of debt securities in the held-to-maturity portfolio.
Principal Financial purchases a five-year $100,000 bond from Baker Company with a 7% coupon interest rate for $108,659 on January 1, 20X1. The effective yield on this bond investment is 5%, meaning the discount rate that equates the $108,659 purchase price with the present value of the promised cash flows is 5%. The bond matures on December 31, 20X5, and a $7,000 coupon payment is due at the end of each year.
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Accounting for Held-to-Maturity Securities 2
| Year-End | Interest Income | Premium Amortization | Amortized Cost | Fair Value |
| Jan. 1 | – | – | $108,659 | $108,659 |
| 20X1 | $ 5,433 | $ (1,567) | 107,092 | 107,500 |
| 20X2 | 5,355 | (1,645) | 105,447 | 105,000 |
| 20X3 | 5,272 | (1,728) | 103,719 | 103,000 |
| 20X4 | 5,186 | (1,814) | 101,905 | 102,000 |
| 20X5 | 5,095 | (1,905) | 100,000* | 100,000 |
*Before payment of principal on December 31, 20X5.
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Accounting for Held-to-Maturity Securities 3
| Year-End | Interest Income | Premium Amortization | Amortized Cost | Fair Value |
| Jan. 1 | – | – | $108,659 | $108,659 |
| 20X1 | $ 5,433 | $ (1,567) | 107,092 | 107,500 |
| 20X2 | 5,355 | (1,645) | 105,447 | 105,000 |
| 20X3 | 5,272 | (1,728) | 103,719 | 103,000 |
| 20X4 | 5,186 | (1,814) | 101,905 | 102,000 |
| 20X5 | 5,095 | (1,905) | 100,000* | 100,000 |
*Before payment of principal on December 31, 20X5.
Entry on January 1, 20X1, to record the acquisition of the bond:
| DR Investment in bonds | $108,659 | |
| CR Cash | $108,659 |
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Accounting for Held-to-Maturity Securities 4
Entry on December 31, 20X1, to record interest income and amortization of the bond premium:
| DR Cash | $7,000* | |
| CR Interest Income | $5,433† | |
| CR Investment in Bonds | 1,567‡ |
*$100,000 × 7%
†$108,659 × 5%
‡$7,000 − $5,433
Firms may elect to account for held-to-maturity investments using use fair value accounting.
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Available-for-Sale Securities 1
Available-for-Sale Securities
Investments in debt securities classified as available for sale are presented in the balance sheet at fair value, requiring an adjustment at each balance sheet date.
The investor applies the effective interest method just as it would for a held-to-maturity investment, and adjusts the amortized cost at each balance sheet date to the fair value.
The fair value adjustment is reported as part of other comprehensive income.
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Available-for-Sale Securities 2
Suppose Principal Financial had classified its investment as available for sale. At December 31, 20X1, the bonds had an amortized cost of $107,092, but a fair value of $107,500. The following entry would be made:
| DR Fair value adjustment—available-for-sale securities | $408 | |
| CR OCI—unrealized gain or loss in fair value of available-for-sale securities | $408 |
If an available for sale security is sold, the full holding period gain or loss is recognized in the income statement and the balance in AOCI is “recycled.”
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Trading Securities
Trading Securities
The accounting for trading securities is similar to available-for-sale securities, except that the fair value adjustments are recognized in net income rather than in OCI.
Suppose Principal Financial had classified its investment as trading:
20X1:
| DR Cash | $ 7,000 | |
| CR Interest income | $ 5,433 | |
| CR Investment in bonds | 1,567 | |
| DR Fair value adjustment—trading securities | $ 408 | |
| CR Gain on trading securities | $ 408 |
The gain is recognized in net income for trading securities.
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Recording Credit Losses
Effective for fiscal years beginning after December 15, 2019, SEC registrants are subject to the Current Expected Credit Loss (CECL) rules for investments in debt securities.
Firms must accrue a loss currently when there is the expectation that not all of the promised principal or interest payments will be received.
The amount of the loss accrued is generally the difference between the present value of the expected cash flows and the amortized cost of the investment.
The rules are generally not applicable to trading securities, which are already reported at fair value with unrealized gains and losses reported in net income.
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Soon-to-Be Superseded Guidance: Other-Than-Temporary Impairments
Until firms adopt the CECL rules, they might incur an other-than-temporary impairment.
For available-for-sale debt securities:
If a firm intends or it is likely that the firm will be required to sell the security, the entire amount of impairment is recognized in earnings.
If a firm does not intend to sell the security and it is unlikely that the firm will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, then the other-than-temporary impairment is separated into the amounts:
Representing the credit loss, which is recognized in earnings.
Related to all other factors, which is recognized in other comprehensive earnings.
For held-to-maturity securities, the analysis is simpler:
If the fair value of the security is less than amortized cost and the firm does not expect to recover the entire amortized cost basis, OTTI is recognized.
The OTTI is split between credit loss recognized in net income and losses related to other factors recognized in OCI.
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Types of Equity Investments
Under GAAP, the method of accounting for equity investments depends on the degree to which the investor company is able to influence the operating decisions of the investee.
EXHIBIT 17.1 Financial Reporting Alternatives for Intercorporate Equity Investments
| Type of Investment: | Minority Passive | Minority Active | Controlling |
| Level of influence: | No substantial influence | Substantial influence | Effective control |
| Level of ownership: | Less than 20%* | 20%–50%* | More than 50% |
| Accounting: | Fair value measurement with unrealized gains and losses reported in income statement | Equity method | Full consolidation |
| Fair value option permitted | Transactions completed 2009 or later: Acquisition Method | ||
| Transactions completed July 1, 2001 through 2008: Purchase Method | |||
| Transactions completed prior to July 1, 2001: Purchase Method or Pooling of Interests† |
* Presumptive ownership level. May be rebutted by evidence indicating level of influence is substantial even though ownership is below 20% or that level of influence is not substantial even though ownership exceeds 20%.
†For qualifying transactions completed through an exchange of shares.
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Minority Passive Investments: Fair Value Accounting 1
In general, all minority passive equity investments are accounted for at fair value, with changes in fair value accounted for in net income.
One exception is for investments where fair value is not readily determinable.
For those securities, firms may opt to report at fair value or to report at cost, adjusted for changes in observable prices minus impairment.
Example:
Principal Financial purchased two securities in 20X1 and two in 20X2.
It sold its Company B preferred stock in 20X4.
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Minority Passive Investments: Fair Value Accounting 2
Purchases and Sales of Minority-Passive Investments by Principal Financial Corporation
Fair Value at December 31,
| Security | Acquisition Cost | Date Acquired | Date Sold | 20X1 | 20X2 | 20X3 | 20X4 |
| Company A Common Stock | $ 10,000 | 1/1/X1 | $11,000 | $ 13,000 | $ 14,000 | $12,000 | |
| Company B Preferred Stock | 20,000 | 1/1/X1 | 2/1/X4 | 18,000 | 17,000 | 18,000 | * |
| Company C Common Stock | 30,000 | 7/1/X2 | 26,000 | 33,000 | 34,000 | ||
| Company D Common Stock | 40,000 | 7/1/X2 | – | 41,000 | 37,000 | 30,000 | |
| Fair value of portfolio at December 31 | $29,000 | $ 97,000 | $102,000 | $76,000 | |||
| Cost of portfolio at December 31 | $30,000 | $100,000 | $100,000 | $80,000 | |||
| Fair value adjustment at December 31 | $(1,000) | $ (3,000) | $ 2,000 | $(4,000) |
*Company B preferred stock was sold on February 1, 20X4, for $18,500.
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Minority Passive Investments: Fair Value Accounting 3
Purchases and Sales of Minority-Passive Investments by Principal Financial Corporation
Fair Value at December 31,
| Security | Acquisition Cost | Date Acquired | Date Sold | 20X1 | 20X2 | 20X3 | 20X4 |
| Company A Common Stock | $ 10,000 | 1/1/X1 | $11,000 | $ 13,000 | $ 14,000 | $12,000 | |
| Company B Preferred Stock | 20,000 | 1/1/X1 | 2/1/X4 | 18,000 | 17,000 | 18,000 | * |
| Company C Common Stock | 30,000 | 7/1/X2 | 26,000 | 33,000 | 34,000 | ||
| Company D Common Stock | 40,000 | 7/1/X2 | – | 41,000 | 37,000 | 30,000 | |
| Fair value of portfolio at December 31 | $29,000 | $ 97,000 | $102,000 | $76,000 | |||
| Cost of portfolio at December 31 | $30,000 | $100,000 | $100,000 | $80,000 | |||
| Fair value adjustment at December 31 | $(1,000) | $ (3,000) | $ 2,000 | $ (4,000) |
*Company B preferred stock was sold on February 1, 20X4, for $18,500.
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Minority Passive Investments: Fair Value Accounting 4
To record the purchase of shares on January 1, 20X1:
| DR Investment in Company A common | $ 10,000 | |
| DR Investment in Company B preferred | 20,000 | |
| CR Cash | $ 30,000 |
The total fair value of all minority-passive investments is compared to the total cost of the securities. The fair value is $1,000 less than the cost so a fair value adjustment is required:
| DR Unrealized holding loss on minority-passive investments (income statement) | $ 1,000 | |
| CR Fair value adjustment—minority-passive investments | $ 1,000 |
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Minority Passive Investments: Fair Value Accounting 5
Purchases and Sales of Minority-Passive Investments by Principal Financial Corporation
Fair Value at December 31,
| Security | Acquisition Cost | Date Acquired | Date Sold | 20X1 | 20X2 | 20X3 | 20X4 |
| Company A Common Stock | $ 10,000 | 1/1/X1 | $11,000 | $ 13,000 | $ 14,000 | $12,000 | |
| Company B Preferred Stock | 20,000 | 1/1/X1 | 2/1/X4 | 18,000 | 17,000 | 18,000 | * |
| Company C Common Stock | 30,000 | 7/1/X2 | 26,000 | 33,000 | 34,000 | ||
| Company D Common Stock | 40,000 | 7/1/X2 | – | 41,000 | 37,000 | 30,000 | |
| Fair value of portfolio at December 31 | $29,000 | $ 97,000 | $102,000 | $76,000 | |||
| Cost of portfolio at December 31 | $30,000 | $100,000 | $100,000 | $80,000 | |||
| Fair value adjustment at December 31 | $ (1,000) | $ (3,000) | $ 2,000 | $ (4,000) |
*Company B preferred stock was sold on February 1, 20X4, for $18,500.
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Minority Passive Investments: Fair Value Accounting 6
To record the purchase of shares on July 1, 20X2:
| DR Investment in Company C common | $ 30,000 | |
| DR Investment in Company D common | 40,000 | |
| CR Cash | $ 70,000 |
At year-end 20X2, the portfolio’s value is $97,000 versus a $100,000 cost, so a $3,000 credit is the required balance in the fair value adjustment account. It currently has a $1,000 credit so the following is required:
| DR Unrealized holding loss on minority-passive investments (income statement) | $ 2,000 | |
| CR Fair value adjustment—minority-passive investments | $ 2,000 |
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Minority Passive Investments: Fair Value Accounting 7
Purchases and Sales of Minority-Passive Investments by Principal Financial Corporation
Fair Value at December 31,
| Security | Acquisition Cost | Date Acquired | Date Sold | 20X1 | 20X2 | 20X3 | 20X4 |
| Company A Common Stock | $ 10,000 | 1/1/X1 | $11,000 | $ 13,000 | $ 14,000 | $12,000 | |
| Company B Preferred Stock | 20,000 | 1/1/X1 | 2/1/X4 | 18,000 | 17,000 | 18,000 | * |
| Company C Common Stock | 30,000 | 7/1/X2 | 26,000 | 33,000 | 34,000 | ||
| Company D Common Stock | 40,000 | 7/1/X2 | – | 41,000 | 37,000 | 30,000 | |
| Fair value of portfolio at December 31 | $29,000 | $ 97,000 | $102,000 | $76,000 | |||
| Cost of portfolio at December 31 | $30,000 | $100,000 | $100,000 | $80,000 | |||
| Fair value adjustment at December 31 | $ (1,000) | $ (3,000) | $ 2,000 | $ (4,000) |
*Company B preferred stock was sold on February 1, 20X4, for $18,500.
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Minority Passive Investments: Fair Value Accounting 8
When minority passive investments are sold, a realized gain or loss is recorded.
Computation of Realized Gain or Loss
| Selling price of Company B preferred stock | $ 18,500 |
| Fair value at 12/31/X3 balance sheet date | (18,000) |
| Realized gain | $ 500 |
Entry to Record the Sale of Company B Common Stock
| DR Cash | $ 18,500 | |
| DR Fair value adjustment—minority-passive investments | 2,000* | |
| CR Realized gain on sale of minority-passive investments | $ 500 | |
| CR Investment in Company B preferred | 20,000 |
*$20,000 cost − $18,000 fair value at 12/31/20X3 = $2,000.
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Minority Passive Investments: Income Tax Effects
Fair value adjustments have income tax consequences but, because under income tax law gains and losses are not recognized until a security is sold, the tax effects are deferred.
Principal recorded a $1000 loss in 20X1. That loss reduced the company’s pre-tax income but had no effect on 20X1 taxable income, resulting in a temporary difference.
Assume a 21% marginal tax rate:
| DR Deferred tax asset/liability………………………….. | $ 210 | |
| CR Income tax expense—deferred……………….. | $210 |
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Minority Active Investments 1
EXHIBIT 17.1 Financial Reporting Alternatives for Intercorporate Equity Investments
| Type of Investment: | Minority Passive | Minority Active | Controlling |
| Level of influence: | No substantial influence | Substantial influence | Effective control |
| Level of ownership: | Less than 20%* | 20%–50%* | More than 50% |
| Accounting: | Fair value measurement with unrealized gains and losses reported in income statement | Equity method | Full consolidation |
| Fair value option permitted | Transactions completed 2009 or later: Acquisition Method | ||
| Transactions completed July 1, 2001 through 2008: Purchase Method | |||
| Transactions completed prior to July 1, 2001: Purchase Method or Pooling of Interests† |
* Presumptive ownership level. May be rebutted by evidence indicating level of influence is substantial even though ownership is below 20% or that level of influence is not substantial even though ownership exceeds 20%.
†For qualifying transactions completed through an exchange of shares.
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Minority Active Investments 2
When an investor has the ability to exert significant influence over an investee’s decisions, the investor has an active investment.
Unless there is evidence that the investor is unable to influence the investee, there is a presumption that an investor holding 20% to 50% is able to exert significant influence over the investee.
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Minority Active Investments: Equity Method 1
Minority active investments are accounted for using the equity method.
The investor records its initial investment in the investee at cost.
Subsequently, the Investment account is increased for the investor’s pro rata share of the investee’s net income, and there is a corresponding credit to the Investment income account.
In the case of a loss, the investor’s Investment account decreases and there’s a corresponding debit to the Investment loss account.
Dividends from the investee reduce the Investment account.
The net increase in the investment account is the amount by which the investor’s share of the investee’s earnings exceed its share of the investee’s dividends declared.
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Minority Active Investments: Equity Method 2
EXAMPLE
On January 1, 20X1, Willis Company purchases 30% of the outstanding common shares of Planet Burbank Inc. for $9 million. The book value and fair value of Planet Burbank’s net assets (assets minus liabilities) is $30 million. Thus, Willis pays book value for its investment in Planet Burbank (30% × $30 million = $9 million). During 20X1, Planet Burbank earns a $10 million net profit and declares a $500,000 dividend on December 15, 20X1. Under the equity method, Willis makes these entries:
January 1, 20X1: Initial Investment in Planet Burbank
| DR Investment in Planet Burbank | $9,000,000 | |
| CR Cash | $9,000,000 | |
| To record investment at cost. |
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Minority Active Investments: Equity Method 3
Planet Burbank’s dividend declaration and subsequent payment, has no effect on Willis’s income.
December 15, 20X1: Investor’s Share of Dividends Declared
| DR Dividend receivable from affiliate | $150,000 | |
| CR Investment in Planet Burbank | $150,000 | |
| To reduce the investment account for dividends declared—30% of $500,000. |
December 31, 20X1: Investor’s Share of Earnings
| DR Investment in Planet Burbank | $3,000,000 | |
| CR Income from affiliate | $3,000,000 | |
| To recognize 30% of Planet Burbank’s reported net income of $10,000,000. |
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Minority Active Investments: Equity Method 4
The carrying value in the investment account at the end of the year would be:
| Initial investment amount | $ 9,000,000 |
| Plus: Willis’s cumulative pro rata share of Planet Burbank’s net income | 3,000,000 |
| Minus: Willis’s cumulative pro rata share of dividends declared by Planet Burbank | (150,000) |
| Investment account carrying value | $11,850,000 |
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When Cost and Book Value Differ
Investors rarely buy shares at a price exactly equal to the book value of those shares. Why?
The investee’s books are prepared under GAAP, and reflect most balance sheet items at historical cost rather than at current value. Sellers of the investee’s stock presumable know what the net assets of the investee are worth.
An informed buyer would knowingly pay a premium to acquire an investment in another company.
Goodwill exists because thriving, successful companies are generally worth more than the sum of their individual net assets.
When the cost of the shares acquired exceeds the underlying book value at the acquisition date, the investor is required to amortize any excess that is attributable to separately identifiable assets and liabilities not having an indefinite life.
Amortization is recorded as a reduction (debit) to Investment income and a reduction (credit) to the Investment account.
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Illustration of Equity Investment with Goodwill 1
On January 1, 20X1, Willis Company purchases 30% of the outstanding common shares of Planet Burbank Inc. for $9 million. The book value and fair value of Planet Burbank’s net assets (assets minus liabilities) is $30 million. Initially, we assumed that Willis pays book value for its investment in Planet Burbank (30% × $30 million = $9 million). Now, we assume Willis paid $24 million for its 30% stake, which is $15 million more than the related book value of $9 million).
EXHIBIT 17.2 Willis Company: Equity Investment with Goodwill
Panel (a)
| ($ in millions) | Book Value | Fair Value | Difference | Investor’s Share (30%) |
| Cash and receivables | $ 10 | $ 10 | $ 0 | $ 0 |
| Inventories (FIFO cost flow) | 15 | 25 | 10 | 3 |
| Depreciable assets (net of depreciation)* | 25 | 55 | 30 | 9 |
| Liabilities | (20) | (20) | 0 | 0 |
| Net assets | $ 30 | $ 70 | $40 | $12 |
*Average remaining useful life of 10 years.
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Illustration of Equity Investment with Goodwill 2
Panel (b)
| ($ in millions) | |
| Analysis of Willis’s investment cost over book value | $24 |
| Cost of 30% investment | 9 |
| 30% of book value of Planet Burbank’s net assets (30% × $30) | $15 |
| Excess of cost over book value of Willis’s shares | |
| Amount of excess attributable to | $ 3 |
| Inventories—30% × ($25 − $15) | 9 |
| Depreciable assets—30% × ($55 − $25) | 3 |
| Goodwill | $15 |
The difference between fair value and book value of inventories and fixed assets explains only $12 million of the disparity, leaving $3 million unexplained.
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Illustration of Equity Investment with Goodwill 3
On January 1, 20X1, Willis Company purchases 30% of the outstanding common shares of Planet Burbank Inc. for $9 million. The book value and fair value of Planet Burbank’s net assets (assets minus liabilities) is $30 million. Initially, we assumed that Willis pays book value for its investment in Planet Burbank (30% × $30 million = $9 million). Now, we assume Willis paid $24 million for its 30% stake, which is $15 million more than the related book value of $9 million).
The cost of the shares acquired exceeds the underlying book value at the acquisition date.
The investor is required to amortize any excess that is attributable to separately identifiable assets and liabilities not having an indefinite life.
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Illustration of Equity Investment with Goodwill 4
January 1, 20X1: Initial Investment in Planet Burbank
| DR Investment in Planet Burbank | $24,000,000 | |
| CR Cash | $24,000,000 | |
| To record investment at cost. |
December 15, 20X1: Investor’s Share of Dividends Declared
| DR Dividend receivable from Planet Burbank | $ 150,000 | |
| CR Investment in Planet Burbank | $ 150,000 | |
| To reduce the investment account for dividends declared—30% of $500,000. |
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Illustration of Equity Investment with Goodwill 5
December 31, 20X1: Investor’s Share of Earnings
| DR Investment in Planet Burbank | $ 3,000,000 | |
| CR Income from affiliate | $ 3,000,000 | |
| To recognize 30% of Planet Burbank’s reported net income of $10 million. |
December 31, 20X1: Amortization of Excess Cost over Book Value Attributable to Inventory and Depreciable Assets
| DR Income from affiliate | $ 3,900,000 | |
| CR Investment in Planet Burbank | $ 3,900,000 | |
| To amortize excess cost per calculation below. |
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Illustration of Equity Investment with Goodwill 6
| Excess Investment Cost | 20X1 Amortization | |
| Amortization is computed as | ||
| Attributed to inventory (all sold during the year) | $ 3,000,000 | $3,000,000 |
| Attributed to depreciable assets (over 10 years) | 9,000,000 | 900,000 |
| Attributed to goodwill (not amortized) | 3,000,000 | — |
| $15,000,000 | $3,900,000 |
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Fair Value Option for Equity Method Investments
Firms may elect the fair value option for investments that would otherwise be accounted for under the equity method; this election is irrevocable.
A firm is allowed to elect the fair value option on an election date, which is when one of the following events occurs:
The firm first acquires an investment that is eligible for equity method treatment.
The investment becomes subject to the equity method of accounting.
The investor ceases to consolidate a subsidiary.
Unrealized gains and losses from changes in fair value are reported in the investor’s income statement
The investor firm does not report its proportionate share of the investee profits and losses in earnings. Dividends received flow directly to earnings.
Assets and liabilities measured at fair value must be reported on the balance sheet separately from investments not reported at fair value
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Controlling (Majority) Interest: Acquisition Method and Consolidation
An entity that gains a controlling financial interest in another entity is referred to as the parent company.
Controlling financial interest is generally deemed to occur when one entity, directly or indirectly, owns more than 50 percent of the outstanding voting shares of another entity, called a subsidiary.
The financial statements of the subsidiary are combined—line by line—with those of the parent using a process called consolidation.
Consolidated financial statements portray the economic activities of the parent and the subsidiary as if they were one entity.
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Acquisition Method and Preparation of Consolidated Statements (100% Acquisition)
Alphonse Corporation paid $10 million cash to buy all of the outstanding shares of Gaston Corporation.
The balance sheet of Alphonse Corporation immediately before the acquisition:
Assets
| Current assets | $15,000,000 |
| Fixed assets, net of accumulated depreciation | 20,000,000 |
| Total assets | $35,000,000 |
Liabilities and Stockholders’ Equity
| Current liabilities | $ 1,000,000 |
| Common stock ($1 par) | 28,000,000 |
| Capital in excess of par | 2,000,000 |
| Retained earnings | 4,000,000 |
| Total liabilities and equity | $35,000,000 |
After the transaction is recorded, Alphonse’s current assets will be $10 million lower due to the payment of cash, and an investment account of $10 million will exist.
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Adjustments for Consolidating the Balance Sheet
EXHIBIT 17.3 Alphonse Company and Gaston Company: Acquisition Method—100% Ownership
Step 1 [entry (A)] Eliminate the Investment in Gaston account against Gaston’s equity
Step 2 [entry (B)] Reclassify the remainder of the Investment in Gaston account
The process described here is solely for the purpose of preparing consolidated statements.
The adjustments are not recorded on the books of the acquirer (parent company).
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Acquisition with Noncontrolling Interests (Less Than 100% Acquisition)
A controlled company must be consolidated as a whole regardless of the parent’s level of ownership.
The parent must measure and recognize the subsidiary as a whole at business fair value.
Under the acquisition method, the parent company includes in its consolidated financial statements 100% of the subsidiary’s individual assets acquired and liabilities assumed at their full fair values determined as of the acquisition date, even when the parent owns less than 100% of the controlled subsidiary.
Measuring the controlling interest fair value is relatively straightforward.
For the vast majority of cases, the value of the consideration transferred provides the best evidence of the controlling interest fair value.
Measuring the noncontrolling interest fair value is more difficult because the noncontrolling shareholders are not parties to the transaction.
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Acquisition Method with Noncontrolling Interests: Consolidated Balance Sheet
EXHIBIT 17.4 Alphonse and Gaston: Acquisition Method—80% Ownership
Entry A: Eliminates the Investment in Gaston account against stockholders’ equity accounts and sets up noncontrolling interest in Gaston
Entry B: Reclassifies the remainder of the investment account by writing up net assets to fair value and recording goodwill attributed to the controlling interest
Entry C: Recognizes the noncontrolling interest in the total business fair value of Gaston
Here, Alphonse pays $9 million to acquire 80% (rather than 100%) of Gaston’s outstanding shares.
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Acquisition Method with Noncontrolling Interests: Consolidated Income Statement
A subsidiary’s income is consolidated into its parents from the date of acquisition.
EXHIBIT 17.5 Alphonse and Gaston: Acquisition Method
We must amortize the portion of the excess acquisition value attributed to fixed assets of $1,500,000 over 20 years (which is the remaining useful life of those fixed assets), resulting in $75,000 of amortization per year.
The Alphonse income statement is prepared under the equity method so it reflects an income accrual for Alphonse’s share of Gaston’s income.
Finally, we must subtract that portion of Gaston’s earnings assigned to the 20% noncontrolling interests to arrive at net income attributable to the Alphonse shareholders.
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Additional Consolidation Issues
Intercompany Receivables and Payables are eliminated against each other in consolidating the balance sheet because when the firm is viewed as a single entity, it cannot owe itself money.
Adjustments are required for Intercompany Sales. These adjustments are addressed in advanced accounting courses focusing on consolidations.
Goodwill must be assessed annually to determine if an impairment is necessary.
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Additional Consolidation Issues: Variable Interest Entities
A variable interest entities (VIE) is a corporation, partnership, trust, or any other legal structure used for business purposes that either:
a) does not have equity investors with voting rights or
b) has equity investors that do not provide sufficient financial resources for the entity to support its activities.
VIEs are often formed to engage in what are called structured financing arrangements.
GAAP requires the VIE to be consolidated if that company has a controlling financial interest in the VIE and is the VIE’s primary beneficiary.
A company has a controlling interest in a VIE if it has both of the following characteristics:
The power to direct the activities of a VIE that most significantly impact the VIE’s economic performance.
The obligation to absorb losses of the VIE that could be potentially be significant to the VIE.
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Previous Approaches to Consolidated Statements 1
EXHIBIT 17.8 M&A Accounting Rules Over Time
Panel (a): Methods to Account for Acquisitions
| Dates | |
| Prior to July 1, 2001 | Pooling-of-interests method for qualifying transactions; otherwise purchase method |
| July 1, 2001, through 2008 2009 and later | Purchase method only Acquisition method only |
Panel (b): Goodwill
| Dates | |
| 2001 and earlier | Goodwill amortized over not more than 40 years |
| 2002 and later | Goodwill not amortized; subject to review for impairment* |
* Goodwill impairment test simplified from the two-step method to the one-step method beginning in 2020 (for calendar-year SEC registrants).
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Previous Approaches to Consolidated Statements 2
EXHIBIT 17.8 M&A Accounting Rules Over Time
Panel (c): Presentation of Noncontrolling Interests
| Dates | |
| 2008 and earlier | Subtract noncontrolling interest to arrive at net income; i.e., consolidated net income includes only the controlling interest’s portion of the subsidiary’s income |
| 2009 and later | Net income is before subtracting noncontrolling interest; consolidated net income separated into portion attributable to noncontrolling interest and portion attributable to parent company shareholders |
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Previous Approaches to Consolidated Statements 3
The only acquisition method permitted for merger and acquisition transactions entered into today is the acquisition method.
Transactions originally accounted for under either of the following two methods continue to be accounted for under those methods.
Pooling of interests.
Purchase.
To determine which method was (and should continue to be) used for a given transaction, determine the date that the parent acquired the subsidiary.
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Pooling of Interests Method
The pooling of interests method was permitted for transactions that met certain criteria, including:
Acquiring more than 90% of the voting common stock.
Consummation of the transaction through an exchange of stock.
The transaction was treated as if the two companies joined together to become a new entity, rather than that one of the companies acquired the other.
The financial statements were restated retroactively as if the two companies had always been one.
There is no resetting of asset values to fair value or any recognition of goodwill.
Amid concerns that many transactions were structured to qualify as poolings of interests even though they were clearly acquisitions, the FASB banned poolings effective July 1, 2001.
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Purchase Method
Beginning July 1, 2001, only the purchase method was permitted.
This method treated the transaction as an acquisition of one company by another, regardless of whether the consideration paid was in cash or stock.
If the consideration was in stock, the purchase price was deemed to be the fair value of the stock given up in the transaction.
Any excess paid above book value for the acquired company was attributed to specific assets and liabilities as well as to goodwill.
The step-up in values and recognition of goodwill only occurred on the portion of the assets acquired.
Through 2001, goodwill was amortized over not more than 40 years.
Since 2002, goodwill is not amortized; rather, it is subject to an annual review for impairment.
Effective in 2009, the purchase method was replaced with the acquisition method.
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Presentation of Noncontrolling Interests
Beginning in 2009, consolidated net income is defined to include all earnings of a parent and its consolidated subsidiaries, even if the consolidated subsidiaries are not wholly owned.
That net income is then attributed to the parent company shareholders and the noncontrolling interests (i.e., the minority shareholders of the subsidiary’s stock).
When the noncontrolling interests are subtracted from consolidated net income, the resulting amount is called consolidated net income attributable to parent company shareholders.
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Financial Analysis Issues
Trend analysis is difficult because U.S. GAAP comparative financial statements are not retroactively adjusted to include data for the acquired company for periods prior to the acquisition.
| Parent Company Results Included | Subsidiary Company Results Included | |
| Year prior to acquisition | Full Year | No portion |
| Year of acquisition | Full Year | Fraction of year owned by the parent |
| Year after acquisition | Full Year | Full Year |
This can lead to distortions in year-to-year growth rates in revenue and profits that statement users should be aware of.
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Global Vantage Point: Accounting for Financial Assets 1
EXHIBIT 17.11 U.S. GAAP versus IFRS
| Asset Category | U.S. GAAP | IFRS |
| Minority-Passive Equity Investments | Fair Value through Net Income, except when fair value is not readily determinable | Fair Value through Net Income |
| Subject to an irrevocable option when an investment is acquired to use Fair Value through Other Comprehensive Income. In that case, no amounts are recorded in Net Income, even after the investment is sold | ||
| Debt Securities | Trading Securities: Fair Value through Net Income | Financial assets held to collect contractual cash flows, which represent solely principal and interest: Amortized Cost |
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Global Vantage Point: Accounting for Financial Assets 2
EXHIBIT 17.11 U.S. GAAP vs. IFRS
| Asset Category | U.S. GAAP | IFRS |
| Available-for-Sale Securities: Fair Value through Other Comprehensive Income | The objective of the business model is achieved both by collecting contractual cash flows and selling financial assets and the contractual cash flows represent solely principal and interest: Fair Value through Other Comprehensive Income | |
| Held-to-Maturity Securities: Amortized Cost | All other financial assets: Fair Value through Net Income Note: A firm may elect to use Fair Value through Net Income for any security if doing so eliminates a measurement or recognition inconsistency, i.e., an accounting mismatch. | |
| Minority-Active Equity Investments | Equity method with fair value option | Equity method but no fair value option |
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Global Vantage Point: Consolidations and Business Combinations
| GAAP | IFRS | |
| Conclusions regarding the need to consolidate | IFRS defines control more broadly than does U.S. GAAP | |
| Accounting policies | A parent and a subsidiary are permitted to have different accounting policies | The accounting policies of the subsidiary must conform to those used by the parent |
| Classification of noncontrolling interest on income statement | Under the acquisition method, the noncontrolling interest is measured at the full business fair value of the subsidiary at time of acquisition | Firms may choose to measure a noncontrolling interest using the same approach as under U.S. GAAP or to measure noncontrolling interest at the fair value of the identifiable net assets (i.e., those reported by the subsidiary) at the acquisition date |
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Global Vantage Point: Accounting for Special Purpose Entities (SPEs) or Variable Interest Entities (VIEs)
Because the criteria are different, the decision as to whether to consolidate the activities of a SPE or VIE can sometimes differ under IFRS vs. U.S. GAAP.
Special purpose entities (SPE) are legal entities created to accomplish a narrow and well-defined objective. U.S. GAAP refers to these entities as variable interest entities (VIE).
U.S. GAAP requires the “primary beneficiary” to consolidate the activities of the VIE.
A company is deemed to be the primary beneficiary if it has the (a) the power to direct the economic activities that most significantly impact the VIE and (b) the obligation to absorb losses or the right to receive benefits considered potentially significant to the VIE.
Under IFRS, SPEs are consolidated when evidence indicates the reporting company “controls” the SPE.
Control has been established when the firm has (a) power over the investee; (b) exposure, or rights, to variable returns from its involvement with the investee; and (c) the ability to use its power over the investee to affect the amount of the firm’s returns.
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Summary 1
The accounting for investments in debt securities depends on the security’s classification. Held-to-maturity securities are reported at amortized cost. Trading securities are reported at fair value with gains and losses reported in the income statement. Available-for-sale securities are reported at fair value with gains and losses reported in other comprehensive income.
Financial reporting for intercorporate equity investments depends on the degree to which the investor is able to influence the investee’s operating decisions. Proportionate share size is a presumptive factor in assessing an investor’s influence over an investee.
Minority-passive equity investments are reported at fair value with unrealized gains and losses reported in the income statement.
For minority active investments, the equity method is used, whereby the investor records its proportionate share of the investee’s profits and losses, net of any excess cost amortization. However, using the fair value option, firms may instead elect to report these investments at fair value.
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Summary 2
When one entity controls another, consolidation is required.
Currently, acquisitions are accounted for under the acquisition method, but two other methods—pooling of interests and the purchase method—were permitted previously. Acquisitions are not restated, so transactions previously recorded as poolings or purchases continue to be reported on that basis.
Goodwill is typically recorded in business combinations other than those that were treated as poolings of interest. Goodwill is subject to an annual impairment test.
Under current accounting for mergers and acquisitions, income of an acquired company is included in the parent’s income statement from date of acquisition, which greatly complicates trend analysis.
Certain entities must be consolidated even if they are not majority owned. When a company is the primary beneficiary of an entity that does not have equity investors with voting rights or whose equity investors do not provide sufficient financial resources to the entity’s activities, it must consolidate the entity, which is called a variable interest entity, or VIE.
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Summary 3
There are a number of important differences between IFRS and U.S. GAAP: measurement and reporting of financial assets, how noncontrolling interests are measured in consolidated statements, and when VIEs (called SPEs under IFRS) must be consolidated.
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Accessibility Content: Text Alternatives for Images
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Adjustments for Consolidating the Balance Sheet – Text Alternative
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Individual and consolidated balance sheets for Alphonse and Gaston with adjustments and eliminations columns are shown. The 8,000,000 investment in Gaston is credited, or eliminated against Gaston's equity (6,000,000 debited to common stock and 2,000,000 to retained earnings). The remainder of the investment is reclassified, with 1,500,000 recorded as a debit to fixed assets and 500,000 to goodwill, and 2,000,000 credited. Footnote shows calculations to arrive at acquisition value of $10,000,000. This is detailed as $8,000,000 recorded book value of Gaston's net assets, plus unrecorded difference between fair value and book value of Gaston's fixed assets ($8,000,000 minus $6,500,000) or 1,500,000, plus unrecorded value of Gaston's goodwill of 500,000.
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Acquisition Method with Noncontrolling Interests: Consolidated Balance Sheet – Text Alternative
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Individual and consolidated balance sheets for Alphonse and Gaston with adjustments and eliminations columns are shown. The 6,400,000 investment in Gaston is credited, or eliminated against Gaston's equity (6,000,000 debited to common stock and 2,000,000 debited to retained earnings, with $1,600,000 credited to noncontrolling interest in Gaston). The remainder of the investment is reclassified, with 1,200,000 recorded as a debit to fixed assets and 350,000 to goodwill, and 2,600,000 credited. The noncontrolling interest in the total business fair value of Gaston is shown as 300,000 debit to fixed assets and 350,000 debit to goodwill, and a 650,000 credit to noncontrolling interest in Gaston.
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Acquisition Method with Noncontrolling Interests: Consolidated Income Statement – Text Alternative
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Individual and consolidated income statements for 20X1 for Alphonse and Gaston with debit and credit columns are shown. Debited is $75,000 for selling, general, and administrative expenses. Debited is $1,507,360 for investment income (equity method). And lastly, debited is $376,840 for net income attributable to noncontrolling interest.
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