Accounting for Business Combinations 15.501/516 Accounting Spring 2004
Professor S. Roychowdhury Sloan School of Management Massachusetts Institute of Technology
April 26, 2004
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Investments and Acquisitions Agenda ¾ Understand that the accounting method used for acquisitions depends on the extent to which the investor exerts influence over the investee. ¾ Understand the effects of dividends received and investee income on the financial statements of the investor under the equity method. ¾ Understand the effects of consolidated accounting on the balance sheet and income statement of the investor.
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Investments in the Stock of Other Companies ¾ The accounting method for stock investments depends on the degree of influence the investing company has on the decisions of the investee. ¾ Three methods of accounting for this investment: Ownership:
50%
Influence:
“passive”
“significant influence”
“controlling”
Reporting Method:
Mark-tomarket
Equity
Consolidation 3
Equity Investment Accounting Rationale
¾For any company: Ending RE = Beginning RE + Net Income – Dividends ¾Following the same logic => Ending value of investment on investing company’s books = Beginning value of investment + investor’s share of investee’s net income – investor’s share of investee’s dividends 4
Significant Influence Î Equity Method ¾ Assume the following events 1. Purchase: Investor acquires 48,000 shares amounting to 40% of EE Corporation for $10 per share 2. Dividends: EE Corporation pays a dividend of $60,000 or 50 cents per share 3. Affiliate earnings: EE Corporation Earns $100,000 in Net Income
¾ Record these events on BSE of investor company.
1. Purchase 2. Dividends 3. Aff. earnings
Cash (480,000) 24,000
Long-term Investment 480,000 (24,000) 40,000
R/E Comment 40% × $60,000 40,000 Investment income 5
Equity Investment Journal Entries – For The Investing Company ¾ At the time of investment Dr Long Term Investments Cr Cash
480,000 480,000
¾ At the time of dividends payment Dr Cash Cr Long Term Investments
24,000 24,000
¾ At the time investee declares net income Dr Long Term Investments Cr Investment income
40,000 40,000
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Control Î Consolidation Method ¾ When the investor controls the investee, The investor corporation = parent. The investee corporation = subsidiary. The parent prepares consolidated financial statements that treat the parent and the subsidiary as a single economic entity even though they are separate legal entities.
¾ Consolidated financial reporting brings together multiple sets of financial records at the time of reporting to outsiders Each subsidiary maintains its own set of books that is independent of who owns it, whether it is one person/company or one million. Parent has its set of books pre-consolidation.
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Consolidation Method: Initial purchase ¾ P Co. acquires 100% of S Co.’s stock for $110 cash. ¾ Assume the book value of S’s assets, liabilities, and shareholder’s equity equal their market value. P Co. P Co. pre-acq. post-acq. Cash, other assets $ 500 Investment in S 500 Liabilities S. E.
200 300 500
Consolidated S Co.Adjustment P+S $ 150 150 40 110 150 8
Consolidation Method: Initial purchase ¾ P Co. acquires 100% of S Co.’s stock for $110 cash. ¾ Assume the book value of S’s assets, liabilities, and shareholder’s equity equal their market value. P Co. P Co. pre-acq. post-acq. Cash, other assets $ 500 390 Investment in S 110 500 500 Liabilities S. E.
200 300 500
Consolidated S Co.Adjustment P+S $ 150 150 40 110 150 9
Consolidation Method: Initial purchase ¾ P Co. acquires 100% of S Co.’s stock for $110 cash. ¾ Assume the book value of S’s assets, liabilities, and shareholder’s equity equal their market value. P Co. P Co. pre-acq. post-acq. Cash, other assets $ 500 390 Investment in S 110 500 500 Liabilities S. E.
200 300 500
200 300 500
Consolidated S Co.Adjustment P+S $ 150 150 40 110 150 10
Consolidation Method: Initial purchase ¾ P Co. acquires 100% of S Co.’s stock for $110 cash. ¾ Assume the book value of S’s assets, liabilities, and shareholder’s equity equal their market value. P Co. P Co. pre-acq. post-acq. Cash, other assets $ 500 390 Investment in S 110 500 500 Liabilities S. E.
200 300 500
200 300 500
Consolidated S Co.Adjustment P+S $ 150 540 150 40 110 150
240
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Consolidation Method: Initial purchase ¾ P Co. acquires 100% of S Co.’s stock for $110 cash. ¾ Assume the book value of S’s assets, liabilities, and shareholder’s equity equal their market value. P Co. P Co. pre-acq. post-acq. Cash, other assets $ 500 390 Investment in S 110 500 500 Liabilities S. E.
200 300 500
200 300 500
Eliminated
Consolidated S Co.Adjustment P+S $ 150 540 –110 150 40 110 150
240 –110
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Consolidation Method: Initial purchase ¾ P Co. acquires 100% of S Co.’s stock for $110 cash. ¾ Assume the book value of S’s assets, liabilities, and shareholder’s equity equal their market value. P Co. P Co. pre-acq. post-acq. Cash, other assets $ 500 390 Investment in S 110 500 500 Liabilities S. E.
200 300 500
200 300 500
Eliminated
Consolidated S Co.Adjustment P+S $ 150 540 –110 0 150 540 40 110 150
–110
240 300 540 13
Intuition Behind Consolidation Method
¾ The effect of consolidation is to treat P’s purchase of S as if P purchased the assets and liabilities of S. The equity of S does not appear in P’s consolidated financial reports. The equity of the consolidated entity reflects the ownership of the parent (P Co.) by its shareholders.
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Schematic of a 100% Acquisition After
Before
Shareholders of P
Shareholders of P $ P Co. shares
Shareholders of S
P Co.
S Co.
S Co.
ÎConsolidated equity reflects ownership interest of P’s shareholders
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Consolidation: Post-purchase Events ¾ P Co. owns 100% of S Co.’s stock. ¾ Prepare a consolidated income statement using the following separate income statements for P and S.
Sales Expenses Investment income Net income
P Co. 600 – 450 150
Consolidated S Co. Adjustment P+S $ 180 – 160 20 -20
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Consolidation: Post-purchase Events ¾ P Co. owns 100% of S Co.’s stock. ¾ Prepare a consolidated income statement using the following separate income statements for P and S.
Sales Expenses Investment income Net income
P Co. 600 – 450 150 20 170
Consolidated S Co. Adjustment P+S $ 180 – 160 20 -20
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Consolidation: Post-purchase Events ¾ P Co. owns 100% of S Co.’s stock. ¾ Prepare a consolidated income statement using the following separate income statements for P and S.
Sales Expenses Investment income Net income
P Co. 600 – 450 150 20 170
Consolidated S Co. Adjustment P+S $ 180 780 – 160 – 610 20 170 -20
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Consolidation: Post-purchase Events ¾ P Co. owns 100% of S Co.’s stock. ¾ Prepare a consolidated income statement using the following separate income statements for P and S.
Sales Expenses Investment income Net income
P Co. 600 – 450 150 20 170
Consolidated S Co. Adjustment P+S $ 180 780 – 160 – 610 20 170 -– 20 0 20 170
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