Chapter 11: Highlights

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Chapter 11: Highlights
1. For a variety of reasons, corporations often acquire the securities (bonds, preferred stock, common stock) of other entities. For example, a business may invest (in the short term) some of its excess cash in income-yielding securi­ties such as bonds or stocks. A business may also invest in securities intending to hold them for a longer period.
2. The accounting for investments in securities depends on the expected holding period and the purpose of the investment.
3. The expected holding period determines where investments in securities appear in the balance sheet. Securities that firms expect to sell within the next year appear as “Marketable Securities” in the Current Asset section of the balance sheet. Securities that firms expect to hold for more than one year from the date of the balance sheet appear in “Investments in Securities,” which firms include in a separate section of the balance sheet between Current Assets and Property, Plant and Equipment. When a company owns sufficient number of shares to control another company, it prepares consolidated financial statements. Consolidated financial statements combine, with some adjustments, the assets, liabilities, revenues, expenses, and cash flows of both companies.
4. The accounting for the investment in securities depends on the purpose of the investment and the percentage of voting stock that one corporation owns of another. Three types of investments are: (1) minority, passive investments, (2) minority, active investments, and (3) majority, active investments.
5. Minority, passive investments are bonds or shares of capital stock of another corpora­tion viewed as a worthwhile expenditure and acquired for the anticipated interest, divi­dends and capital gains (increases in the market price of the shares). The percentage of shares owned is not so large (less than 20 percent of the voting stock) that the acquiring company can control or exert significant influence over the other company. The owner may intend to hold these shares for relatively short time spans and classify them as current assets, called marketable securities, or for an indefinite time and classify them as investments.
6. Minority, active investments are shares of another corporation acquired so that the acquiring corporation can exert significant influence over the other company's activities. Generally accepted accounting principles view investments of 20 percent to 50 percent of the voting stock of another company as minority, active investments "unless evidence indicates that significant influence cannot be exercised." Minority, active investments appear under investments on the balance sheet.
7. Majority, active investments are shares of another corporation acquired so that the acquiring corporation can control the other company both at the broad policy-making level and at the day-to-day operations level. Ownership of more than 50 percent of the voting stock of another company implies ability to control, unless there is evidence to the contrary.
8. Firms initially record securities classified as minority, passive investments at acqui­sition cost, which includes the purchase price, plus any commissions, taxes and other costs incurred. Dividends on equity securities become revenue when declared. Interest on debt securities becomes revenue when earned.
9. Generally accepted accounting principles require firms to classify minority, passive investments into three categories: (a) debt securities for which a firm has a positive intent and ability to hold to maturity; (b) debt and equity securities, as well as derivatives, held as trading securities; and (c) debt and equity securities, as well as derivatives, held as securities available for sale. This classification scheme is relevant for valuation of securities subsequent to acquisition. This classification scheme is applicable to securities held as current assets (Marketable Securities) and some long-term investments.
10. Debt securities for which a firm has a positive intent and ability to hold to maturity appear in the balance sheet at amortized acquisition cost. The acquisition cost of debt securities may differ from their maturity value. The difference between acquisition cost and maturity value is amortized over the life of the debt security as an adjustment to interest revenue.
11. Trading securities are securities that firms acquire for their short-term profit potential and imply active and frequent buying and selling. Firms report trading securities on the balance sheet at market value because (a) active securities markets provide objective measures of market values, and (b) market values provide financial statement users with the most relevant information for assessing the success of a firm's trading activities over time.
12. Firms report increases and decreases in the market value of trading securities in the account, Unrealized Holding Gain or Unrealized Holding Loss on Trading Securities, on the income statement.
13. Debt and equity securities held as securities available for sale trade in active securities markets and have easily measurable market values. Securities that a firm intends to sell within one year appear in Marketable Securities in the current assets section of the balance sheet. All others appear as a noncurrent asset, Investment in Securities, on the balance sheet. Securities available for sale appear in the balance sheet at market value. Net income includes dividends or interest earned on securities available for sale each period. Any unrealized holding gain or loss each period does not affect income immediately but instead increases or decreases a separate shareholders' equity account, Unrealized Holding Gain or Unrealized Holding Loss on Securities Available for Sale. These accounts are part of Accumulated Other Comprehensive Income, typically appearing between Additional Paid-In Capital and Retained Earnings. Holding gains and losses on securities available for sale affect net income only when the firm sells the securities and reports a Realized Gain or Realized Loss on Sale of Securities Available for Sale.
14. When firms transfer securities from one of the three categories to another one, the firm transfers the security at its market value at the time of the transfer.
15. Firms can purchase financial instruments to lessen the risks of economic losses from changes in interest rate, foreign exchange rates, and commodity prices. The term used for these financial instruments is a derivative. A derivative is a financial instrument that obtains its value from some other financial item. Changes in the value of the derivative instrument offset changes in the value of an asset or liability or changes in future cash flow, thereby neutralizing, or at least reducing, the economic loss.

  1. For example, in accounting and finance, firm frequently purchase (or sell) a derivative contract, such as an interest rate swap. An interest rate swap is a derivative that typically obligates one party and counterparty to exchange the difference between fixed and floating rate interest payments on otherwise similar loans. The term counterparty refers to the opposite party in a legal contract.

  1. Some elements of a derivative include: a. Derivatives have one or more underlyings. An underlying is a variable such as a specified interest rate, commodity price, or foreign exchange rate. b. A derivative has one or more notional amounts. A notional amount is a number of currency unites, bushels, shares, or other units specified in the contract. c. A derivative often requires no initial investments. The firm usually acquires a derivative by exchanging promises with a counter party (for example, a commercial or investment bank). d. Derivatives typically require, or permit, net settlement.

  1. A firm must recognize derivatives in its balance sheet as assets or liabilities, depending on the rights and obligations under the contract. Firms must revalue the derivatives to market value each period. The revaluation amount, in addition to increasing or decreasing the derivative asset or liability, also affects either a) net income immediately or b) other comprehensive income immediately and net income later. Other Comprehensive Income is a temporary shareholders’ equity account that reports changes during an accounting period in the recorded amounts of certain assets and liabilities, such as derivatives.

  1. Generally accepted accounting principles classify derivatives as a) speculative investments, b) fair value hedges, or c) cash flow hedges. Firms must choose to designate a derivative as either a fair value or cash flow hedge (depending on the strategy and purpose of acquiring a particular derivative) or account for the derivative as a speculative investment.

  1. A firm must report changes in the market value of a speculative investment as a gain or loss in current earnings, the same accounting as for trading securities.

  1. When a firm acquires a derivative and attempts to reduce risks involving fluctuations in a market value of a recognized asset or liability, the FASB classifies the transaction as a fair-value hedge. The derivative appears on the balance sheet at its fair value. The FASB requires the firm to show in income each period the change in the fair value of a derivative that qualifies as a fair-value hedge. The firm will also record at fair value the asset or liability it is hedging, so under most circumstances the net effect on both net assets and net income will be zero. If the firm does not acquire a perfect hedge, the firm will report in income the net cost of the unsuccessful hedge or the net benefit of the over-successful hedge.

  1. When a firm acquires a derivative and attempts to reduce the risk in future streams of cash flows (inflows or outflows), the FASB classifies the transaction as a cash-flow hedge. A firm will show the cash-flow hedge at its fair value on the balance sheet, but will not report the matching gain or loss in net earnings of the period. The gain or loss will appear as part of other comprehensive income (discussed in Chapter 12) and will appear on the balance sheet in the separate shareholders’ equity account, Accumulated Other Comprehensive Income. This unrealized gain or loss from changes in the fair value of the cash-flow hedge remains on the balance sheet in a separate shareholders’ equity account to later match against any loss or gain on the cash-flow commitment when the firm settles it.

  1. In the following discussion the acquiring firm is Company P, for purchaser or parent, and the acquired firm is Company S, for seller or subsidiary.

24. Generally accepted accounting principles require the use of the equity method for minority, active investments (Company P owns 20 percent or more of the voting stock of Company S, but not more than 50 percent). Under the equity method, Company P records the purchase of Company S’s stock at acquisition cost. Company P treats as income each period its proportionate share of the earnings of Company S. The entry to record this income is a debit to the account, Investment in Stock of S, and a credit to Equity in Earnings of Affiliate, an income statement account. Company P treats dividends received from Company S as a reduction in its investment in Company S. The entry to record dividends received is a debit to Cash and a credit to Investment in Stock of S.

25. One complication from using the equity method arises when the acquisition cost of P's shares exceeds P's proportionate share of the book value of the net assets (assets minus liabilities), or stockholders' equity, of S at the date of acquisition. P may pay an amount that differs from the book value of S’s recorded net assets because the market values of the net assets (for example, land, buildings) differ from their book values or because of unrecorded assets (for example, patents, goodwill) or unrecorded liabilities (for example, an unsettled lawsuit). To the extent that the excess purchase price results from anything other than goodwill, GAAP requires firms to write off the excess over the expected useful life. GAAP also previously required firms to write off any excess acquisition cost allocated to goodwill over a period not to exceed 40 years. Beginning in 2001, firms need no longer amortize this excess to the extent it relates to goodwill. Firms may also discontinue amortizing goodwill from investments made prior to 2001.
26. Under the equity method the amount shown in the noncurrent section of the balance sheet for Invest­ment in Stock of S will generally be equal to the acquisition cost of the shares plus Company P's share of Company S's undistributed earnings since the date Compnay P acquired the shares. Company P shows its share of Company S's net income as revenue each period on its income statement.
27. Ownership (by Company P) of more than 50 percent of another corporation’s (Company S’s) common stock usually implies an ability to control the investee. Company P can control both broad policy-making and day-to-day operations. The corporation exercising control through stock ownership is the parent, and the one subject to control is the subsidiary. Generally accepted accounting principles require the parent company to prepare consolidated financial statements with controlled subsidiaries. Consolidated statements report the financial position and operations of two or more legally distinct entities as if they were a single, centrally controlled economic entity.
28. When one company controls another, the controlling company could bring the legal existence of the controlled company to an end. However, some impor­tant reasons for continued existence of subsidiary companies are (a) to reduce financial risk of one segment (subsidiary) becoming insolvent, (b) to meet more effectively the requirements of state corporation and tax legisla­tion, (c) to expand or diversify with a minimum of capital investment, and (d) to sell an unwanted operation with a minimum of administrative, legal and other costs.
29. Generally, consolidated financial statements provide more useful information than would separate financial statements of the parent and each subsidiary or than the equity method provides. The parent, because of its voting interest, can control the use of all of the subsidiary's assets. Consoli­dation of the individual assets, liabilities, revenues, expenses and cash flows of both the parent and the subsidiary provides a more realistic picture of the operations, cash flows and financial position of the single economic entity. Consolidated financial statements are generally prepared when the following two criteria are met: (1) the parent owns more than 50 percent of the voting stock of the subsidiary; and (2) there are no important restrictions on the ability of the parent to exercise control of the subsidiary. However, the FASB requires the consolidation of certain entities where one company (P) may be the primary beneficiary of the relationship with another entity even if ownership is less than 50 percent.
30. State laws typically require each legally separate corporation to maintain its own set of books. The consolidation of these financial statements basically involves summing the amounts for various financial statement items across the separate company statements. Consolidated financial statements reflect the transactions between the consolidated group of entities and others outside the entity. Thus, the consolidation process involves adjustments to these summations to eliminate double counting resulting from intercompany transactions. The eliminations typically appear on a consolidation work sheet and not on the books of any of the legal entities being consolidated.
31. For example, a parent may lend money to its subsidiary. If the separate balance sheets were added together, then the funds would be counted twice - once as the notes receivable on the parent's books and again as cash or other assets on the subsidiary's books. Therefore, the consolidation process requires an entry to eliminate the receivable of the parent and the payable of the subsidiary in preparing consolidated statements.
32. Another example of an elimination entry to avoid double counting relates to the parent's investment account. If the assets of the parent (including the investment account) were added to the assets of the subsidiary, there would be double counting of the subsidiary's assets. At the same time the sources of financing would be counted twice if the shareholders equity accounts of Company S were added to those of Company P. Therefore, an eliminating entry removes the investment account of the parent and, correspondingly, shareholders' equity items of the subsidiary. In addition, the consolidation process requires the elimination of Company P's account, Equity in Earnings of Company S, to avoid the double counting of Company S's revenues and expenses.
33. A consolidated income statement is little more than the sum of the income statements of the parent and the subsidiaries. The consolidation process eliminates intercompany transactions such as sales and purchases in order to avoid double count­ing. Thus, the consolidated income statement attempts to show sales, expenses, and net income figures that report the results of operations of the group of companies in their dealings with the outside world.
34. The amount of consolidated net income for a period is the same as the amount that a parent company would report if it used the equity method of accounting for the intercorporate investment. That is, consolidated net income is equal to parent company's net income plus parent's share of subsidiary's net income minus profit (or plus loss) on intercompany transac­tions. However, under the equity method for an unconsolidated subsidiary, the parent's share of subsidiary's net income (adjusted for intercompany transactions) appears on a single line, Equity in Earnings of Unconsolidated Subsidiary. The consolidation process combines the individual revenues and expenses of the subsidiary (adjusted for intercompany transactions) with those of the parent, and eliminates the account Equity in Earnings of Unconsolidated Subsidiary, shown on the parent's books.
35. When a parent company owns less than 100 percent of the subsidiary, the minority stockholders continue to have a proportionate interest in the shareholders' equity of the subsidiary as shown in its separate corporate records. The amount of minority interest appearing in the balance sheet results from multiplying the common stockholders' equity of the subsidiary by the minority's percentage of ownership.
36. The amount of the minority interest in the subsidiary's net income shown on the consolidated income statement is generally the result of multiplying the subsidiary's net income by the minority's percentage of ownership. The consolidated income statement allocates the portion applicable to the parent company and the portion of the subsidiary's income applicable to the minori­ty interest. Typically, the minority interest in the subsidiary's net income appears as a deduction in calculating consolidated net income.
37. Consolidated statements do not replace financial statements of individual corporations. For example, creditors of a consolidated subsidiary must rely on resources of the subsidiary to which they loaned funds and not on the assets of the consolidated entity. A corporation can declare dividends only from its own retained earnings. When a parent owns less than 100 percent of the shares, minority shareholder can judge the dividend constraints, both legal and financial, only by inspecting the subsidiary’s statements.
38. Most countries outside the United States account for minority, passive investments using a lower-of-cost-or-market method, instead of the market value method. In recent years the accounting for active investments has become similar to practices in the United States: the equity method for minority, active investments and consolidation for majority investments.
39. The various methods of accounting for long-term investments in corporate securities have effects on the statement of cash flows. When a firm uses the market value method, dividend revenues generally produce cash. Therefore, calculating cash flow from operations normally requires no adjustment for this component of income. Changes in the Investment account and the Unrealized Holding Gain or Loss account from applying the market method do not appear in the statement of cash flows for securities available for sale. In contrast, holding gains and losses on trading securities do appear in income but do not affect cash flow, so they do require an adjustment to net income in deriving cash flow from operations if the firm uses the indirect method. However, under the equity method, firms must subtract its equity in investee's undistributed earnings from net income to derive cash provided from operations of investor.

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