Accounting for fun and profit a guide to understanding advanced topics in accounting

Balance Sheet at the time the investment is made, an investment account isincreased and cash is reduced and recognizes any dividends paid to theinvesting firm as earnings on the date of

Accounting for Fun and Profit

Accounting for Fun and Profit

A Guide to Understanding Advanced Topics in Accounting

Lawrence A Weiss

Accounting for Fun and Profit: A Guide to Understanding Advanced Topics in Accounting

Copyright © Lawrence A Weiss, 2017.

All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means—electronic, mechanical, photocopy, recording, or any other except for brief quotations, not to exceed 250 words, without the prior permission of the publisher

First published in 2017 by

Business Expert Press, LLC

222 East 46th Street, New York, NY 10017

www.businessexpertpress.com

ISBN-13: 978-1-63157-513-6 (paperback)

ISBN-13: 978-1-63157-514-3 (e-book)

Business Expert Press Financial Accounting and Auditing Collection

Collection ISSN: 2151-2795 (print)

Collection ISSN: 2151-2817 (electronic)

Cover and interior design by S4Carlisle Publishing Services

Private Ltd., Chennai, India

First edition: 2017

10 9 8 7 6 5 4 3 2 1

Accounting is an economic information system, and can be thought of as thelanguage of business Accounting principles are created, developed, ordecreed and are supported or justified by intuition, authority, andacceptability Managers have alternatives in their accounting choices; thedecisions are political, and trade-offs will be made

Accounting information provides individuals, both inside and outside afirm, with a starting point to understand and evaluate the key drivers of afirm, its financial position, and performance If you are managing a firm,investing in a firm, lending to a firm, or even working for a firm, you should

be able to read the firm’s financial statements and ask questions based onthose statements

This book examines some of the more advanced topics in accounting Assuch, it assumes that the reader already has some familiarity with basic

accounting (A related book covering the basics is Accounting for Fun and

Profit: A Guide to Understanding Financial Statements.) The book explains

how the user of financial statements should interpret advanced accountingtechniques presented, and helps the user conduct in-depth analysis of annualreports

The author will show you that accounting, even the advanced topics, can

be informative and fun

Keywords

Advanced Accounting, Comprehensive Income, Consolidations, DeferredBenefits, EPS, Financial Statement Analysis, Foreign Currency Translation,Government Accounting, Leases, Nonprofits

Chapter 4 Deferred Benefits

Chapter 5 Advanced Topics

Chapter 6 Financial Statement Analysis

Chapter 7 Accounting at Governmental and Nonprofit Organizations

Index

I am grateful to Bridgette Hayes and Stephanie Landers, who corrected mymany editorial mistakes and helped make my prose easier to read I wouldalso like to thank Michael Duh for helping to ensure the numbers areconsistent A special thanks is also owed to Prof Mark Bettner for hiseditorial comments as well as Scott Isenberg and the team at Business ExpertPress Finally, I would like to thank my former teachers for setting me on myacademic path and all my former students who have made my career such apleasure

to build the house you want to live in Any time you hire a professional, it isbest to have a basic understanding of what the professional does so you cantell the professional what you want them to do If you are managing a firm,investing in a firm, lending to a firm, or even working for a firm, you should

be able to read the firm’s financial statements and ask questions based onthose statements

This book examines some of the more advanced topics in accounting Assuch, it assumes the reader already has some familiarity with basicaccounting (If not, a related book covering the basics of accounting is

Accounting for Fun and Profit: A Guide to Understanding Financial Statements.) Many accountants would benefit from reading this book to

improve their understanding of why they are doing what they do, and to helpthem better explain accounting However, the book is designed and meant fornonaccountants (i.e., those who hire accountants)

The book takes the perspective of a user of financial information andtherefore limits its coverage of some of the technical aspects The book ismeant to explain what an accountant means when she uses certain terms, howthe user of financial statements should interpret the accounting techniquespresented, and help the user conduct in-depth analyses of annual reports.Hopefully this book shows that accounting, even the advanced topics, can

be fun and informative, or at least that it is not as painful as you may fear

“goodwill” and “noncontrolling interest” (also called “minority interest”)actually mean and how they are computed Consolidation is an advancedaccounting topic It is often covered in the third course offered to those goinginto the accounting profession and may encompass more than half the course.The presentation here is a simplified version of what is actually done.

Long-Term Intercorporate Investments1

Why would a firm buy another firm’s shares? The objective is, as with any

investment, to obtain returns above its cost of capital If the expected cashflows discounted at the appropriate discount rate provide a positive netpresent value2 (NPV), then an investment provides more than competitivereturns If the investment is for long-term strategic purposes, with nointention of selling it in the coming year, it is classified as a long-term asset

If a firm does buy another for long-term strategic purposes, why buy shares? Why not simply buy the business itself (the assets and liabilities)?

There are many reasons First, buying shares may limit liability Normally,the most a shareholder of a firm (whether that shareholder is an individual oranother firm) can lose is the amount invested Imagine you buy shares of apharmaceutical firm that sells a medication that turns out to have a harmfulside effect, is sued, and is ordered to pay more than the value of its assets.The pharmaceutical firm will go bankrupt, and the shareholders will lose theirinvestment Normally, the shareholders are not liable for damages beyond thevalue of the firm itself The court does not pierce the “corporate veil” to

demand that the assets of the individual investors be used to complete thepayment required by the lawsuit This is a key benefit of the corporate form:owners can shield their personal assets By contrast, in most partnerships, thepartners (or at least certain key partners) have unlimited liability, whichmeans their personal assets are at risk.3 Many people argue that the seeds ofthe financial crisis of 2008 were set when investment banks stopped beingpartnerships and became corporations As partnerships, the investment banks’senior managers were partners and were much more cautious about theinvestments they made As corporations, the investment bank managers weremore willing to bet the firm If the bet won, the managers would each receive

a portion of a potentially enormous gain If the bet lost, the managers simplyhad to find another job

Another advantage of purchasing shares in an intercorporate investment isthe ease of selling and buying Transferring all the assets of one firm toanother may be more difficult for several reasons First, assets often cannot

be sold without agreement of lenders Second, it may be difficult to transferthe business itself (e.g., the organizational form, the human capital, thedistribution networks) Imagine an individual has an employment contract

with Firm A, which sells all its assets to Firm B Can Firm A sell the

employment contract when it sells its assets to Firm B? The answer, other

than for certain sports franchises, is normally no By contrast, when a firm’sshares are purchased, the sale includes all the assets and liabilities of thebusiness, including the corporate structure, employment contracts, and so on.Finally, the details of the sale—what is included in the sale and what is not—are much simpler when purchasing shares than when detailing specific assetsand liabilities

There are also corporate tax reasons which make purchasing shares apreferred method for intercorporate investments Many multinational firmstoday have multiple operating firms (sometimes more than one in eachcountry where they have operations) These multinational firms often set up asubsidiary, which owns and controls the multinational firm’s intellectualcapital (e.g., patents and copyrights), in a country with low income taxes(e.g., Ireland).4 All the operating firms pay a royalty fee to the intellectualcapital subsidiary, thereby lowering the taxable profits in high-tax countriesand creating profits in the low-tax country

In addition, certain countries limit foreign ownership, forcing firms tocreate local subsidiaries in these countries where the parent firm’s ownership

is below the legally set percentage (e.g., 50 percent).

Creating a new separate entity may also be an easier way for a firm toexpand and diversify with few of its own investment funds, as once created itcan then sell additional shares of the new entity to others For example,Disney set up Disneyland Paris without investing very much of its own funds

by selling shares of Disneyland Paris to others Disney’s profit from theventure came primarily from licensing fees Likewise, when the Coca-ColaCompany was establishing itself across the United States and then the world,

it created separate bottlers to package and sell its product Coca-Cola mayhave kept a percentage of the ownership in each bottler, but it was able toexpand much more rapidly by allowing others to buy a majority stake and runthese enterprises.5

Clearly, there are many reasons for intercorporate investments

Accounting for Long-Term Intercorporate Investments

The accounting for long-term intercorporate investments is based upon theinvesting firm’s ability to extract profits from the subsidiary The ability toextract profits is broken into three categories: minority passive, minorityactive, and majority Depending on the category, the parent firm will use thecost method or equity method in accounting for its investment in thesubsidiary firm and present the investment as a line item or “consolidate” allthe subsidiaries’ accounts with the parent companies’ accounts Let usexamine each of the three types of situations and then the related accountingtreatment

Minority passive occurs when the investing firm owns less than 50 percent

of the voting shares of the subsidiary (i.e., is a minority owner) and has noinfluence (i.e., is passive) regarding if or when the subsidiary pays dividends

In the case of minority passive, accounting for the investment is done usingthe cost method One situation in which this minority passive status occurs iswhen another firm (or a group of investors acting together) owns a majoritystake in the subsidiary This means that the investing firm necessarily has noinfluence on dividends because the majority group has control (with morethan 50 percent of the votes) However, if no other firm or group has amajority stake, the question regarding whether or not the investing firm has a

minority passive situation becomes one of influence: Does the investing firm

own sufficient shares to effectively select enough board members to influence

dividend policy? In the absence of any other information, a cutoff of 20

percent is often used: if the investing firm owns less than 20 percent, it isdeemed to be minority passive However, this is an arbitrary cutoff, and whatreally matters is influence on dividend policy There are situations where,even though the investing firm owns more than 20 percent of the votingshares, it is unable to select any board members

Minority active occurs when the investing firm owns less than 50 percent

of the voting shares of the subsidiary but has the ability to influence (i.e., isactive) if or when the subsidiary pays dividends In the minority active case,accounting for the investment is done using the equity method Note that, bydefinition, minority active can only occur when no other firm or cohesivegroup of investors has a majority stake in the subsidiary As above, in theabsence of any other information, a cutoff of 20 percent is often used (i.e., ifthe investing firm owns 20 percent or more, it is deemed to be minorityactive) However, this is once again an arbitrary cutoff, and what reallymatters is whether or not the investing firm has influence on dividend policy.There are situations where, with much less than 20 percent of the votingshares, a firm is able to choose a majority of board members and therebycontrol the amount and timing of the subsidiary’s dividends

Majority occurs when the investing firm has more than 50 percent of thevoting shares of the subsidiary Here, the investing or “parent” firm hascontrol because it can elect a majority of the board members, therebychoosing management and dictating the amount and timing of any dividendpayments In this case, the parent company’s accounting for the investment(for the shares owned in the subsidiary) is done using the equity method;however, the financial statements are presented on a “consolidated” basis.6

This means the investment will not be presented as a single-line item, butrather will be “consolidated” with the parent companies accounts asexplained below

The Cost Method of Accounting for Intercorporate

Investments

The cost method is used, as noted above, when a firm has a minority passiveinvestment in another firm Under the cost method, as the name implies, thelong-term intercorporate investment is recorded and presented at cost on the

Balance Sheet (at the time the investment is made, an investment account isincreased and cash is reduced) and recognizes any dividends paid to theinvesting firm as earnings on the date of record.7 That is, earnings from theinvestment are recognized when the investing firm is entitled to receive them.This contrasts with the parent firm picking up its share of profits (or losses)

as earned by the subsidiary, which does not occur in the case of minoritypassive investors Being a minority passive investor means the investing firmhas no influence on the timing of dividend payments, and so revenue isincluded only when the parent is entitled to receive it

There is one caveat to the above (not something about which the readernormally has to be aware but included here for completeness and to show therational of the method): the dividends are considered earnings only if they arepaid from postacquisition (i.e., after the date of the share purchase) retainedearnings If the dividend reduces the subsidiary’s retained earnings belowwhat they were at the date the shares were acquired, the investing firmaccounts for the dividend upon receiving it by reducing the investmentaccount (cash up, investment down) This may sound complex, butillustrating the process with the following examples may help break it down.Assume a firm called Parent Co buys 10 percent of the outstanding equity

of Subsidiary Co on January 1, 2017, for $67,000 At the time the shares arepurchased, Subsidiary Co.’s Balance Sheet shows the following:

Subsidiary Co Balance Sheet as at January 1, 2017

Parent Co., records its purchase of Subsidiary Co shares on January 1,

2017, by increasing a long-term investment account and reducing cash in theamount of $67,000

Parent Co entry on January 1, 2017

In example 1, assume Subsidiary Co earns $50,000, pays no dividendsduring 2017, and has the following year-end Balance Sheet (note thatretained earnings increase by $50,000 from $170,000 to $220,000):

Subsidiary Co Balance Sheet as at December 31, 2017, for example 1

In this case, Parent Co makes no entry for any of Subsidiary Co.’searnings because no dividends were declared

In example 2, assume Subsidiary Co still earns $50,000 but now declaresand pays a $20,000 dividend during 2017 This makes its assets and retainedearnings $20,000 lower than in example 1 Subsidiary Co.’s year-end BalanceSheet would be the following:

Subsidiary Co Balance Sheet as at December 31, 2017, for example 2

In this case, Parent Co receives its 10 percent share of the $20,000dividend, or $2,000 Parent Co would record the $2,000 it received as anincrease in cash on the Balance Sheet and an increase in dividend revenue onthe Income Statement (which is closed at year end to retained earnings).Remember, in this example Parent Co and Subsidiary Co are two separatefirms and each has its own set of accounting records

Parent Co entry on receipt of dividends during 2017

In example 3, assume Subsidiary Co still earns $50,000 but now declaresand pays a dividend of $120,000 during 2017 This makes its assets andretained earnings $120,000 lower than in example 1 Its year-end BalanceSheet would be the following:

Subsidiary Co Balance Sheet as at December 31, 2017, for example 3

In this case, Parent Co receives its 10 percent share of the $120,000dividend, or $12,000 in cash The first part of the accounting entry is simple:

cash goes up $12,000 on the Balance Sheet What about the second part, the

entry for the Income Statement? Does it make sense for Parent Co to record the full $12,000 as dividend revenue? Absolutely not Notice that when

Parent Co purchased Subsidiary Co., the latter had retained earnings of

$170,000 When it bought 10 percent of Subsidiary Co.’s shares, Parent Co.essentially purchased 10 percent of these retained earnings After ParentCo.’s share purchase on January 1, 2017, Subsidiary Co earned a total of

$50,000 and paid dividends totaling $120,000 This means Subsidiary Co.’sretained earnings decrease by the $70,000 difference ($120,000 − $50,000).Parent Co gets 10 percent of this decrease ($7,000) This $7,000 decrease is

a return of Parent Co.’s initial investment and is not revenue

In example 3, when the dividends are received in 2017, Parent Co wouldrecord an increase in cash of $12,000, a decrease in its Investment inSubsidiary Co of $7,000 (from $67,000 down to $60,000), and dividendrevenue of $5,000

Parent Co entry on receipt of dividends during 2017

The rational is as follows: Only those dividends paid from the earnings thatSubsidiary Co makes after Parent Co.’s purchase of shares can be treated asrevenue by Parent Co Any dividends paid from retained earnings (whichwere purchased by Parent Co as part of its 10-percent equity stake) are areturn of the initial investment and treated as a reduction in Parent Co.’sinvestment in Subsidiary Co account Imagine an extreme case whereSubsidiary Co paid a $170,000 dividend on January 2, 2017 (the day after

the Parent Co purchase) Would any of the $17,000 (10 percent) in dividends

that Parent Co would receive be recorded as revenue? No, because

Subsidiary Co has not yet had earnings after the share purchase and the full

$17,000 would be a return of the acquisition price paid by Parent Co

Going forward in example 3, Parent Co will use Subsidiary Co.’s adjustedretained earnings amount of $100,000 to determine if future dividends arerevenue or a reduction in the investment account (i.e., if future dividends paid

by Subsidiary Co reduce its retained earnings below, then a reduction inParent Co.’s investment account will occur) Only dividends paid fromSubsidiary Co.’s future earnings (without having to dip into the $100,000

adjusted retained earnings amount) will be recorded as revenue by Parent Co.Also, it is important to note that once it is written down (reduced), theinvestment account is not written back up (increased), even if SubsidiaryCo.’s retained earnings increase.8

A final point: Under the cost method of accounting for intercorporateinvestments, the investment account is not written down (reduced) whenSubsidiary Co incurs losses The investment would be written down if, asnoted above, Subsidiary Co pays dividends that lower or further lowerretained earnings below what they were when Parent Co purchased shares

Of course, as with any asset, if Parent Co at any point believes that itsinvestment in Subsidiary Co has sustained a permanent decline in its value tobelow the accounting value, then Parent Co must make an adjustment in itsaccounting books to take that value decline into account

The Equity Method of Accounting for Intercorporate

Investments

The equity method is used, as noted above, when a firm has a minority activeinvestment or a majority stake in another firm.9 Under the equity method, thelong-term intercorporate investment is initially recorded at cost on theBalance Sheet (investment up, cash down) The method then picks up theinvesting firm’s share of the subsidiary’s earnings or losses (investment up ordown and an Income Statement item up or down) and recognizes anydividends received from the subsidiary as a reduction of the investment (cash

up, investment down).10 That is, the investing firm recognizes earnings orlosses from the investment in the same period as they are recognized by thesubsidiary This happens because being a minority active investor (or amajority owner) means the investing firm is able to influence the timing ofthe subsidiary’s dividend payments This means the investing firm has atleast some control over when it receives the dividends and could take them inthe period they are earned by the subsidiary It would make no sense to allowthe investing firm’s management to manipulate earnings by choosing when itpays itself dividends

For example, assume a firm called Parent Co buys 30 percent of theoutstanding equity of Subsidiary Co on January 1, 2017, for $201,000 At thetime of purchase, Subsidiary Co.’s Balance Sheet shows the following:

Subsidiary Co Balance Sheet as at January 1, 2017

Parent Co records its purchase of Subsidiary Co shares on January 1,

2017, by increasing a long-term investment account and reducing cash

Parent Co entry on January 1, 2017

In example 1, assume Subsidiary Co earns $50,000, pays no dividendsduring 2017, and shows the following year-end Balance Sheet:

Subsidiary Co Balance Sheet as at December 31, 2017, for example 1

In this case, Parent Co increases its investment account by $15,000 (its 30percent share of Subsidiary Co.’s profit) and records an Income Statementline item called “income from equity investment in Subsidiary Co.” (or moresimply, “equity income”) of $15,000 Thus, Parent Co picks up its share ofthe profits or losses of Subsidiary Co

Parent Co entry on receipt of dividends during 2017

In example 2, assume Subsidiary Co earns $50,000 and pays a $20,000dividend during 2017 This reduces its assets and retained earnings by

$20,000 (when compared to example 1) Subsidiary Co.’s year-end BalanceSheet would be the following:

Subsidiary Co Balance Sheet as at December 31, 2017, for example 2

In this case, Parent Co receives its 30 percent share of the $20,000dividend, or $6,000 As in example 1, Parent Co records its share ofSubsidiary Co.’s $50,000 profit with an increase in the investment account of

$15,000 (Parent Co.’s 30 percent share of Subsidiary Co.’s profit) and a lineitem in the Income Statement of $15,000 Then Parent Co records the $6,000dividend received as an increase in cash and a decrease in its investmentaccount of $6,000 Thus, Parent Co.’s “investment in Subsidiary Co.”account goes up a net of $9,000 (the $15,000 increase for its share of theprofits less the $6,000 for its share of the dividends)

Parent Co entry on receipt of dividends during 2017

There is no need to provide a third example for how the equity methodwould handle a higher dividend because the only difference would be thelarger increase in cash and reduction in the investment account due to theincreased dividend

Is that it? Not even close The equity method is in fact much more

complex The equity method has additional adjustments for unrealizedintercompany profits and for any differences between what Parent Co paidfor Subsidiary Co.’s assets and liabilities and what its book (accounting)values were In effect, using the equity method results in the same net income

as when a firm consolidates a subsidiary Consolidation is described next

Summary of the accounting for the cost versus equity methods:

Consolidations

The financial statements of public firms normally do not reflect theaccounting records of the firm being examined The statements are rather an

accounting fiction of what the firm and all its subsidiaries would look like ifthey comprised a single legal entity Consider the following chart, where aholding company called Parent Co fully owns three operating firms calledSubsidiary 1, Subsidiary 2, and Subsidiary 3:

The nonconsolidated Income Statement and Balance Sheet of the Parent

Co., as shown in Exhibit 1.1, are completely uninformative What are the

assets of Parent Co.? Some cash, dividends receivable from the operating

firms, and its investments in the three subsidiaries What are the liabilities of

Parent Co.? It has some debt and owes some dividends to its owners But

Exhibit 1.1 says nothing about the sales or costs of the combinedorganization, nor does it provide any sense of the breakdown of variousassets or liabilities There is no financial analysis that can be done tounderstand the nature of the firm’s business Although legally accurate, thesestatements are not useful to an outsider trying to understand Parent Co orpredict its future cash flows

In contrast, consolidated financial statements present a fictional picture ofwhat the firm would look like if it were a single legal entity (if the parent firmand its subsidiaries were combined) This is needed to understand the nature

of the firm’s business and predict future cash flows In other words, the legalreality of separate firms, where one owns the others, must be undone Thelegal reality is replaced with a combination of each subsidiary’s assets,liabilities, revenues, and expenses rather than a line on the Balance Sheet forinvestment in subsidiary and a line on the Income Statement for dividendrevenue or equity income

Exhibit 1.1: An Unconsolidated Income Statement and

Balance Sheet

Parent Co Income Statement for the year ended December 31, 2017

Dividend revenue $52,000

Interest expense $20,000

Profit before tax $32,000

Parent Co Balance Sheet as at December 31, 2017

Consolidated financial statements are prepared from a worksheet Whenconsolidating the statements of a parent and a single subsidiary, the Parent

Co accounts are listed in the first two columns (debits and credits) and arefollowed by the Subsidiary Co accounts (debits and credits).11 Thus, the twofirms’ actual accounts are listed in the first four columns of the worksheet.12

The next two columns are the adjustments, which is the consolidation processdiscussed below Finally, each line is totaled horizontally, and the last twocolumns are the consolidated financial statements

The Consolidated Balance Sheet

Let us start with a very simple example The date is January 2, 2017, andParent Co has just purchased 100 percent of the outstanding common stock

of Subsidiary Co for $670,000 On the date of the acquisition the BalanceSheets of each company are as follows:

Balance Sheet as at January 2, 2017 ($ thousands)

These two Balance Sheets can be placed into a worksheet as follows:

Note that, in the example above, Parent Co.’s 100 percent ownershipinvestment in Subsidiary Co., at $670,000, is exactly the net book value(assets less liabilities) of Subsidiary Co ($920,000 less $250,000) This is anextreme simplification In reality, an acquirer (Parent Co in this example)would almost always pay above book value (i.e., above accounting value) for

a firm Why do acquirers typically pay more for their acquisition target than

the target’s accounting value? Because the accounting value does not include

human capital, distribution rights, the value of the organizational form, andfirm-created intangibles (copyrights, trade-names, and patents) In addition,accounting values do not reflect economic reality The economic values ofassets are likely to be more than the accounting values, the economic value ofthe current liabilities are likely to be close to accounting values, and theeconomic value of the long-term liabilities could be more or less than theaccounting values How the differences between economic and accountingvalues are treated will be discussed below For now, assume a miracle hasoccurred and that the economic and accounting values of Subsidiary Co areexactly the same, which is what Parent Co paid.

To create a consolidated Balance Sheet for this example on the acquisitiondate, two adjustments are required First, Parent Co.’s investment inSubsidiary Co must be removed from Parent Co.’s consolidated BalanceSheet and replaced with Subsidiary Co.’s assets and liabilities as though theseassets and liabilities were part of a single entity This is done by reducing theinvestment in Subsidiary Co account to zero with a credit of $670,000 (andadding across the columns will now show all the assets and liabilities of thetwo firms) Second, the equity of Subsidiary Co must be removed, with adebit of $500,000 to common stock and $170,000 to retained earnings, fromthe combined firm When the two firms are combined and presented as onefirm, called Parent Co consolidated, the only owners are those of Parent Co.(who own 100 percent of Subsidiary Co through their ownership of ParentCo.) The Balance Sheet of Parent Co consolidated will show 100 percent ofthe assets and liabilities of Subsidiary Co and Parent Co.’s common stockand retained earnings ($2,500,000 and $256,000, respectively) Including theinvestment in Subsidiary Co account or the owner’s equity of Subsidiary Co.would double-count these amounts In other words, what is being added tothe Parent Co.’s accounts are the assets and liabilities of Subsidiary Co Thus,the investment in Subsidiary Co and the owners’ equity of Subsidiary Co.must be removed (reduce, credit, investment in Subsidiary Co $670,000;reduce, debit, common stock $500,000; and reduce, debit, retained earnings

$170,000)

With these two adjustments, the spreadsheet now looks as follows when

we add the rows across and put the totals in the consolidated debit andconsolidated credit columns:

The last two columns of the spreadsheet provide the consolidated BalanceSheet as follows:

Parent Co consolidated Balance Sheet as at January 2, 2017 ($ thousands)

This is the start of the consolidation process: a consolidated Balance Sheet

at the date of acquisition The single line of the investment account has beenreplaced by the assets and liabilities of the subsidiary Also, remember thatthe consolidated Balance Sheet conveys a fiction that exists only in theaccounting world (it is an accounting fiction) In fact, these are two separatefirms, and in the legal records of Parent Co., its investment in Subsidiary Co

is listed at $670,000

A More Realistic Example

Let us now make the above example more realistic in two ways: First, Parent

Co no longer buys 100 percent of Subsidiary Co Second, Parent Co paysmore than the accounting value for Subsidiary Co.’s assets less liabilities.The date is still January 2, 2017, and Parent Co has just purchased 80 percent(not 100 percent as above) of the outstanding common stock of Subsidiary

$556,000 (instead of $670,000), leaving Parent Co with $114,000 inadditional cash

On the date of acquisition, the Balance Sheets of each company are asfollows:

Balance Sheet as at January 2, 2017 ($ thousands)

These two Balance Sheets can be placed into a worksheet as follows ($

thousands):

As above, the consolidation process begins by reducing Parent Co.’saccount for its investment in Subsidiary Co to zero (with an adjusting credit

to investment in Subsidiary Co of $556,000) and then eliminating the equity

of Subsidiary Co (with adjusting debits of $500,000 to common stock and

$170,000 to retained earnings) However, now the adjustments do not balance

(the debits are still $670,000, but the credit is only $556,000) What

happened? Two things: First, Parent Co does not own 100 percent of

Subsidiary Co as it did above Second, Parent Co paid more than SubsidiaryCo.’s accounting value when it purchased 80 percent of Subsidiary Co.’sshares Let us deal with each of these in turn

First, let us deal with the fact that Parent Co does not own 100 percent ofSubsidiary Co The adjustment still removes 100 percent of the SubsidiaryCo.’s equity in the consolidated totals This is correct, as the consolidatedentity should only show Parent Co.’s equity However, when added across,the consolidation will show 100 percent of Subsidiary Co.’s assets and

liabilities, whereas Parent Co only owns 80 percent What about the other 20

percent? Someone else owns it It does not matter who owns it: the only thing

that matters to our present exercise is that it is not Parent Co

There are two possible ways to handle the 20 percent difference: Onerarely used alternative is called “proportional” or “partial” consolidation.14

This method records (adds) only the percentage Parent Co owns ofSubsidiary Co.’s assets and liabilities (in this case 80 percent) This meansadjustments reducing the subsidiary’s assets and liabilities (in this case 20%)would have to be made The second method, what is normally done, is called

“full consolidation” (or just “consolidation”) In this method, Parent Co.records 100 percentage of Subsidiary Co.’s assets and liabilities and then sets

up a new account for the percentage it does not own (in this case 20 percent).The new account is called noncontrolling or minority interest The account islisted as part of the consolidated Balance Sheets owners’ equity account.15

The amount in the account is calculated as the percentage not owned by theparent times the net book value (assets minus liabilities or owners’ equity) ofthe subsidiary In this case, the amount is $134,000 (20 percent × $670,000)

So, we now have four adjusting entries: one to eliminate the investmentaccount (a credit of $556,000); one to eliminate the common stock or equity

of the subsidiary (a debit of $500,000); one to eliminate the retained earnings

of the subsidiary (a debit of $170,000); and a new entry creating an accountcalled noncontrolling interest (a credit of $134,000) Alas, the debits($500,000 + $170,000 = $670,000) still do not equal the credits ($556,000 +134,000 = $690,000), taking us to our final adjustment

Now let us deal with the fact that Parent Co paid more than accountingvalue for Subsidiary Co As can be seen from the calculation below, Parent

Co paid $20,000 more than the underlying book value of the SubsidiaryCo.’s assets and liabilities Accountants call this a purchase pricediscrepancy

Why did Parent Co pay more for its ownership in Subsidiary Co than the ownership percentage times the accounting values? As noted above, the

“fair” or economic values of the underlying assets and liabilities may beworth more or less than their accounting values In addition, Subsidiary Co.may have human capital, distribution rights, the value of the organizationalform, and firm-created intangibles (copyrights, trade-names, and patents) notincluded in the accounts

How is the purchase price discrepancy accounted for? This can become

somewhat complex In effect, each of Subsidiary Co.’s assets and liabilitieswill be separately valued (estimated) This includes computing values for anyintangible assets (even those with no accounting value) Then an adjustmentwill be made for the differences between these “fair” values and the

accounting values Is the adjustment for 100 percent of this difference even

when Parent Co purchased less than 100 percent of the subsidiary? No The

adjustment is for the difference times Parent Co.’s ownership percentage.For example, assume the economic and accounting values in our exampleabove are the same for all assets and liabilities except PP&E.16 Further,assume the economic value of PP&E is $915,000 Because the accountingvalue is $900,000, this is a difference of $15,000 The adjustment to PP&E is

an increase or debit of $12,000 (calculated from $15,000 × 80 percent)

However, the purchase price discrepancy and the amount by which theconsolidated Balance Sheet does not balance is $20,000 The adjustment to

PP&E is only $12,000 Where is the final $8,000 required to balance all the

adjustments? This is what accountants call “goodwill.” To an accountant,

goodwill is the portion of the purchase price discrepancy that the accountant cannot attribute to differences between the purchase price and the fair market value of the firm’s assets and liabilities This last line

should be reread several times It is important that readers understand whatgoodwill on the Balance Sheet means It does not represent goodwill thatParent Co created over time by providing quality products and services ontime in a friendly, helpful manner Rather, it represents what the Parent Co.paid above the identifiable market value of the subsidiary’s assets andliabilities (in other words, the $8,000 required to balance all the adjustments).Goodwill can only exist after an acquisition

The following spreadsheet can now be prepared for our more realistic

example ($ thousands):

And from the spreadsheet, we can now create a consolidated BalanceSheet:

Parent Co consolidated Balance Sheet as at January 2, 2017 ($ thousands)

The Consolidated Income Statement

Let us now continue the example above (Parent Co purchases 80 percent of

Subsidiary Co for $556,000) to the end of the year We start with the end consolidated Income Statement, and then turn to the consolidatedBalance Sheet The date is now December 31, 2017, and Parent Co andSubsidiary Co have the following individual Income Statements for the year:

year-We also have some additional information: Parent Co purchased $40,000

of product from Subsidiary Co during the year, paying $28,000 to Subsidiary

Co by year end and leaving $12,000 unpaid Parent Co resold all of thisproduct to its customers for $45,000 Also, Parent Co declared and paid adividend of $46,000, while Subsidiary Co declared and paid a dividend of

$15,000

As with the Balance Sheet, creating a consolidated Income Statement isdone on a worksheet Note that the difference in the total debits and totalcredits of each company is its profit (or loss)

Income Statements for the year ended December 31, 2017 ($ thousands)

The initial spreadsheet looks as follows ($ thousands):

The first adjustment is for any intercompany transactions that arise when afirm sells its products (or provides services) to a related firm Assume that all

of a subsidiary’s sales are to its parent company and that none of this product

is resold at year end Has the combined firm made any profit on these sales?

The subsidiary shows a profit, but what happened was simply a transfer fromone related entity to another In effect, a firm cannot recognize sales, costs,profits, or losses by selling products (or providing services) to itself A profit(or loss) can only be made when there are sales to unrelated parties

In our example, Subsidiary Co sold $40,000 worth of product to Parent

Co Because Parent Co owns Subsidiary Co (even if only 80 percent of it),this is an intercompany sale on which Subsidiary Co realized a gross profit

of $27,200 How is that computed? Subsidiary Co has gross profit of

$170,000 on $250,000 sales This is a gross profit percentage of 68 percent($170,000/$250,000) Subsidiary Co.’s gross profit on $40,000 of sales istherefore $27,200 ($40,000 × 68 percent) Separately, Parent Co resold all ofthis product for $45,000, realizing a gross profit of $5,000 (its sale price of

$45,000 less the cost of $40,000 that Parent Co paid to Subsidiary Co.).Combining the profits of both parent and subsidiary gives us $32,200($27,200 + $5,000).17

However, for consolidation purposes, the intercompany sale itself requires

an adjustment to avoid double counting In this case, the Subsidiary Co.’s

$40,000 sale must be removed (with a debit) and the Parent Co.’s $40,000cost must be removed (with a credit) Note, if Parent Co and Subsidiary Co.were one legal entity (remember, the two firms being one is the consolidationfiction), then the revenue from the sale to the unrelated customer would bethe $45,000 Parent Co sold the product for, and the cost from an unrelated

suppler would be the $12,800 Subsidiary Co purchased the product for fromthe unrelated supplier The difference is the $32,200 profit noted above Theremoval of the intercompany sale and cost does not affect profits, but it doesaffect the total amounts for sales and COGS and the gross margin (grossprofit/sales).

Next, notice Parent Co has “equity earnings” in the amount of $39,000.Remember, as noted above, the equity method is used in cases of majorityownership, and it requires the Parent Co to pick up its share of thesubsidiary’s earnings for the year However, the reader may note that the

$39,000 amount is less than 80 percent of Subsidiary Co.’s profit of $50,000,

which would have been $40,000 Why is Parent Co.’s equity earnings

account $39,000 and not $40,000? Remember the closing comment from the

end of the explanation of the equity method above: the equity method hasadditional adjustments for (1) unrealized intercompany profits and (2)differences between what the parent paid for the subsidiary’s assets andliabilities, on the one hand, and the book (accounting) values, on the other

We handled the first by eliminating intercompany sales and costs andassuming there were no unrealized profits left at year end Now let usconsider the second

Above, on the start-of-the-year consolidated Balance Sheet, the PP&E isincreased by $12,000 at the date of acquisition (January 2, 2017) Thisincreased amount must now be depreciated over the assets remaining life,which in this example is assumed to be done straight-line with no salvagevalue over 12 years, or $1,000 per year This means that the consolidatedIncome Statement must show $1,000 of additional depreciation expenseabove what is shown on the combined accounts of Parent Co and Subsidiary

Co An increase of $1,000 in the consolidated depreciation expense reducesthe consolidated profit by $1,000 Because, as noted above, the equitymethod results in the same net profit as consolidations, this mean anadjustment of $1,000 is required to Parent Co.’s equity income Parent Co.’sshare of Subsidiary Co.’s profit is $40,000 before adjustments (SubsidiaryCo.’s profits of $50,000 × Parent Co.’s share of 80 percent) A reduction of

$1,000 for the additional consolidated depreciation reduces equity income tothe $39,000 ($40,000 − $1,000) amount recorded by Parent Co above Thus,the equity income is $39,000 (the $40,000 of Parent Co.’s share of SubsidiaryCo.’s profit less the extra $1,000 depreciation)

The next adjustment to the year-end consolidated Income Statement is to

replace the single line item of equity earnings on Parent Co.’s IncomeStatement with the sales and expenses of Subsidiary Co This is done with adebit in the adjustment column of $39,000 to equity earnings (therebyreducing them to zero) followed by a $1,000 increase to the consolidateddepreciation (with a debit of $1,000) These two adjustments reflect ParentCo.’s ownership percentage times the net profit of the subsidiary (80 percent

× $50,000 = $40,000) adjusted for the required increased depreciation

With no other adjustments, adding across columns would include 100percent of Subsidiary Co.’s revenues and expenses However, Parent Co.only owns 80 percent of Subsidiary Co The final adjustment in this example

is for Parent Co.’s ownership being less than 100 percent As with theconsolidated Balance Sheet, Parent Co.’s consolidated Income Statement willrecord all of Subsidiary Co.’s sales and expenses (adjusted for any inter-company sales) and then set up a new expense to recognize the percentage itdoes not own (in this case 20 percent) and so is not entitled to.18 The newexpense is called noncontrolling or minority interest expense This can beslightly confusing, as there are now two accounts with a similar name, onecalled noncontrolling interest under owner’s equity on the Balance Sheet, theother noncontrolling interest after operating profits on the Income Statement

In our example, the adjustment for noncontrolling (or minority interest)expense is a debit (which reduces profit) of $10,000 (Subsidiary Co.’s netprofit of $50,000 × the 20 percent outside ownership)

What about Goodwill? If the increased consolidated PP&E ($12,000 at the start of the year) has to be reduced over time, is the same not true of Goodwill ($8,000 at the start of the year)? Goodwill used to be amortized on

a straight-line basis over a period not to exceed 40 years Today the goodwillcomputation is much more complex: each year, goodwill must be evaluated

If management believes the reported value has, more likely than not,materially declined, then a quantitative revaluation is done Essentially, thesubsidiary’s future cash flows are estimated and discounted to create a valuefor the subsidiary This value is then used to estimate the current value ofgoodwill If the quantitative value has fallen during the year (accountants callthis being “impaired”), it must be written down (never to be written back up).Otherwise, it is left alone (neither increased nor decreased) In this example,for simplicity, we assume there is no impairment

The reader should appreciate how detailed the consolidation process canbecome Each difference has to be adjusted over time For example,

differences in accounts receivable would be adjusted when collected,differences in inventory when sold, differences in debt when repaid, and so

on And this would be done for each account

The adjustments are recorded onto the spreadsheet, cross totals arecomputed, and a consolidated Income Statement is prepared as follows ($thousands):

Note that the Parent Co.’s unconsolidated net income (which includedequity income of $39,000) matches Parent Co.’s consolidated net income

Why? It is by definition: as noted above, the equity method requires

adjustments (in this case, the $1,000 reduction for the additional consolidateddepreciation) so that a firm’s profit or loss using the equity method (the net ofall the adjustments, in this case $40,000 − $1,000) must be the same as if afirm consolidates the subsidiary

Parent Co consolidated Income Statement for the year ended December

31, 2017 ($ thousands)

The Consolidated Year-End Balance Sheet

Now we turn to the year-end consolidated Balance Sheet Naturally, at yearend there would be numerous differences based on both firms’ varioustransactions However, let us start with a few specific differences ParentCo.’s investment in Subsidiary Co has grown from $556,000 to $583,000.This $27,000 increase reflects Parent Co.’s $39,000 share of Subsidiary Co.’searnings (described above) less the dividend received of $12,000 (80 percent

of the $15,000 dividend paid by Subsidiary Co.) Parent Co.’s retainedearnings increased from $256,000 to $410,000 This $154,000 increasereflects Parent Co.’s $200,000 profit less the $46,000 dividend it paid to itsowners

Subsidiary Co.’s retained earnings increased from $170,000 to $205,000.This $35,000 increase reflects Subsidiary Co.’s $50,000 profit less the

$15,000 dividend it paid to its owners (of which $12,000 was paid to ParentCo.)

Balance Sheet as at January 2, 2017 ($ thousands)

These two Balance Sheets can be placed into a worksheet as follows ($

thousands):

The adjustment process begins as it did at the start of the year First, ParentCo.’s investment account of $583,000 and then the Subsidiary Co.’s commonstock of $500,000 and retained earnings of $205,000 are eliminated Next,noncontrolling (the Balance Sheet account, not the Income Statement one) isset up at $141,000: this is the subsidiary’s year-end net book value

($1,000,000 – $295,000 = $705,000) times the percentage not owned byParent Co (20 percent).

Next, the purchase price discrepancies are set up PP&E is increased by

$12,000, and goodwill is increased by $8,000 PP&E is further adjusted forthe increase in accumulated depreciation of $1,000, resulting in a net year-end increase in PP&E of $11,000

Finally, Parent Co purchased $40,000 worth of goods from Subsidiary Co.but only paid $28,000 by year end Thus Parent Co has a $12,000 payable toSubsidiary Co., which has a $12,000 receivable from Parent Co Because afirm cannot owe itself anything, all intercompany receivables and payablesmust be eliminated, so the receivable and payable are reduced by $12,000

Other Complications

As noted at the start, in reality consolidations is a very detailed process Forexample, firms rarely purchase publicly traded firms at one time with onepayment Usually, numerous small purchases are made until the parent owns

5 percent, at which time it must publicly announce its intention to buy more.Even then, it may make many small additional purchases before gaining amajority ownership For consolidations, each of these small purchases must

be tracked and a separate purchase price discrepancy calculated This is notdifficult, but it is detailed The sheer number of pieces to this puzzle is whatmakes consolidation an advanced topic for accountants

The worksheet is now adjusted to look as follows ($ thousands):

The consolidated year-end Balance Sheet can now be produced:

Parent Co consolidated Balance Sheet as at January 2, 2017 ($ thousands)

The Bottom Line

There are several key points the reader should take away from this chapter:

If an investing firm has no control over the dividends paid by the firm inwhich it is investing, then an investment account is used to record theinvestment at cost, the investment account is kept at cost, and revenue is onlyrecognized when dividends accrue to the investing firm

If a firm has some control over dividends and owns less than 50 percent ofthe voting shares, revenue is recognized, and the investment account isincreased (decreased) with the investing company’s share of the subsidiary’searnings (losses) and reduced by any dividends received from the subsidiary.There are additional adjustments and the final income (or loss) recognizedusing the equity method will match the one that would be computed ifconsolidating financial statements were prepared

Consolidation is a fiction: it represents what two (or more) firms mightlook like if they were one legal entity Instead of an investment account, all ofthe subsidiary’s assets and liabilities, revenues and expenses are included inthe parent’s consolidated financial statement after numerous adjustments.Noncontrolling or minority interest on the Balance Sheet is what the parentdoes not own in the subsidiary It is computed as the outside ownershippercentage times the subsidiary’s net book (accounting) value of assets lessliabilities

Noncontrolling or minority interest expense on the Income Statement is theoutside ownership’s share of the subsidiary’s profits or loss It is computed asthe outside ownership percentage times the subsidiary’s profit (or loss)

A purchase price discrepancy is the difference between what the Parent Co.pays for its ownership in a subsidiary and the subsidiary’s net book valuetimes the ownership percentage

Goodwill is the portion of the purchase price discrepancy that cannot beattributed to fair market value differences (economic values versusaccounting values) Goodwill is reduced if it is determined to have declined

in value during the year

The next chapter examines the time value of money and how it is used invaluation

_

1 A long-term intercorporate investment occurs when one firm buys shares of another.

2 The time value of money and how to compute a net present value is discussed in Chapter 2.

Investments are evaluated based on whether or not they provide at least a competitive return, in

addition to legal, ethical, and environmental concerns.

3 There is a form of partnership today, which most auditing firms have embraced, called a “limited liability partnership” (LLP) An LLP limits the liabilities of the partners (i.e., the liability of one partner for the negligence of another is limited).

4 A subsidiary is a firm that is owned by another firm The firm that owns the shares is called the

“parent” firm or “holding” firm Most public firms (and many private firms) are holding companies owning multiple operating firms.

5 More recently, Coca-Cola has purchased a majority and even sole ownership of its bottlers.

6 If only consolidated statements are presented, then the Parent Co.’s statements can use either the cost

or equity method Whether they decide to use one method or the other will not matter because, as shown below, the investment account is eliminated upon consolidation.

7 Dividends never have to be paid until a board of directors declares them and become payable to the shareholders of record on a specific date If the parent firm owns the shares on the date of record, they are entitled to receive them, which is why this is the date they are recognized.

8 This is similar to the write-down of any long-term asset The write-down is like a reset and then treated as if it was the original cost.

9 For majority stakes it will not matter whether the cost or equity method is used since, as will be shown in the section on consolidations, the investment under either method is removed from the final presentation.

10 If the dividends were unpaid at year end, then the investing firm would show dividends receivable and reduce the investment account.

11 The word “debit” means to the left (the first column) and the word “credit” means to the right (the second column) Assets are increased with debits whereas liabilities and equity are increased with credits (revenue is increased with credits because it increases equity while expenses are increased with debits) A Balance Sheet not only will have total assets equal to total liabilities plus equity, but the total debits will equal the total credits.

12 For simplicity, the case of just one subsidiary is shown Two additional columns would be added for each additional subsidiary.

13 As a reminder, assets are increased with debits; liabilities and owners’ equity are increased with credits.

14 One situation where proportional consolidation may be used if a firm owns exactly 50 percent of the voting shares.

15 At one time it was listed after liabilities but before owners’ equity, but accounting norms have changed.

16 Again, in reality there would be numerous adjustments to virtually all assets and liabilities.

17 For simplicity, there is no unrealized intercompany profit, so only the intercompany sales and costs have to be removed It is sufficient at this point for the reader to simply know that an adjustment is required.

18 The rarely used proportional method would adjust down the 20 percent of Subsidiary Co.’s sales and costs that Parent Co does not own.

CHAPTER 2

The Time Value of Money1

For both accounting and finance, it is critical to understand the time value ofmoney This chapter begins with a review of compounding and discountingand then extends the discussion to explain the concept of net present value(NPV), why it is superior to other valuation methods (namely, the internalrate of return and payback) and reviews perpetuities (payments that continueforever) and their usefulness in valuation

Discounting and Compounding

The time value of money is one of the most powerful concepts in finance It

is a concept that small children express when they say, “I want it now, notlater, now!” Quite simply, the idea is that a dollar today (or anything, for thatmatter) is worth more than a dollar tomorrow

Taking an amount today and computing what it will be worth in the future

is called compounding Taking an amount in the future and figuring out what

it would be worth today is called discounting Compounding and discountingare inverses of each other

An easy way to start the explanation of the time value of money is to

consider a bank account If you invest $100 in a bank account at the start of

the year and earn 5 percent annual interest on your funds during the course

of the year, how much will you have at the end of the year? You will have

$105, which is your original deposit of $100 plus the interest of $5 that youearned during the year ($100 × 5 percent) This means that with a 5 percentinterest rate, $100 today is equivalent to $105 in a year Conversely, $105 in

a year is worth $100 today at that interest rate

What if you leave the $105 in the bank for a second year, again earning 5 percent? How much would you have at the end of the second year? You

would have $110.25 You start the second year with $105 and earn anadditional $5.25 of interest during the second year ($105 × 5 percent) Youearned more in interest during the second year ($5.25) than in the first year