Financial

Statement
Analysis

K R Subramanyam
John J Wild

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 5-2

Analyzing Investing Activities:

Intercorporate Investments

05
CHAPTER
 5-3

Investment Securities
Composition

Investment
Investment (marketable)
(marketable) securities:
securities:
Debt
Debt Securities
Securities
•• Government
Government or
or corporate
corporate debt
debt obligations
obligations
Equity
Equity Securities
Securities
•• Corporate
Corporate stock
stock that
that is
is readily
readily marketable
marketable
 5-4

Investment Securities
Composition
 5-5

Investment Securities
Accounting for Investment Securities

• SFAS 115.
– Departure from the traditional lower-of-cost-or-
market principle.
– Prescribes that investment securities be reported on
the balance sheet at cost or fair (market) value,
depending on the type of security and the degree of
influence or control that the investor company has
over the investee company.
– Accounting is determined by its classification.
 5-6

Investment Securities
Accounting for Investment Securities

• SFAS 115.
– Departure from the traditional lower-of-cost-or-
market principle.
– Prescribes that investment securities be reported on
the balance sheet at cost or fair (market) value,
depending on the type of security and the degree of
influence or control that the investor company has
over the investee company.
– Accounting is determined by its classification.
 5-7

Investment Securities

Accounting for Debt Securities

 5-8

Investment Securities
Accounting for Transfers between Security Classes
 5-9

*Maksud: pembagian dividen

Investment Securities
Classification and Accounting for Equity Securities

In net income*
 5-10

Investment Securities
Analyzing Investment Securities
• Two main objectives:
– To separate operating performance from investing (and
financing) performance
• Remove all gains (losses) relating to investing activities
• Separate operating and nonoperating assets when
determining RNOA
– To analyze accounting distortions from securities
• Opportunities for gains trading
• Liabilities recognized at cost
• Inconsistent definition of equity securities
• Classification based on intent
 5-11

Equity Method Accounting

• Required for intercorporate investments in which
the investor company can exert significant
influence over, but does not control, the investee.
– Reports the parent’s investment in the subsidiary, and
the parent’s share of the subsidiary’s results, as line
items in the parent’s financial statements (one-line
consolidation)

Note: Generally used for investments representing

20 to 50 percent of the voting stock of a company’s
equity securities--main difference between
consolidation and equity method accounting rests in
the level of detail reported in financial statements
 5-12

Equity Method Accounting

Equity Method Accounting

• Investment account:
– Initially recorded at acquisition cost
– Increased by % share of investee earnings
– Decreased by dividends received
• Income:
– Investor reports % share of investee company earnings
as “equity earnings” in its income statement
– Dividends are reported as a reduction of the investment
account, not as income
 5-13

Equity Method Accounting

Equity Method Mechanics
• Assume that Global Corp. Synergy, Inc.
acquires for cash a 25%
interest in Synergy, Inc. for Current assets 700,000
$500,000, representing one-
PP&E 5,600,000
fourth of Synergy’s
stockholders’ equity as of the Total assets 6,300,000
acquisition date.
Current liabilities 300,000
• Acquisition entry: Long-term debt 4,000,000
Stockholders’ Equity 2,000,000
Investment500,000 Total liabs and equity 6,300,000
Cash
500,000
 Equity Method Accounting
5-14

Equity Method Mechanics

• Subsequent to the Investment 25,000
acquisition date, Synergy Equity earnings
reports net income of 25,000
$100,000 and pays (to record proportionate share of
dividends of $20,000. investee company earnings)
Global records its
proportionate share of
Cash 5,000
Synergy’s earnings and
the receipt of dividends Investment
as follows: 5,000
(to record receipt of dividends)
 5-15

Equity Method Accounting

• Important points:
– Investment account reported at an amount equal to the proportionate
share of the stockholders’ equity of the investee company. Substantial
assets and liabilities may not be recorded on balance sheet unless the
investee is consolidated.
– Investment earnings should be distinguished from core operating
earnings (unless strategic).
– Investments are reported at adjusted cost, not at market value.
– Should discontinue equity method when investment is reduced to zero
and should not provide for additional losses unless the investor has
guaranteed the obligations of the investee or is otherwise committed to
providing further financial support to the investee.
• Resumes once all cumulative deficits have been recovered via investee
earnings.
– Excess of initial investment over the proportionate share of the book
value is allocated to identifiable tangible and intangible assets that are
depreciated/amortized over their respective useful lives. Investment
income is reduced by this additional expense. The excess not allocated in
this manner is treated as goodwill and is no longer amortized.
 5-16

Business Combinations
The merger, acquisition, reorganization, or restructuring of two or more
businesses to form another business entity

Motivations

• enhance company image and growth potential

• acquiring valuable materials and facilities
• acquiring technology and marketing channels
• securing financial resources
• strengthening management
• enhancing operating efficiency
• encouraging diversification
• rapidity in market entry
• achieving economies of scale
• acquiring tax advantages
• management prestige and perquisites
• management compensation
 5-17

Business Combinations
Accounting for Business Combinations

• Purchase method of accounting

– Companies are required to recognize on their balance sheets
the fair market value of the (tangible and intangible) assets
acquired together with the fair market value of any liabilities
assumed.
• Tangible assets are depreciated and the identifiable intangible
assets amortized over their estimated useful lives.

• Nonamortization of goodwill
 5-18

Business Combinations
Consolidated Financial Statements
Consolidated
Consolidatedfinancial
financialstatements
statementsreport
reportthe
theresults
resultsof
ofoperations
operationsand
and
financial
financialcondition
conditionof
ofaaparent
parentcorporation
corporationand
andits
itssubsidiaries
subsidiariesin
inone
oneset
setof
of
statements
statements
Basic Technique of Consolidation
Consolidation
Consolidationinvolves
involvestwo
twosteps:
steps:aggregation
aggregationand
andelimination
elimination

Aggregation
Aggregationof
ofassets,
assets,liabilities,
liabilities,revenues,
revenues,and
and
expenses of subsidiaries with the parent
expenses of subsidiaries with the parent

Elimination
Eliminationof
ofintercompany
intercompanytransactions
transactions
(and
(andaccounts)
accounts)between
betweensubsidiaries
subsidiariesand
andthe
theparent
parent

Note:Minority
Note: Minorityinterest
interestrepresents
representsthe
theportion
portionof
ofaasubsidiary’s
subsidiary’sequity
equity
securities
securitiesowned
ownedby
byother
otherthan
thanthe
theparent
parentcompany
company
 5-19

Business Combinations
Consolidation Illustration
On
OnDecember
December31,31, Year
Year1,
1, Synergy
SynergyCorp.
Corp. purchases
purchases100% 100%of
of
Micron
MicronCompany
Companyby byexchanging
exchanging10,000
10,000shares
sharesof of its
itscommon
common
stock
stock($5
($5par
parvalue,
value, $77
$77market
market value)
value)for
forall
allof
of the
thecommon
common
stock
stockof
of Micron.
Micron.

On
Onthethedate
dateofof the
theacquisition,
acquisition, the
thebook
bookvalue
valueof
of Micron
Micronisis
$620,000.
$620,000. Synergy
Synergyisiswilling
willingto
topay
paythe
themarket
market price
priceof of
$770,000
$770,000because
becauseitit feels
feelsthat
that Micron’s
Micron’sproperty,
property, plant,
plant, and
and
equipment
equipment (PP&E)
(PP&E)isisundervalued
undervaluedby by$20,000,
$20,000, itit has
hasanan
unrecorded
unrecordedtrademark
trademarkworth
worth$30,000
$30,000andandintangible
intangiblebenefits
benefits
of
of the
thebusiness
businesscombination
combination(corporate
(corporatesynergies,
synergies, market
market
position,
position, and
andthethelike)
like)are
arevalued
valuedat at $100,000.
$100,000.
 5-20

Business Combinations
Consolidation Illustration
The
Thepurchase
purchaseprice
priceis,
is,therefore,
therefore,allocated
allocatedas
asfollows:
follows:
Purchase
Purchaseprice
price 770,000
770,000
Book
Bookvalue
valueof
ofMicron
Micron 620,000
620,000
Excess
Excess 150,000
150,000
Excess
Excessallocated
allocatedtoto–– useful
usefullife
life annual
annual
deprec/amort.
deprec/amort.
Undervalued
UndervaluedPP&E
PP&E 20,000
20,000 10
10 2,000
2,000
Trademark
Trademark 30,000
30,000 55 6,000
6,000
Goodwill
Goodwill 100,000
100,000 indefinite
indefinite -0-
-0-
150,000
150,000
5-21
 5-22

Business Combinations
Synergy Corp and Micron Company
Consolidated Income Statement Steps
• The four consolidation entries are
1. Replace $620,000 of the investment account with the book
value of the assets acquired. If less than 100% of the
subsidiary is owned, the credit to the investment account is
equal to the percentage of the book value owned and the
remaining credit is to a liability account, minority interest.
2. Replace $150,000 of the investment account with the fair value
adjustments required to fully record Micron’s assets at fair
market value.
3. Eliminate the investment income recorded by Synergy and
replace that account with the income statement of Micron. If
less than 100% of the subsidiary is owned, the investment
income reported by the Synergy is equal to its proportionate
share, and an additional expense for the balance is reported
for the minority interest in Micron’s earnings.
4. Record the depreciation of the fair value adjustment for
Micron’s PP&E and the amortization of the trademark. Note,
there is no amortization of goodwill under current GAAP.
 5-23

Business Combinations
Synergy Corp and Micron Company
Consolidated Income Statement Steps
• Income statement of Synergy is combined with that of Micron.
• Depreciation / amortization of excess of purchase price over the
book value of Micron’s assets is recorded as an additional
expense in the consolidated income statement.
• Any intercompany profits on sales of inventories held by the
consolidated entity at year-end, along with any intercompany
profits on other asset transactions, are eliminated.
• Equity investment account on Synergy’s balance sheet is
replaced with the Micron assets / liabilities to which it relates.
• Consolidated assets / liabilities reflect the book value of Synergy
plus the book value of Micron, plus the remaining undepreciated
excess of purchase price over the book value of Micron assets.
• Goodwill, which was previously included in the investment
account balance, is now broken out as a separately identifiable
asset on the consolidated balance sheet.
 5-24

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