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Product Details
ISBN-13: | 9780071429696 |
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Publisher: | McGraw Hill LLC |
Publication date: | 06/03/2004 |
Pages: | 288 |
Sales rank: | 668,907 |
Product dimensions: | 7.60(w) x 9.30(h) x 1.03(d) |
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Accounting for M&A, Equity, and Credit Analysts
By James Morris
The McGraw-Hill Companies, Inc.
Copyright © 2004The McGraw-Hill Companies, Inc.All rights reserved.
ISBN: 978-0-07-142969-6
Excerpt
CHAPTER 1Equity Method of Consolidation
INTRODUCTION
When dealing with firms that account for investments using the equity method of accounting, analysts often find the reality of applying the equity method to be more complex than the simple one-line consolidation they had envisioned. Beyond that initial hurdle lies the complexity of accurately projecting the effect of equity method investments on the firm's earnings-per-share and cash flow.
To work through some of the more common areas of uncertainty, I begin with a basic introduction of the equity method, recognition of affiliate income, and the receipt of dividends. The next level involves considering the tax implications of the equity method; a common trap is ignoring the taxes because equity earnings and the associated taxes are noncash when, in actuality, they are only noncash for now and impact future cash flows. Following are two more subtle and less well-understood topics: equity method goodwill and intercompany transactions. Finally, we examine the analysis of cash flows from equity method investments and how all of the aspects of the equity method of accounting for investments are properly modeled together in a projection/valuation framework.
DESCRIPTION OF THE EQUITY METHOD
The equity method of accounting for investments describes how corporations and other entities account for the investments they make in other firms. It is the appropriate accounting method for them to use when the investments that they make are large enough to exert significant influence yet too small to require full consolidation accounting. The equity method is generally used for investments of greater than 20-percent ownership (delineating where significant influence is assumed to exist) and less than 50-percent ownership (delineating where consolidation is required). These are nominal measures and, as we see later in this chapter, it is possible for investors to structure aspects of their ownership to extend the range over which they may use the equity method. Figure 1–1 illustrates the accounting relationship between an investor and its investee that it consolidates using the equity method.
Accounting Standards
Accounting Principles Board Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock (APB 18), summarizes the process of accounting for an investment using the equity method as:
* An investor initially records an investment in the stock of an investee at cost, and adjusts the carrying amount of the investment to recognize the investor's share of the earnings or losses of the investee after the date of acquisition.
* The amount of the adjustment is included in the determination of net income by the investor, and such amount reflects adjustments similar to those made in preparing consolidated statements, including adjustments to eliminate intercompany gains and losses, and to amortize, if appropriate, any difference between investor cost and underlying equity in net assets of the investee at the date of investment.
* The investment of an investor is also adjusted to reflect the investor's share of changes in the investee's capital.
* Dividends received from an investee reduce the carrying amount of the investment.
* A series of operating losses of an investee or other factors might indicate that a decrease in value of the investment has occurred that is other than temporary and that should be recognized even though the decrease in value is in excess of what would otherwise be recognized by application of the equity method.
Accounting Under the Equity Method-Fundamental Approach
The fundamental approach for accounting for investments under the equity method is referred to as a one-line consolidation. Using the one-line consolidation approach, the investor presents her portion of the investee's net income as a single line on the income statement and the inferred value of the investment in the investee (historical cost plus the accumulated share of earnings) as a single line on the balance sheet. So, for the simplest of investments, the investor represents the impacts of the entire investment with one line on the income statement and one line on the balance sheet.
Less commonly, when the investee presents either discontinued operations, extraordinary gains and losses, or the effects of changes in accounting principle on its income statement separately after net income, the investor reports them the same way.
EXAMPLE 1–1. Accounting for the Investor's Portion of Investee's Net Income
Assume that on 31-Dec-20x0 Investor paid 1200 for 25 percent of the common stock of Investee. Investor recognizes the investment on its 31-Dec-20x0 balance sheet in the account titled Investment in affiliates as 1200. (Any income tax effects are initially ignored for this discussion.)
Investee's net income for the period ending 31-Dec-20x1 is 400. Investor recognizes 25% x 400 = 100 in its income statement in the account titled Equity in earnings of affiliates. The balance sheet account increases by the amount from the Equity in earnings of affiliates income statement account making the 31-Dec-20x1 balance 1300.
EXAMPLE 1–2. Accounting for Investor's Portion of Investee's Extraordinary Items
Assume the same fact pattern as above except that Investee also reports an extraordinary gain of 200. Investor recognizes 25% x 400 = 100 in its income statement as equity in earnings of affiliates (same treatment as above) and also recognizes 25% x 200 = 50 as equity in extraordinary gain of affiliates. If Investee has reported any items for discontinued operations or effects of changes in accounting principle, they would be presented similarly on Investor's income statement.
If Investee pays a common dividend, Investor reduces its investment account by the amount of the dividend received. Note that receipt of the dividend is not recognized as income in Investor's income statement and is actually a capital transaction affecting only the balance sheet accounts (because we are ignoring, for the moment, any income tax effect). Investor treats the dividend distribution as a capital transaction because the dividend is merely a cash distribution of income that Investor has previously recorded as equity in earnings of affiliates.
EXAMPLE 1–3. Accounting for Investor's Receipt of Dividends from Investee
Assume the same fact pattern as in Example 1–2 above, except that on 31- Dec-20x1 Investee pays a total dividend of 80 to all holders of common stock. The first two entries are the same as in the previous example:
The new entry accounts for the cash received as a cash dividend from Investee that reduces the amount carried in Investor's Investment in affiliates account.
TAX CONSIDERATIONS WHEN USING THE EQUITY METHOD
When assessing the tax effects of equity investments, our first reaction is to sometimes think that the Investee has already paid income taxes on its earnings and that, because of that, there should be no additional tax impact to Investor. While it is true that Investee pays income taxes on its earnings, under U.S. tax law, any gain that Investor realizes on its investment is generally subjected to a second level of taxation, i.e., double taxation; those tax effects must be reflected in Investor's accounting. The general tax effects of an equity method investment include the:
* Recognition of book taxes in each period to reflect the accrued tax burden associated with the equity in earnings of the affiliate
(Continues...)
Excerpted from Accounting for M&A, Equity, and Credit Analysts by James Morris. Copyright © 2004 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc..
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