Chapter 17
Understanding and Analyzing
Consolidated Financial Statements LEARNING OBJECTIVES:
When your students have finished studying this chapter, they should be able to:
1. Contrast accounting for investments using the equity method and the market–value
method.
2. Explain the basic ideas and methods used to prepare consolidated financial statements.
3. Describe how goodwill arises and how to account for it.
4. Use financial statements analysis to evaluate an organization’s performance
5. Explain and use a variety of popular financial ratios.
6. Identify the major implications that efficient stock markets have for accounting.
CHAPTER 17: ASSIGNMENTS
CRITICAL THINKING EXERCISES
25. Market Method, Equity Method, and Total Assets
26. Depreciation in Consolidated Financial Statements
27. Just-in-Time (JIT) Inventory and Current Ratio
28. Market Efficiency
GENERAL EXERCISES and PROBLEMS
29. Equity Method
30Consolidated Financial Statements
31.Determination of Goodwill
32.Purchased Goodwill
33.Amortization and Depreciation
34.Allocating Total Purchase Price to Assets
35.Preparation of Consolidated Financial Statements
36.Intercorporate Investments and Ethics
37.Profitability Ratios
38.Financial Ratio
UNDERSTANDING PUBLISHED FINANCIAL REPORTS
39.Meaning of Account Descriptions
40.Classification on Balance Sheet
41.Effects of Transactions Under the Equity Method
42.Noncontrolling Interests
43.General Electric and GECS
44.Goodwill
45.Accounting for Goodwill
46.Income Ratios and Asset Turnover
47.Financial Ratios
48.Nike 10-K Problem: Using Consolidated Financial Statements
EXCEL APPLICATION EXERCISE
49. Calculating Financial Ratios
COLLABORATIVE LEARNING EXERCISE
50. Financial Ratios
INTERNET EXERCISE
51. General Electric’s Annual Report
(https://www.doczj.com/doc/014459458.html,)
CHAPTER 17: OUTLINE
Part One: Intercorporate Investments Including Consolidations
Firms often invest in the equity securities of other companies. The investor may be simply investing excess cash, or he may be seeking some degree of control over the investee. There are three methods of accounting for intercorporate investments: the equity and market methods and consolidation.
An investor that holds less than 20% of another company is assumed to be a passive investor—it cannot significantly influence the decisions of the investee—and it uses the market method. Investors with between 20% and 50% interest use the equity method.
At this level of ownership, the investor has the ability to exert significant influence on the investee. Firms with an interest in excess of 50% must use the consolidation approach.
I. Market Value and Equity Methods{L. O. 1}
A.Market-Value Method—records the initial investment on the balance
sheet at fair market value (FMV). Such investments are often called
marketable securities in the financial statements. Trading Securities—
investments that the company buys only with the intent to resell them
shortly. Available-for-Sale Securities—investments that the company
does not intend to sell in the near future. Changes in market value of
trading securities are reported as gains (increase in FMV) or losses
(decrease in FMV), whereas available-for-sale securities have their
unrealized gains or losses shown in a separate valuation allowance
account in the stockholders’equity section of the balance sheet. (See
EXHIBIT 17-1)
B.Equity Method—accounts for the investment at the acquisition cost
adjusted for the investor’s share of dividends and earnings or losses of
the investee after the date of investment. Investors increase the carrying
amount of the investment by their share of investee’s earnings and
reduce the carrying amount by dividends received from the investee
and by their share in investee’s losses.
II. Consolidated Financial Statements {L. O. 2}
Parent Company—the company owning more than 50% of the other business’s stock.
Subsidiary—the company whose stock is owned by the other business. Although parent and subsidiary companies typically are separate legal entities, in many regards
they function as one unit. Consolidated Financial Statements—financial statements that combine the financial statements of the parent company with those of various subsidiaries.
A.The Acquisition
When a parent acquires a subsidiary, the evidence of interest is recorded as
Investment in Subsidiary. When the consolidated statements are prepared,
they cannot show both the evidence of interest and the underlying assets and
liabilities of the subsidiary. To avoid such double-counting, the reciprocal
evidence of ownership present is eliminated in two places: (1) the Investment
in Subsidiary on the parent company’s books and (2) the Stockholders’ Equity
on the subsidiary company’s books. The entries necessary to accomplish this
are called eliminating entries.
III. Recognizing Income After Acquisition
Long-term investments in equity securities (e.g., the investments in a subsidiary) are carried in the investor’s balance sheet by the equity method. The income generated by
a subsidiary is recognized by the parent company as an increase in an account titled
Investment in Subsidiary.
A. Noncontrolling Interests
When a parent holds less than 100% of the stock of a subsidiary, a
consolidated balance sheet includes an account on the equities side called
Noncontrolling Interests in Subsidiaries, or simply Noncontrolling Interests—
the account that shows the outside stockholders’interest, as opposed to the
parent’s interest, in a subsidiary corporation.
B. Perspective on Consolidated Statements
See EXHIBIT 17-2 and EXHIBIT 17-3for an illustration of how
investments in subsidiaries are presented in companie s’ annual reports. The
headings of the statements indicate that they are consolidated statements. On
balance sheets, the minority interest typically appears just above the
stockholders’ equity section. On income statements, the minority interest in
the net income is deducted as if it were an expense of the consolidated entity
after all the other expenses are listed. Investments in Affiliates(or
Investments in Associates)—listed as an asset on the balance sheet and reflect
the purchase cost and interests in income or loss of investees. The FASB
requires all subsidiaries to be consolidated. The major reason for forcing
consolidation is to provide a more complete picture of the economic entity.
See EXHIBIT 17-4for a summary of the accounting for different levels of
investment in subsidiaries.
C. Accounting for Goodwill {L. O. 3}
In CHAPTER 16, goodwill is defined as the excess of cost over fair value of
net identifiable assets of businesses acquired. The purchase price of a
subsidiary often exceeds its book value. In fact, it frequently exceeds the sum of
the fair market values of the identifiable individual assets less the liabilities.
When the amount paid exceeds the book values, the assets will be valued at
their fair market values for the consolidated statements. Any amounts paid
above the fair market values of the individual assets are carried as goodwill in
the consolidated financial statements.
A purchaser may be willing to pay more than the current values of the
individual assets received because the acquired company is able to generate
abnormally high earnings. The causes of this excess earnings power may be
traced to personalities, skills, locations, operating methods, and so forth.
―Goodwill‖is originally generated internally. For example, a happy
combination of advertising, research, management talent, and timing may give a
particular company a dominant market position for which another company is
willing to pay dearly. This ability to command a premium price for the total
business is goodwill. The selling company will never record goodwill.
Therefore, the only goodwill recognized as an asset is that identified when one
company is purchased by another.
Part Two: Analysis of Financial Statements
Careful analysis of financial statements can help decision makers evaluate an organization’s past performance and predict its future performance. Financial statements of Microsoft Corporation in EXHIBIT 17-5 and EXHIBIT 17-6 are used to focus on financial statement analysis.
Investors analyze financial statements in order to decide whether to buy, sell, or hold common stock. Managers and the financial community (e.g., bank officers and stockholders) use them as clues to help evaluate the operating and financial outlook for an organization. Budgets or pro forma statements, carefully formulated expressions of predicted results including a schedule of the amounts and timings of cash repayments, are helpful to creditors. They want assurances of being paid in full and on time.
IV. Component Percentages
Component Percentages—analysis and presentation of financial statements in percentage form to aid comparability, and is frequently used when comparing companies that differ in size (see EXHIBIT 17-7). The resulting statements are called Common-Size Statements.
Income statement percentages are usually based on sales = 100%. Comparing the gross margin rate or the net income percentage with those of other firms in the industry or with prior years may be useful. Better yet, a comparison of these percentages (along with those for other items on the income statement) with what was budgeted for the current year may help in diagnosing what changes created better or worse results.
Balance sheet percentages are usually based on total assets = 100%. One can see the shifts in the composition of assets between current and long term. In addition, one can see shifts in the equities side of the balance sheet between current liabilities, noncurrent liabilities, and stockholders’ equity.
V. Use of Ratios {L. O. 4}
See EXHIBIT 17-8for how typical ratios are computed from financial statements.
Many more ratios could be computed. For example, Standard & Poor’s Corporation sells a COMPUSTAT service. Via computer, COMPUSTAT can provide financial and statistical information for thousands of companies. The information includes 175 financial statement items on an annual basis and 100 items on a quarterly basis, plus limited footnote information. The SEC makes annual financial statements available online in its Edgar database (https://www.doczj.com/doc/014459458.html,/edgar.shtml). The ratios shown in EXHIBIT 17-8 are as follows:
TYPICAL NAME NUMERATOR DENOMINATOR OF RATIO
Short-Term Ratios:
Current ratio Current assets Current liabilities
Avg. collection period
in days Avg. A/R x 365 Sales on account Debt-to-Equity Ratios:
Current debt to equity Current liabilities Stockholders’ equity Total debt to equity Total liabilities Stockholders’ equity Profitability Ratios:
Gross profit rate or Gross profit or
percentage gross margin Sales
Return on sales Net income Sales
Return on stockholders’Net income Average
equity stockholders’ equity Earnings per share Net income less Avg. common shares
dividends on P/S outstanding Price earnings Market price per Earnings per share
share of common stock
Dividend Ratios:
Dividend yield Dividends per Market price per
common share common share Dividend payout Dividends per Earnings per share
common share
A. Comparisons {L. O. 5}
Evaluation of a financial ratio requires a comparison. There are three main types of comparisons: (1) Time Series Comparisons—with a company’s own historical ratios (e.g., for 5 to 10 years); (2) Benchmark Comparisons—general rules of thumb (e.g., there is trouble if a company’s current debt is at least 80% of its tangible net worth); and (3) Cross-Sectional Comparisons—ratios of other companies or with industry averages from Dun and Bradstreet. Comparisons for the Microsoft Company data across years, against benchmarks, and to the industry are presented.
B. Discussion of Specific Ratios
The current ratio is a widely used statistic. Other things being equal, the higher the current ratio, the more assurance the creditor has about being paid in full and on time. The average collection period in days is another important short-term ratio. An increase in this ratio might indicate increasing acceptance of poor credit risks or less energetic collection efforts.
Both creditors and shareholders watch the debt-to-equity ratios to judge the degree of risk of insolvency and stability of profits. Companies with heavy debt in relation to ownership capital are in greater danger of suffering net losses or even bankruptcy when business conditions sour, revenues and many expenses decline, but interest expenses and maturity dates do not change.
Investors find profitability ratios especially helpful. The gross profit rate and return on sales are both measures of operating success. Shareholders view the return on their invested capital as more important. The return on equity provides a measure of overall accomplishment.
The final four ratios in EXHIBIT 17-8 are based on earnings and dividends.
The first, earnings per share of common stock (EPS), is the most popular of all ratios. This is the only ratio that is required as part of the body of the financial statements of publicly held companies in the United States. The EPS must be presented on the face of the income statement. The calculation of EPS can be more complicated than is indicated in EXHIBIT 17-8depending on the capital structure of the firm and the presence of common-stock equivalents.
The price earnings, dividend yield, and dividend payout ratios are especially useful to investors in the common stock of the company.
C. Operating Performance Ratios
Businesspeople often look at invested capital’s rate of return as an important
measure of overall accomplishment:
rate of return on investment = income / invested capital
The measurement of operating performance (i.e., how profitably assets are
employed) should not be influenced by the management’s financial decisions
(i.e., how assets are obtained). Operating performance is best measured by
pretax operating rate of return on average total assets:
pretax operating rate = operating income
of return on average total assets average total assets
The right-hand side of the equation above consists of two important ratios:
operating inc. = operating income x sales
avg. total assets sales avg. tot. assets The right-hand side terms in the equation above are often called the operating
income percentage on sales and total asset turnover (i.e., the two basic factors
in profit making). An improvement in either will, by itself, increase the rate of
return on total assets.
If ratios are used to evaluate operating performance, they should exclude
extraordinary items. Such items are not expected to recur, and therefore they
should not be included in measures of normal performance.
VI. Efficient Markets and Investor Decisions {L. O. 6}
Much research in accounting and finance has concentrated on whether the stock markets are ―efficient‖.Efficient Capital Market—market prices ―fully reflect‖all information available to the public. Therefore, searching for ―underpriced‖ securities in such a market would be fruitless, unless an investor has information that is not generally available. If the real-world markets are indeed efficient, a relatively inactive portfolio approach would be an appropriate investment strategy for most investors.
The hallmarks of the approach are risk control, high diversification, and low turnover of securities. The role of accounting information would mainly be in identifying the different degrees of risk among various stocks so that investors can maintain desired levels of risk and diversification.
Many ratios are used simultaneously rather than one at a time for such predictions. Research showed that accounting reports are only one source of information. In the aggregate, companies that choose the least-conservative accounting policies do not fool the market. In sum, the market as a whole generally sees through any attempts by companies to gain favor through the choice of accounting policies that tend to boost immediate income.
Some alternative sources of financial information are the following: company press releases, trade association publications, brokerage house analyses, and government economic reports. If accounting reports are to be useful, they must have some advantage over alternative sources in disclosing new information. Financial statement information may be more directly related to the item of interest, more reliable, lower in cost, and/or more timely than alternative sources.
CHAPTER 17: Quiz/Demonstration Exercises
Learning Objective 1
1. The Colts Corporation has acquired a 10% interest in the shares of Giants
Corporation. Colts reported income for 20X1 of $25 million and issued dividends of $10 million during the year. Becaise Colts use the available for sale method of accounting for their investment in Giants, for 20X1 the value of their income will _____.
a. increase by $25 million, the amount of Giants earnings
b. increase by $1 million, the dividends paid by Giants to Colts
c. decrease by $10 million, the amount Giants paid out in dividends
d. increase by $1.5 million, Colts’ share in the earnin g s of Giants reduced by their
share of the dividends paid out
2. The Raiders Corporation owns 40% of the outstanding shares of the Warriors
Corporation. During 20X1, Warriors reported income of $25 million and paid dividends of $10 million to shareholders. Raiders use the equity method to account for their investment in Warriors. Accordingly, the value of their Warriors investment during 20X1 will increase by _____.
a. $14 million, the sum of the dividends received by Raiders and their share in
the earnings of Warriors
b. $6 million, Raiders’ share in earnings of Warriors reduced by the dividends
received
c. $4 million, the dividends paid by Warriors to Raiders
d. $10 million, Raiders’ share in the earnings of Warriors
Learning Objective 2
3. When a company purchases more than 50% of the stock of another business, the two
companies’ financial statements must be presented _____.
a. separately in the same annual report with the nature of the ownership interest
fully disclosed
b. in two separate sets of financial statements that cannot appear in the same
annual report
c. in the form of consolidated financial statements after eliminating entries are
recorded to avoid the double counting of assets and equity
d. together regardless of whether the ownership interest continues
4. Taylor Company owns 90% of the outstanding shares of Turner Company. If Turner
Company reports earnings for the year of $20 million, the consolidated financial statements will show a _____ million increase in the _____.
a. $20; consolidated sh areholders’ equity
b. $2; noncontrolling interest in Turner
c. $20; consolidated net assets
d. $20; noncontrolling interest in Turner
Learning Objective 3
5. Goodwill is recognized for accounting purposes _____.
a. when a business is purchased for a price that exceeds the fair market value of
its assets less liabilities
b. every year as long as the IRS does not object
c. when the value of a business exceeds its historical cost book value
d. when a business is purchased for a price that exceeds the book value of its
assets less liabilities
6.Goodwill may be caused by _____.
a.excellent general management skills
b.potential efficiency by rearrangement
c.dominant market position
d.all of the above
e.none of the above
Learning Objective 5
Use the comparative balance sheets and income statements below for the Louise Company in answering questions 7 through 10:
Louise Company
Comparative Balance Sheets
December 31, 20X1 and 20X2
20X1 20X2
Assets
Cash $ 61,100 $ 27,200
Accounts Receivable (net) 72,500 142,700
Inventory 122,600 107,800
Property, Plant, and Equipment (net) 577,700 507,500
Total Assets $833,900 $785,200
Liabilities and Stockholders’ Equity
Accounts Payable $104,700 $ 72,300
Notes Payable within one year 50,000 50,000
Bonds Payable 200,000 210,000
Common Stock—$10 par value 300,000 300,000
Retained Earnings 179,200 152,900
Total Liabilities and Stockholders Equity $833,900 $785,200
Louise Company
Comparative Income Statements
For the Years Ended 12/31/X1 and 12/31/X2
20X2 20X1 Sales $ 800,400 $ 900,000
Cost of Goods Sold 454,100 396,200
Gross Profit $ 346,300 $ 503,800
Operating Expenses
Selling Expenses $ 130,100 $ 104,600
Administrative Expenses 40,300 115,500
Interest Expense 25,000 20,000
Income Tax Expense 14,000 35,000
Total Operating Expenses $ 209,400 $ 275,100
Net Income $ 136,900 $ 71,300
7. The Louise Company’s current ratio for 20X2 was _____.
a. 1.66
b. 5.39
c. 1.23
d. 1.00
8. Louise Company’s total debt to equity ratio has _____.
a. decreased from 0.74 to 0.73 from 20X1 to 20X2
b. increase from 0.73 to 0.27 from 20X1 to 20X2
c. decrease from 0.32 to 0.74 from 20X1 to 20X2
d. increased from 0.27 to 0.32 from 20X1 to 20X2
9. Louise Company’s gross profit rate for 20X1 was _____.
a. 20.58%
b. 55.98%
c. 46.65%
d. 61.92%
10. In 20X2, Louise Company’s return on sales was _____.
a. 2.39%
b. 4.61%
c. 23,27%
d. 17.10% Learning Objective 6
11. An efficient capital market _____.
a. creates an opportunity for investors to spot ―underpriced‖ securities using
publicly available information
b. is one in which market prices ―fully reflect‖ all information to the public
c. has no bearing on accounting statements and procedures
d. explains why some individuals are able to ―beat the market‖ through the use of
publicly available information
12.If markets are truly efficient, then the proper portfolio includes which of the following
characteristics?
a.high diversification
b.risk control
c.low turnover of securities
d.all of the above
e.none of the above
CHAPTER 17: Solutions to Quiz/Demonstration Exercises
1. [b]The amount of dividends received will increase the dividend income account.
2. [b]With the equity method, the investor recognizes his share in earnings, but
reduces the investment by the amount of dividends received.
3. [c]Consolidated financial statements must be issued when ownership exceeds
50%.
4. [b]The noncontrolling interest will be increased by its share in the earnings of the
subsidiary.
5. [a]Goodwill is recorded for the amount by which the purchase cost exceeds the
fair market value of the net assets obtained. First, the assets are written up to
their fair market values. Then any excess is recorded as goodwill, which is
amortized over a period not exceeding 40 years.
6. [d]
7. [a]The current ratio is found by dividing the current assets by the current liabilities.
Here current assets are $256,200 [$61,100 + $72,500 + $122,600] and current
liabilities are $154,700 [$104,700 + $50,000]. Therefore, the current ratio is
1.66 [$256,200/$154,700].
8. [b]In 20X1 the total debt-to-equity ratio was 0.73, which was computed as
[($72,300 + $50,000 + $210,000) / ($300,000 + $152,900)]. In 20X2, the total
debt-to-equity ratio has increased to 0.74 [($104,700 + $50,000 + $200,000) /
($300,000 + $179,200)].
9. [b]The gross profit rate is found by dividing the gross profit by sales. For 20X1,
that would be $503,800 / $900,000 = 55.98%.
10. [d]The return on sales is found by dividing the net income by sales. For 20X2,
that was $136,900 / $800,400 = 17.10%.
11. [b] 12. [d]