Advanced Financial Reporting - Exam 1 Review

Sarbanes-Oxley Act of 2002

"Full Employment for Accountants Act" Created by congress in wake of numerous financial reporting scandals Requires: Reports on internal controls Top management certifications of financial statements filed with the SEC Created the PCAOB which monitors auditing firms and sets audit standards

Securities Act of 1933

"The New Securities Act" "Truth in Securities" Law Deals mainly with the issuance of new securities (IPOs) Regulates public offering of securities Prohibits offering and sale of securities unless registered with government Prohibits fraud and deception Requires compliance

Securities Act of 1934

"What happens Next Act" Established the SEC Granted Jurisdiction over securites markets Governs trading in securities once they are issued and outstanding Authorizes SEC to establish accounting, reporting, and disclosure requirements for public companies Prohibits deceptive or manipulative practices in security sales

Consolidation Process

(CEADI) - "Seedy" C - Eliminate the Changes in the equity investment account during the year E - Eliminate stockholder's Equity of the subsidiary as of beginning of the year A - Eliminate the AAP (acquisition accounting premium) as of beginning of the year D - Depreciation for current year AAP I - Eliminate Intercompany transactions during the periods and remaining balances

When to use Equity Method: External Reporting

(FASB ASC 323) According to GAAP, equity method should be used for equity investments when the investor has ability to excercise "significant influence" over financial and operating policies of an investee

Recognition Principle

(FASB ASC 805-20-25-1) As of the acquisition date, the acquirer shall recognize, separately from goodwill, the identifiable assets acquired, the liabilities assumed, and any noncontrolling interests

Measurement Principle

(FASB ASC 805-20-30-1) The acquirer shall measure the identifiable assets acquired, the liabilities assumed and any noncontrolling interests in the acquiree at their acquisition date fair values

What is Significant Influence?

(TIPMOR) T - Technological Dependency I - Interchange of managerial personell P - Participation in investee's policy making process M - Material intra-entity transactions O - Other investor ownership percentages R - Representation on investee's board of directors Only one of the above is needed. (also see pg 6 of textbook for indicators of no significant influence)

True Under Acquisition Method

1. Acquired net assets are recorded on the balance sheet at their fair value, regardless of amount paid 2. All transaction costs are expensed in the period they are incurred 3. Any difference between the FV of those identifiable net assets and consideration paid will be recorded as goodwill, which is an intangible assets that is only recorded in transactions that qualify as business combinations

What disclosures are required for equity method investments under FASB ASC 323?

1. Name of each investee and % of CS, accounting policies of investor (investments in CS), difference between carrying value of investment and underlying equity in net assets and accoutning treatment of difference 2. If there is a quoted market price for the CS the aggregate value of each identified investment should be disclosed (not required for investment in CS of subsidiaries) 3. When investments in CS under the equity method are, in total, material to the financial position or results of operations of an investor, summarized information about assets, liabilities, and operational results of investees shuold be disclosed 4. Material effects of possible conversions, exercises or contingent issuances should be disclosed in notes to the financial statements of the investor

Criticism of the Equity Method

1. Single line consolidation - can't really see any details 2. Carrying value is less than fair value 3. Accruing income with no expectation of actual cash receipt

Steps in Acquisition Method

1. Who bought who? Who has control 2. When did we get control? Birth date of acquisition is the date consideration transfers 3. What did we get? Assets, liabilities, noncontrolling interests... all at fair value 4. Does that result in goodwill or bargain purchase gain? Residual asset or gain (this is pretty rare)

Control

Accounting Method: Consolidation Internal Accounting: Parent's bookkeeping for subsidiary is whatever they want External Accounting: Must be consolidation in accordance with GAAP

Significant Influence

Accounting Method: Equity Method Accounting for Dividends Received: DR Cash xxx CR Equity Investment xxx Accounting for Sub Net Income: (Equity Pickup) DR Equity Investment xxx CR Equity Income xxx Accounting for Changes in Market Value: N/A

No Influence

Accounting Method: Fair Value Accounting for Dividends Received: DR Cash xxx CR Dividend Income xxx Accounting for Sub Net Income: N/A Accounting for Changes in Market Value: Gain or loss in net income, market to market

Typical Accounting and Valuations

Accounts Receivable: NRV Inventories: lower cost or NRV PPE: NBV Good reputation of companies: not "synergies" Current liabilities: fair value Long term liabilities: amortized value Customer list: don't

Why do I care about business combinations?

Because in an acquisition of a business, we must use the Acquisition Method of accounting

1/1/19, investor purchases 18,000 common shares of investee at $12 each. Shares total to 20% ownership of investee. Investee CS has readily determinable FV. 1/1/19, BV of investee assets and liabilites are 1,230,000 and 150,000 respectively, appraised FV of identifiable net assets equal BVs. EOY 19' investee reports net income of 50,000 and dividends of 15,000. 12/31/19, FV of investee stock is 16 per share Determine the balance in the "investment in investee" account on 12/31/19 assuming no significant influence

Because this is a noncontrolling investment in an equity security that doesnt confer significant influence and has a readily determinable FV we use the fair value method. The investment is reported by the investor at the FV of the investment on reporting date. $16 x 18,000 shares = 288,000 on 12/31/19

Investor company owns 40% of outstanding common stock of investee, allowing significant influence over investee. Equity investment reported at 750,000 as of the end of prior year. During the year, the investor received dividends of 80,000 from the investee. Investee reports on income statement: Revenues 2,400,000 Expenses 1,800,000 Net Income 600,000 Other Comp Income 100,000 Comprehensive Income 700,000 a. How much equity income should the investor report in its net income? b. What amount should the investor report for the equity investment in its balance sheet at the end of the year?

FASB ASC 323-10-35-18 Equity method investors must record proportionate share of investee's equity adjustment for comprehensive income as increases or decreases to the investment account with corresponding adjustments in equity a. 600,000 x 40% = 240,000 b. 750,000 + 40% x 700,000 - 80,000 = 950,000

Why are profits on intercompany sales of assets eliminated using the equity method?

FASB ASC 323-10-35-7 Intra-entity profits and losses shall be eliminated until realized by either party as if the investee were consolidated. This prevents double counting and premature recognization of income.

Separately Identifiable Intangible Assets

FASB ASC 805 requires intangible assets to be considered separately identifiable if they are either backed by a legal document or separable/able to be sold

Communication from the SEC

Comment letters are issued every 3 years Responses are required and both the letter and the response become public record in EDGAR

Observable and Unobservable Inputs

Companies are required to maximize the use of observable inputs and minimize the use of unobservable inputs Level 1: quoted market price for same asset Level 2: similar asset Level 3: best guess, unobservable assets

15. Provide at least two examples of intangible assets that would be included in each of the following general categories: contract-based, marketing-related, customer-related, technology-based, and artistic-related.

Contract-based: Lease agreements, franchise agreements, licensing agreements, construction contracts, employment contracts, and mineral rights Marketing-related: Brand names, trademarks, and Internet domain names Customer-related: Customer contracts, relationships, and orders Technology-based: Patent rights, computer software, and trade secrets Artistic-related: Television programs, motion pictures and videos, recordings, books, photographs, and advertising jingles

Investor purchases 25% interest in investee, has significant influence. BV of investee stockholder equity on DOA is 500,000 and investor purchases interest for 145,000. Investee owns unrecorded patent with FV of 80,000 with remaining life of 10 years. After acquisition, investee reports net income of 100,000 and pays dividend of 20,000. At the end of the first year, the investor sells the equity investment for 180,000. Prepare all required JEs to account for equity investment for the year

DR equity investment 145,000 CR cash 145,000 (record purchase of equity investment) DR equity investment (100,000 x 25%) = 25,000 CR equity income 25,000 (record equity income) DR cash 20,000 CR equity investment 20,000 (record receipt of the cash dividend) DR equity income (80,000/10 x 25%) = 2,000 CR equity investment 2,000 (record amortization of patent) DR cash 180,000 CR equity investment (145k+25k-20k-2k) = 148,000 CR gain on sale 32,000

Goodwill

Does the parent control the goodwill asset? Will the goodwill asset provide future benefits? (use impairment review) (private companies may elect to amortize goodwill over 10 or less years) Goodwill should be tested for impairment annually OR if events or circumstances occur between the annual evaluation dates "if an event occurs or circumstances change that would more than likely reduce the fair value of a reporting unit below its carrying amount

How to tell if parent is using the cost method

Equity investment equals purchase No equity income, dividend income = dividends

Cost Method vs Equity Method

Equity method is only option for external reporting under GAAP Cost method: no changes in equity investment, dividend income (parent) = dividends (sub) Equity method: accrue for equity pickup (equity income), changes in equity investment balance

Why are dividends treated as reduction in equity investment instead of dividend income using the equity method?

FASB ASC 323-10 The objective of the equity method is to report the investor's investment and income in relation two the companies. The equity investment account decreases whenever a dividend is collected because distribution of cash dividends reduces the carrying value of the investee company. The investor mirrors this by recording the receipt as a decrease in the carrying value of the investment rather than as revenue.

Equity income comes from net income of investee. What problems does this cause for evaluation of cash flows of the investor?

Recognition of equity income doesn't mean cash was received. Dividends paid by investee to investor are only a small part of net income. Projections of future net income including equity income might not imply a significant cash inflow

Public Entity

Required to file financial statments with the SEC Issues publicly traded debt or equity Provides financial statements for purpose of issuing any class of securities in public market

What would be the approach you would use to determine if a portion of the purchase price should be assigned to goodwill, as part of a business combination?

Residual value

SEC: Delegation

SEC initially delegated development of accounting standards to AICPA, then to FASB since 1973. FASB created and maintains the Accounting Standards Codification or "Codification"

Investor owns 10% of investee, publicly traded stock, licenses tech to investee for production of only product, no interchange of management, no board representation, license agreement restricting behavior of investee. How should the investor account for the investment in the investee?

Significant Influence (Technological dependence) --> Equity method

Company hired a candidate as its new CEO under a 10-year contract. The contract required the company to pay the candidate $5 million if the company is acquired before the contract expires. A parent acquires the company eight years later. The CEO was still employed at the acquisition date and will receive the additional payment under the existing contract. Should the parent company include the employment contract liability in its assignment of fair values in a business combination?

FASB ASC 805-10-55-35 provides the following guidance (the acquired company is referenced as the "Target"): "In this Example, Target entered into the employment agreement before the negotiations of the combination began, and the purpose of the agreement was to obtain the services of the chief executive officer. Thus, there is no evidence that the agreement was arranged primarily to provide benefits to Acquirer or the combined entity. Therefore, the liability to pay $5 million is included in the application of the acquisition method."

What are "provisional" amounts recorded in business combinations? How do we account for them?

If financial statements are issued before the final allocations of the purchase can be made, FASB ASC 805-10-55-16 allows us to use "provisional amounts," that is, estimates of those values. When the allocation adjustments are made, we prospectively adjust those amounts, provided that the final measurement of all assets and liabilities is completed within one year from the acquisition date. Also, during the measurement period, the acquirer can recognize additional assets or liabilities if new information that existed as of the acquisition date that, if known, would have resulted in the recognition of those assets and liabilities as of that date.

How is the reporting of an equity investment like a consolidation? How is it different?

If the investor acquires all of the investee at BV, the equity investment account is equal to stockholder's equity of the investee. All assets and liabilities are in one account. The investor's balance sheet includes the stockholders' equity of the investee, which includes assets and liabilities. In consolidations the balance sheets of investor and investee are brought together. Consolidated stockholders' equity is the same only total assets and liabilities changes.

How is the reporting of equity income in the investor's income statement a consolidation? How is it different?

If the investor owns all of the investee, equity income that the investor reports is equal to net income of investee (including revenues and expenses). Replacing equity income with revenues and expenses of investee company gives same net income

1/1/18, investor acquires 30% of investee CS for 600,000. As a result investor has significant influence. EOY 18' and 19', investee reports net income of 120,000 and 50,000 in dividends. 1/1/18, BV of investee net assets is 2,000,000 and all individual net assets had matching FV and BV. What is the balance of the equity investment account on investor's balance sheet on 12/31/19?

Initial equity investment balance 12/31/18 = 600,000 18' share of investee net inc (30% x 120,000) = 36,000 18' share of investee dividends (30% x 50,000) = (15,000) 19' share of investee net inc (30% x 120,000) = 36,000 19' share of investee dividends (30% x 50,000) = (15,000) Equity investment balance 12/31/19 = 642,000

Investor and Investee: Legal Entities

Investor and Investee companies are separate legal entities. Their operations must be accounted for separately.

When can investors write down investments?

Investors can write down carrying amounts of equity investments if the FV of the investment is less than its carrying value (FV < CV) and the decline seems to be 'other than temporary'

Key Consolidation Concepts

It's all about Control Consolidation is a 2 step process of replacement. First you remove, then you input new information. The goal is to show the financials of the single economic entity

SEC Structure

Led by 5 commissioners and the office of the chief accountant Managed through 5 divisions: Corporate Finance (monitors actions of FASB, at least every 3 years reviews financial statements and disclosures of all public companies and may issue comment letters) Enforcement (you don't want to hear from them, in 2018 821 cases filed 4B recovered, paid 262M to whistleblowers since 2012) Trading & Markets Investment Management Economic & Risk Analysis

Private Entity

Literally just not a public entity

How to qualify as a business combination?

Needs to include: Inputs - economic resource contributing to creating outputs Substantive processes - when applied to inputs creates outputs Outputs - the result of inputs and substantive processes providing goods or services to customers, other revenue, or investment income When substantially all of the fair value of gross assets acquired is concentrated in a single asset (or group of similar assets), the assets acquired would NOT represent a business

Assume investor places considerable value on workforce of investee as result of low turnover and high morale. Can this be recognized as a separately identifiable intangible asset?

No it would be rolled into good will. FASB ASC 805-20-55-6 states the acquirer takes into goodwill the value of an acquired intangible asset that is not identifiable as of the DOA.

Investor places considerable value on new contract investee is negotiating as of DOA but is not finalized. Can this be recognized as a separately identifiable intangible asset?

No it would be rooled into goodwill. FASB ASC 805-20-55-6 states the acquirer takes into goodwill the value of an acquired intangible asset that is not identifiable as of the DOA.

Why do I care about the SEC?

Our numbers will ultimately be reported to users and need to be an accurate reflection of the results of operations and financials should be comparable and consistent

SEC: Mission

Protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation

What if we dont know everything exactly on the date of the acquisition?

Provisional amounts: We can adjust for up to 1 year after the date of acquisition with better information Measurement period: 1 year after the date of acquisition

7/1/19, an investor owns 20% of the CS of an investee and has significant influence. Before the sale of 10% of the investee to an unaffiliated party for 30,000, the balance in the equity investment account was 50,000. The investor determined that after the sale it no longer had significant influence and that the remaining 10% has a readily determinable fair value. Immediately after the sale of the 10% interest, what is the carrying amount of the equity investment and what method of accounting must be used?

Since there is no longer significant influence we must determine if the CS has a readily determinable fair value. Since the investee has a readily determinable fair value, the investment must be carried at the current fair value. The best estimate for the current fair value of the remaining 10% is the selling price of the 10% interest to a third party at 30,000.

1/1/19, investor purchases 32,000 common shares of investee at 11 per share. Shares total to 24% ownership of investee. Investee CS does not have a readily determinable FV. 1/1/19, BV assets: 1,700,000 liabilities: 600,000,. Appraised fair values of identifiable net assets equal BV except for unrecorded customer list: estimated 90,000 and 5 years remaining. During 19', investee reported net income of 120,000 and dividends of 40,000. 12/31/19, FV of investee stock is 15 per share Determine the balance in the investment in investee account on 12/31/19 assuming significant influence

Since there is significant influence we must use the equity method. The investment is reported by the investor at original cost and then is adjusted for ownership percenatage of all items that change stockholders equity of the investee. Initial investment (11 x 32,000) = 352,000 % own x net inc (24% x 120,000) = 28,800 less: % own x dividends (24% x 40,000) = (9,600) less: % own AAP amor (21,600/5) = (4.320) Ending investment = 366,880

1/1/19, investor purchases 32,000 common shares of investee at 11 per share. Shares total to 24% ownership of investee. Investee CS does not have a readily determinable FV. 1/1/19, BV assets: 1,700,000 liabilities: 600,000,. Appraised fair values of identifiable net assets equal BV except for unrecorded customer list: estimated 90,000 and 5 years remaining. During 19', investee reported net income of 120,000 and dividends of 40,000. 12/31/19, FV of investee stock is 15 per share Determine the balance in the investment in investee account on 12/31/19 assuming no significant influence

Since this is a noncontrolling investment that doesnt give significant influence and does not have a readily determinable fair value we must use the cost method. The investment is reported at the original cost of investment. 11 x 32,000 shares = 352,000

1/1/19, investor purchases 18,000 common shares of investee at $12 each. Shares total to 20% ownership of investee. Investee CS has readily determinable FV. 1/1/19, BV of investee assets and liabilites are 1,230,000 and 150,000 respectively, appraised FV of identifiable net assets equal BVs. EOY 19' investee reports net income of 50,000 and dividends of 15,000. 12/31/19, FV of investee stock is 16 per share Determine the balance in the "investment in investee" account on 12/31/19 assuming significant influence

We must use the equity method because there is significant influence over the investee. Initial investment ($12 x 18,000 shares) = 216,000 % ownership x net inc (20% x 50,000) = 10,000 less: % own x dividends (20% x 15,000) = (3,000) Ending investment = 223,000

Investor owns 30% of CS of investee. Investor has significant influence. During 19', the investee bought 100,000 of inventory from investor. Investor includes gross profit of 40% on all inventory sales transactions. 12/31/19, investee holds 200,000 of total inventory (20,000 of this from investor). 19', investor and investee report 90,000 and 40,000 net income respectively. What amount of investment income from the investee did the investor recognize during 19'?

We must use the equity method because there is significant influence. Investee holds 20,000 (from investor) x Gross profit % (40%) = 8,000 Investor must defer proportionate share (8,000 x 30%) = 2,400 40,000 x 30% - 2,400 = 9,600

Why do I care about CEADI?: Part 1

When control is obtained the parent cannot publish financial statements to outside parties reporting its subsidiary as an equity investment. It must consolidate financial statements with subsidiary.

Business Combinations

When obtaining control over a group of net assests qualifies as the acquisition of a business a special set of accounting principles called Acquisition Method applies

12. Assume an investor purchases a 20% interest in an investee company. In addition to the infusion of badly needed cash into the investee, the investor also agrees to license technology to the investee company. Since the technology is valuable, the investor includes in the terms of the license agreement that it has the right to appoint the majority of the Board of Directors, effective with the acquisition. Should the investee company be consolidated with the investor?

Yes, the investor has gained effective control of the investee company by virtue of its control of the Board of Directors. Even though it owns less than 50% of the outstanding voting stock, the license agreement gives it control of the investee company and, as a result, the investee must be consolidated with the investor.

Acquisition date: October 25 Price of acquiring company stock: $20.00/share Paid by: Issuance of 800,000 shares of $1 par value common stock, and exchange of those shares for all of the voting shares owned by the investee's shareholders. In addition, you are told that your company and the investee could not agree on the purchase price, and, as a result, your company consented to include a provision in the purchase and sale agreement providing for an additional payment of $4 million if the new subsidiary reports cumulative earnings in excess of $30 million within one year of the acquisition date. Your independent appraisal indicates that the fair value of this liability as of the acquisition date is $1.5 million. a. Record the journal entry for the purchase. b. Your company has a calendar year-end, and will issue financial statements as of December 31. As of that date, and based on its operating performance to date, you estimate that the fair value of the contingent consideration liability is now $2,100,000. Record any additional required journal entry to reflect this new information. c. Now, assume the subsidiary meets the earnings hurdle and that the additional $4 million must be paid. Record the journal entry for this payment.

a. DR Equity investment 17,500,000 CR Common Stock 800,000 CR APIC 15,200,000 CR Contingent earnings liability 1,500,000 (to record the acquisition) b. DR Expense - contingent earnings liability 600,000 CR Contingent earnings liability 600,000 (to record the increase in the expected value of the contingent earnings liability) c. DR Expense - contingent earnings liability 1,900,000 DR Contingent earnings liability 2,100,000 CR Cash 4,000,000 (to record payment of the contingent earnings liability)

Investor owns 30% of investee and uses equity method. BOY, equity investment was reported on investor balance sheet at 400,000. During the year, the investee reported net income of 100,000 and paid dividends of 60,000. In addition, the investor sold inventory to the investee realizing a gross profit of 40,000. EOY, 15% of inventory remained unsold by investee a. How much equity income should the investor report for the current year? b. What is the balance of the equity investment at the end of the current year? c. Assuming the inventories are all sold the following year and that the investee reports 150,000 net income. How much equity income will the investor report for the following year?

a. Gross profit remaining in ending inventory = 40-,000 x 15% = 6,000 Equity income = 100,000 - 6,000) x 30% = 28,200 b. Initial equity investment 400,000 equity income 28,200 less: dividends (18,000) Ending equity investment 410,200 c. equity income = (150,000 + 6,000) x 30% = 46,800

Investor owns 25% of investee, and uses equity method. BOY, equity investment was reported at 1,000,000. Investee reports net income of 400,000 and dividends of 100,000. Investor sold inventory to investee with gross profit of 120,000. EOY, 30% of inventory remains unsold by investee a. Equity method JEs required for the year? b. What is the balance of the equity investment at the end of the year? c. Assume all inventories are sold following year. Investee reports 450,000. How much equity income will the investor report for the following year?

a. DR Equity investment (25% of 400,000) = 100,000 CR equity income 100,000 (recognize percent of net income) DR equity income (25% x 30% x 120,000) = 9,000 CR equity investment 9,000 (defer profits in ending inventory) DR cash (100,000 x 25%) = 25,000 CR equity investment 25,000 (record receipt of dividends) b. ending investment = 1,000,000 + 100,000 - 9,000 - 25,000 = 1,066,000 c. equity income in following year = 25% x 450,000 + 9,000 = 121,500

Prepare JEs for transactions below relating to an equity investment using the equity method a. Investor purchases 12,000 CS of investee at 10 per share, shares represent 20% ownership in investee and has significant influence b. Investee reports net income of 100,000 c. The investor receives a cash dividend of 1 per common share from investee d. The investor sells all common shares of the investee for 150,000

a. DR equity investment 120,000 (12,000 x 10) CR cash 120,000 (record the purchase of the equity investment) b. DR equity investment (100,000 x 20%) 20,000 CR equity income 20,000 (record equity income) c. DR cash (12,000 x 1) 12,000 CR equity investment 12,000 (record receipt of cash dividend) d. DR cash 150,000 (from sale) CR equity investment (120,000+20,000-12,000) = 128,000 CR gain on sale 22,000

Investor owns 30% of CS of investee company. Investor has significant influence. Investor acquires equity interest on 1/1/18 for 525,000. On DOA, investee stockholder equity was 1,500,000 and fair values of identifiable net assets equal to BV. During 18', investee reports net inc of 50,000 and dividends of 10,000. During 19', investee reports net inc of 60,000 and dividends of 15,000. The investor routinely sells inventory to investee at 25% profit margin. 12/31/18 inventory is 30,000 and 12/31/19 is 40,000. What is the balance in the equity investment account on 12/31/19?

Significant influence --> Equity method Beginning balance at 1/1/18 = 525,000 30% net inc 18' (30% x 50,000) = 15,000 less: 30% 18' profit defer to 19' (30% x (25% x 30,000)) = (2,250) less: 18' dividends rec (30% x 10,000) = (3,000) 30% x net inc 19' (30% x 60,000) = 18,000 less: 30% 19' profit defer to 20' (30% x (25% x 40,000)) = (3,000) 30% profit from 18' recognized in 19' (30% x (25% x 30,000)) = 2,250 less: 19' dividends rec (30% x 15,000) = (4,500) Ending balance 12/31/19 = 547,000

Prior to 2008, CBS Corp owned ~18% of Westwood, which managed CBS Radio. CBS managed Westwood under a management agreement. An employee of CBS was on the board of Westwood. CBS did not control the board. How should CBS account for investment in Westwood?

Significant influence --> Equity method CBS has board representation and owns a decent share of Westwood stock in addition to having a management agreement.

How much judgement is involved in the decision to write down an investment and how might a company use that judgement to manage reported net income?

There is considerable judgement used when a company decides to write down an investment. Part of this is determining whether the decline in FV is not temporary. Write downs are a result of predictions that the future FV will not rise above the carrying amount. If deemed temporary then no write down and no loss recognized. Otherwise then there is a loss recognized. Losses can be recognized in the current year or in the future based on the judgement.

Changes from FASB ASU 2016-07

There is no more Trading Security or AFS classification for equity investments Required to classify as Fair Value if there is a readily determinable market value

Investor owns 30% of investee. Remaining percentage is owned by founder who takes no direction from outsiders. How should the investor account for its investment?

There is no significant influence here, even though the investor owns 30% of stock. Since the investee is a private company (remaining stock is privately held) the cost method should be used because the fair value method assumes public stock.

Enron disclosed that it invested in companies that reported substantial losses and were insolvent. Enron used the equity method, did not make any advances, and did not guarantee debts. How did the losses by investees affect Enron's income statement?

They didn't affect the income statement. The investees were insolvent so the equity investment from Enron was reduced to zero. Thus Enron stoped reporting equity investments using equity method and didn't recognize a share of investee losses

Interpret FASB ASC 323-10-35-22: "only after its share of that net income equals the share of net losses not recognized during the period the equity method was suspended

This means that the investee has recouped all losses that have been reported. Since the investor stops accounting for the equity investment using the equity method once there is a zero balance, this implies that the investee's stockholder equity is negative. Once the investee's stockholder equity is positive again then the investor resumes accounting for the equity investment using the equity method.

Companies can recognize assets in a business combination that were not recognized by the company acquired. Give some examples

Under FASB ASC 805-10-65-1, the acquirer's application of the recognition principle may result in recognizing some assets and liabilities that the acquiree may not have recognized. For example, acquired identifiable intangible assets, patents, customer relationships, brand names, ect.

Companies often enter into joint ventures for R&D, marketing, and distribution. Do these joint ventures need to be consolidated?

Under FASC ASC 805-10-15 joint ventures are specifically excluded from the standard. Joint ventures are not required to be consolidated and should be accounted for using the equity method

How to find SEC filings

Use EDGAR database

Investor company acquires 20% of investee voting CS. Investee CS has readily determinable FV. Investor has board representation for investee, participates in policy creation, and has material business transactions. How should the investor account for its interest in the investee?

The investor should recognize a portion of the net income of the investee as its own because there is significant influence and must use the equity method

Business Combinations and Valuations

All on date of acquisition All fair value

Restructuring Activities Investor Expects but are not Obligated

Announce prior to date of acquisition --> accrue for prior to acquisition must be obligated Original sub takes the expense hit Obligated after date of acquisition, then the new entity takes the expense hit

Primary Reports to SEC

Annual Report (Form 10-K): 60-90 days Proxy Statement (Form Def14A): 30-60 days, can be part of annual report, executive compensation Quarterly Report (Form 10-Q):40-45 days, often filed early Special Reports (Form 8-K): 4 business days, after a specified event occurs, up to disgression of management

Company hired a candidate as its new CEO under a 10-year contract. The contract required the company to pay the candidate $5 million if the company is acquired before the contract expires. A parent acquires the company eight years later. The CEO was still employed at the acquisition date and will receive the additional payment under the existing contract. But, now, assume the parent company asks the subsidiary to provide the severance to the CEO during the negotiations. Should the parent company include the employment contract liability in its assignment of fair values in a business combination?

FASB ASC 805-10-55-36: "In other circumstances, Target might enter into a similar agreement with the chief executive officer at the suggestion of Acquirer during the negotiations for the business combination. If so, the primary purpose of the agreement might be to provide severance pay to the chief executive officer, and the agreement may primarily benefit Acquirer or the combined entity rather than Target or its former owners. In that situation, Acquirer accounts for the liability to pay the chief executive officer in its post-combination financial statements separately from application of the acquisition method."

What is an "indemnification asset"? How do we account for it?

FASB ASC 805-20 An indemnification asset represents the agreement by the seller to guarantee that the acquirer will not suffer a loss as a result of the outcome of a contingency related to all or part of a specific asset or liability. The acquirer recognizes an indemnification asset at the same time that it recognizes the indemnified item. Both the indemnification asset and the related liability are revalued subsequent to the acquisition

The investor purchases all of the assets and liabilities of the investee, even those not shown on the balance sheet, such as operating leases. Even though the acquiree has not recognized on its balance sheet either the leased asset nor the lease obligation relating to operating leases, the investor may recognize assets or liabilities relating to those leases in its assignment of fair values in a business combination. How?

FASB ASC 805-20-25-12 allows the acquirer to determine if the operating leases are favorable or not depending on the market terms of similar leases at DOA. Acquirer recognizes an intangible asset if the terms of the lease are favorable or a liability if unfavorable. May also be deemed a lease if terms are not favoarble if the leases provide future economic benefits that quialify as identifiable intangible assets.

Parent company acquires a subsidiary that does business with its customers solely through purchase and sales orders. DOA, the subsidiary has a backlog of customer purchase orders from 60 % of its customers, all of whom are recurring customers. The other 40 % of the subsidiary's customers also are recurring customers. However, as of the acquisition date, the subsidiary has no open purchase orders or other contracts with those customers. Can the customer backlog and ongoing customer relationship be recognized as an intangible asset?

FASB ASC 805-20-55-22: Yes they can. "An order or production backlog arises from contracts such as purchase or sales orders. An order or production backlog acquired in a business combination meets the contractual-legal criterion". The purchase orders from 60 percent of the Subsidiary's customers meet the contractual-legal criterion. Also, because the Subsidiary has established its relationship with 60 percent of its customers through contracts, also the Subsidiary's customer relationships meet the contractual-legal criterion. Because the subsidiary has a practice of establishing contracts with the remaining 40 percent of its customers, its relationship with those customers also arises through contractual rights and therefore meets the contractual-legal criterion

Assume a parent company acquires a subsidiary that has a portfolio of one-year auto insurance contracts that are cancelable by policyholders. Can the customer relationships be identified as an intangible asset?

FASB ASC 805-20-55-23: "If an entity establishes relationships with its customers through contracts, those customer relationships arise from contractual rights. Therefore, customer contracts and the related customer relationships acquired in a business combination meet the contractual-legal criterion...." Because the Subsidiary establishes its relationships with policyholders through insurance contracts, the customer relationship with policyholders meets the contractual-legal criterion, and can be identified as an intangible asset in the acquisition

Parent acquires a subsidiary that has a 5 year agreement to supply goods to a customer. Both the parent and the subsidiary believe that customer will renew the agreement at the end of the current contract. The agreement is not separable. Can the parent recognize an intangible asset related to the agreement?

FASB ASC 805-20-55-25: The agreement, whether cancelable or not, meets the contractual-legal criterion. Additionally, because the Subsidiary establishes its relationship with Customer through a contract, not only the agreement itself but also the subsidiary's relationship with the Customer meets the criterion.

Investors sometimes transfer assets to the investee's shareholders other than cash and the investor's stock. How should these transferred assets be accounted for in the acquisition?

FASB ASC 805-30-30-8 If the asset will not remain with the consolidated group following the acquisition, the acquirer can write upp the asset before transfer and record the resulting income gain. If it remains with the consolidated entity after acquistion, it can't be written up and there is no recognized gain

Valuation Techniques for the Measurement of the Acquisitions Date Fair Value

FASB ASC 820 "MIC" 1. Market Approach: quoted price for same asset, use for stocks 2. Income Approach: discounted CF, use for customer list, patents, IPRD 3. Cost Approach: to replace capacity or sell it for, use for PPE

Investor owns 30% of CS of investee company. Investor has significant influence. Investor acquires equity interest on 1/1/18 for 525,000. On DOA, investee stockholder equity was 1,500,000 and fair values of identifiable net assets equal to BV. During 18', investee reports net inc of 50,000 and dividends of 10,000. During 19', investee reports net inc of 60,000 and dividends of 15,000. The investor routinely sells inventory to investee at 25% profit margin. 12/31/18 inventory is 30,000 and 12/31/19 is 40,000. What amount of investment income from the investee did the investor recognize during 19'?

Since we have significant influence we must use the equity method. Investee holding 40,000 of inventory from owner, 25% profit margin means 10,000 of ending inventory balance is intercompany profits. Beginning of period investee held 30,000 of inventory from owner meaning 7,500 is intercompany profits. Investor must defer proportionate share of the ending profits in inventory (30% x 10,000) = 3,000. Investor must recognize proportionate share of equity method income method (30% x 7,500) = 2,250. (30% x 60,000) - 3,000 + 2,250 = 17, 250

Acquired in Process Research and Development

Start of R&D: Expense all costs Date of Acquisition: Record at current fair value and continue to expense Point of Feasibility: Start to capitalize new costs and add in from date of acquisition and amortize over life or discontinue and write off from date of acquisition

Stock vs Stuff

Stock: Buying stock results in equity investments Stuff: Buying stuff results in one time consolidations

Pushdown Accounting

Subsidiary's pre-consolidation financial statements are adjusted to include the AAP. Unobservable in consolidated financial statements (it only changes the behind the scenes bookkeeping) Use of pushdown accounting is an irrecovable choice. It must be performed as of the most recent change in control events in which the acquiree becomes controlled. If done later it must be reported as a change in accounting principle.

Why do I care about the relationship between companies?

The accounting for investments in other companies' equity (stock) depends on the relationship between the investor and investee

An investor company acquires the assets of an investee for $10.5 million. The investee is a start-up company that had devoted all of its energy to the development of patentable technology. Now, the development stage is finished, but commercial production hasn't started. The investee company has hired production and sales employees and has developed an operating plan for the upcoming year to produce and sell its products. As of the acquisition date, however, no production or sales had yet taken place. Should this acquisition be accounted for as an asset purchase or a business combination requiring consolidation?

The acquisition should be accounted for as a business combination, thus requiring consolidation. It is not necessary for the business to have outputs. FASB ASC 805-10-55-4 defines a business as follows: "A business consists of inputs and processes applied to those inputs that have the ability to create outputs."

Why do I care about CEADI: Part 2?

The consolidation process combines the financial statements of the parent and subsidiary by eliminating the equity investment related balance sheet and income statement accounts and replaces them with the assets, liabilities, revenues, and expenses of the subsidiary

Investor uses the equity method to account for investment in 25% of outstanding CS of investee. How should cash dividends received from the investee affect the financial statements of the investor?

The equity investment account should decrease. The company paying dividends decreases retained earnings for dividends.

Intangibles and Acquisitions

The existence of significant unrecorded intangible assets may be both a major reason why a given acquisition occurs and a major factor in determining the purchase price

Equity in Consolidation

The only equity reported in consolidation is that held by the parent's shareholders

14. Assume, as part of recording a business combination, you were given the task of assigning fair values to the acquired identifiable net assets. The investee's balance sheet reports cash, accounts receivable, inventories, PPE, accounts payable, accruals, and long-term debt. a. Describe the approach you would use to value these assets and liabilities. b. Describe the approach you would use to determine if a portion of the purchase price should be assigned to the Goodwill asset. c. Describe the approach you would use to value any additional assets acquired.

a. Assets and liabilities can be valued using any reasonable approach. Accounts receivable: Net realizable value Inventories: Estimated selling price less cost to complete (if work-in-process) and less selling costs and a reasonable profit margin on the sale. Raw materials are valued at replacement cost. PPE: Current replacement costs if continued to be used in the business or at selling price less cost to sell if to be sold. Current liabilities: Book value Long-term liabilities: Present value (i.e., discounted expected cash outflows) b. Before any portion of the purchase price can be allocated to the Goodwill asset, you must know if you are acquiring any intangible assets that are not recorded on the acquiree's balance sheet. FASB ASC 805 requires us to make a positive assessment whether any of these intangible assets were valued by us in arriving at our purchase price for the acquiree and, if so, we must assign that value to the intangible assets acquired before any of the purchase price can be assigned to the Goodwill c. Intangible assets are typically valued at the present value of expected future cash flows. We must, first, project the cash flows to be derived from the intangible asset. Then, we need to discount those expected cash flows using an appropriate discount rate.

Identify three intangible assets related to customers.

a. Customer lists— meets the separability criterion. b. Order backlog—meets the contractual-legal criterion even if the purchase or sales orders are cancelable. c. Customer relationship—sales orders, they meet the contractual-legal criterion. May arise through means other than contracts, such as through regular contact by sales or service representatives.

Investor owns 30% of outstanding CS of investee, allowing significant influence. Equity investment reported at 500,000 at end of prior year. During the year the investor received dividends of 60,000 from investee. Investee reports: Revenues 2,000,000 Expenses 1,600,000 Net Income 400,000 a. How much equity income should the investor report in current year income statement? b. What amount should the investor report for the equity investment in the balance sheet at EOY? c. Assuming the fair value of the investee is 2,100,000 at EOY, how should the fair value of the investee be reflected in the investor's financial statements?

a. Investor reports equity income equal to proportionate share of net income from investee (400,000 x 30%) = 120,000 b. Balance of the equity investment account at EOY (500,000 + 120,000 - 60,000) = 560,000 c. The fair value of the investee is not reflected in the financial statements of the investor. Using equity method, the equity investment account is reported after adjusting for equity income and dividends. Changes to the FV of the investee doesn't affect this amount. The fair value should be disclosed in the notes.

Investor acquires 8% investment in investee for 320,000 on 2/15/18. CS has readily determinable fair value. 12/31/18, FV of 8% CS investment is 340,000 and all adjustments have been made. 3/1/19, investor acquires additional 17% for 765,000 increasing overall ownership to 25%. a. JEs for 3/1/19 b. assume on 2/15/18 that there was no readily determinable FV and that the additional stock purchase qualifies as observable price change in orderly transaction. JEs for 3/1/19 c. assume on 2/15/18 that there was no readily determinable FV and that the additional stock purchase does not qualify as an observable price change in orderly transaction. JEs for 3/1/19

a. Must use FV method DR equity investment 20,000 CR unrealized holding gain 20,000 (mark the pre-existing holding of equity securities to fair value, based on FV of 3/1/19 transasction the entire entity's FV is 765,000/17% = 4,500,000, thus the original 8% FV is 360,000, knowing this 360,000 - 340,000 = 20,000) DR equity investment 765,000 CR cash 765,000 (record the acquisition of additional equity securities) b. Must use cost method DR equity investment 40,000 CR unrealized holding gain 40,000 (see above for FV calculation and see problem for cost) (mark pre-existing holding of equity securities to fair value) DR equity investment 765,000 CR cash 765,000 (record the acquisition of additional equity securities) c. Must use cost method Since the transaction to purchase the additional interest is not considered an observable price change in orderly transition, the original investment remains at original cost. Only the entry for the purchase of additional securities is needed DR equity investment 765,000 CR cash 765,000 (record the acquisition of additional equity securities)

Assume, as part of recording a business combination, you were given the task of assigning fair values to the acquired identifiable net assets.A lawyer tells you that the company has been sued for patent infringement. The company's lawyer says that the odds of an adverse judgment are slightly better than 50/50, and that, if the company loses the lawsuit, she expects a liability of about $10 million. a. Are you justified in assigning fair value to this liability? If so, how much? b. Assume the company's lawyer also tells you that the investee has indemnified the company against any loss as a result of this lawsuit in the purchase and sale agreement. How do you handle this additional information in your assignment of fair values?

a. No, a contingent liability for the employee litigation is not recognized at fair value on the acquisition date because your attorney has determined that an unfavorable outcome is reasonably possible, but not probable (ASC 450-20-25-2). Therefore, your company would recognize a liability in the post-combination period when the recognition and measurement criteria in ASC 450 are met. b. The indemnification by the acquiree becomes an "indemnification asset" for the purchaser and can be recognized as such on the consolidated balance sheet at the same amount. Net assets acquired are, therefore, unaffected. Until the lawsuit is settled, the contingent liability and the indemnification asset must both be revalued at each balance sheet date and the change in value reflected in income. Since the asset and liability are offsetting, however, their revaluation will have offsetting amounts in the income statement, leaving net income unaffected.

18. In business combinations, assigning fair values to liabilities has two implications: 1. the fair value of the identifiable net assets acquired decreases (because of the increase in liabilities), resulting in the assignment of more fair value to the Goodwill asset, and 2. Future cash payments are debited to this accrued liability rather than to expense, thus increasing post-acquisition profitability. a. Describe what the liability relating to a restructuring plan is. b. How does Acquisition Accounting prescribe how we should account for these liabilities?

a. Restructuring plans typically include the termination of employees as departments are merged, the divestiture of lines of businesses with related plant closing costs, the relocation and training of employees, and the write-off of assets such as Goodwill on the acquiree's balance sheet that relate to previous acquisitions that will no longer play a part in the consolidated company. b. FASB ASC 805-20-25-2: "To qualify for recognition as part of applying the acquisition method, the identifiable assets acquired and liabilities assumed must meet the definitions of assets and liabilities at DOA". For example, costs the acquirer expects but is not obligated to incur in the future to effect its plan to exit an activity of an acquiree or to terminate the employment of or relocate an acquiree's employees are not liabilities at the acquisition date. Therefore, the acquirer does not recognize those costs as part of applying the acquisition method. Instead, the acquirer recognizes those costs in its post-combination financial statements in accordance with other applicable generally accepted accounting principles (GAAP)."