Copyright © 2006 by South- Western. All rights reserved. CHAPTER 2 WHOLLY OWNED SUBSIDIARIES: POSTCREATION PERIODS.

Copyright © 2006 by South-Western. All rights reserved.

CHAPTER 2

WHOLLY OWNED SUBSIDIARIES:

POSTCREATION PERIODS


FOCUS OF CHAPTER 2• Ways to Value the Parent’s Investment

Account in POSTCREATION Periods• Cost Method vs. Equity Method Driven

Consolidation Procedures– Income Statements– Statements of Retained Earnings

• Parent-Company-Only (PCO) Statements– Articulation with Consolidated Statements


The Cost Method:How It Works

• It is cash basis driven: – Record income at the parent level ONLY

when sub declares a dividend.– Ignore sub’s earnings.– Do NOT ignore sub’s losses.– Write-down investment ONLY IF value

has been impaired.– Write-downs result in a NEW cost basis.


The Cost Method: How It Works (cont.)

• It is a one-way street!

The investment can be written down—but NEVER written up.


The Cost Method: Pros & Cons

• Pros:– Minimal G/L bookkeeping by parent.– Simple consolidation procedures.

• Cons:– Overly conservative valuation.– Parent can manipulate its reported

income.– PCO statements—if used internally or

issued—may be of limited value.


The Cost Method: MAJOR Point of Interest

• Although the parent CAN manipulate its OWN reported net income, it can NEVER manipulate CONSOLIDATED net income.


The Equity Method:How It Works

• It is accrual basis driven:– Record income at the parent level

based on sub’s earnings and losses—an AUTOMATIC VALUATION TECHNIQUE.

– Sub’s dividends reduce the parent’s investment (the parent has less invested).


The Equity Method: How It Works (cont.)

It is a two-way street!

The investment can be:(1) written up AND(2) written down.


The Equity Method:Pros and Cons

• Pros:– Based on economic activity—not the

parent-controlled dividend policy.

– Has 2 built-in checking figures.

• Cons:– Entails continual bookkeeping.– Unnecessary work if PCO statements

are not used internally or issued to outsiders.


The Equity Method: MAJOR Point of Interest

• Compared with the cost method, the consolidation entry under the equity method has a “new kid on the block.”

• A posting must be made to eliminate the subsidiary’s beginning retained earnings.


The Cost Method: Things to Remember in Consolidation

• Consolidated NET INCOME does NOT equal the parent’s NET INCOME.

• Consolidated RETAINED EARNINGSdoes NOT equal the parent’s RETAINED EARNINGS.

P S Sub’s Divies CON.$54,000 + $24,000 - $4,000 = $74,000

P S CON.$103,000 + $20,000 = $123,000


The Cost Method: Things to Remember in Consolidation

• NONE of the sub’s beginning or ending RETAINED EARNINGS is eliminated in consolidation.

• ONLY the parent’s DIVIDENDS are reported in the consolidated column.

P S CON. $54,000 + $20,000 = $74,000

P S Sub’s Divies CON.$(51,000) + $(4,000) - $4,000 = $(51,000)


The Equity Method: Things to Remember in Consolidation

• Consolidated net income EQUALS the parent’s net income.

• Consolidated retained earnings EQUALS the parent’s retained earnings.

P CON. $74,000 = $74,000

P CON. $123,000 = $123,000


The Equity Method: Things to Remember in Consolidation

• ALL of sub’s beginning & ending RETAINED EARNINGS are eliminated in consolidation.

• ONLY the parent’s DIVIDENDS are reported in the consolidated column (also occurs under the cost method).

P S Sub’s Divies CON.$(51,000) + $(4,000) - $4,000 = $(51,000)

P S Sub’s R.E. CON.$123,000 + $20,000 - $20,000 = $123,000


PCO Statements: Presented in Notes to the Consolidated Statements

• PCO statements are mandatory for publicly owned banks and S&Ls (SEC rules).– Can ONLY use the equity method.

• Equity method results in 100% articulation between PCO statements and consolidated statements:– SAME net income amounts. – SAME retained earnings amounts.


PCO Statements: Presented in Notes to the Consolidated Statements

• Retained Earnings Available for Dividends: – Based on the parent’s G/L amount—

NOT on the consolidated retained earnings amount.

– Use of the equity method in PCO statements produces IDENTICALretained earnings amounts.

– Use of the cost method in PCO statements creates CONFUSION.


Consolidation: The Most Important Point of All on Investment Basis

• The consolidated statement amounts are identical whether the parent usesthe cost method or the equity method—this holds true for ALL 3 statements.


Total Investment Loss Situations: Equity Method Procedures

• Parent Has GUARANTEED Sub’s Debt:– NO interruption occurs in the

application of the equity method.– Parent can lose more than it has

invested—parent is “on the hook.”


Total Investment Loss Situations: Equity Method Procedures (cont.)• Parent Has NOT GUARANTEED Sub’s

Debt:– Discontinue equity method when sub’s

equity reaches zero—resume ONLY WHEN sub’s equity becomes positive.

– Parent can NEVER lose more than it has invested.


AROI Versus IRR: They Serve Entirely Different Purposes

Annual Return on Investment (AROI):• Tells what was actually earned on an

investment EACH year.• Based on actual GAAP net income.• Can be used to calculate an average AROI

covering several years.

1 2 3 AVG. 18% + 12% + 15% = 45%; 45%/3 = 15%


AROI Versus IRR: They Serve Entirely Different Purposes

• Internal Rate of Return (IRR):– An assumed rate covering SEVERAL

years.• Based on cash flows for those years.

– CANNOT show what was actually earned in any GIVEN year.• Artificially assumes that each year’s

unrecovered investment (at B-O-Y) earns the SAME rate.


AROI vs. IRR: They Serve Entirely Different Purposes


Review Question #1Under the COST METHOD, a sub’s DIVIDENDS would:

A. NOT be eliminated in consolidation.B. Be the parent’s investment income.C. Reduce the parent’s investment. D. Increase the parent’s investment.E. None of the above.


Review Question #1With Answer

Under the COST METHOD, a sub’s DIVIDENDS would:



Review Question #2Under the COST METHOD, a sub’s LOSSES would:

A. Never reduce the parent’s income.B. Always reduce the parent’s income.C. Always reduce the parent’s investment. D. Always be eliminated in consolidation.E. None of the above.



Under the COST METHOD, a sub’s LOSSES would:

A. Never reduce the parent’s income.B. Always reduce the parent’s income.C. Always reduce the parent’s investment. D. Always be eliminated in consolidation.E. None of the above.


Review Question #3Under the EQUITY METHOD, a sub’s DIVIDENDS would:




Under the EQUITY METHOD, a sub’s DIVIDENDS would:



Review Question #4Under the EQUITY METHOD, a sub’s LOSSES would:

A. Never reduce the parent’s income.B. Normally reduce the parent’s income.C. Always reduce the parent’s investment. D. Always be eliminated in consolidation.E. None of the above.



Under the EQUITY METHOD, a sub’s LOSSES would:

A. Never reduce the parent’s income.B. Normally reduce the parent’s income.C. Always reduce the parent’s investment. D. Always be eliminated in consolidation.E. None of the above.


Review Question #5On 1/1/04, Paxco invested $500,000 in Saxco (100%-owned). For 2004, Saxco: (1) earned $70,000, (2) declared dividends of $40,000, and (3) paid dividends of $30,000. What amounts does Paxco report? Cost EquityInvestment income for 2004.....

Investment in Saxco at Y/E......

Retained earnings increase.......



On 1/1/04, Paxco invested $500,000 in Saxco (100%-owned). For 2004, Saxco: (1) earned $70,000, (2) declared dividends of $40,000, and (3) paid dividends of $30,000. What amounts does Paxco report? Cost EquityInvestment income for 2004..... Investment in Saxco at Y/E......Retained earnings increase.......

$40,000 $70,000

$500,000 $530,000

$40,000 $70,000


Review Question #6A parent can lose MORE THAN than it has invested:

A. Only under the cost method.B. Only under the equity method.C. Under either the cost or equitymethods.D. Only if the subsidiary is not consolidated.E. None of the above.



A parent can lose MORE THAN than it has invested:

A. Only under the cost method.B. Only under the equity method.C. Under either the cost or equity methods.D. Only if the subsidiary is not consolidated.E. None of the above.


Review Question #7Parent-company-only (PCO) statements are usually presented in notes only when:

A. The parent uses the cost method.B. The parent uses the equity method.C. The subsidiary is not consolidated. D. The SEC’s rules require them. E. None of the above.



Parent-company-only (PCO) statements are usually presented in notes only when:

A. The parent uses the cost method.B. The parent uses the equity method.C. The subsidiary is not consolidated. D. The SEC’s rules require them. E. None of the above.


Review Question #8When a parent-sub relationship exists, STATE LAWS require dividends to be based on the:

A. Parent’s retained earnings.B. Sub’s retained earnings.C. Consolidated retained earnings.D. The lower of the parent’s OR the

consolidated retained earnings.E. None of the above.



When a parent-sub relationship exists, STATE LAWS require dividends to be based on the:

A. Parent’s retained earnings.B. Sub’s retained earnings.C. Consolidated retained earnings.D. The lower of the parent’s OR the

consolidated retained earnings.E. None of the above.


End of Chapter 2

• Time to Clear Things Up—Any Questions?

Copyright © 2006 by South- Western. All rights reserved. CHAPTER 2 WHOLLY OWNED SUBSIDIARIES: POSTCREATION PERIODS.

Documents

equity method

subs earnings

retained earnings

parents net income

reported income

earnings parentcompany

consolidated net income

parent level