Slide 2-1 2 CHAPTER 2 WHOLLY OWNED SUBSIDIARIES: POSTCREATION PERIODS
Slide 2-2
2FOCUS 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
Slide 2-3
2 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.
Slide 2-4
2 The Cost Method: How It Works (cont.)
It is a one-way street!
The investment can be written down--but NEVER written up.
Slide 2-5
2 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.
Slide 2-6
2 The Cost Method: MAJOR Point of Interest
Although the parent CANmanipulate its OWNreported net income,
it can NEVER manipulate
CONSOLIDATED net income.
Slide 2-7
2 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).
Sub’s P/L
autopilot
Slide 2-8
2 The Equity Method: How It Works (cont.)
It is a two-way street!
The investment can be:(1) written down AND(2) written up.
Slide 2-9
2 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.
Slide 2-10
2 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.
Slide 2-11
2 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
Slide 2-12
2 The Cost Method: Things to Remember in Consolidation
NONE NONE of the sub’s beginning or ending RETAINED EARNINGS is eliminated in consolidation.
ONLY ONLY the parent’s DIVIDENDS arereported 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)
Slide 2-13
2 The Equity Method: Things to Remember in Consolidation
Consolidated net income EQUALSthe parent’s net income.
Consolidated retained earnings EQUALSthe parent’s retained earnings.
P CON. $74,000 = $74,000
P CON. $123,000 = $123,000
Slide 2-14
2 The Equity Method: Things to Remember in Consolidation
ALL of sub’s beginning & ending RETAINED EARNINGS are eliminated in consolidation.
ONLYONLY the parent’s DIVIDENDS arereported 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
Slide 2-15
2 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 statementsand consolidated statements : SAME net income amounts. SAME retained earnings amounts.
Bank of USA
Slide 2-16
2 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.
Slide 2-17
2 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.
Slide 2-18
2 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.”
Slide 2-19
2 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.
Slide 2-20
2 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%
Slide 2-21
2 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
earnedin any GIVEN year.Artificially assumes that each
year’s unrecovered investment (at B-O-Y) earns the SAME rate.
Slide 2-22
2 AROI vs. IRR: They Serve Entirely Different Purposes
AROI IRR
Purpose served:
Tells what was actually earned for a given year.
Tells what was or will be earned over several years.
Short-coming:
An average AROI covering several years is less reliable than IRR.
Reveals nothing about a given year.
Slide 2-23
2Review Question #1
Under 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.
Slide 2-24
2Review Question #1--With Answer
Under 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.
Slide 2-25
2Review Question #2
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.
Slide 2-26
2Review Question #2--With Answer
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.
Slide 2-27
2Review Question #3
Under the EQUITY 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.
Slide 2-28
2Review Question #3--With Answer
Under the EQUITY 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.
Slide 2-29
2Review Question #4
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.
Slide 2-30
2Review Question #4--With Answer
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.
Slide 2-31
2Review Question #5
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.......
Slide 2-32
2Review Question #5--With Answer
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
Slide 2-33
2Review Question #6
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.
Slide 2-34
2Review Question #6--With Answer
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.
Slide 2-35
2Review Question #7
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.
Slide 2-36
2Review Question #7--With Answer
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.
Slide 2-37
2Review Question #8
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.
Slide 2-38
2Review Question #8--With Answer
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.