Accounting for M & A, equity, and credit analysts : [in-depth coverage of taxes, pensions, and stock options ; covers accounting rules for changes in plan assets ; includes sample accounting entries and forms

Excerpt CHAPTER 1 Equity Method of Consolidation INTRODUCTION When dealing with firms that account for investments using the equity method of accounting, analysts often find the reality of applying the equity method to be more complex than the simple one-line consolidation they had envisioned. Beyond that initial hurdle lies the complexity of accurately projecting the effect of equity method investments on the firm's earnings-per-share and cash flow. To work through some of the more common areas of uncertainty, I begin with a basic introduction of the equity method, recognition of affiliate income, and the receipt of dividends. The next level involves considering the tax implications of the equity method; a common trap is ignoring the taxes because equity earnings and the associated taxes are noncash when, in actuality, they are only noncash for now and impact future cash flows. Following are two more subtle and less well-understood topics: equity method goodwill and intercompany transactions. Finally, we examine the analysis of cash flows from equity method investments and how all of the aspects of the equity method of accounting for investments are properly modeled together in a projection/valuation framework. DESCRIPTION OF THE EQUITY METHOD The equity method of accounting for investments describes how corporations and other entities account for the investments they make in other firms. It is the appropriate accounting method for them to use when the investments that they make are large enough to exert significant influence yet too small to require full consolidation accounting. The equity method is generally used for investments of greater than 20-percent ownership (delineating where significant influence is assumed to exist) and less than 50-percent ownership (delineating where consolidation is required). These are nominal measures and, as we see later in this chapter, it is possible for investors to structure aspects of their ownership to extend the range over which they may use the equity method. Figure 1–1 illustrates the accounting relationship between an investor and its investee that it consolidates using the equity method. Accounting Standards Accounting Principles Board Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock (APB 18), summarizes the process of accounting for an investment using the equity method as: * An investor initially records an investment in the stock of an investee at cost, and adjusts the carrying amount of the investment to recognize the investor's share of the earnings or losses of the investee after the date of acquisition. * The amount of the adjustment is included in the determination of net income by the investor, and such amount reflects adjustments similar to those made in preparing consolidated statements, including adjustments to eliminate intercompany gains and losses, and to amortize, if appropriate, any difference between investor cost and underlying equity in net assets of the investee at the date of investment. * The investment of an investor is also adjusted to reflect the investor's share of changes in the investee's capital. * Dividends received from an investee reduce the carrying amount of the investment. * A series of operating losses of an investee or other factors might indicate that a decrease in value of the investment has occurred that is other than temporary and that should be recognized even though the decrease in value is in excess of what would otherwise be recognized by application of the equity method. Accounting Under the Equity Method-Fundamental Approach The fundamental approach for accounting for investments under the equity method is referred to as a one-line consolidation. Using the one-line consolidation approach, the investor presents her portion of the investee's net income as a single line on the income statement and the inferred value of the investment in the investee (historical cost plus the accumulated share of earnings) as a single line on the balance sheet. So, for the simplest of investments, the investor represents the impacts of the entire investment with one line on the income statement and one line on the balance sheet. Less commonly, when the investee presents either discontinued operations, extraordinary gains and losses, or the effects of changes in accounting principle on its income statement separately after net income, the investor reports them the same way. EXAMPLE 1–1. Accounting for the Investor's Portion of Investee's Net Income Assume that on 31-Dec-20x0 Investor paid 1200 for 25 percent of the common stock of Investee. Investor recognizes the investment on its 31-Dec-20x0 balance sheet in the account titled Investment in affiliates as 1200. (Any income tax effects are initially ignored for this discussion.) Investee's net income for the period ending 31-Dec-20x1 is 400. Investor recognizes 25% x 400 = 100 in its income statement in the account titled Equity in earnings of affiliates . The balance sheet account increases by the amount from the Equity in earnings of affiliates income statement account making the 31-Dec-20x1 balance 1300. EXAMPLE 1–2. Accounting for Investor's Portion of Investee's Extraordinary Items Assume the same fact pattern as above except that Investee also reports an extraordinary gain of 200. Investor recognizes 25% x 400 = 100 in its income statement as equity in earnings of affiliates (same treatment as above) and also recognizes 25% x 200 = 50 as equity in extraordinary gain of affiliates. If Investee has reported any items for discontinued operations or effects of changes in accounting principle, they would be presented similarly on Investor's income statement. If Investee pays a common dividend, Investor reduces its investment account by the amount of the dividend received. Note that receipt of the dividend is not recognized as income in Investor's income statement and is actually a capital transaction affecting only the balance sheet accounts (because we are ignoring, for the moment, any income tax effect). Investor treats the dividend distribution as a capital transaction because the dividend is merely a cash distribution of income that Investor has previously recorded as equity in earnings of affiliates. EXAMPLE 1–3. Accounting for Investor's Receipt of Dividends from Investee Assume the same fact pattern as in Example 1–2 above, except that on 31- Dec-20x1 Investee pays a total dividend of 80 to all holders of common stock. The first two entries are the same as in the previous example: The new entry accounts for the cash received as a cash dividend from Investee that reduces the amount carried in Investor's Investment in affiliates account. TAX CONSIDERATIONS WHEN USING THE EQUITY METHOD When assessing the tax effects of equity investments, our first reaction is to sometimes think that the Investee has already paid income taxes on its earnings and that, because of that, there should be no additional tax impact to Investor. While it is true that Investee pays income taxes on its earnings, under U.S. tax law, any gain that Investor realizes on its investment is generally subjected to a second level of taxation, i.e., double taxation; those tax effects must be reflected in Investor's accounting. The general tax effects of an equity method investment include the: * Recognition of book taxes in each period to reflect the accrued tax burden associated with the equity in earnings of the affiliates * Realization of a cash tax burden in periods when dividends of cash or property are actually received Book Tax Considerations The tax burden or benefit associated with a firm's financial reporting, or book earnings, is often referred to as its book taxes . Similarly, the taxes actually paid (or sometimes received as refunds) by a firm are referred to as cash taxes . Because the goals and objectives of financial reporting and income tax reporting are different, book taxes and cash taxes are never the same. The matching principle of financial accounting requires that the income tax burden on the investment's earnings be recognized, for book purposes, in the same period as those earnings. Federal income tax reporting, on the other hand, is not interested in when the earnings actually occurred but rather when the cash from those earnings passes to Investor. This creates a disconnect between the book taxes that Investor recognizes and the cash taxes that Investor pays. Accounting for the accrued tax burden of an equity method investment becomes a matter of calculating the book taxes on the equity in earnings of affiliates. This appears relatively straightforward but requires Investor to estimate the appropriate tax rate based on how the investment is expected to be recovered. Investments under the equity method are recovered in one of four ways, by: 1. Receiving a stream of cash dividends 2. Realizing a gain on the sale of the investment 3. A combination of dividends and gain on sale, or 4. The less common case, never directly recovering the investment in cash The tax rate for the first case, receiving a stream of dividends, can be as low as 8 percent due to the dividends received deduction. Corporate investors may usually exclude 80 percent of the dividends received from their equity investments from taxable income. The remaining 20 percent of the dividends are taxed at the corporate tax rate (which we will estimate as being 40 percent for our discussion, which approximates the combined effects of state and federal taxes). (20% x 40%) = 8%.) In the second case, realizing the entire gain from the sale of the investment, the gain is taxed at the corporate capital gain rate, which is currently the same as the corporate tax rate for ordinary income. As before, using our estimate, gains from the sale of the investment would be taxed at 40 percent. More practically, the investment would be recovered using the third approach, partially through receipt of dividends, with the remainder being realized as a gain on the sale of the investment. Investor determines the amount of the investment he expects to recover from each method, dividends or gain on sale, and apportions the amounts to calculate an effective blended tax rate between 8 percent and 40 percent. Finally, there are instances where strategic investments, usually those involving true joint ventures (where control of the joint venture is truly shared and no single party has control), are accounted for using the equity method. These investments may never be directly recovered because all profits may be reinvested, and the strategic nature of the investment would bar Investor from ever selling. Recovery of the investment would occur indirectly, often in the form of reduced costs of goods sold. In these situations, the appropriate tax rate to use for the equity method investment may actually be zero. An example of such an investment might be a brewer's investment in a joint venture of a beer can manufacturer. The beer can manufacturer uses all of the capital that it generates to maintain and expand production so it never has or intends to pay a dividend. The brewer needs a secure source of beer cans at predictable prices, so its strategy precludes it from ever selling or disposing of its investment in the beer can manufacturer. To account for its investment in the beer can manufacturer, the brewer would use the equity method and calculate the deferred tax items associated with the equity method investment using a zero- percent expected future tax rate. When accounting for the income tax effects of equity investments, recognizing amounts of equity in earnings (loss) of affiliates requires that Investor recognize income taxes for book purposes before they are actually paid in cash. Because in most cases, the taxes will eventually be paid in cash (either when the earnings are paid to Investor in cash or when Investor sells its investment for cash), the difference between book taxes and cash taxes is only temporary. This type of temporary difference, taxes recognized for book purposes before they are for federal tax purposes, gives rise to a deferred tax liability equal to the amount of the expected future tax burden (income taxes that Investor expects to pay in the future). In future periods when either the cash dividends are actually received or the investment eventually sold, Investor reverses the recorded deferred tax liability to offset the cash taxes actually being paid. EXAMPLE 1–4. Investor's Treatment of the Tax Effects of Income from Equity Method Investments Assume that on 31-Dec-20x0 Investor paid 1200 for 25 percent of the common stock of Investee. Investor recognizes the investment on its 31-Dec-20x0 balance sheet as an investment in affiliates of 1200. Also at that date, the tax basis of the investment is equal to the cost basis of 1200. Investor holds the investment unchanged and Investee's net income for the period ending 31-Dec-20x1 is 400. Investor recognizes (25% x 400) = 100 in its income statement as equity in earnings of affiliates. Investor also increases the balance sheet account, Investment in affiliates, by the same amount recognized as equity in earnings of affiliates (100) making the 31-Dec-20x1 balance (1200 + 100) = 1300. For federal income tax purposes, the 100 of income recognized by Investor in tax year 20x1 is attributed to appreciation of the equity asset, which is not taxable until Investor eventually recovers it by either receiving cash dividends or gain on sale. For book accounting purposes, Investor recognizes a deferred income tax expense for the income received in 20x1. However, the actual cash tax expense is not realized until the period in the future when the cash is received. To account for this temporary difference, a deferred tax liability is funded as a noncash expense in the current period. 8% is used because only 20% of the dividends are taxable at a 40% rate. (20% x 40%) = 8%. Cash Tax Considerations Because Investor intends to realize its investment by receiving a stream of dividends, no cash effect occurs until cash dividends are actually received in the future. At that point, Investor pays income taxes on the cash taxes received in each future period, and the deferred tax liability on Investor's balance sheet reverses by an amount equal to the cash taxes as they are paid. EXAMPLE 1–5. Investor's Treatment of the Tax Effects of Dividends Received Assume that on 31-Dec-20x2 Investee declares and pays a cash dividend of 80 to all holders of common equity. Remember that the dividends are generally a distribution of earnings from prior periods, i.e., the dividends that Investee pays in 20x1 may have been earned in 20x0. Those earnings, and their associated income tax expense, have already been accounted for on Investor's income statement in the prior periods. Because of this, when Investor receives its portion (80 x 25%) = 20 of dividends from Investee, it is not recognized in Investor's income statement, but only as an adjustment to the Investment in affiliates balance sheet account. The tax effect of receiving the dividend is payment of cash taxes on 20 percent of the dividends received (because under U.S. tax law, 80 percent of the dividends received are excluded) and reversing the associated portion of the deferred tax liability. Investor pays cash taxes on 20 percent of the 20 received (20 x 20%) = 4 at a tax rate of 40% (4 x 40%) = 1.6. ACCOUNTING UNDER THE EQUITY METHOD-EXCESS OF COST OVER EQUITY PURCHASED Another aspect of the equity method that is often overlooked or underexplained is the allocation of any excess cost of the equity investment to the underlying accounts and to goodwill. The basic approach is the same as that used under purchase accounting. The purchase price (amount of the investment) is allocated to the assets and liabilities of Investee according to their fair market value at the time of purchase, and the remainder is allocated to goodwill. Because these allocations appear in only Investor's working papers and not in the financial statements, they are sometimes referred to as "phantom write-ups" or "phantom goodwill." This allocation only occurs in Investor's working papers for purposes of determining the correct amount of additional depreciation and amortization to use when adjusting the Investment in affiliates account. Investor's balance sheet reflects the investment in Investee at cost, and no goodwill is recorded on the balance sheet for the purchase. Where the effect of the allocations is primarily felt is in the recognition of Investor's proportionate share of Investee's earnings, which is reduced in each period to reflect the additional depreciation and amortization. Many find this approach far from intuitive, so let me begin by framing the problem that this approach is intended to resolve. Recall that the fair market value purchase price paid is initially recorded in the Investment in affiliates account and is increased (or decreased) in each subsequent period by the proportionate share of Investee's earnings. Investee's earnings result, in part, from reducing its revenues by the expense associated with depreciation and amortization of the historic book values of the assets employed to generate those revenues. This produces a disconnect between the amounts recognized in Investor's and Investee's books because the depreciation based on historic book values is not the same as the actual depreciation based on the fair market value at the time of purchase. If the lower depreciation based on Investee's historic book values is not adjusted for by Investor when recognizing the equity in earnings of affiliates, Investor ends up overstating earnings, assets, and owner's equity. The next example illustrates more clearly how this occurs. EXAMPLE 1–6. Overstatement of Investor's Financials Resulting from Failure to Properly Allocate the Equity Purchase Price Assume that Investee is a very simple company employing a single asset to generate revenues and, other than the depreciation of that asset, incurs no other expenses. Investor purchases 20 percent of Investee for 1200 at the end of year 20x0 when the asset has a book value of 3000 and a remaining useful life of three years. Investee realizes revenues of 2000 in each of the subsequent three years. To simplify further, Investor holds a single asset, its investment in Investee, and generates no other revenues. As we see in Figure 1–2 , Investee completely consumes its only asset and fully depreciates it by the end of 20x3. (Continues...) Excerpted from Accounting for M&A, Equity, and Credit Analysts by James Morris . Copyright © 2004 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc.. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher. Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

everything Investment Professionals Need To Know About Accounting—in A Practical Desk Reference Format

in Today's World Of Constantly Changing Accounting Rules, Models, And Practices, Investment Professionals Need An Authoritative, All-in-one, Fast-access Reference For The Latest Knowledge And Information. accounting For M&a, Equity, And Credit Analysts Provides Comprehensive And Easy-to-understand Answers To The Everyday Accounting Questions That Come Up Time And Again In The Investing Arena.

noted M&a Accounting Authority James E. Morris Has Spent Years Dispensing Accounting Advice On Wall Street, And He Knows Which Questions Consistently Baffle Even The Most Experienced Investment Pros. He Answers Those Questions And Hundreds More As He Provides Clear And Concise Explanations Of Areas Including:

• subtle, Less Understood Aspects Of Common Accounting Areas And Procedures
• purchase Accounting For Business Combinations—essential Not Only For M&a Analysts But For Credit And Equity Analysts As Well
• accounting For Employee Stock Options, And Its Effect On Both Earnings And Cash Flow

today's Investment Accounting Landscape Is Undergoing Tumultuous And Unprecedented Change. Professionals Who Fail To Keep Up With That Change Risk Being Left Behind. accounting For M&a, Equity, And Credit Analysts updates You On Virtually Every Important Facet Of Investment Accounting, And Provides The Handy Reference You Need To Instantly Know What The Numbers Are really saying To You—and, Just As Important, What They Are Not.

this Is Not, By Any Means, Another Financial Accounting Textbook. Instead, I Intend It As A Sort Of Spotlight, Illuminating What I Have Found In My Investment Experience To Be The 'black Holes' Of Accounting. It Is Merely The Collected Answers To The Questions That Analysts (associates, Vice Presidents, Managing Directors And Clients As Well) Have Asked Me During The Time I Spent Giving Accounting Advice On Wall Street.

—from The Preface

investment Professionals Too Often Regard The Acquisition Of Accounting Knowledge As A Necessary Evil—and, Therefore, Too Often Know Less Than They Should. This Lack Of Knowledge Often Leads To Simple Misunderstandings Or Even Out And Out Errors That, At Best, Serve As Minor Speed Bumps In A High-stakes Transaction And, At Worst, Lead To The Delay Or Even Derailing Of The Deals In Question.

accounting For M&a, Equity, And Credit Analysts helps Investment Professionals As Well As Undergraduate And Graduate Students Of And Investment Banking Ensure That They Will Always Be Able To Quickly And Confidently Get Their Hands On The Right Answers To Virtually Every Accounting Question. Providing Easy-access Accounting Information Without Needless Detail And Cpa Doublespeak, This Invaluable Reference Distinguishes Itself From Other Texts Of Its Type In Four Major Areas As It:

• bypasses Common-knowledge Accounting Basics To Concentrate Only On Information Vital To Investment Analysts
• takes An Investment Banking Perspective As Opposed To One Solely Focused On Generally Accepted Accounting Principles (gaap) And Reporting
• integrates Financial Modeling And Spreadsheet Approaches That Are Essential To Forecasting And Analysis
• provides In-depth Coverage Of Items In Enterprise Valuation And Business Combination Transactions

in The Investment Profession, Few Factors Are As Valuable Or Overlooked As Solid Knowledge In Accounting. Unfortunately, When Professionals Seek To Increase Their Accounting Expertise, They Are Too Often Faced With Either Cartoonish Workbooks Or Incomprehensible, 600-page Textbooks.

accounting For M&a, Equity, And Credit Analysts Provides Investment Professionals, Analysts, And Bankers With Only The Information They Need To Understand How Accounting Impacts their everyday Environment. The First Investment Accounting Desk Reference To Bridge The Gap Between What Is Taught In Business School And What Is Actually Needed In The Real World, It Allows Investment Pros To Focus On And Truly Understand The Vital Accounting Details They Encounter Every Day—and Helps Them Ensure That Minor Accounting Misunderstandings Or Mistakes Won't Mushroom Into Major Deal-killers.

james E. Morris, C.p.a., C.f.a. (baltimore, Md) Is A Project Manager

of Financial Analysis For The U.s. Nuclear Regulatory Commission.

he Also Trains Analysts And Associates To Value Companies.

Everything investment professionals need to know about accounting--in a practical desk reference formatIn today's world of constantly changing accounting rules, models, and practices, investment professionals need an authoritative, all-in-one, fast-access reference for the latest knowledge and information. Accounting for M&A, Equity, and Credit Analysts provides comprehensive and easy-to-understand answers to the everyday accounting questions that come up time and again in the investing arena.Noted M&A accounting authority James E. Morris has spent years dispensing accounting advice on Wall Street, and he knows which questions consistently baffle even the most experienced investment pros. He answers those questions and hundreds more as he provides clear and concise explanations of areas including:Subtle, less understood aspects of common accounting areas and procedures Purchase accounting for business combinations--essential not only for M&A analysts but for credit and equity analysts as well Accounting for employee stock options, and its effect on both earnings and cash flow Today's investment accounting landscape is undergoing tumultuous and unprecedented change. Professionals who fail to keep up with that change risk being left behind. Accounting for M&A, Equity, and Credit Analysts updates you on virtually every important facet of investment accounting, and provides the handy reference you need to instantly know what the numbers are really saying to you--and, just as important, what they are not. "This is not, by any means, another financial accounting textbook. Instead, I intend it as a sort of spotlight, illuminating what I have found in my investment experience to be the 'black holes' of accounting. It is merely the collected answers to the questions that analysts (associates, vice presidents, managing directors and clients as well) have asked me during the time I spent giving accounting advice on Wall Street." --From the PrefaceInvestment professionals too often regard the acquisition of accounting knowledge as a necessary evil--and, therefore, too often know less than they should. This lack of knowledge often leads to simple misunderstandings or even out and out errors that, at best, serve as minor speed bumps in a high-stakes transaction and, at worst, lead to the delay or even derailing of the deals in question. Accounting for M&A, Equity, and Credit Analysts helps investment professionals as well as undergraduate and graduate students of and investment banking ensure that they will always be able to quickly and confidently get their hands on the right answers to virtually every accounting question. Providing easy-access accounting information without needless detail and CPA doublespeak, this invaluable reference distinguishes itself from other texts of its type in four major areas as it:Bypasses common-knowledge accounting basics to concentrate only on information vital to investment analysts Takes an investment banking perspective as opposed to one solely focused on Generally Accepted Accounting Principles (GAAP) and reporting Integrates financial modeling and spreadsheet approaches that are essential to forecasting and analysis Provides in-depth coverage of items in enterprise valuation and business combination transactions In the investment profession, few factors are as valuable or overlooked as solid knowledge in accounting. Unfortunately, when professionals seek to increase their accounting expertise, they are too often faced with either cartoonish workbooks or incomprehensible, 600-page textbooks. Investment professionals too often regard the acquisition of accounting knowledge as a necessary evil -- and, therefore, too often know less than they should. This lack of knowledge often leads to simple misunderstandings or even out and out errors that, at best, serve as minor speed bumps in a high-stakes transaction and, at worst, lead to the delay or even derailing of the deals in question.Accounting for M&A, Equity, and Credit Analysts helps investment professionals as well as undergraduate and graduate students of investment banking ensure that they will always be able to quickly and confidently get their hands on the right answers to virtually every accounting question. Providing easy-access accounting information without needless detail and CPA doublespeak, this invaluable reference distinguishes itself from other texts of its type in four major areas.In the investment profession, few factors are as valuable or overlooked as solid knowledge in accounting. Unfortunately, when professionals seek to increase their accounting expertise, they are too often faced with either cartoonish workbooks or incomprehensible, 600-page textbooks.Accounting for M&A, Equity, and Credit Analysts provides investment professionals, analysts, and bankers with only the information they need to understand how accounting impacts their everyday environment. The first investment accounting desk reference to bridge the gap between what is taught in business school and what is actually needed in the real world, it allows investment pros to focus on and truly understand the vital accounting details they encounter every day -- and helps them ensure that minor accounting misunderstandings or mistakes won't mushroom into major deal-killers.