Introduction
We will explore financial investments and acquisitions from the perspective of a company that owns the investments. We will shed light on the basics of acquisitions, including how financial accounting records these transactions, the intricacies of goodwill accounting, and the challenges that accompany accounting for goodwill. We will also investigate the representation of financial investments on a company's balance sheet and income statement. Our discussion will encompass methods for accounting for passive investments with less than a 20% ownership stake, the equity method of accounting for financial investments of more than 20% but less than 50%, and the consolidation accounting for investments of more than 50%.
Acquisitions
Acquisitions are a commonplace occurrence in today's corporate world. Over the past decade, tech giants like the FAANG companies have acquired hundreds of businesses. The driving force behind acquisitions is the acquirer's belief in the potential benefits of merging the acquired assets with their own. While alternatives exist, such as developing similar tangible and intangible assets internally, the company's management often deems a financial investment via an acquisition the most effective route towards achieving the company's objectives.
Upon acquisition, the purchasing company assumes all of the acquired company's assets and liabilities. A key motivator behind the acquisition is the synergy anticipated when combining assets such as intellectual property, licenses, brand value, customer lists, and goodwill. This synergy potentially enhances the value of the combined assets compared to their standalone value. The acquiring company often pays a premium above the current market price of the acquired due to the advantages of complete control over the assets and the anticipated synergies following the acquisition.
Corporate Financial Investment
Many companies often find themselves with substantial amounts of idle cash, which may not be immediately required for operational purposes. Leaving this cash idle is not desirable as it does not generate a return for the company's investors. Hence, it is common for mature companies with surplus cash to invest in equity and debt securities. According to GAAP accounting rules, such investments must be recorded on the company's balance sheet at fair value, and under certain circumstances, unrealized gains/losses must also be reflected on the income statement.
The method used to account for these investments varies depending on factors such as the investment horizon, ownership stake, and the nature of the security (debt versus equity). We will examine these accounting concepts and more in the following sections.
Accounting for Acquisitions
Purchase Accounting
Under US Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS), all firms are obligated to apply purchase accounting for acquisitions. According to these standards, the basis of assets is increased to market value, and identifiable intangible assets are added to the balance sheet to be subsequently amortized and are assumed to have zero salvage value. We will explore this in more detail.
Within the framework of purchase accounting, the acquisition price is incorporated into the acquirer's balance sheet. This integration involves allocating the value among:
- Tangible Assets: Reflecting the fair value of tangible assets.
- Intangible Assets: Accounting for identifiable intangible assets.
- Goodwill: Calculated using the balance sheet equation.
To achieve a reasonable allocation of the acquisition price across these categories, it's often necessary to engage professionals who can accurately appraise the value of the tangible and intangible assets. Once this assessment is complete, the balance sheet equation can be used to determine the value of goodwill.
\[\begin{align*} &+ \text{Tangible Assets}\\ &+ \text{Intangible Assets}\\ &+ \text{Goodwill} \\ &- \text{Total Liabilities}\\ &= \text{Book Value of Net Assets (SE)} \end{align*} \]Here the Book Value of Net Assets is equal to the purchase price.
For instance, suppose the acquisition price of a hypothetical ABC company was one million dollars, paid with $200,000 in cash and by issuing $800,000 in stock. Regarding the valuation of the acquired company, if the fair value of tangible assets was determined to be $175,000, the fair value of intangible assets was determined to be $350,000, and the fair value of liabilities was determined to be $125,000, then the following transaction would be recorded as a balance sheet entry:
Balance Sheet Entry
- Cash Account: -$200,000
- Fair Value Tangible Assets: +$175,000
- Identifiable Intangible Assets: +$350,000
- Goodwill: +$600,000
- Fair Value Liabilities: +$125,000
- Shareholders Equity (S/E): +$800,000
Notice that the $600,000 value of goodwill was calculated using the above balance sheet equation.
Suppose that prior to the acquisition of ABC, the balance sheet of ABC indicated no intangible assets or goodwill, a tangible asset book value of $155,000, and total liabilities of $110,000. Given this information, it is common to create a balance sheet that displays the values before and after the acquisition.
| Book Value Before Merger (BV) | Change MV-BV (Acqusition Adjustments) | Market Value after Merger (MV) | |
|---|---|---|---|
| Tangible Assets | $155,000 | +25,000 | $175,000 |
| Intangible Assets | $0 | +350,000 | $350,000 |
| Goodwill | $0 | +600,000 | $600,000 |
| Total Assets | $155,000 | +970,000 | $1,125,000 |
| Total Liabilities | $110,000 | +15,000 | $125,000 |
| Book Value of Net Assets (SE) | $45,000 | +955,000 | $1,000,000 |
As demonstrated above, once the experts have assessed the value of the tangible and intangible assets, we can use the balance sheet equation to deduce the value of goodwill. Following this, we record the newly determined market values for the tangible assets, intangible assets, and goodwill of the acquired company. These values add up to the total assets of the acquired company. Subsequently, we register these values along with the newly determined market value of the total liabilities of the acquired company in the right-most column of the above table. Given the balance sheet values from before the acquisition, we can record the acquisition adjustments, which represent the difference between the post and pre-acquisition prices.
The values calculated here can then be utilized to create a Pro Forma Combined Balance Sheet for the acquiring company, which essentially includes the sum of the acquired company's balance sheet, the pre-acquisition acquiring company's balance sheet, the acquisition price, and adjustments made to the acquired company's assets and liabilities.
Goodwill Impairment
After an acquisition, it may be later discovered that the market value of goodwill is less than the recorded book value of goodwill on the balance sheet. As we saw earlier, the value of goodwill was not estimated, but rather derived from the balance sheet equation. Hence, post-acquisition, it's up to management to assess the value of goodwill to determine if it needs to be impaired.
When goodwill is impaired, the value of the goodwill is written down by recording an entry to reduce the goodwill balance sheet account by the amount to be written down. This same amount is recorded as a loss in the Retained Earnings (R/E) account on the balance sheet and as a loss on the income statement.
It's important to note that under GAAP, goodwill impairment allows for a reduction in the value of goodwill, but there's no similar method permitted to increase the value of goodwill.
The decision to impair goodwill rests with management. Under certain circumstances, management may be aware of a significant reduction in the market value of goodwill but may choose to postpone a goodwill impairment, potentially for several years.
Lastly, it should be noted that goodwill is only added to a balance sheet when it is purchased, where the purchase price was greater than the identifiable intangible and tangible assets less market value of total liabilities. Management cannot estimate and report new goodwill for a firm.
Financial Investments
In this section, we explore the trading and available-for-sale securities where accounting moves away from a historical cost model and shifts towards market-driven valuations. We will see that held-to-maturity securities as well as majority control and significant influence investments apply a historical cost approach. Our objective is to comprehend how financial investments are valued on a company's balance sheet. Additionally, we will examine the impact of financial investments on the income statement and the cash flow statement due to valuation adjustments, and observe how acquisitions essentially represent a special case of financial investments.
Overview of Financial Investments
In the world of financial accounting, investments are broadly categorized based on the level of control or influence a company possesses over the invested entity. These are grouped into three primary classes: majority control, significant influence, and passive investments. Majority control refers to situations where the investing company owns more than 50% of the investee, thus having the authority to dictate its operational and strategic direction. Significant influence, on the other hand, occurs when the investor owns between 20% and 50% of the investee, allowing them to exert substantial impact over the investee's activities. The third category, passive investments, is characterized by an ownership stake of 20% or less, where the investor has no meaningful sway over the investee's operations.
For passive investments, the least controlling class, the Statement of Financial Accounting Standards (SFAS) 115 (now modified by ASU 2016-01) requires the firm to categorize its securities into three classifications based on the intent of the acquirer: held-to-maturity securities, trading securities, and available-for-sale securities.
- Held-to-maturity securities are debt securities that a company intends and has the ability to hold until they mature.
- Trading securities represent short-term investments intended for quick turnover and profit, such as debt or equity securities.
- Available-for-sale securities, typically debt-only instruments, are those not classified as held-to-maturity or trading securities. They provide a means for companies to generate passive income without any specific intention for short-term trading or long-term holding.
Each of these passive investment categories has unique accounting considerations, such as the use of cost, amortized cost, or the mark-to-market method, and is reported accordingly in the company's financial statements. Which of these is used partially depends on the intent of the acquirer.
Lower of Cost or Market (LCM) - US GAAP
When a firm manages its inventory, plant, property, and equipment, it may occasionally be necessary to make adjustments to the book value of such assets. The general rule is to use the Lower of Cost or Market (LCM).
Under LCM, if the market value of an asset is less than its net book value, then under GAAP, the firm is obliged to reduce the value of the asset and recognize a loss on the income statement. However, if the market value is higher than the book value of the asset, no adjustment is permitted. For inventory and PPE, most firms use LCM for a majority of their assets.
LCM is required for majority control and significant influence investments and is not used for passive control investments.
Accounting for Financial Investment
Given the nature of securities that are traded in liquid markets, it makes sense that such securities would be recorded on the balance sheet at their fair market price, which is readily available. For illiquid investments it makes sense that a historical cost approach is used.
Passive control level securities can affect the income statement, balance sheet, and statement of cash flows, depending on the type of investment and how the company opts to account for it.
Summary of Financial Investment Accounting Methods
| Ownership Level | Control Level | Accounting Method |
|---|---|---|
| More than 50% | Majority Control |
Consolidation Method
|
| Between 20% and 50% | Significant Influence |
Equity Method
|
| 20% or less | Passive Control |
Held-to-Maturity: Cost Method (Debt Securities Only)
|
Trading Securities: Fair Value Method (Debt or Equity Securities)
|
||
Available-for-Sale: Fair Value Method (Debt Securities Only)
|
Majority Control - Consolidation Method
When a firm takes a majority stake in a financial investment, signifying ownership of over 50%, it uses the consolidation method for accounting. This method can significantly influence the financial picture as it necessitates incorporating the liabilities of the acquired asset into a consolidated balance sheet—a requirement not present in the equity method and other methods used for passive investments.
When a parent company consolidates its financial statements with a subsidiary, it must include 100% of the subsidiary's income, expenses, assets, and liabilities, regardless of the parent company's actual percentage ownership.
However, it's important to note that the portion of income and equity not owned by the parent company is accounted for as a non-controlling interest (also known as a minority interest) in the consolidated financial statements. The non-controlling interest is reported as a separate line item in the equity section of the consolidated balance sheet and is allocated its share of the subsidiary's net income or loss in the consolidated income statement.
So, while the parent company consolidates 100% of the subsidiary's financial information, it still recognizes the portion of the subsidiary that it doesn't own by reporting the non-controlling interest separately.
Consolidation Method Explained
The consolidation method involves the following steps:
- Any existing investment balance associated with the asset is removed. The assets and liabilities of the newly acquired asset are then added to the firm's consolidated balance sheet.
- All of the subsidiary's income and expenses are reported on the parent company's consolidated financial statements. This is the case even if the parent company owns less than 100% of the subsidiary.
- Intercompany transactions between the parent company and the subsidiary are eliminated to avoid double-counting of revenue, expenses, or profits.
Significant Influence - Equity Method
When a firm has a significant influence over a financial investment, such as owning more than 20% but less than 50% of a stock or bond, the equity method is used. In this case, the firm carries the asset on the balance sheet at the historical cost of the asset. A firm is also deemed to have significant influence if it controls a board seat of the asset, even if the percent owned is less than 20%.
Equity Method Explained
The equity method involves:
- Recording the acquisition cost when the asset is purchased.
- Revaluing intangible assets to market value and amortizing the firm's percentage ownership them over time.
- Adjusting the book value of the asset over time by subtracting dividends received, treating it as a portion of the investment being returned to the firm. Note that dividends received are not treated as dividend income.
- If the asset's value, such as a stock or bond, increases or decreases over a period, no accounting entry is made since the equity method uses historical cost.
- Making adjustments to the book value of the asset for the firm's percentage ownership of earnings gains/losses the asset experiences. These are recorded in the balance sheet retained earnings (R/E) and the firm's income statement.
- Recording the firm's share of the asset's profits on the firm's income statement.
- When the asset is sold, recording the gain/loss from the sale of the asset as an increase or decrease in cash and a corresponding change in net investment value. This is recorded in retained earnings (R/E) as well as the income statement. The net investment value, which is the sum of the historical cost plus any adjustments, is then subtracted from the balance sheet asset investment account.
Held-to-Maturity (HTM): Cost Method (Debt Securities Only)
Held-to-Maturity (HTM) securities are financial instruments that a company intends to hold until they mature. These are generally debt securities like bonds. They are measured at amortized cost rather than at fair value. Let's examine the accounting implications during their lifecycle:
- Upon purchase, the cost of the HTM classified security is recorded as an asset on the balance sheet.
- When the HTM security pays interest, this interest is recorded as interest income on the income statement, and as an increase in cash and retained earnings (R/E) on the balance sheet.
- Under the HTM classification, changes in the market value of the security are typically not recognized. Thus, fluctuations in market value do not impact the accounting equation.
- If the HTM security is sold before maturity, the company will need to recognize a gain or loss, which is the difference between the selling price and the carrying amount of the security. The gain or loss is recognized on the income statement, and the cash received is recorded on the balance sheet. Note that frequent sales of HTM securities can lead to reclassification of these securities by auditors, potentially requiring a shift to fair value accounting.
The carrying amount, also known as the carrying value or book value, of a cost method security is the original cost of the security adjusted for any amortization, if applicable. It does not account for changes in market value.
Trading Securities - Fair Value Method
The trading securities category uses the fair value method for accounting for investments. Applicable to both debt and equity securities acquired for short-term profit potential, this method records unrealized gains of the investment on both the balance sheet and income statement. Let's consider a bond for example:
- When the bond is purchased, the transaction is recorded on the balance sheet: the cash account decreases and the marketable securities account increases by the bond's purchase price.
- If or when the bond pays interest, these payments are recorded in the retained earnings account and as income on the income statement.
- Each period that the bond is owned by the company, the unrealized gain or loss (the change in market price) is recorded in the balance sheet's marketable securities account, effectively adjusting the marketable security to its market value. The same unrealized gain or loss is also recorded in the retained earnings account and on the income statement.
- Upon selling the bond or upon its maturity, the transaction is recorded on the balance sheet. The cash account increases by the amount of the bond sale proceeds, the marketable securities account decreases by the net value of the bond as recorded (the original purchase price plus all adjustments made over time), and the gain or loss is recorded in retained earnings and on the income statement.
Available-For-Sale - Fair Value Method for Debt Securities
Unrealized gains of an Available-for-sale securities, a category of passive control level investment for debt-only securities, impacts only the balance sheet and not the income statement. To illustrate, let's consider the purchase of a bond:
- Upon purchase, the balance sheet cash account decreases by the purchase amount, while the marketable securities account increases by the bond's market value.
- When the bond pays interest, the cash account increases by the payment value. Similarly, the retained earnings increase by this value, which is also recorded on the income statement.
- Subsequently, for each period that the firm owns the bond, the marketable securities account on the balance sheet is adjusted by the unrealized gain or loss, calculated as the difference between the bond's market value and the recorded price from the previous period. This unrealized gain or loss also gets recorded in the Other Comprehensive Income (OCI) equity account.
The balance sheet's Accumulated Other Comprehensive Income (AOCI) is an equity account used to account for unrealized gains or losses on available-for-sale financial investments. It ensures that these gains or losses do not affect retained earnings and the income statement.
Finally, when the bond is sold, the realized gain or loss is calculated as the Bond Sale Proceeds minus the Net Marketable Security Value and the Net Bond AOCI. This amount is recorded in the balance sheet's Retained Earnings (R/E) account and on the income statement.
Conclusion
Understanding the mechanisms of accounting for acquisitions and financial investments is a powerful tool in the arsenal of anyone wanting to study the topic of financial statement analysis. These processes, although complex, underpin the financial landscapes of businesses worldwide, shaping their strategic decisions and influencing their future paths.
By comprehending these principles, you're not only opening the door to a more profound understanding of a company's financial health, but also preparing yourself to make more informed decisions in your career, whether you're an investor, a business professional, or a student of finance. You gain the ability to discern the subtle nuances that distinguish a robust company from a financially weak one, all from analyzing their financial statements.
While the challenge of learning these accounting principles might seem overwhelming at first, the reward is an invaluable insight that sets you apart in the business and finance world. So, keep learning, keep analyzing, and keep growing. The world of finance is an ever-evolving landscape that rewards the curious and the persistent.
Remember, every financial statement tells a story. By mastering the accounting of acquisitions and financial investments, you're learning to read these stories, to understand their plot twists, and, ultimately, to predict their next chapters. So, here's to you - the future fluent reader of the financial world's narratives!