Advanced Financial Accounting Flashcards
How do you report an initial investment?
At cost
What are 4 methods for valuing an investment? (depends on degree of control)
- Fair value (<20%)
- Cost method (20-50%)
- Equity method (20-50%)
- Consolidation method (>50%)
Fair value Investment (<20%)?
Dividend and capital appreciation.
Changes in FMV is reported as income.
Dividend is reported in income.
Cost method investment (<20%)?
FV not readily available
dividend reported as income
Consolidation(>50%)?
Single set of financial statements.
explain the equity method of accounting for investments
The equity method of accounting for investments is a way to report the value of an investment in another company when the investor has significant influence, but not full control, over the investee. It’s commonly used when an investor owns between 20% and 50% of the voting stock of the investee. Here’s how the equity method works:
- Initial Investment
When the investor initially acquires the investment, they record it on their balance sheet at cost, including any expenses incurred in acquiring the investment. - Initial Recognition
At the time of acquisition, the investor recognizes the initial investment as an asset on their balance sheet. This investment is recorded at cost. - Subsequent Adjustments
Periodically, typically at the end of each reporting period, the investor adjusts the carrying amount of the investment to reflect their share of the investee’s earnings or losses, as well as any distributions received from the investee.
The investor’s share of the investee’s net income increases the carrying amount of the investment, while their share of net losses decreases it.
***Distributions received from the investee reduce the carrying amount of the investment. - Recognizing Income
The investor recognizes their share of the investee’s net income or loss in their own income statement.
For example, if the investee reports a net income of $1 million for the year and the investor owns 30% of the investee, the investor would recognize $300,000 ($1 million × 30%) as income in their own financial statements. - Carrying Amount Adjustment
The carrying amount of the investment is adjusted on the investor’s balance sheet to reflect the changes in the investee’s earnings or losses.
This adjustment ensures that the investment is reported at its equity value, representing the investor’s ownership interest in the investee. - Reporting Distributions
***Any distributions received from the investee reduce the carrying amount of the investment on the investor’s balance sheet.
These distributions are recorded as income on the investor’s income statement, typically as a reduction of the equity method income. - Disclosure
The investor must disclose the nature and extent of their significant investments in other entities and provide information about the financial performance and position of those investees.
Purpose and Impact
The equity method allows the investor to reflect their economic interest in the investee more accurately in their own financial statements.
It also provides users of the financial statements with more relevant information about the investor’s financial position and performance, particularly when the investee is a significant part of the investor’s operations.
In summary, the equity method of accounting for investments allows investors to report their ownership interests in investee companies on their balance sheet and recognize their share of the investee’s earnings or losses in their income statement. It’s a way to reflect the economic reality of the investor’s relationship with the investee.
Explain a distribution?
A distribution, in the context of finance and business, refers to the transfer of assets or funds from a company to its owners, shareholders, or investors. This transfer typically takes the form of dividends, although it can also include other types of payments or distributions of assets. Here’s an explanation of distributions:
Types of Distributions:
Dividends: Dividends are the most common type of distribution. They represent a portion of a company’s profits that is paid out to its shareholders on a regular basis, typically quarterly or annually. Dividends are usually paid in cash, but they can also be paid in the form of additional shares of stock or other assets.
Stock Repurchases: Companies may also distribute funds to shareholders by repurchasing their own shares on the open market. This reduces the number of outstanding shares, increasing the ownership stake of existing shareholders.
Return of Capital: In some cases, a distribution may involve returning capital to shareholders, such as when a company sells off assets or liquidates a portion of its business.
Special Distributions: Occasionally, companies may make one-time or special distributions to shareholders, such as proceeds from the sale of a subsidiary or a legal settlement.
Purpose of Distributions:
Rewarding Shareholders: Distributions, particularly dividends, are a way for companies to reward their shareholders for their investment in the company. They provide a tangible return on investment and can enhance shareholder value.
Attracting Investors: Consistent dividend payments can attract investors who are seeking steady income streams from their investments. Companies with a history of reliable dividends may be viewed favorably by income-oriented investors.
Signal of Financial Health: Distributions can be seen as a signal of a company’s financial health and stability. Regular dividend payments may indicate that a company is profitable and generating sufficient cash flow to support its operations.
Capital Allocation: Share repurchases and other distributions can be part of a company’s capital allocation strategy, allowing it to efficiently deploy excess cash or return capital to shareholders when other investment opportunities are limited.
Impact on Financial Statements:
Balance Sheet: Distributions reduce the company’s retained earnings, which is a component of owner’s equity on the balance sheet. They may also impact other balance sheet accounts, such as cash or treasury stock.
Income Statement: Dividend payments are typically recorded as expenses on the income statement, reducing net income for the period in which they are paid.
Cash Flow Statement: Distributions are reflected in the cash flow statement as cash outflows from financing activities.
In summary, a distribution represents the transfer of assets or funds from a company to its owners or shareholders, often in the form of dividends or stock repurchases. Distributions serve various purposes, including rewarding shareholders, attracting investors, and signaling financial health, and they can have significant implications for a company’s financial statements and overall financial position
What is intercompany gross profit of inventory using the equity method.
When using the equity method to account for investments, intercompany gross profit of inventory refers to the portion of gross profit resulting from transactions between the investor company and its investee, where the investor has significant influence over the investee’s operations. Here’s how it works:
- Equity Method of Accounting:
Under the equity method, the investor initially records the investment at cost and subsequently adjusts the carrying value of the investment to reflect its share of the investee’s earnings or losses over time.
The investor recognizes its share of the investee’s profits or losses on its income statement, increasing or decreasing the carrying amount of the investment on its balance sheet accordingly. - Intercompany Transactions:
When the investor company sells inventory to its investee, the sale generates revenue for the investor and cost of goods sold (COGS) for the investee.
The intercompany sale impacts both the investor’s financial statements (as revenue) and the investee’s financial statements (as COGS). - Intercompany Gross Profit Calculation:
The intercompany gross profit of inventory, in the context of the equity method, represents the portion of gross profit resulting from the intercompany sale between the investor and investee.
It is calculated by subtracting the investee’s portion of COGS associated with the intercompany sale from the revenue recognized by the investor from the sale.
The investor’s share of the gross profit is then recorded as part of its equity income from the investee. - Accounting Treatment:
The investor recognizes revenue from the intercompany sale on its income statement.
The investee recognizes COGS from the intercompany purchase on its income statement.
The investor’s equity income from the investee includes its share of the investee’s net income, including the portion related to the intercompany gross profit.
Example:
Suppose Investor Company A sells $10,000 worth of inventory to Investee Company B.
Company A’s revenue from the sale is $10,000.
Company B records $10,000 as COGS on its income statement.
If Investor Company A owns 70% of Investee Company B, then Investor Company A would recognize $7,000 ($10,000 × 70%) as its share of the gross profit from the intercompany sale.
Importance:
Intercompany gross profit of inventory using the equity method reflects the economic reality of the relationship between the investor and its investee.
It ensures that the investor accurately reflects its share of the investee’s profits from intercompany transactions on its financial statements.
Proper accounting treatment is essential for transparency and compliance with accounting standards.
What is a downstream sale?
What is an upstream sale?
What are some reasons companies combine?
Cost savings
eliminate duplicate positions
improvements in speed and quality of product
Quick entry into foreign and domestic markets
Vertical integration
diversify business risk
What are 5 types of business combinations?
- Statutory merger via asset acquisition
- Statutory merger via stock acquisition
- Statutory consolidation via capital or asset acquisition
- acquisition of more than 50% of voting stock
- Variable interest
Business combinations refer to transactions where two or more businesses come together to form a single entity. There are various types of business combinations, each with its own characteristics and implications. Here are five common types:
Merger: A merger involves the consolidation of two or more businesses into a single entity, typically with the goal of achieving synergies and enhancing competitiveness. In a merger, the original companies cease to exist as separate entities, and a new entity is formed to combine their operations.
Acquisition: An acquisition occurs when one company (the acquirer) purchases the majority stake in another company (the target). Unlike a merger where two companies combine to form a new entity, in an acquisition, the acquiring company retains its identity while gaining control over the target company. Acquisitions can be friendly or hostile, depending on the willingness of the target company to be acquired.
Consolidation: Consolidation is a type of business combination where two or more companies combine their financial statements and operations to create a single, larger entity. This often involves the creation of a parent company that holds controlling interests in the subsidiaries. Consolidation allows companies to streamline operations, reduce costs, and improve efficiency.
Joint Venture: A joint venture is a business arrangement where two or more companies collaborate to undertake a specific project or business activity while retaining their separate identities. Joint ventures are often formed to combine complementary resources, expertise, and market access to pursue opportunities that may be too risky or costly for each company to pursue individually.
Vertical Integration: Vertical integration occurs when a company expands its operations into different stages of the production or distribution process by acquiring businesses involved in upstream or downstream activities. For example, a manufacturer may acquire suppliers of raw materials or distributors to gain more control over its supply chain and reduce costs. Vertical integration can help companies capture a larger share of the value chain and improve coordination and efficiency.
These are just a few examples of business combinations, and in practice, combinations may involve elements of more than one type. Each type of business combination has its own advantages, disadvantages, and strategic considerations, which companies carefully evaluate before engaging in such transactions.
