F4 - Investments, Business Combinations, and Goodwill

Question 1

What happens when parent company uses the cost method vs equity method on its books to carry its investment of its subsidiary?

How are dividends on those investments recognized? Is Goodwill amortized?

Answer 1

1) Under the cost method:
- Investment - the parent recognizes only its share of the subsidiary’s dividends declared.
- Dividends - recorded as dividend revenue

2) Under equity method:
- Investment - investor recognizes its share of investee earnings (used when company has 30% or above ownership) ie ownership x earnings
- Dividends - common stock dividends treated as return on capital. Only preferred dividends recognized as dividend revenue.
- Only income increases the investment account

3) Goodwill is never amortized but only assessed at least annually for impairment at the REPORTING level

Dividends never increases investment account under either method

Question 2

Under the Equity Method, do dividends affect the Balance Sheet or the Income Statement?

How are stock liquidations and stock dividends treated?

Answer 2

Under Equity Method:

• the % of earnings is what is shown in the IS NOT dividends
• dividends have 0 effect on IS = they ONLY decrease the investment account on the Balance Sheet
• Liquidations are treated as a return on capital
• Not reported as dividend on IS
• Reduce both Equity and FV investment accounts
• Stock dividends are NOT reported as dividend income

Question 3

What happens if FV of plant assets or Inventory is above the carrying value when buying a controlling interest in a business? (Equity Method)

Answer 3

You must amortize the PPE (PPE/useful life) and Inventory by the percentage of ownership you’re buying

Then, SUBTRACT them from the earnings in the Income Statement.

Question 4

In a consolidation, how does a newly issued entity issue capital to consolidate 2 business into 1?

Immediately after a consolidation, what is retained earnings and goodwill?

In a consolidation, merger, or acquisition - how are legal, consulting, registration and issuance costs accounted for?

Answer 4

• As it has no prior market value, the FV of new stock is the FV of the net assets being acquired. Thats why there is no goodwill.

BUT there can be APIC if Par value is given .

• The combined companies will NOT have retained earnings until after an operating period.
• No goodwill
• Registration and issuance costs are NOT capitalized. They’re deducted from APIC. They reduce APIC.
• Consulting/legal fees are expenses in period incurred

Question 5

Goodwill and Impairment

Under US GAAP and IFRS, how is goodwill tested for impairment? And at what levels?

Answer 5

US GAAP

• Each Reporting Unit
• 2 steps:
  1) Undiscounted Future CF
  2) Then subtract Goodwill Implied FV from the Goodwill CV

IFRS

• Cash Generating Unit
• Recoverable cost - CV
• Recoverable cost = the greater of (FV - cost to sell) OR (Value in use = PV of future cash flows)

Question 6

In an acquisition, how are intangible assets like unpatented and in-process R&D treated?

Answer 6

• You should subtract these from goodwill

- OR you just add it to the FV of the entity (which also

Question 7

Goodwill and Impairment

Under US GAAP and IFRS, how is goodwill tested for impairment? And at what levels?

Answer 7

US GAAP

• Each Reporting Unit
• 2 steps:
  1) Compare FV with CV
  2) Then subtract Implied FV with CV

IFRS

• Cash Generating Unit
• Recoverable cost

Question 8

Treasury Stock

Difference between Cost and Par Value method?

Answer 8

Cost method
- Gain/loss is calculated upon reissue

Buyback:
Treasury Stock
Cash

Reissue above cost:
Cash
Treasury
APIC - TS

Par Value
- Gain/loss is calculated in APIC - TS immediately when you buy it back.

Buyback:
Treasury stock
APIC - CS
       Cash
       APIC - TS

Reissue above cost:
Cash
TS
APIC - CS

Question 9

What is the effect on total OE, RE and shares outstanding for both a 100% stock dividend and 2-1 stock split?

Answer 9

OE - (100%) none, (2-1) None

RE - decrease, none

Outstanding - Double both

Question 10

JE when small and large stock dividend are declared.

Answer 10

Declaration: (Small = <25%):
RE xx (div % x MV)
CS xxx
APIC - CS xxx

Declaration (large=>25%):
RE xxx (div % x Par)
CS xxx
**>25% = No decrease to stockholders equity because of the dividend. **

• The reason is that if its more than 25% you can’t assume stock price will stay the same so use PAR.

Question 11

What are fully participating preferred stock? and how do they affect a declared dividend for CS?

i.e. declare dividends $100,000 on 200,000 shares of CS while there are 30,000 5% $10 full participating preferred stock

Answer 11

Fully participating - share equally then pro rata SO they share equally at a 5% return.

PS
30,000 x 10 = 300,000 x 5% = 15,000

CS
200,000 x5% = 10,000

100,000 (div)
- 25,000
= 75,000

pro rata CS
200/500 total x 75,000 = 30,000

Payable to CS share holders is
30,000 + 10,000 = 40,000