Accounting for M&A, Credit, & Equity Analysts

by James Morris

Overview

As each new accounting question or scandal hits Wall Street,investment professionals too often find themselves asking,“What happened?” Accounting for M&A, Equity, and CreditAnalysts answers the most common accounting questions, all inan easy-to-follow format designed to provide investment professionalswith real-world, hands-on knowledge of key accountingtreatments, models, and practices. Written by well-knownM&A expert James E. Morris, this versatile accounting deskreference bridges the gap between what is taught in businessschool and what is needed in the real world.

Product Details

ISBN-13:	9780071429696
Publisher:	McGraw Hill LLC
Publication date:	06/03/2004
Pages:	288
Sales rank:	669,275
Product dimensions:	7.60(w) x 9.30(h) x 1.03(d)

About the Author

James E. Morris, C.P.A., C.F.A. (Baltimore, MD) is a project managerof financial analysis for the U.S. Nuclear Regulatory Commission.He also trains analysts and associates to value companies.

Read an Excerpt

Accounting for M&A, Equity, and Credit Analysts

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By James Morris

The McGraw-Hill Companies, Inc.

Copyright © 2004The McGraw-Hill Companies, Inc.
All rights reserved.
ISBN: 978-0-07-142969-6

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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 affiliate
(Continues...)

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Table of Contents

Introduction
List of Abbreviations
Chapter 1 Equity Method of Consolidation
Introduction
Description of the Equity Method
Tax Considerations When Using the Equity Method
Accounting under the Equity Method—Excess of Cost over Equity Purchased
Accounting under the Equity Method—Intercompany Transactions
Guidance for Applying the Equity Method
SEC Staff Views Concerning the Equity Method
When to Use the Equity Method—Summary
Accounting for Cash Flows from Equity Method Investments
Modeling the Equity Method of Accounting in Projection Models
Chapter Summary
Chapter 2 Minority Interests
Introduction
Minority Interests
Overview of Accounting for Minority Interests
Treatment of Minority Interests for Enterprise Valuation
Forecasting Minority Interests
Treatment of Minority Interests in M&A Transactions
Modeling Minority Interests
Chapter Summary
Chapter 3 Deferred Income Taxes and Income Tax Reporting
Introduction
Basic Principles of Tax Reporting
The First Principle
The Second Principle
The Third Principle
The Fourth Principle
Treatment of Deferred Income Tax Items in M&A Transactions
Modeling Income Taxes in Projection Models
Calculating the Provision for Taxes—Detailed Calculation
Chapter Summary
Chapter 4 Deciphering the Deferred Tax Footnote
Introduction
Financial Statement Disclosure for Income Taxes
Reconstructing Deferred Taxes on the Financial Statements
Problems with Ratio Analysis
Valuation of Deferred Tax Items
Chapter Summary
Chapter 5 Estimating the Tax Basis of a Firm’s Assets
Introduction
Factors Affecting Differences Between Asset’s Book and Tax Bases
Depreciation (or Amortization) Using Different Schedules
Recognizing Asset Impairments
Transaction Fair Value Adjustments
Asset Sales or Deemed Asset Sales
Estimating the Tax Bases of Target Company’s Assets—Known Balance Sheet
Estimating the Tax Bases of Target Company’s Assets—Unknown Balance Sheet
Chapter Summary
Chapter 6 Pension and Other Postretirement Benefits
Introduction
Pension versus Other Postretirement Benefit Plans
Types of Pension Plans
Economic Objectives of Pension Plans
How Pension Plans Work
Net Periodic Pension Cost
Minimum Pension Liability
Pension Benefits Summary
Other Postretirement Benefit Plans
Net Periodic Postretirement Benefit Cost
Effects of Business Combinations
Chapter Summary
Chapter 7 Deciphering the Pension Footnote
Introduction
Pension Benefit Disclosure Requirements
Benefit Obligation Reconciliation
Plan Fair Value Reconciliation
Employer Securities Included in Plan Assets
Net Periodic Benefit Cost Disclosure
Funded Status and Unrecognized Items
Rate Disclosures
Health Care Disclosures
Chapter Summary
Chapter 8 Analyzing the Firm’s Pension Cash Flows
Introduction
Estimating Future Funding Cash Flows
Employer Company’s Plan Assets and Liabilities in an Acquisition
Plan Liquidation Values
Chapter Summary
Chapter 9 Employee Stock Options
Introduction
The Intrinsic Valuation Method
The Fair Value Method
Evaluating the Firm’s Inputs to the Option-Pricing Model
Tax Effects of Employee Stock Options
Calculation of Diluted Earnings per Share for Companies Expensing Stock Options
Accounting for Target Stock Options Rolled Over in a Purchase Acquisition
Projecting Earnings Per Share (EPS) for Option-Intensive Firms
Chapter Summary
Chapter 10 Restructuring Charges
Introduction
FASB’s New Changes to Financial Accounting for Restructuring Charges
Restructuring Charges—U.S. GAAP
Restructuring Charges—International Accounting Standards
Disclosure of Restructuring Charges
Restructuring Liabilities in Business Combinations
Chapter Summary
Chapter 11 Discontinued Operations
Introduction
How Results of Discontinued Operations Impact Earnings from Continuing Operations
Sources of Classification Bias
Criteria for Classifying Items as Discontinued Operations
The Operations Being Discontinued—Component of a Business
Disposal Criteria
International Accounting Treatment of Discontinued Operations
Chapter Summary
Chapter 12 Net Operating Loss Deductions
Introduction
Net Operating Loss Deductions
Other Tax Considerations Relating to NOLs
M&A Considerations Relating to NOLs
NOL Effects on Financial (GAAP) Reporting
Valuation Considerations
Modeling NOL Carrybacks and Carryforwards
Chapter Summary
Chapter 13 Purchase Accounting for Business Combinations
Introduction
Purchase Accounting Basics
Calculating Target Company’s Net Identifiable Assets
The Net Identifiable Assets Calculation
Calculating the Purchase Price
Transaction Fees
Fair Value of the Consideration Given
Calculating Goodwill
Negative Goodwill
Amortization of Goodwill
Accretion and Dilution of Earnings
Pro Forma Presentation (as If Combined)
Statements of Cash Flows Following Business Combinations
Limitations on the Use of Target Company’s Net Operating Loss (NOL) Carryforwards
Effects on Minority Interests in Business Combination Transactions
Chapter Summary
Chapter 14 Deemed Asset Sales under IRC Sections 338(h)(10) or 338(g)
Introduction
Overview of the Section 338(h)(10) Election
Benefits of Section 338(h)(10) Sales
Determining the Sale Price for a Section 338(h)(10) Election
Modeling Section 338(h)(10) Transactions
Chapter Summary
Glossary
Endnotes
Index